Losing appetite for Domino's

Domino’s has about a 46 per cent share of the UK pizza market, but it doesn’t directly operate many of its stores. Instead it has franchise agreements whereby Domino's sells franchisees ingredients and takes a 5.5 per cent royalty fee and takes fees based on their sales. 

The model means much of the capital needed to expand the business has historically been supplied by franchisees who keep day-to-day operating issues at arms length, too. That has left Domino’s to focus on the developing its top-class supply chain, ordering platform and brand. Meanwhile, the limited need for capital means shareholders have seen superb earnings growth hand in hand with consistently high returns on capital employed (ROCE) and excellent cash generation.

However, over recent years capital employed has been rising sharply as Domino's expands into less mature European markets, buys into UK franchisees and invests in its supply chain. ROCE, while still high (see chart below), is falling. With the company now targeting a net-debt-to-cash-profits range of 1.75 to 2.5 compared with 0.8 at the end of December 2017, it looks like capital employed will continue to grow.

The key question for investors is whether the expansion of capital employed will be justified by future returns? We see reasons for doubts. Part of last year's £46.6m capital expenditure represents the completion of a £30m investment in a new supply chain facility in Warrington. This underpins Domino’s aim to increase UK store numbers to 1,600 from 1,045, but some analysts fear the consequent reduction of store catchment areas will squeeze profit per store. Meanwhile, to help an expansion drive in London, Domino's has paid £24.4m to take a 75 per cent stake in a major franchisee – hardly capital-light expansion. Returns on UK expansion also face the nebulous threats weakening consumer spending and the rise of services such as Just Eat (JE.).

Domino's has been setting its sights beyond the maturing home market by investing heavily in overseas expansion, which last year meant £20.1m for franchise acquistions. The group is having to establish a corporate store presence before rolling out the franchise model, and store openings contributed £7.2m to capital spending. 

The lower profitability of international start-up stores has weighed on margins, and the company has also been bearing some of the cost of price inflation for its UK franchisees, which have also had to deal with a 12 per cent rise in the minimum wage over two years. In all, 2017 operating margins were down from 8.5 per cent to 8.1 per cent. And while growth remains impressive compared with peers, broker Liberum points to a declining trend over recent quarters, with 10.5 per cent in the first quarter of 2018 comparing with 13.3 per cent in the final quarter of 2017 and 14.3 per cent in in the third quarter. Meanwhile, trading comparisons get tougher in the second half.

With Domino's also continuing to buy back its highly-rated shares, it is unsurprising the financial position has changed dramatically with the company moving from a net cash position at the end of 2015 to £89.2m net debt at the end of 2017.