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Domino’s Pizza Delivers Upbeat Outlook

Australia | Aug 17 2016


Domino's Pizza produced characteristically strong results in FY16 and brokers are upbeat about the outlook, yet several question the lofty valuation that now prevails.

-Highest level of growth ever forecast by management so early in the year
-Long-term store targets in Australasia raised to 1,200 and existing stores moving to capacity
-Rise in Australian labour costs a risk, given elevated trading multiple leaves little room for slowdown

By Eva Brocklehurst

Domino’s Pizza Enterprises ((DMP))  delivered  characteristically strong earnings growth in FY16 and more is expected. The company expects earnings growth in FY17 of over 25%.

Macquarie forecasts growth to be 5% ahead of the company’s estimates, noting historically Domino’s has taken a conservative approach towards guidance, which usually results in several upgrades throughout the year. The long-term store target for the Australasian business is increased by 300 to 1,200 stores by 2025, a result of existing stores moving to capacity faster than expected.

The company’s Project 3/10, which targets pick-up of orders in three minutes and delivery in ten, is expected to be the largest contributor to long-term growth. Reducing consumer perceptions around timing should help increase its share of the market, Macquarie maintains.

Automated delivery in some stores is expected by the end of FY17 and information regarding maintenance and costs will be used to develop a roll-out strategy. Meanwhile, European markets are presenting significant opportunities. Macquarie observes the contribution from offshore earnings has now reached a point where the company can no longer fully frank dividends, reducing its franking on FY16 dividends to 70%. Still, given the low dividend yield this is not expected to be material to the share price.

What is there not to like? Management expects a significant increase in Australian labour costs and, while an agreement is yet to be reached, envisages franchisee profitability will grow despite wage increases. Also, the weak economy in Japan and the roll-out of IT projects across that country suggests trading will continue to be tough.

Deutsche Bank envisages an opportunity to improve returns in Japan through store conversions and momentum maintained via continued product and digital innovation. The broker considers the increase in Australian labour costs a risk, particularly given the stock’s elevated trading multiple leaves little room for a slowdown. Deutsche Bank now expects underlying FY17 profit growth of 37.4%.

The broker asserts that while franchisees have become accustomed to the earnings benefit stemming from rapid sales growth – a reason they have been willing to invest in new stores, refurbishment and marketing – the risk is that even if profit growth slows for just one year, their appetite for this investment may diminish. Moreover, profitability varies significantly across the portfolio.

The broker finds it interesting the company did not discuss price increases as a method of offsetting the impact of wage costs. Deutsche Bank perceives there are risks in using price, given aggressive pricing has been a key driver of the company’s success.

On the subject of the stores moving to capacity faster than expected, the broker believes part of the rationale for expanding the number of stores is to enable the group to achieve its 3/10 target by locating stores closer to the customer. Deutsche Bank’s main concern is that the profitability of existing franchisees may be affected if the catchment is split.

The growth story is intact, long term, in Morgan Stanley’s view. The broker projects a 10-year earnings growth rate of 19%. With leverage to fixed costs and scale, earnings margins on network sales are expected to expand to 13.5% from 9.2% by FY26. Growth in Europe is accelerating and the store upgrades could imply 7,500-13,000 stores long term, versus the existing target of 4,550, the broker maintains.

Further upside is envisaged should the company exceed its current store targets and maintain same store sales growth for a prolonged period. Needless to say the broker retains its bullish estimates and an Overweight rating.

Despite all the positives, the share price presents a very elevated price/earnings ratio and enterprise value/earnings multiple in Ord Minnett’s view, with limited room for tolerance of any performance that does not materially exceed the market’s expectations.

While the guidance provided is the highest level of growth ever forecast by management this early in a year, Morgans still expects it to prove conservative. The broker is convinced of the longevity of the growth story, with a store footprint that could more than double and margin upside from scale and leveraging the digital platforms offshore.

The multiple has never been so high or so demanding but Morgans retains an Add rating, given FY17 is the year the highly successful digital platforms will be exported to Japan, France and Germany.

The consensus target on FNArena’s database is $71.03, suggesting 8.8% downside to the last share price. This compares with $61.69 ahead of the results. Targets range from $56 (UBS, yet to update on the results) to $82.01 (Morgans). There are two Buy ratings and four Hold.

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