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Domino’s Pizza Valuation Puzzles Brokers

Australia | Sep 18 2017

While there are few catalysts available for Domino's Pizza at present, Morgans believes the stock warrants a more positive view. Others are more hesitant about the stock.

-AGM likely to reveal softer growth and first half may disappoint
-Yet is the stock now undervalued?
-Concerns over margins and share of the profit pool

 

By Eva Brocklehurst

What is the current state of play with Domino's Pizza Enterprises ((DMP))? Is it undervalued? The stock was sold off in the wake of the FY17 as technical problems affected its digital roll-out and earnings forecasts were missed.

Morgans has now decided to upgrade to Add from Hold. The broker accepts that the trading update at the AGM and the first half result could show softer growth in Australasia, given the exceptionally strong base being cycled, but Europe should be accelerating as technology/menu issues have now been resolved.

While not envisaging any upcoming catalysts for the stock, and acknowledging the potential for the AGM to disappoint, Morgans still takes a more positive view based on the fact Domino's Pizza (DMP) is now trading at a discount to its global peer group, despite offering superior growth. Domino's Pizza has guided to 20% growth in net profit for FY18.

The broker envisages the rolling out of stores, mid single-digit same-store-sales growth and margin improvement across all divisions should deliver this level of growth alone and remains comfortable with the company's guidance. Moreover, the buying back of the 25% stake in the Japanese business should be further accretive.

Valuation

Hence, the main question for Morgans centres on the right multiple for the stock going forward. Looking at the global peer group, the average price/earnings (PE) ratio for the next 12 months is 25x and the enterprise value/operating earnings (EBIT) ratio is 18.3x. Growth profiles vary, therefore Morgans believes the most appropriate comparison is the company's US parent, which trades on 30x and 21.7x, respectively.

On the broker's price target of $47.21, Domino's Pizza would trade at 28x and 20.8x, respectively, a discount to the parent, despite a superior growth profile and a less leveraged balance sheet.

Citi believes net profit guidance for FY18 can be met but the extent of upside is modest compared with history. The question of what is the right multiple for the stock also plagues Citi. The broker envisages headwinds to margins on the medium-term horizon, particularly for Australia. The broker's fair value P/E is 23x, given the balance of risks, and a Sell rating is maintained.

After the FY17 results Macquarie downgraded to Neutral from Outperform. Despite the fact much of the de-rating of the stock occurred ahead of the FY17 results, the broker envisages merit pulling back to Neutral because of concerns around the growth drivers and the earnings quality. The broker estimates the company's share of the profit pool outstripped the franchisees in FY17.

Wage inflation and compliance cost increases could exacerbate this trend, and the company's decision to stop disclosing this information reinforces the broker's concerns. Macquarie has also flagged the fact the company may take a number of years before the low value/high-volume model is accepted in Germany, following similar difficulties in France. This suggested the broker that growth may lag expectations should the model not catch on.

Deutsche Bank is also of the view that Domino's Pizza is taking too much from the profit pool. The main disappointment for this broker in the FY17 results was the announcement of a $300m buy-back. The stock delivers an earnings yield of 3-4% and this signals to Deutsche Bank that the buy-back will be barely accretive to earnings, let alone to value, and this will leave the group with too much debt.

Domino's, historically, has taken advantage of its high trading multiple to create value by buying franchises and new territories for lower multiples. The buy-back upturns this strategy and Deutsche Bank cannot comprehend why purchasing a business (DMP) which generates a 3-4% earnings yield can be sound use of shareholder funds.

FNArena's database shows three Buy ratings, two Hold and two Sell. The consensus target is $46.83, suggesting 7.1% upside to the last share price. Targets range from $38 (Deutsche Bank) to $60 (UBS).
 

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