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Domino's Q1 Earnings: Is the "Fortress" Strategy Working Yet?

Rich Duprey, The Motley Fool

One of the most important initiatives Domino's Pizza (NYSE: DPZ) has undertaken to drive sales is called "fortressing;" that is, siting enough restaurants close enough to customers that its delivery times are short and the freshness of its pizzas is preserved. During its fourth quarter, the pizzeria opened 560 net new stores, with 125 of them in the U.S. Domino's has over 15,900 stores globally and almost 5,900 in the U.S., of which only 390 are company-owned.

The organization believes the program will protect its market share from rivals as well as a growing host of third-party delivery services. With first-quarter 2019 earnings scheduled for Wednesday, April 24, investors will get a glimpse of how well the leading pizza-delivery company is faring, and they'll also be able to see whether expansion is just cannibalizing sales.

A Domino's Pizza employee holding pizza boxes beside her delivery vehicle.

Image source: Domino's.

Storming the ramparts

Wall Street is certainly bullish on Domino's, with 14 of the 22 analysts covering the stock rating it a buy. However, they've lowered their earnings expectations over the past three months, dropping average first-quarter forecasts to $2.09 per share from $2.10 just a month ago and $2.13 per share at the end of the fourth quarter.

The fortressing strategy has been in place since 2010 but is taking on new urgency these days as sales begin to slow. Domino's reported same-store sales growth of 5.6% in the fourth quarter, down from 12.2% in the year-ago period. The company says that sales were hurt by 1 to 1.5 points in 2018 because of fortressing, but it's willing to take the hit if the strategy helps grow the business long term.

More is better...and more profitable

Building out more stores can help individual franchisees grow more profitable at the store level as they gain increased volume. They also don't have to spend as much on marketing their stores, as an expanded store base creates a sort of network effect which promotes customer awareness.

Domino's says the average franchisee owns seven locations, with a typical restaurant generating $137,000 to $140,000 a year in EBITDA (earnings before interest, taxes, depreciation, and amortization). That means typical franchisees are generating in the ballpark of $1 million in annual profits. 

The risk, of course, is there is no shortage of pizzerias for customers to visit. Pizza Hut has over 18,400 restaurants worldwide, but the U.S. is its most important market, accounting for 46% of the chain's $3.3 billion in sales. Papa John's International also has more than 3,350 stores in North America and over 5,200 worldwide. And there are tens of thousands of independent pizzerias that dot almost every town in the country.

If Domino's adds as many as 2,000 more stores over the next decade, as it wants to do -- even as its rivals are growing -- it may inundate an already-saturated market.

Tech-savvy too

To stand out from the crowd, pizzerias seem to be resorting to gimmicks to make a difference, like Pizza Hut's sneakers that allow you to order a pie, and Domino's paying to fill potholes in streets to make pizza deliveries smoother.

But Domino's has also invested heavily in technology, which it has often tied to its loyalty program, such as its "Piece of the Pie" rewards promotion that allows people to take a picture of a pizza -- any pizza, whether real or a rubber toy for dogs -- and earn points toward a free pie. While such stunts may build brand loyalty (and that's questionable), Domino's' more important investments have been behind the scenes, in its supply chain and in more efficiently getting its pizzas out the door.

Domino's only offers long-range guidance, not quarterly or annual. In January 2017, it said it was looking for global retail sales growth to range from 8% to 12% higher over the following three to five years, a slightly elevated outlook from previous years, while comps growth (both domestic and international) was expected to range between 3% and 6%. The company reaffirmed this outlook in January 2019, so these sales and comps numbers remain as the expectation for the next three to five years.

While the pizza shop is worried about the impact its fortressing plan may have on individual stores, it's also looking more broadly at the overall effect of store clusters on specific geographical areas and how such clustering can impact the business as a whole. Domino's' track record on expansion has been positive so far, and it maintains that franchisees are largely on board, but the company may get to a point of diminishing returns -- if this happens it may have a more difficult time convincing others that "more stores" is the right strategy.

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Rich Duprey has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.