When it comes to the restaurant business, we would usually shake our heads. In our view, restaurants generally tend to be a no-moat, low-predictability businesses in an intensely competitive space. They typically find it challenging to gain a competitive advantage or even to really differentiate, as they face market pressure due to the low barrier of entry and have to deal with the discretionary nature of consumer tastes.
However, Michigan-based Domino's Pizza (DPZ) has been generating superior returns in this space against all the odds. The company not only survived well but also thrived for the good of shareholders.
As described below, Domino's Pizza delivered outperforming free cash returns on assets most of the time for more than a decade, compared with a select group of other restaurant leaders (including McDonald's (MCD), Yum! Brands (YUM), Papa John's (PZZA) and Wingstop (WING)).
In terms of the business model, Domino's Pizza receives royalties and fees (28% of fiscal 2018 sales) from franchisees as well as revenue from supply chain operations (57%), covering ingredients, equipment and supplies. The company also operates its own stores in the U.S., which contributes to 15% of total sales compared with 44% at Papa Jonh's. At Urbem, we highly prefer a large franchisee base - what is better than using others' money to grow your business?
Unlike an "old-fashioned" franchise model, Domino's Pizza controls the supply chain on top of its franchising operations, which encourages a more cohesive economic tie between the franchisor and its franchisees. A franchise contract renewal rate of 99% (in the U.S. in fiscal 2018) strongly indicates the robustness of the partnership. Although it is not involved in the real estate business like McDonald's, Domino's Pizza "owns" an online space that generates traffics of more than 23 million active users (as of Q3 2019) and contributes to over 65% of its U.S. sales. This is how Domino's Pizza brings the restaurant franchise model to the next level - one store offering two businesses (i.e. delivery and carryout) with low initial capital expenditures, smaller space requirements and same-store-sales growth potential.
Per the chart below, Domino's Pizza consistently outperformed all its peers, though rising star Wingstop surpassed it in terms of top-line year-over-year growth for recent years. The company also achieved healthy same-store-sales growths year after year (an average of 7.4% domestically and 5.6% internationally for the past decade).
While Domino's Pizza has more international stores than domestic ones (10,543 in over 85 markets vs. 5,652 as of Q3 2019), it is interesting to see an overwhelming revenue contribution in its home market. Less than 12% of total sales were generated outside of the U.S. as of fiscal 2018. This is because 1) the company charges a lower royalty rate internationally (an average of 3% vs. 5.5% domestically) through a master franchise model; 2) there are no company-owned stores outside of the U.S. and 3) limited supply chain coverage (less than 10% of total supply chain revenue from outside of the U.S.).
The management sees potential for an additional 5,600 stores (or a 53% increase) in the top 15 international markets alone. Some of the critical growth markets include China (1000 potential stores vs. 251 current stores), Brazil (750 vs. 259), Germany (1000 vs. 322) and France (1000 vs. 409). Without a doubt, the fundamental assumption here is that the pizza travels well. Many investors should still remember the struggle of Domino's Pizza Group PLC (LSE:DOM), one of Domino's master franchises, in the Nordic regions and Switzerland and the resulting retreat last year.
In the domestic market, Domino's Pizza sees growth opportunities of additional 2,300 stores through the so-called "fortressing" strategy. The management thinks it is a smart way to shorten delivery times while consolidating the still fragmented pizza category. But in the meantime, it inevitably puts pressure on finding appropriate territories and avoiding cannibalization.
We are cautiously optimistic about the growth strategy and keep same-store-sales growth and asset turnover closely monitored.
Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We own shares of Domino's Pizza.
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This article first appeared on GuruFocus.