Domino’s Pizza Group has been a growth monster for most of the past 30 years. Historically it has doubled in size every five years or so and as a result the shares are currently trading at a premium price.
That premium share price isn’t necessarily a problem though.
If Domino’s can keep doubling in size every few years then the share price will have little choice but to do the same. On the other hand, if that growth fails to materialise, shareholders could be severely disappointed.
Domino’s Pizza Group: A rapid rise to the top
Domino’s Pizza has managed to double in size every five years or so primarily by opening more and more stores which are set up, managed and owned by independent franchisees.
As a franchise business Domino’s can grow without the need for heavy capital investment as franchisees provide the capital required to get each new store up and running.
There are pros and cons to this business model but one thing it does allow is rapid growth, as the chart below shows.
Progress has been both rapid and consistent, with the financial crisis and recession of recent years completely invisible in the company’s results.
My key stats for the company, as compared to the FTSE 100, are as follows:
- 10-Yr growth rate = 17.5% (FTSE 100 = 1.7%)
- 10-Yr growth quality (i.e. consistency) = 100% (FTSE 100 = 50%)
- 10-Yr average profitability (ROCE) = 39% (FTSE 100 = 10%)
During this period the number of Domino’s Pizza stores has gone from 500 to over 900, which means that while the number of stores has been the primary driver of growth, returns per store have also increased markedly (i.e. the number of stores are almost doubled, while revenues, earnings and dividends have quadrupled).
The company has other features which I like, such as a strong brand, market leading position, little need for capital investment, very little debt and no defined benefit pension scheme.
But beyond that, what I’m really interested in is how long it can keep up that historic record of approximately doubling in size every five years.
Are there limits to how much pizza people will eat?
Currently Domino’s Pizza has 900 stores, about 90% of which are within the UK with the remainder in the Republic of Ireland and Switzerland.
As a rough comparison, Pizza Hut has 650, Sainsbury 1300, Greggs 1700, Next 500 and Marks & Spencer 850.
With 900 stores, Domino’s Pizza Group in the UK is getting pretty close to the highest number of outlets that any other retailer has managed to achieve.
If it keeps up that historic 15%+ growth rate and doubles the number of stores in the next few years, it will have around 1800 in the UK. That would make Domino’s Pizza outlets about as numerous in the UK as any other national retailer.
Beyond 1800 stores I think it’s likely that the market would be saturated and that new stores would cannibalise sales and profits from existing Domino’s outlet.
From that quick back-of-a-fag-packet comparison I don’t expect Domino’s to achieve much more than one more doubling of size before its UK growth rate drops off dramatically; probably to low single digits.
And even that may be a stretch given Pizza Hut Delivery’s recently announced expansion plans.
So any rapid growth beyond the next doubling will probably have to come from abroad.
The company does already have operations in the Republic of Ireland, Switzerland and a joint venture in Germany, but the scale of these international businesses are nothing like its UK business.
On that basis I would say that Domino’s Pizza Group does not have any meaningful track record of rapid international growth. They have succeeded massively in the UK, but nowhere else so far (and its expansion into Germany over the past few years could easily be described as a serious failure).
This uncertainty about the company’s long-term future growth prospects is precisely why I’m wary of paying a premium price.
However, at the right price it’s a company I would be happy to invest in.
A target purchase price for Domino’s Pizza Group
With the share price at 975p as I write, the company has the following valuation stats, as compared to the FTSE 100 at 6145:
- Dividend yield = 2.1% (FTSE 100 = 4.0%)
- PE10 ratio = 48.2 (FTSE 100 = 14.4)
- PD10 ratio = 80.4 (FTSE 100 = 28.6)
The premium share price shows up in Domino’s low dividend yield and high price to earnings and dividend ratios shown above (PE10 and PD10 are 10-year versions of the price to earnings and price to dividend ratios).
That low dividend yield leads to the following unpleasant situation:
If Domino’s did manage to double its revenues, earnings and dividend in the next five years, then its shares would still only yield 4.2% at a today’s share price of 975p.
A dividend yield of 4.2% is about in line with the market’s yield, so if Domino’s growth prospects beyond the next doubling are not exceptional, there would be:
- No compelling reason for the shares to trade at a premium,
- no compelling reason for the yield the be lower than 4.2% and
- no compelling reason for the share price to be above 975p.
In other words, today’s shareholders could easily see zero capital gains over the next few years, combined with a relatively meagre dividend income.
Of course, that outcome is based on the assumption that Domino’s growth drops to low single digits after its next doubling of size, but I think that’s a pretty sensible, conservative and cautious assumption.
If one more rapid doubling is all that Domino’s Pizza can muster then I wouldn’t want to pay today’s price.
Another problem is that the current share price of 975p breaks two of my rules of thumb:
- Only invest in a company if its PE10 ratio is below 30
- Only invest in a company if its PD10 ratio is below 60
Those rules may seem arbitrary, but they are in fact based on hard-won experience.
Companies which trade on higher valuations than those above are more often than not just expensive, no matter how impressive their growth records.
Taking all of that into account, in order for me to invest in Domino’s Pizza Group I would have to see its share price fall below 700p at the very least.
At 700p its dividend yield would be a more reasonable 3%, while its PE10 and PD10 ratios would be just about acceptable.
Just as importantly, a doubling of Domino’s revenues, earnings and dividend from where they are today would almost certainly lead to the share price climbing higher than 700p, otherwise the yield would reach an unrealistically high 6%.
Of course that’s a hypothetical situation, and to get to 700p in the first place the company would have to run into some obvious problems.
But if the problems were fixable in the short-term and unlikely to damage the company in the longer-term, I think I would be happy to jump onboard at 700p.