Domino's Pizza: Fundamentals Remain Strong With Improving Investor Sentiment (Rating Upgrade)

seekingalpha11-19 22:53

DPZ's stock price has declined 15% since my first article but has maintained strong fundamentals over this time, leading me to upgrade my rating from a sell to a buy.Recent earnings reports show ...

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(NYSE:DPZ) back at the end of May with the article titled \"Domino's Pizza: Currently Trading At An Extended Valuation,\" and designated the stock a sell due to what I believed to be about a 14% overvaluation. Since then, the stock price has declined by more than 15% at some points throughout the last six months and there have been a couple of quarterly earnings reports with strong fundamentals. Also in recent news, Warren Buffett's Berkshire Hathaway initiated a position in this company, which has improved overall investor sentiment as this is being perceived as a value play. Reviewing the changes over the last six months, I'm upgrading my sell rating to a buy because DPZ continues to focus on producing value for investors through their growth strategies and has now fallen within fair value based on the stock analysis in my first article. Given the current market conditions, DPZ may be at risk of further decline as a consumer discretionary if consumer spending changes, however, as mentioned previously, short-term stock price declines would open up the opportunity for long-term investors. Previous Coverage Previously I covered DPZ back at the end of May, rating the company a sell due to a slight overvaluation of about 14% based on their current earnings per share, the discount rate I applied, and an expected growth rate. My conclusion was that I expected the stock price to decline over the next few months given this overvaluation, but the company still displayed strong fundamentals such as growing revenue, high ROIC, and high gross margins. Since this article, the stock price has declined about 15% and earnings per share have increased, which has brought DPZ closer to what I believe to be fair value. Fundamentals have also remained strong, and they've continued to grow both store count and their revenues. Looking forward, I'm a buyer of DPZ as the stock price fluctuates between what I previously calculated as fair value at ~$445 per share with lower earnings and the current price, which is due to a positive change in investor sentiment. Recent Earnings Call and News Since my last article, there has been some news on the company as well as two quarterly earnings with updates on earnings per share. In their recent earnings call, the company described a strong earnings report where they've seen a 6.6% increase in retail sales in the US while competitors are growing at less than 2% in the category and a 6.5% increase in international retail sales. This growth is mainly driven by their Hungry for MORE strategy. Another highlight is the success of their rewards program, which has brought customers back to the franchise more often. On to the numbers, gross profit grew 8.6% in the quarter, they benefited from 1.6% price increases and added 24 net new stores in the US. Given that sales continue to rise even though pricing slightly increased, this does show the company has some pricing power for their product, along with a good strategy for continued growth. Further, as a vote of confidence, there was a recent news article last week highlighting that Warren Buffett's Berkshire Hathaway started a position in Domino's Pizza according to his quarterly 13F filing. Although this is a small position relative to other holdings in his portfolio, the market already reacted with positive sentiment that caused an increase in stock price. I believe that this positive change will act as a catalyst for near-term stock price appreciation, that will continue as the company provides value to investors with strong fundamentals moving forward each quarter. Updated Fundamentals Currently, DPZ trades at a forward GAAP P/E of 25.76, a trailing twelve-month GAAP P/E of 26.44, a forward EV/EBITDA of 20.51, and a forward price/sales ratio of 3.21. Compared to the sector medians, these values are all significantly higher, however, compared to DPZ's five-year averages, these values are all lower. Now as you will see in the updated fundamental analysis below, which also includes data over a few recent quarters, DPZ continues to grow and provide value for investors, even as inflation continues to rise, and the cost environment becomes uncertain. Revenue As you can see in the charts below, DPZ has continued to grow revenue at a fast rate while maintaining high gross margins. Over the trailing twelve months, gross margins rose to 39%, for 28% growth in margins over the last decade. Revenue also grew by 159% over the last decade, while costs of goods rose by 127%. Looking on a quarterly basis, we can see that costs and revenue have been relatively consistent, while margins improved. As DPZ continues its plan for growth and implements similar marketing strategies in international markets as mentioned in its recent earnings call, I expect fundamentals to continue growing, and overall revenue to continue growing as gross margins remain high. DPZ: Gross margins, revenue, and costs of goods sold over the last ten years. The right vertical axis is shown as gross margin percentage. (Author's Calculations)DPZ: Gross margins, revenue, and costs of goods sold over the last few quarters since March 2022. (Author's Calculations) Margin Expansion Great companies are usually able to generate high returns on investment and maintain or grow their margins. These are indicators that show the company has a dominant share in their sector. When looking at DPZ for the last few quarters, we can see that they have been able to maintain high gross margins, double-digit net margin returns, and over 13% free cash flow margin over the trailing twelve months. Given how consistent margins have been, I would expect them to remain consistent as the company continues to grow. Looking forward, as the economic environment changes, inflation continues to cool, and employment remains strong, I expect DPZ to continue profiting and maintain the current margin levels in the near future. DPZ: Quarterly margins since March 2023. (Author's Calculations) Return on Invested Capital As you can see in the charts below, DPZ continues to maintain a high return on invested capital (ROIC) when compared to the weighted cost of capital (WACC). Over the last 6 months, these fundamentals have not significantly changed, but the stock price is 15% cheaper. This is one indicator that management is continuing to make good investment decisions to provide high returns while keeping costs consistent, and the stock price has not priced this in. As you can see below, on a yearly basis, ROIC seems to be back in an uptrend and may reach the mid-60s again. On a quarterly basis, we can see a little more movement in ROIC, with a decline over the last four quarters, and this is a metric investors should focus on over the next 12-18 months. I would expect the next quarter to be around 60%, and if lower than 50%, following the quarterly trend, the stock price may be further impacted. DPZ: ROIC and WACC over the last ten years. (Author's Calculations)DPZ: Quarterly ROIC, WACC, and gross margins shown on the right axis, all since March 2022. (Author's Calculations) Per Share Value DPZ has continued to have high revenue growth, high EBITDA growth, and high free cash flow growth over the last decade. Earnings have also increased significantly during this time. Over the trailing twelve months, DPZ has achieved $16.27 EPS, which exceeds my previous calculations where I had valued the stock ~14% overvalued based on EPS of $15.31. Further, as you can see in the chart below depicting the recent few quarters, we can see DPZ also provides growing dividends which are currently yielding 1.4%, but have a 5-year growth rate of 18% and a payout ratio of only 35.26% which indicates to me that there's still room to grow. Not shown in the chart below, DPZ does carry a large amount of debt compared to other metrics, which is a concern if they are unable to generate consistent revenue for any reason, like if the economic environment became unfavorable such as during a recession. However, up until this point, DPZ has not had problems with their high debt levels. In the most recent earnings call, they also highlighted the upcoming debt maturity, and the more favorable interest rate environment, which allowed them to repurchase more shares in the last quarter. Looking ahead, I expect DPZ to continue providing value to their shareholders through dividend growth and share repurchases, which will help drive continued earnings growth as well. DPZ: Quarterly per share data since March 2023. (Author's Calculations) Risk to Investment Thesis There are a few risks to this investment thesis given that I am using historical data which I'm speculating to determine the future performance of the stock. Aside from past performance not being able to guarantee future performance, one concern that I have is that DPZ has a large amount of debt. Although I believe that DPZ is a great company which it has demonstrated through their solid fundamentals, there's a chance a large event happens that causes significant change to their business operations which may impact the company given their large debt levels. So far, they have managed well in difficult times, but this is one concern I have. Another risk to this thesis is that if margins begin to decline because of increased competition or higher costs of goods due to ramped inflation. Some costs, such as labor, have increased significantly over the last few years, and other cost increases are a concern moving forward. However, with current economic conditions, inflation has significantly cooled over the last six months, and this will continue to help costs for DPZ. Finally, if we enter into a more recessionary environment where investors are not as favorable to risk, equities may be significantly affected. Conclusion  Previously I covered Domino's Pizza, Inc. where I had given a sell rating based on a slight overvaluation of about 14% using the earnings per share at the time, applied discount and growth rates; however, the fundamentals were strong, and I noted that there may be an opportunity for long-term investors with a slight decline. Given recent updates in the stock, positive investor sentiment from Warren Buffett's investment, and the 15% discount we've already seen in the stock over the last 6 months, I believe now may be a time for long-term value investors to consider an investment in a great company that has maintained solid fundamentals over the last ten years, and over the last 2 quarters. As the investment environment remains risk on, and DPZ trades below their 5-year averages, this might be one of the few opportunities to buy this great company that continues to add to their strong fundamentals. Investors should do their own research before making financial decisions and consider their own risk/reward profiles. 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