Domino’s eat a slice of humble pie

dominos-cheltenhamShareholders gave Domino’s a severe case of indigestion when the fast food retailer reported lower earnings for the 2017 full financial year than the company had forecast last February.

Underlining the volatility of the retail stocks on the sharemarket, investors reacted savagely to the retailer missing its profit guidance and sliced $854 million or close to 20 per cent from its market capitalisation.

Domino’s attempted to cushion adverse reaction to the missed guidance on earnings with the announcement of an on-market share buyback, a 26.9 per cent increase in the final dividend payable to shareholders and assurance that the new financial year had started well.

Short sellers on the stock market had a field day when the results were announced last week after stalking Domino’s in the past 12 months as the retailer’s share price fell from a high of $80.69 in August 2016.

Shareholders cut the share price to $40.28 within minutes of the results announcement last Tuesday, but the price recovered by the end of the week to $44.97.

Don Meij, CEO of Domino’s, blamed some operational issues with the retailer’s online platform in France and under performance of the business in that country and in Japan.

The Domino’s results were always going to test the nerve of investors and financial analysts given the stress points in the business, including an ongoing audit of employee entitlements across the franchise network and concerns by some franchisees about the viability of their stores.

The viability of the franchise stores was inextricably linked to the underpayment of employees across the Australian store network, which prompted Meij to order a compliance audit of 740 stores.

Investors were concerned that the underpayment of wages to employees would result in higher costs for the retailer, yet Meij was bullish announcing the half year results in February.

However, the second half of the financial year did not meet expectations with lower than forecast total and same store sales in the Australia and New Zealand markets, possibly reflecting a measure of consumer reaction to the negative publicity on the wages issue.

With more sober consideration, the company’s full year result was far from a disaster, despite the weak second half performance.

Total sales were up to $2.32 billion after a 16.6 per cent increase in Australia and New Zealand, a 26.9 per cent lift in Europe and an 8.4 per cent gain in Japan.

Domino’s posted a record $118.5 million net profit, representing a 28.8 per cent increase on 2016, yet investors were dissatisfied because the retailer missed the forecast 32.5 per cent increase touted in February.

While the share price has tumbled markedly in the past year, at around $45, it has generally outpaced most retailers in market value after listing on the ASX at $2.20 a share in 2005.

The question financial analysts and investors are now mulling over is whether or not Domino’s has peaked and will be unable to maintain its sales and earnings momentum, despite its adoption of gadgetry such as drone deliveries, ordering apps for mobile devices and GPS tracking of delivery drivers.

In the Australian market, other fast food rivals are developing home delivery options for customers, as well as the emerging UberEATS, which Domino’s may in the future be forced to sign up to in a bid to keep a lid on wages costs and meet consumer preferences on food ordering systems.

Domino’s growth has been underpinned by fast and convenient home deliveries for competitively priced pizzas, but technology is also assisting competitors to develop home delivery and more food options.

Domino'sIt would seem Domino’s has successfully absorbed some of the costs associated with the wages scandal, having paid out more than $1 million of wages and superannuation after investigating allegations of underpayments.

There may well be more payments necessary as the company’s audit continues and potentially other costs associated with changes to its business model or franchisee contracts to ensure the viability of its store network. However, the retailer seems to have the capacity to meet those possible liabilities.

But there has been reputational damage that may well explain the lower growth rate in Australia in the six months to June – and that damage may also impact on the recruitment of new franchisees for the 50 plus stores the retailer must open each year, if it is to reach a 2025 network target of 4,650 stores.

Domino’s currently has 2,135 stores and to more than double the network, it must also open around 200 new stores a year in Europe and 45 a year in Japan, along with the 400 additional Australian and New Zealand outlets planned over the next eight years.

The ambitious store expansion is critical to earnings growth as sign-up fees boost the bottom line and the additional stores spread costs on marketing, retail support and product ingredients.

More than $18 million of the retailer’s profits in FY17 came directly from sales of corporate stores to franchisees.

Domino’s currently has 74 corporate stores in its portfolio of 777 outlets in Australia, as well as 71 company-owned stores in its European network of 865 stores.

In Japan, Domino’s currently has 310 corporate outlets and just 183 franchises.

The company has always been aggressive in terms of expansion, but some of the investor concern about future growth relates to the likelihood of cannibalisation of sales that will create further pressure for franchisees.

Meij claims franchisee have averaged a 25 per cent increase in earnings over the past two years, but there are still rumblings within the franchise system about costs and operating rules that are impacting on the viability of some outlets.

Meij claims around 90 per cent of new stores are opened by existing franchisees and says there is no need to make any significant changes to the business model or to rework the franchisor and franchisee profit shares, as the 7-Eleven convenience chain was forced to do last year.

Some analysts, including Citigroup, have viewed Domino’s as overvalued despite its impressive growth over the past three years that has lifted sales across its three market territories from around $1.48 billion in 2014 to $2.31 billion this year.

The sharp decline in the share price last week will actually make those analysts more comfortable about the retailer’s value and its ability to resolve the outstanding industrial relations issues and to boost the sluggish Japanese and French sales.

Meij is certainly bullish about the company’s future prospects, predicting a 20 per cent lift in net earnings for the current financial year.

For investors distracted by the wages issues in the Australian market, which remain under investigation by government agencies, Meij indicates that Europe will be the main growth engine for the company in the foreseeable future.

Domino’s is expected to pass the 1,000-store mark in Europe within 18 months and the forecast sales growth in that territory is five to seven per cent.

Meij expects sales growth to also be in high single digits for FY18 at between seven and nine per cent, but concedes the Japan territory will probably lift its revenues by no more than two per cent while the company addresses a range of issues in the year ahead.

 

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