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Morningstar | Domino’s Pizza Profitability Takes a Short-Term Hit, but Not Material to Our Long-Term View or FVE. See Updated Analyst Note from 20 Feb 2019

Narrow-moat Domino’s Pizza same-store sales growth of 3.3% in the first half of fiscal 2019 beat the 2.9% announced at the trading update in November 2018. The positive sales momentum continued in the initial seven weeks of the second half, with like-for-like sales up again and tracking at 4.0%. However, sales growth remains at the bottom end of the targeted 3%-6%, held back by a maturing, core Australian market, but also in France. Weak French sales growth dragged down the European segment, which otherwise performed relatively strongly.

However, our key concern rests with lower-than-expected EBITDA margins in Australia and New Zealand, as well as in Europe. We have reduced our EBITDA margin forecast for Europe in the near term and Australia longer term. But these negatives are offset by higher expected sales growth and margins for Japan, and the impact of the time value of money on our DCF valuation. Our fair value estimate is unchanged at AUD 53. At current prices, shares screen as undervalued.

In Australia, Domino’s added six more company-owned stores, which are lower-margin and dilutionary on profitability. The poor performance in France, led to only 2.3% same-store sales growth in Europe, below the global target of 3%-6% and resulted in operational deleverage, as costs grew faster than sales. We expect the French and European business to rebound towards the back end of fiscal 2019, as new regional management gets its feet under the desk and a contract with an aggregator is signed for France--to be used as an additional sales channel, not for deliveries in which Domino’s excels. In Australia, we expect EBITDA margins to remain flat for the next two years, due to continued growth in company owned-stores as underperforming franchisees leave the system.

From fiscal 2021, we now expect EBITDA margins to tick up by 50 basis points a year, up to 41.6% in fiscal 2028, which is 140 basis points lower than our prior estimate. This is well short of management’s aspirational target of 45%. In fact, upside does exist to our Australian EBITDA margin forecast from unwinding of the corporate store count in the medium term, as seen in Japan. However, this is dependent on improving franchisee profitability at the store level, which slightly deteriorated in the half year on the previous corresponding period.

The Japanese market was the standout of the half-year result, with relatively strong 4.8% like-for-like sales growth against Europe and Australia at 2.3% and 3.5%, respectively. However, the Japanese growth rate is also noticeable against its past performance, as the Domino’s like-for-like sales are virtually flat from four years ago. This growth, together with ongoing unwinding of the percentage of company-owned stores in the Japanese network resulted in EBITDA margins expanding. We remain cautious on the outlook for Japan, given the demographic headwinds. Nevertheless, we increased our average like-for-like sales growth forecast to 2% from 1% over the longer term.

For fiscal 2019, management slightly amended its store count guidance range and provided an indication how the group is tracking against the other, unchanged guidance ranges. Management expects to add 200-215 stores in fiscal 2019, down from 225-250 previously. We adjusted our forecast to 200 new organic stores, down from 220 prior.

We forecast same-store sales growth for the group at 3.2% in fiscal 2019, versus the 3.3% achieved in the first half, and a slight increase from our previous estimate of 3.0%. Management guidance is for the mid to lower end of the 3%-6% range. Our lower EBITDA margin and store addition estimates for fiscal 2019, result in a decline to our underlying EBIT estimate of 8% to AUD 229 million from AUD 250 million prior. This is in line with management’s guidance for EBIT at the lower end of the AUD 227-247 million range.