Domino’s Pizza, Inc. (DPZ) new short report is out from the famed research firm, GeoInvesting. The firm prepared the DPZ thesis in late April for submission to the Sohn Conf, where we were chosen as a finalist.
In short – They believe DPZ, which has been on a tear over the last several years, could be reaching its inevitable end and that a “perfect storm” of factors could cause the stock to fall as much as 34% just to recalibrate with its peers. Domino’s is an overvalued and leveraged company in a high flying sector of a market that is near an all-time high. With a free cash flow (“FCF”) yield of just 2.6%, DPZ generated just $128 million in levered FCF during the last 12-months versus the company’s gargantuan $2.2 billion debt load.
The company will face headwinds in wage increases and eventual volatility in commodities; DPZ has already been fined numerous times in NY for wage violations. The Street has simply mis-valued this stock.
Below is a brief excerpt from the report sent to clients.
Summary
- We think an impressive five-year run in Domino’s Pizza (DPZ) stock could be reaching its inevitable end and that a “perfect storm” of factors may make DPZ a lucrative short.
- Domino’s is an overvalued and leveraged company in a high flying sector of a market near all-time highs.
- With a free cash flow (“FCF”) yield of just 2.6%, DPZ generated just $128 million in levered FCF during the ttm period versus the company’s gargantuan $2.2 billion debt load.
- The company will face headwinds in wage increases and eventual volatility in commodities; the company has already been fined numerous times in NY for wage violations.
- Domino’s could have up to 34% downside simply to recalibrate it with its peers.
How Will the Domino’s Fall?
[drizzle]On paper, DPZ carries with it a stockholders’ deficit of ($1.7 billion). With no real foundation of equity to build upon, those buying DPZ here are focused purely on the future earnings and cash flow of the company, which we will call into question in this report.
Domino’s Q1 2016 proves exactly why the stock does not deserve a premium multiple of 29.4 times forward estimates. On the surface, EPS grew 9.9% (missing analyst estimates by $0.09), but net income was actually down 1.7% YOY. Additional interest expense from an overly leveraged balance sheet wiped out operating income gains. It seems like the only way DPZ managed to grow EPS was through pulling financial levers like buying back stock. Sure, “it’s all about EPS growth”, but there is only so much financial engineering a company can do before investors and the Street start to pay attention to how much growth is fundamentally taking place at the company.
In this quarter (and in future quarters) interest expense is, and will be, one main culprit that puts pressure on net income growth. Combine this with possible future chinks in the armor related to expenses like commodities and labor and all of a sudden the situation becomes worse. In the case of DPZ, its margins before the interest expense line are walking on “thin” ice. An eventual probable rise in commodity prices and imminent increase in minimum wage expense could be the next round of surprises that will leave the market and analysts scrambling to adjust DPZ growth forecasts lower. Markets tend to move before looming changes are reflected in operating results. Also, wage hikes sweeping across the nation may be priced in long before it actually impacts DPZ and wind up being a larger problem for the company and its franchisees.
In fact, we tracked DPZ’s press releases over the last year to seek out management statements about the impact of future wage increases and we couldn’t find any meaningful comments, but for some brief conference call mentions. This past quarter, management spent more time and used more impactful language when describing the potential negative effects of labor costs. The company didn’t make any mention of labor costs in their Q1 2016 press release. Later in this report, we construct a pro-forma income statement that shows the meaningful negative impact that minor adjustments to increases in labor and commodity prices can have on the company’s EPS.
Introduction
There is no doubt that Domino’s has been on a tear for the last five years. The stock has been on a run that has seen long term investors make five times their money. Many would make the case that this is a reason to get long. Instead, we think Domino’s is a perfect choice for investors looking to add a logical short position that should play out over time. Look what is happening to large cap stocks that led our 7 year bull market – cracks are starting to appear and growth is starting to wear. Investors have been recalibrated to look for value with little tolerance for operational “hiccups”.
Does it make sense to pay 29X analysts’ estimates for a company with a large amount of debt and negative shareholder equity where growth is expected to decelerate and margin compression is a great possibility? Already with DPZ, downgrades have begun. Maxim has just downgraded DPZ on valuation and Goldman Sachs just dropped the company from its “conviction buy” list. It won’t be long until more firms jump on the bandwagon, letting their clients get out before Main Street has a chance. Despite the impressive margins reported for Q1 2016, we believe the company has pushed margins towards their limits, and as the negative influences on its business we highlight play out Domino’s could see as much as 34% downside. We expected a certain amount of volatility following the company’s Q1 2016 earnings report, and believe the stock’s abrupt drop from around $135.00 to $120.00 following the report is an indication of what’s to come for unsuspecting shareholders.
Domino’s has bolstered its business over the last 5 years by aggressive geographical expansion, the implementation of technology to make ordering significantly easier, low labor costs, the tailwind of both direct (cheese, pork) and indirect (oil) lower commodity prices, and the constant expansion of margin across all fronts.
But we know the company’s ordering technology is now being adopted by competitors, commodity and labor costs are bound to rise again, and margin expansion simply cannot continue ad infinitum. In addition, the company’s poor FCF yield when compared to its long term debt and market cap makes the quality of its earnings questionable. When tides like commodity prices and labor costs turn, when the restaurant sector adjusts its absurd expectations for future earnings, and/or when the overall market does the same, we think it’ll start a “Domino” effect – leaving DPZ a leveraged, underperforming company with a poor cash flow yield trading at unreasonable multiples.
The question then becomes how one picks the beginning of a turning point for a stock that is up 500% over the last five years.
Ideally, we’d want to try and make a call like this when we have identified a bubble within either a company or sector. We believe we have both of these. Aside from our concerns about the business, we believe DPZ and other like-minded companies in fast food/casual dining who have found success over the last 7 to 8 years – like Chipotle Mexican Grill (CMG), Panera Bread (PNRA) and Jack in the Box (JACK) – have given the restaurant sector an unreasonable valuation. This sector valuation then carries over to its components, leading to this 55 year-old pizza chain that is forecasted to underperform its peers but sporting a multiple that’s pricing in over 120 more quarters of exceptional operations. The company’s lofty multiple has certainly been earned due to its performance over the past few years, but the fact that it is forecasted to underperform Papa John’s International (PZZA) in the future is far more important when considering if it deserves its current multiple. In addition, PZZA is not nearly as leveraged of a company as DPZ, leading us to believe the divergence between the two multiples needs to revert to the mean eventually.
We expect DPZ’s EPS to grow to $4.78 in 2019, a CAGR of 8.34%, down significantly from its CAGR of 19.35% between 2011 and 2015, when its stock had the meat of its run.
It is extraordinarily difficult to zoom in on turning points for companies that are growth-story-turn-around hedge fund darlings like DPZ – but bold calls must be made at some point – and we think DPZ’s time is looming large.
Contact GeoInvesting for the full report.
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