Costs for cheese, meats, and other toppings have been rising faster than thick-crust pizza dough in a 500-degree oven. Despite the higher food bills, shareholders of Domino's Pizza (NYSE: DPZ ) continue to see their slices of the company pie climb to mouthwatering levels as the company delivers record profits seemingly as easily as it delivers the meat lovers' special.
How can the pizza king cope with this?
On a per-block basis, cheese prices have risen from $1.77 per pound in Q2 2013 to $2.20 per pound in Q2 2014. The farm industry is still suffering from a 2012 drought that left cattle feed in short supply.
The domino effect has been higher price of feed, which has led to farmers cutting back on cattle rearing. This has resulted in a shortage of cows, which means a shortage in cow's milk and of course a shortage of cheese.
Supply and demand came into play, and now we're all facing higher cheese prices. Luckily for Domino's, there is more to a pizza than just cheese.
While many other commodity prices, such as pork and beef, have risen too, certain other items actually got cheaper. However, the overall basket of commodities for Domino's rose 5.8% in the second fiscal quarter according to the company's most recent conference call.
The delicious results, costs be damned
In Domino's Pizza's second-quarter fiscal earnings results, reported on July 22, the company reported total revenue that popped 8.8% year over year. Same-store sales rose 7.7% domestically and 11.7% internationally.
Earnings per diluted share tacked on 17.5%. Both gross and net profit margins remained roughly the same percentage.
The numbers certainly don't suggest any obvious major problems with commodity costs holding Domino's Pizza back. Domino's Pizza expects between 4% and 6% commodity price inflation in total for this year.
CFO Michael Lawton stated, "We believe that this increase is manageable in the overall context of our business."
How Domino's Pizza manages the seemingly unmanageable
Domino's Pizza sells many of the required ingredients directly to the franchisees. The franchisees are the ones who ended up eating all of the higher costs, not the parent company.
Franchisees pay a royalty fee to Domino's Pizza based on a percentage of sales regardless of their profits. According to the company's annual report, this royalty fee is generally 5.5% of retail sales no matter what the input cost.
If a franchisee raises his menu prices in response to higher bills, Domino's Pizza still gets its 5.5% except that 5.5% is of that higher menu price while it shares none of the cost. With price increases, franchisees maintain their profit margins and everybody wins including the parent company.
Since over 97% of its 11,000 restaurants are franchise-owned, it's a good to be the pizza king.
For the other less than 3% of restaurants that are company-owned, Domino's Pizza aims to pass the higher commodity costs onto consumers in the form of higher retail prices.
In most cases, however, it actually doesn't even have to. CEO Patrick Doyle explained during the conference call, "With food costs where they were in the first half [of the year you saw] that volume growth has offset increases in food costs." Digital ordering has largely been credited with for the volume growth.
Higher demand and higher economies of scale largely neutralized the higher costs. There is much more that goes into a pizza, such as labor and energy, and with higher volume those costs get sliced thinner on a per-pizza basis.
Nobody likes higher prices, and Domino's Pizza isn't crazy about them either. Doyle stated that the company would be happier if cheese costs and pork costs were cheaper as it would allow for menu prices to be lower as well. He was implying this would stimulate even more demand among price-sensitive customers.
However, Doyle doesn't see it as a long term issue and neither should investors. In short, cheese and meat prices may continue to escalate, but that should carry little to no weight for any Foolish analysis of Domino's Pizza stock, as it has little to no negative effect in the long term or even the short term.
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