Domino's Pizza (NYSE: DPZ ) missed the mark this quarter, despite its reputation for delivering on behalf of pizza lovers and investors.
The company beat analyst EPS estimates by a penny, but revenue was lower than expected. Domestic same-store sales fell by 4.4%, which indicates that Domino's is losing steam in the United States. CEO David Brandon blamed failed marketing in the first half of 2006. This led to a chain reaction in which sales fell short, franchisees went into cost-reduction mode, and the company was left unprepared to execute in the second half of 2006.
That's a good explanation, but I believe it's only half the story. The U.S. pizza market is saturated. The United States contains 69,000 pizzerias, with annual sales of more than $30 billion; 93% of Americans eat one pizza per month. With that level of penetration, it's no wonder that Domino's is struggling to grow domestically. Americans can't eat much more pizza.
To combat this problem, Domino's has been growing abroad. International same-store sales grew by 3.9% in the last quarter, and the company opened 85 stores abroad versus 43 stores in the United States. The company has been successful so far, but depending heavily on the international market carries risk. Tastes vary by culture, local competitors have a home-field advantage, and supply chains become more complex. It is possible to thrive as a global restaurateur -- McDonald's (NYSE: MCD ) is the penultimate example -- but a domestic growth story like Chipotle (NYSE: CMG ) is more compelling.
Domino's is also tinkering with its capital structure. Regular dividends have been cancelled, and the board has approved a re-capitalization plan. Under the plan, the company will issue up to $1.85 billion in asset-backed securities, repurchase up to 13.8 million shares (22% of the company), buy back its 2011 subordinated notes, and pay off its entire senior credit facility. With the proceeds of this transaction, the company will likely pay a special one-time dividend and fund future share repurchases. This bit of financial engineering should improve returns to shareholders. Asset-backed securities typically have lower interest rates, and more debt will improve tax efficiency and reduce the cost of capital.
Nonetheless, I'm concerned about Domino's overall potential for growth, especially relative to its earnings multiple. With a P/E of 18 and earnings growth forecasted by Reuters in the low-single digits, the upside seems limited.
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