The world's largest pizza brand entered the third-quarter earnings report needing to show investors something positive after its disappointing outing in the second quarter. Shares of Domino's Pizza (NYSE:DPZ) are richly valued, but a heightened competitive environment has suppressed same-store sales growth this year.

In July, Domino's reported second-quarter U.S. comp sales of 3% and international comps of 2.4%, which was at the low end of management's three- to five-year outlook range. The latest results from the third quarter revealed further deceleration, with U.S. comps at 2.4% and international at 1.7%.

Normally, a downward trend like that would be enough to send a high-P/E stock plunging on the news, especially with earnings per share up only 5.1% year over year. But the day after Domino's earnings release, the stock was trading up about 5%. During the conference call, management spelled out a plan to gain market share and increase profitability over the long term, which investors clearly approve of.

A spatula lifting a slice of pepperoni pizza


There's no profit in free pizza

Domino's is facing an assault by third-party delivery apps like Uber (NYSE:UBER) Eats, DoorDash, and GrubHub (NYSE:GRUB) -- the latter two of which have signed partnerships with rivals Yum! Brands' (NYSE:YUM) Pizza Hut and Papa John's Int'l (NASDAQ:PZZA). These third-party delivery services are essentially trying to buy market share by offering free delivery and discounts. But delivering pizza below cost is not sustainable in the long run.

Domino's CEO Richard Allison believes that "a significant shakeout is coming to the industry," and he is positioning the company to capitalize when that happens. Domino's is expanding its store footprint to get closer to customers, which is designed to shrink delivery times and save costs. Where this could really benefit Domino's is incentivizing more customers to use its carryout service, which is now 45% of Domino's total orders in the U.S. and is more profitable than delivery.   

Management refers to this strategy as "fortressing." While Domino's could see upside to margins down the road, there are negative consequences in the short term, particularly as more stores clustered together cannibalize each other. But Allison believes fortressing is the right strategy, because it will eventually allow Domino's to gain market share once competitors retreat and pass the cost of delivery back to the customer. Allison drove the point home with this colorful analogy: "If you offer to mow my lawn for free, I'm going to say, yes. When you come and charge me for it, I might just go out there and push the mower around myself." 

Maximizing long-term profitability

With the fortressing strategy, Domino's is sacrificing near-term growth for long-term gain. Management doesn't know when the industry shakeout will occur, which also means they don't have clear visibility as to when the pressure on their comp sales will ease. As a result, the company now expects global retail sales growth to be from 7% to 10% over the next two to three years, and it expects U.S. same-store sales growth to be in the range of 2% to 5%. International comps are expected to be 1% to 4%. This is a small downward revision to Domino's previous forecast. 

The silver lining in all this is that management continues to make decisions that are growing free cash flow. Through the first three quarters of the year, Domino's free cash flow increased by 42%. On a trailing 12-month basis, Domino's has generated $333 million in free cash flow, all of which has been returned to shareholders in the form of dividends and share repurchases. The healthy cash generation is fueling a rapid rise in the dividend payout, which has more than doubled over the last five years. The dividend yield is currently 1.03% with a quarterly payout of $0.65 per share. 

It's not every quarter we see market participants willing to reward a company for putting the long term above meeting near-term earnings expectations. Management seems to have a sensible plan that is prioritizing long-term profitability above everything else. Investors have applauded the move, especially given that Domino's is still delivering profitable growth and positive same-store sales in the face of stiff competition. If Domino's can deliver 2.4% U.S. comp growth and 5% earnings growth in a heightened competitive environment, performance should be even better when the free-delivery frenzy dies down.