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With Shares Up Nearly 30% in the Last Month, Are Domino's Investors Getting Ahead of Themselves?

By Asit Sharma - Updated Feb 21, 2020 at 3:30PM

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The pizza chain is experiencing a sudden rejuvenation, but investors should exercise a bit of caution going forward.

The narrative that Domino's (DPZ -0.40%) may be morphing into a growth stock again emerged in a single trading session on Thursday, as shares of the global pizza baker soared 25% at midday, bringing the company's appreciation in February alone to more than 30%.

The company's fourth-quarter earnings catalyzed its impressive share rise, as U.S. same-store sales improved by 3.4% year over year, surpassing investor expectations. Comparable sales have decelerated significantly over the past year as Domino's has battled rising competition from third-party aggregators like DoorDash, Uber Technologies' Uber Eats, and Grubhub.

Fiscal 2019 U.S. comps growth of 3.2% was less than half of fiscal 2018's comps advance of 6.6%. Nonetheless, this quarter's comps result was the fastest in several quarters, and it was supplemented by brisk new store growth, helping the company achieve year-over-year revenue expansion of 7.6%, to $1.2 billion. 

Friends share a steaming hot pepperoni pizza.

Image source: Getty Images.

Why would investors endorse a good, but not fantastic, quarter so resoundingly? The answer lies in the relationship between comps and Domino's "fortressing" strategy. This is the company's practice of building out a dense network of stores to serve more customers at close proximity, even at the risk of cannibalizing sales.

Fortressing increases total company revenue by adding on new units, while helping to insulate against the competition. However, it tends to create a drag on same-store sales. Consider a franchisee who opens multiple units within a defined radius in a metropolitan area. While the franchisee's total sales improve with each restaurant (and Domino's in turn enjoys higher franchise fees), individual store sales growth will prove problematic, as each new unit competes for overlapping sections of the same market.

Theoretically, fortressing-spurred unit growth should dampen comps, and that's what Domino's has experienced over the last several quarters, a phenomenon exacerbated by the relatively recent onslaught of third-party food delivery competition. Yet Thursday's results could be read as a best-of-both-worlds report: Domino's added 141 net new U.S. stores while same-store sales grew vigorously.

There are many interpretations of this positive outcome. It could mean that the fortressing strategy is reaching a mature stage, and that cannibalistic effects may soon subside. It may mean that the novelty of being able to order from a wide array of local restaurants is wearing off as customers realize that delivery charges can run much higher than a typical pizza delivery order. It could also signal that the company's recent promotional activity to recapture market share is paying off.

And of course, none of these interpretations may be correct -- perhaps the comps bump simply represented an anomaly this period. We have one quarter's worth of data to go by, and a single data point doesn't make a trend. Aware of this, management didn't revise any of the company's longer-term growth targets on Thursday (which, as I discussed last quarter, were lowered to reflect the reality of new competition in the delivery market).

Next quarter, it's also possible that U.S. comps could revert back to the 2% to 3% range. While Domino's deserves much credit for increasing total sales in a difficult environment for delivery pizza services, it still has much progress to make to return to the days of 6% expansion in comps.

This quarter's share price ascent has pushed Domino's forward price-to-earnings ratio higher by nearly 10 percentage points: DPZ stock now trades at a pricey 35 times expected one-year earnings. This consumer staples stalwart has suddenly recaptured investors' imaginations. But at least from a market pricing perspective, it may have temporarily raced ahead of itself as well. Prospective investors may be well served to build a Domino's position in increments, rather than one big purchase, over the near term.

Asit Sharma has no position in any of the stocks mentioned. The Motley Fool recommends Uber Technologies. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Domino's Pizza, Inc. Stock Quote
Domino's Pizza, Inc.
DPZ
$404.13 (-0.40%) $-1.62
GrubHub Inc. Stock Quote
GrubHub Inc.
GRUB
Uber Technologies, Inc. Stock Quote
Uber Technologies, Inc.
UBER
$32.24 (-1.71%) $0.56

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