Pizza restaurant chain Domino's Pizza (DPZ 0.46%) has been one of the market's big winners over the past decade, generating roughly 1,000% returns compared to 200% for the S&P 500. However, the stock has fallen more than 30% over the past six months.
The company's growth strategy has heavily leaned on its balance sheet, leaving the business with a high debt load as we possibly head for a recession.
Investors shouldn't panic, but there are legitimate reasons for some concern. Here is what you need to know, and how it could impact the stock.
Domino's gushes free cash flow
Domino's Pizza has enjoyed a decade of strong growth; the company grew its store count from 10,255 at the end of 2012 to 18,848 at the end of 2021. Combine that with consistent same-store sales growth, and the company as a whole has grown revenue by 10% annually on average over the past decade.
Domino's does numerous things to compete in a very fragmented industry. Customers can place their orders through a smartphone app, making ordering a convenient experience. It uses a franchise model for its stores, so the company isn't responsible for most of the day-to-day expenses of running the stores.
Its nearly 19,000 stores also give the company economies of scale. Its larger size gives it buying power on raw ingredients and more efficient logistics. Local mom-and-pop pizzerias often struggle to compete on price because they don't have these advantages.
These factors have made Domino's increasingly good at generating free cash flow. You can see how the company once turned between $0.06 and $0.08 of every revenue dollar into cash flow, but that has risen to nearly $0.13.
But does it have a spending problem?
Earnings-per-share (EPS) has grown an average of 22% annually over the past decade, helping explain the stock's massive success. Profits will double in just over three years at that rate, meaning the share price doubles if the stock's price-to-earnings ratio remains the same.
So how is Domino's growing profits so much faster than revenue? Share repurchases have played a significant role in that. The company buys its own stock, which leaves fewer shares to spread profits across.
Management has used massive repurchase programs, exceeding the company's total free cash flow multiple times over the past ten years. Domino's also pays a dividend, which uses nearly 30% of its cash flow. In other words, it's spending more money than it's making.
What impact could the balance sheet have on the stock?
You can see the evidence of this below in the balance sheet. Domino's is taking on increasingly higher debt over time, now up to $5 billion against just $165 million in cash. Its debt is more than five times the company's EBITDA (earnings before interest, taxes, deprecation, amortization), a higher ratio than I would feel comfortable with.
This is unsustainable, and with interest rates rising amid a potential recession, Domino's will likely get a lot more conservative moving forward. It's one thing when zero-percent rates make debt cheap, but borrowing is harder when rates go up.
Management will probably need to dramatically scale back its share repurchases, which will cause the company's EPS growth to slow down to something much closer to its revenue growth of 10%, which is less than half of Domino's 10-year EPS growth rate).
The market could look at slowing profit growth and decide that the stock deserves a lower valuation, and this "chain reaction" could explain why the stock has stumbled over the past six months.
Shares currently trade at a price-to-earnings ratio of 27, a discount to its 10-year median P/E of 32. However, with a loaded balance sheet that could take years to pay down, the stock could remain below its past valuation, and investors should consider that before rushing to buy shares.