Does Domino's Have a Debt Problem?

A company with too much debt on its balance sheet may have a hard time managing financial headwinds. Mounting debt obligations can severely cut into net profit if operating expenses or costs of goods sold increase or the company sees a decline in sales.

During the first quarter, Domino's (DPZ 0.96%) saw a year-over-year decline in net income. Its $2.21 billion in debt certainly played a role, as its interest expense rose 29% year over year, accounting for nearly 5% of revenue. Domino's is certainly highly leveraged, but how does it stack up against other quick-serve restaurant companies?

A look at the competition

Domino's biggest competitors in the Pizza space are Papa John's (PZZA +0.68%) and Pizza Hut, which is owned by Yum! Brands (YUM 0.37%). (Note that Yum! also owns Taco Bell and KFC.) Smaller pizza chain Papa Murphy's (FRSH +0.00%) takes a slightly different approach with its fresh take-and-bake pies but nonetheless competes directly with Domino's and other pizza chains. Additionally, we'll look at McDonald's (MCD 1.32%) -- as the global leader in fast food.

It's still generating enough earnings to cover its interest expenses, with an interest coverage ratio of 4.1 for both last quarter and over the past 12 months. The only other competitor with a single-digit coverage ratio is Papa Murphy's, which has a much more manageable $109 million in debt on its balance sheet.

Where did all that debt come from?

Warren Buffett says that companies with durable competitive advantages don't need to carry much long-term debt, because the company ought to be so profitable that it can fund expansion by itself. Of course, profitable companies capable of paying down their debt quickly are prime targets for leveraged buyouts. That's exactly what happened with Domino's.

Bain Capital bought out Domino's in the late '90s, and it financed over $700 million of the purchase with debt. Management recapitalized its debt in 2007 by issuing $1.7 billion in notes. It recapitalized again in 2012, leaving $1.57 billion in debt due in 2019. Last year, the company issued another $1.5 billion in debt to retire $551 million of the 2012 notes, with the rest going toward "general corporate purposes."

Over the past 10 years, Domino's debt balance ballooned from $801 million to $2.21 billion, in part as a result of the junk bonds it was saddled with in the leveraged buyout. It's also financed some of its expansion with debt, which has had a positive return. Domino's return on assets (ROA) sits at 25.7%. Its next closest competitor, Papa John's, has an ROA 11 percentage points lower at 14.7%. So, while it's highly leveraged, Domino's has put that debt to good use for investors.

Should investors worry about the debt load going forward?

Domino's posted less than stellar earnings results last quarter, but its same-store sales continue to climb, indicating that its moat is very much intact. Revenue grew across all four of its major segments -- domestic franchises, domestic company-owned stores, international stores, and supply chain. As long as sales continue to grow, Domino's should have enough cash to service its debt.

Additionally, the company is carrying $178 million in cash on its balance sheet. That's much more than it usually carries and provides a nice buffer to service its debt if it opts to go that route. With its current revenue growth, even in spite of aggressive competition, it might not have to do that, especially if it continues to recapitalize and roll out its debt as it's done in the past.

So, right now, Domino's major debt isn't a huge problem for investors. Still, investors should watch that its interest coverage ratio (EBITDA/interest expense) continues to increase and ROA remains high. And if revenue starts to decline again, it could spell big trouble for investors, as variable costs might decline but interest expenses will remain the same.