Once again, thank you to the guys over at Eagle Point Capital. They have some phenomenal pieces that I highly recommend.
This idea is slightly outdated by a few months, thanks to the British government getting their shit together; however, I do think that the price could be attractive depending upon your own hurdle rate. Also, I apologize for how short this is, hopefully my next write up will be more in depth. I need someone to bring back Liz Truss so I can scoop up some more cheap British companies.
Needless to say, Europe has gone through quite a rough period over the last year. I don’t really feel like going into the macro specifics because well that's not as interesting plus there are much smarter people who have already covered it. Instead, I will focus on a few ideas that seem interesting to me as a result of the various headwinds facing Europe and specifically, the UK.
Domino’s Pizza Group (DOM.L)
I’m sure everyone is familiar with the Domino’s brand and how successful investing in the US listed Domino’s Pizza has been. Unfortunately, it has always traded at a rather high multiple, roughly 30x free cash flow since 2016, thus not providing a large enough margin of safety for people like myself, but Domino’s Pizza Group does seem like a cheap way to capitalize on this success.
Domino’s Pizza Group (DPG) is the master franchisor for Domino’s in the United Kingdom. Meaning they have exclusive rights to franchise Domino’s locations in that specific area. These master franchisors, in this case DPG, collect a percentage of revenue from each location, in the same way the US Dominos does, but then they have to give part of that to Domino’s (DPZ). It looks something like this:
Hardly rocket science. Master franchises just add another few layers to structure and make the economics of DPG slightly worse compared to DPZ; therefore, the same growth algorithm applies:
Unit Growth + Same Store Sales Growth + Yield + Operating Leverage
On Unit Growth:
The outstanding unit economics generated from each Domino’s location should supply a line of potential franchisees to fill any reasonable growth target that DPG may set. DPG plans to open roughly 45 locations per year, which results in 3-4% unit growth per year for the foreseeable future. A few people have mentioned to me that there may not be much growth left, but I would disagree. There are roughly half as many Domino’s per person in the UK than there are in the US, so there does seem to be some reasonable room to grow.
On Same Store Sales Growth:
DPG has historically grown same store sales at 3-4% annually and would expect that to continue due to population growth and continuing to take market share from competitors. From FY21 to FY22 DPG increased their share of the UK pizza market from 42% to 48%. Competitors, like Pizza Hut, are running outdated models with dine in as the primary focus, and historically did not offer delivery. This dine in focus has caused their operating costs to be drastically higher than Domino’s, forcing them to charge more for their pizza. Combine this with Domino’s stellar marketing and these dilapidated Pizza Huts stood no chance. Of course I could be wrong, but Domino’s brand represents cheap somewhat ok pizza delivered right to your door, which should bring in more customers for years to come and as Domino’s expand their product offerings people will buy more food at each location.
On Yield:
DPG has a ~4% dividend yield to begin with already, but thanks to a change in capital allocation they have begun to buyback shares as well. Basically exactly the same as DPZ, DPG is using their free cash flow to aggressively buyback stock for a buyback yield of 4-6%. In addition to this free cash flow, DPG could receive between $70-100 million if they are able to exercise their put option on the Germany business at the beginning of FY23.
Putting it all together
3-4% unit growth
3-4% same store sales growth
4% dividend yield
4-6% buyback yield
That adds up to per share forward returns of between 14-18% (I omitted operating leverage to make this point a bit easier). This kind of growth is pretty good, but the multiple that you pay for it is equally important. Luckily, due to some macroeconomic conditions, DPG is trading at an extremely depressed valuation relative to what such a high quality company should trade at. Roughly 10x normalized free cash flow (definitely got a little more expensive, did the research when it was at 10x) does not make sense to me. Looking at other franchise companies like QSR, it seems that a high teen multiple is a much better fit for franchise companies. Regardless if a rerating does occur or not, the per share earnings growth still delivers 15% returns, and if no rerating and no growth occur, then a 10% free cash flow yield is quite a nice floor to have.
Why is this so cheap?
The macroeconomic conditions of Europe, and specifically the UK, have been quite poor. Combine that with Liz Truss being really good at her job, the pandemic, VAT, and recent divestitures, Domino’s valuation got crushed .I won’t comment on Liz Truss any further than please bring her back; I miss my cheap British equities, and well the pandemic obviously had negative effects on the business. The two points that are vastly more interesting are VAT and the divestitures.
Inflation
This is the only macro condition I will comment on because it provides a nice catalyst for a jump in earnings. DPG also operates a supply chain network that sells dough and other pizza supplies to their franchisors. Well inflation has really hurt this segment's margins, but there is hope. Every 6 months they adjust their contracts for inflation, and the newest round of adjustments hasn’t kicked in yet.
“As during prior periods and in line with our agreement, we pass through food cost inflation to our franchisees on a lagged basis. Due to the rapidly changing inflationary environment this year, we began passing through these increases during the first half of the year but will not recognize the full benefit until the second half.”
VAT
During the pandemic, the UK government decided to lower the value-added tax or VAT on restaurants from 20% down to 5%, so that the restaurants wouldn’t go under. Well the UK government decided that everything was back to normal and probably needed some money to pay Truss’s pension, so they raised VAT back to 20%. This caused a 5% drop in system wide sales, which is really not much, but regardless caused many investors to get spooked. Funnily enough, on their quarterly presentation they have the VAT adjusted numbers, so by typing in a few characters and clicking two links they could have seen that the system wide sales actually grew 3.4%.
Divestitures
For the last few years DPG hasn’t exactly done great. They tried venturing into Iceland, Switzerland and Germany, but with poor results. These locations were poorly run and pulled margins down for the business while also burning cash. Luckily, the new management team realized this and has been selling off these units to focus on the core UK business. They are then returning this cash to shareholders. Many investors may have the old image of DPG in their mind, but now it has quite the evolution that many have yet to see.
But What About Food Delivery?
I won’t be the first to tell you that food delivery is quite a terrible business model. UberEats can’t even call their employees actual employees without their entire business imploding. Delivery drivers make below minimum wage and despite the good idea, it somehow made every stakeholder worse off. Domino’s was the original food delivery company and has done it the correct way (they actually make money). There is this weird idea that these food delivery companies are altering Domino’s business, but that's just not the case. If anything it has probably improved it. Thanks to these delivery companies, DPG has implemented an extra delivery fee. DPG has even partnered with Just Eats with promising results.
“In May we commenced a trial with Just Eat to see whether this channel can attract incremental customers to Domino’s. We started the trial with 136 Domino’s stores across the UK and Ireland and following early encouraging results that suggest we are gaining new, incremental, customers, we are extending the trial to approximately one third of the store estate. We believe that this can be a tailwind for future growth.”
Most importantly of all though, these delivery companies can not continue hemorrhaging money forever. Eventually VC funding will dry up (it already is, Deliveroo had to leave Australia) and these businesses will fail. It is only a matter of time.
Conclusion
To me, this seems like quite the home run. The growth alone should outperform the S&P, throw in a rerating and returns could be upwards of 20% annually. This is a business that I am quite happy to hold for a while.