Is Domino’s Pizza Overpriced?

This story features DOMINO'S PIZZA ENTERPRISES LIMITED. For more info SHARE ANALYSIS: DMP

-Further organic trading growth
-Obtains strong potential in Germany
-Is the high P/E ratio defendable?
 

By Eva Brocklehurst

Domino's Pizza Enterprises ((DMP)) is feasting on another acquisition. The company has formed a 67:33 joint venture with Domino's Pizza Group plc, the UK-listed entity, to acquire a major German pizza chain.

The JV will acquire existing Domino's stores in Germany and Joey's Pizza, the country's largest pizza chain, for EUR79m. Joey's Pizza has 25% of this large and fragmented market.

Management has also upgraded FY16 earnings guidance to growth of 30%, from the 25% signalled at its AGM in November. The joint venture will only make a small positive contribution to FY16 (3 months) so the upgrade to forecasts is largely organic, which suggests to brokers that trading has improved further.

Domino's now operates in five of the top 10 developed pizza markets and management continues to target further acquisitions. Management has increased its long-term European store count target by 1,000 to 2,500, taking the group target to 4,250 by 2025.

To gain access to the German market, Domino's will pay the UK entity up to EUR25m to transfer the rights to operate the brand in Germany. Subsequently, 5-10 Domino's stores will close across Germany as well as the Dusseldorf head office and Berlin commissary, at the UK entity's cost.

Deutsche Bank observes the joint venture agreement provides Domino's with a pathway to full ownership at a future date and considers the acquisition strategically sound. It provides a leading position in a large and fragmented German pizza market with substantial scope to increase the store network.

The company has, once again, deployed capital in a low-risk, highly synergistic way, Morgan Stanley contends. This broker remains comfortable retaining an Overweight rating.

The stock is considered a compelling investment opportunity, offering exposure to a solid base in Australia and long-term expansion potential in Europe and Japan. Morgan Stanley highlights the long-term earnings on offer and looks through the demanding near-term multiples.

UBS has shelved its Sell rating in favour of Neutral on the news, factoring in the upgrade to FY16 earnings forecasts and store targets. The broker considers the latest acquisition reflects a excellent business that is supported by a strong management team, factoring in the company's near-flawless execution.

UBS believes, while the move up in the FY16 price/earnings ratio to 56 looks extreme, in the context of the three-year earnings growth rate of around 28% it is defendable. The broker does expect competition in the category in Australia will heat up, as fast food fights for limited dollar growth in consumer spending.

In Europe, UBS believes Domino's will take share in each respective market over the next two years despite challenging, albeit improving, market conditions. In Japan, the broker expects a modest market share shift in favour of Domino's, assuming it is successful in rolling out stores and increasing the mix of take away business.

While no specific synergies were identified, Macquarie accepts that Germany is well positioned geographically relative to the company's other European outlets. The broker believes Domino's deserves to trade at significant premium to peers, given the strong organic growth outlook and its track record on execution.

The investment is considered attractive over the medium term. The joint venture will take up to two years to convert the Joey's stores to Domino's and 1-3 years to test the market before rolling out further stores. Hence, Macquarie does not expect substantial earnings growth in the first three years.

JP Morgan baulks at the stock's multiple of 46 times one-year forward earnings estimates and sticks with a Neutral rating. Even if the company grew earnings by 30% each year it is still trading on 20 times the broker's FY20 projections.

That said, JP Morgan likes the acquisition, with the key advantage being margin expansion from leveraging technology and other systems across a larger distribution base in Europe.

The broker expects European margins to increase to 20% in FY25 from 11% in FY15 and considers the acquisition price also reasonable, given the earnings and value accretion, although it is higher than the price paid for past acquisitions such as Pizza Sprint and Domino's Japan.

FNArena's database has two Buy and four Hold ratings. The consensus target is $53.72, suggesting 1.2% downside to the last share price and compares with $44.92 ahead of the announcement. Targets range from $50.00 to $63.00.
 

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