Domino’s Pizza Japan Fires Enthusiasm

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

-Good potential in Japanese acquisition
-Costs subdue European earnings
-Australasian profits strong
-Store roll-out, online offers growth
 

By Eva Brocklehurst

Domino's Pizza Enterprises ((DMP)). The name tells the story. Takeaways from the latest result? JP Morgan is excited, especially about the acquisition of a 75% stake in Domino's Pizza Japan. Key to the broker's optimism is the company's record of executing on acquisitions and boldly taking market share.

JP Morgan cites the fact the company turned around a loss-making European business to generate $6m in earnings within 18 months. FY13 results were affected by weakness in Europe. Profit rose overall but it was the Australian and New Zealand businesses that contributed the strength. The company expects FY14 earnings will grow around 15%, and helping this along will be the acquisition of the Japanese stake. The remainder of the Japanese business will be retained by the vendor, Bain Capital. The price paid equates to a multiple of 10 times trailing 12-month earnings versus the 18 times on which Domino's is currently trading. Brokers think the price is inexpensive, when coupled with the 15% growth expectations. JP Morgan thinks it's time to be Overweight.

Credit Suisse also believes the acquisition is sound. It is already a profitable business and there is growth ahead in store numbers. Domino's can leverage current expertise to improve services and deliver margin expansion, the same way it did locally. Nevertheless, the acquisition is only marginally adding to forecasts because of the downgrades from the European division. Credit Suisse does expect European profit margins will recover in FY14 but growth will be challenging. It's a matter of the company meeting guidance, rather than materially exceeding it as has been the case in the past.

FY13 sales were up 11.3% and underlying earnings 16.2%. European sales growth was a strong 25.2% but there was significant cost escalation and this reduced earnings growth to 7.3%. The reason costs grew in Europe was the significant roll-out of corporate stores in the Netherlands which, in Credit Suisse's view, led to poor cost management in food and labour sourcing and a reduction in margins. There ware also increased logistics cost from the French commissary being unable to supply the new stores in an efficient manner. Add to that legal costs from the Speed Rabbi Pizza proceedings and a restructure of the European management team.

Credit Suisse thinks Europe is a longer-term proposition and the Japanese expansion should diversify growth and reduce the focus on Europe. JP Morgan expects the European disappointment is short term. Issues are being addressed and, coupled with roll-out of digital ordering platforms, earnings and margins should improve. Macquarie is in much the same camp, viewing the new region as preferable to an acquisition in a related sector. It provides a scale entry, significant earnings accretion and should more than offset Europe.

Increased scale, improved product mix, increased online ordering and the continued sell-down of corporate stores drove margin growth in Australasia. The company should be able to improve margins given the roll out of digital technology and the global POS (Pulse) system in Europe as well. In March 2013, an iPhone application and mobile website were launched in France. Online has now reached 25% of sales in France. The Pulse system has been rolled out to 50% of stores in The Netherlands with the remainder expected to be completed by October 2013.

Domino's is the third largest pizza delivery chain in Japan with 259 stores, comprising 216 corporate stores (83%) and 43 franchise stores (17%). It commenced operations in 1985. Bain Capital acquired the business in 2010. The market has had relatively flat growth potential but JP Morgan thinks the company's strategy will be to gain market share off competitors. This is similar to what was achieved in Europe, where the company entered as the number two or three player. Europe was a loss-making business when acquired, and yet the company was able to quickly gain number one share and turn around the business and post profits within a year.

Domino's aims to grow the Japanese business to 600 stores, which equates to a 28% share of chained pizza stores. This compares to Australia, which is currently at 28%, and in Europe, where the company has 23% of chained stores.Traditionally Japan has been a delivery model and most of the sites are in back streets, which are low cost but have low visual impact. Since April 2012, there were nine re-locations and the Japanese entity was able to generate good returns on these. Domino's expects more than 25% of the existing network can be relocated. This is assisted by supply coming onto the market with a large number of convenience store retailers, such as 7/11, upgrading to larger floor spaces. JP Morgan expects the increase in supply will help keep costs low and there is a less onerous regulatory environment in Japan – it is as easy to open a store in Japan as it is in Brisbane.

There are four Hold and two Buy recommendations on the FNArena database. The consensus target price is $11.69, signalling 1.1% downside to the last share price. It compares with $10.90 before the result.
 

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