Mixed Views On Domino’s German Foray

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This story features DOMINO'S PIZZA ENTERPRISES LIMITED.
For more info SHARE ANALYSIS: DMP
The company is included in ASX200, ASX300 and ALL-ORDS

Domino's Pizza will acquire Germany's Hallo Pizza, the country's largest independent pizza chain, which will install Domino's as the market leader in that country.

-Increased scale, but with a long integration period
-Fragmented market means more consolidation possible
-Deal metrics sensitive to potential synergies and revenue improvements
 

By Eva Brocklehurst

Germany has become key territory for Domino's Pizza Enterprises ((DMP)) to carve out a significant presence. The company's latest acquisition will add substantial scale, brokers suggest, and the benefits should accrue over several years.

Domino's Pizza will acquire Hallo Pizza for EUR32m along with an additional EUR20-32m in integration costs. The Australian company's share of the total cost is EUR35-42m, as 33% shareholder in the German business, Domino's Pizza plc, will fund the remainder.

The company did not comment on existing guidance for 20% operating earnings (EBITDA) margins in FY18 and 25% margins by FY22 yet Ord Minnett suggests increased scale, albeit with a long integration period, should mean these targets are unlikely to change.

The broker notes it will take 2-3 years to convert the existing Hallo Pizza franchisees to Domino's. Conflicting stores will be optimised, based on retaining the superior store. Menu changes are likely, with the burgers that are available at Hallo Pizza expected to be removed, as occurred at the company's previous German acquisition, Joey's Pizza. This is per Domino's Pizza Inc requirements.

Macquarie suggests the metrics of the deal are very sensitive to potential synergies and revenue improvements. The broker notes integration costs increased by one third versus initial expectations when Joey's Pizza was acquired in 2015. The company has signalled it has a better control of integration costs in this transaction, given the Joey's experience.

That success, in the broker's opinion, will come down to the conversion rate of franchisees to Domino's with a new point-of-sale system, signage and access to the online platform the key selling points.

While the stock remains a high quality business with multiple growth sources, the near-term benefits from this acquisition will take time to realise and, as the stock is trading in line with the target, Macquarie retains a Neutral rating. As the stock is now within 10% of its target too, Morgans pulls its recommendation back to Hold from Add.

Citi estimates the deal will be 1.5% accretive to earnings in the first full year, pre-synergies. The broker considers this a sensible deal to build scale more quickly but also adds to the execution risk. Domino's may be number one in Germany but its share is just 7% of a fragmented market, which means more consolidation is possible. Citi expects a pause for two years while Joey's Pizza and Hallo Pizza are integrated.

Weak Sales Productivity

The broker notes Hallo Pizza stores have weak sales productivity and a significant overlap with Domino's. Sales productivity can improve by 20-30%, Citi calculates, while overheads can be cut. The acquisition also provides scale in advertising and IT. While synergies will take time, margin expansion in Europe is expected to be pushed out about two years.

Citi retains a Sell rating and considers margins may still disappoint in Australia and the stock's price/earnings ratio remains very high.

UBS is more buoyant. The broker upgrades estimates for FY19 and FY20 earnings per share by 2% and 3% respectively and believes in the company's ability to transfer its Australasian model to Europe is a material opportunity, also suggesting the market is taking an overly pessimistic view on the Australasian issues and/or discounting the opportunity in Europe.

This deal is important, Morgan Stanley asserts, as pizza is becoming a scale play. Having scale enables buying terms to be improved and national advertising to increase. The broker believes that post this deal, Domino's Pizza will reach a tipping point where margin expansion accelerates.

Deutsche Bank has rather mixed views about the acquisition. While Hallo Pizza is a profitable business the broker believes this is not the way to view this sort of transaction. Earnings and multiples are relevant to the vendor not to Domino's Pizza, and the real issue is about buying store sites and franchise contracts which can be converted to the Domino's system.

The company has confirmed that there is no earn-out component to the purchase consideration. Nevertheless, assuming the conversion is successful, Deutsche Bank acknowledges it should add scale much faster than could be achieved organically.

The broker also suggests large conversion costs and planned store closures are indicative of the complexity of such deals and will only become more difficult and expensive as the company's penetration increases.

Deutsche Bank cannot get away from the downside risk, given a view that the company is taking too much share from the Australasian profit pool. Margin upside potential exists in Europe but expectations are high and the store targets look challenging. The broker opts to retain a Sell rating.

Hallo Pizza is based in Dusseldorf, privately owned and the largest independent chain in Germany. The network consists of 170 franchise stores across 149 franchisees. Domino's Pizza has 209 stores in Germany at present and this will take the store count to 300-340, with 45 stores to be consolidated across either the Hallo Pizza or Domino's network over time.

FNArena's database shows two Buy, three Hold and two Sell ratings. The consensus target is $46.85, suggesting -5.4% downside to the last share price. Targets range from $38 (Deutsche Bank) to $60 (UBS).

This stock is not covered in-house by Ord Minnett. Instead, the broker whitelabels research by JP Morgan.

See also, Domino's Serves Up Pizza With Technology on October 10 2017.
 

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