Like several fund managers, this author has been wrong on Domino’s Pizza Enterprises for years. Great company. Great management. Great execution. Aggressive valuation, or so it seemed, as Domino’s consistently looked overpriced on key valuation metrics.
The pizza empire, one of Australia’s best-run companies, shows how hard it is value management skill and, increasingly, the power of technology disruption. Domino’s stunning half-year profit for FY15 was built on strong digital and product innovation.
As the market valued Domino’s as a fast-growing pizza operator, it was becoming a high-value technology disruptor, by encouraging more consumers to order online. Domino’s digital presence and ability to cook and deliver food quickly should have bigger operators nervously watching, for it could disrupt other takeaway food segments through it innovative ordering and delivery capabilities.
Nevertheless, it is hard to buy Domino’s at these levels. Credit Suisse last week downgraded its recommendation from Neutral to Underperform. It lifted is 12-month price target from $24.70 to $28.85, but that is still miles below the $35.25 share price.
Credit Suisse said Domino’s has an exceptionally strong management team and performance record, but argued the valuation does not reflect the potential risks of increased competition and lower margins, and the sustainably of current price points. “Our valuation still does not come close to the current share price and we are not factoring in any potential risks around the reversion of recent growth drivers or with the strategy in Europe and Japan,” wrote Credit Suisse.
Chart 1: Domino’s Pizza Enterprises
Domino’s strong outperformance might encourage small-cap fund managers to reconsider its nearest listed peer, Retail Food Group. It too has soared, delivering a total shareholder return of 52 per cent over one year and almost 40 per cent over three.
This column identified Retail Food Group in May 2014 in “Fast Food Craze – 2 stocks rev up from supreme growth.” It argued it was the pick of the two stocks. It wasn’t: Domino’s one-year return is 76 per cent, although RFG shareholders cannot complain.
Chart 2: Retail Food Group
To recap, Retail Food Group owns the the Donut King, Brumby’s Bakery, Michel’s Patisserie, bb’s café, Esquires, The Coffee Guy, Pizza Capers Gourmet Kitchen and Crust Gourmet Pizza franchise systems. It also has a large coffee-roasting business and last year bought the Gloria Jean’s and Di Bella Coffee chains. Retail Food looked at buying the La Porchetta Italian casual restaurant chain but did not proceed and there was unfounded speculation it could buy the struggling Pie Face chain.
Retail Food Group’s multi-franchise strategy and overseas growth strategy impresses. Its rapidly growing exposure to gourmet pizza and coffee – two sectors with strong long-term prospects – is a smart move that will provider bigger growth engines in the medium term.
The gourmet pizza chains now contribute almost a quarter of group underlying earnings, in just two years since acquisition. Gloria Jean’s give Retail Food a much bigger international footprint and delivers a pathway into the giant US market with an established brand system and coffee roasting facility.
Retail Food announced in January it had formed a joint venture with a Chinese company to exploit the Gloria Jean’s Coffees and It’s A Grind brand Systems within China.
Retail Food’s big upside is it potential to take popular franchise concepts from Australia into large emerging markets that will stgelop a stronger taste for Western food concepts, such as pizza and coffee, as the number of middle-class Asian consumers boom in coming decades.
Back home, RFG’s “Project Evolution” is a good move as it finds incremental gains in its older franchises. It involves innovating chains such as Donut King by creating standalone stores with a different in-store experience to buying a quick cinnamon donut and coffee at a shopping centre. It could lift price points for RFG franchises and improve the all-important average transaction value per customer.
Retail Food CEO Anthony Alford said at the AGM in November: “Ultimately, it is clear that Project EVO has laid the platform for reinvigorated outlet growth and performance amongst RFG’s traditional Brand Systems, with the initiative having been mandated for application to all new and refurbished outlets moving forward.”
Scale is another asset. As band systems and franchise outlets grow, Retail Food should have better bargaining power with shopping centres for prime locations, and improved economies of scale and capacity to create, stgelop or acquire other franchising systems. A bigger network also allows RFG to run more of its lucrative coffee business through the franchise systems.
More will be known when Retail Food reports its interim profit later this month. There is little room to disappoint, given the share price rally from a 52-week low of $3.67 to $6.55. Watch for strong growth in gourmet pizza to drive a result that beats market expectations.
Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply any stock recommendations or offer financial advice. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at February 18, 2015