Domino's Pizza: Model update - Inflationary pressures see us lower our EPS estimate by 5%
About the author:
- Author name:
- By Alexander Mees
- Job title:
- Co-Head of Research and Senior Analyst
- Date posted:
- 14 April 2022, 8:30 AM
- Sectors Covered:
- Gaming and Retail
- We have updated our model to take account of recent inflationary pressures and a more cautious view on near-term sales growth in Japan.
- Our EPS estimate for the current year (FY22) falls by 4.9%.
- We retain an ADD rating with a reduced target price of (login to view).
Food inflation is widespread. Unfavourable weather patterns, supply chain disruption and the geopolitical tensions associated with the conflict in Ukraine have intensified global inflationary pressures.
The price of many food items, including wheat (for which Russia and Ukraine make up 30% of the global market), vegetable oils and meat, have risen substantially in recent weeks.
The UN FAO Food Price Index, which tracks the international prices of a basket of food commodities, reached an all-time high for many of its constituent commodities in March 2022.
How inflation affects DMP. Inflation affects DMP in three ways. Firstly, the rising price of soft commodities (food), energy and labour all impact store economics, which directly affects DMP’s margins in its corporate-owned stores. Corporate stores made up 20.1% of the overall network at the end of December 2021, with franchised stores making up the rest.
Secondly, where DMP manages the supply of food to its franchise partners, it is likely to share some of the pain of higher prices by accepting a lower margin on supply contracts. Thirdly, the extent to which cost inflation impacts the appetite of franchise partners to open new stores affects the overall royalty opportunity available to DMP.
We note that DMP is able to mitigate some inflation through its own supply contracts, store efficiencies and judicious menu alterations. We believe food inflation may actually enhance DMP’s competitive positioning as many of its smaller competitors have less scope to mitigate inflation through strategies other than simply raising retail prices.
Forecast and valuation update
We have lowered our earnings estimates to take account of rising inflationary pressures and a more cautious view of same-store sales growth in Japan. We have reduced our EPS estimate for the current year (FY22) by 4.9% to 211c. Our revised estimate is 2% above Visible Alpha consensus of 206c.
Our target price declines from (login to view) as a result of the changes to our earnings estimates and a reduction in average peer company multiples.
Our target price is the average of our discounted cash flow valuation and our sum-of-the-parts valuations, which is based on the trading multiples of similar businesses.
Shares in DMP have been under pressure since the company warned of slower growth in Japan in late 2021. This pressure was compounded by a 1H22 result in February 2022 that disappointed on margins, notably in Japan where the extent of the rebasing of profitability following the post-lockdown decline in sales took the market by surprise.
We upgraded to ADD after the result and, although inflationary pressures have worsened since then, we continue to believe there is meaningful upside to the current share price over the next 12 months.
Firstly, demand for DMP’s product is likely to remain resilient in times of inflation and slower economic growth. Analysis of historical trends shows that takeaway food has been one of the best performing categories of consumer spending during periods of rising inflation.
Secondly, the engine of DMP’s growth is the rollout of new stores, which we expect to continue unabated this year and in years to come. DMP expects to add more than 500 stores to its network in FY22 and believes it can double the size of its network (organically) by FY33.
Same-store sales growth is also likely to normalise to the 3-5 year target range of +3-6% in FY23. Thirdly, DMP has developed a solid platform for inorganic expansion. It has both the financial and managerial capacity to execute further value-enhancing M&A.
Further declines in the EBIT margin of the business in Japan would put pressure on our estimates.
Failure to mitigate cost inflation, especially around food, energy and labour.
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