Market overreacts as undervalued ASX share plunges

Domino’s Pizza (ASX: DMP) shares dropped over 8% in trading on Thursday and are currently trading at a 42% discount to our fair value estimate.

Narrow-moat Dominos Pizza plans to support its average store economics by culling underperforming stores in two major markets, Japan and France.

Dominos expanded its Japanese footprint too quickly during the pandemic, leaving it with too many immature stores struggling to break even with normalizing demand. To a lesser extent, the French network is also being rationalized.

In April 2024, management flagged that network growth is unlikely in those jurisdictions before store profitability improves.

We decreased our near-term store count estimate, which was a setback for Dominos rollout strategy. We expect Dominos global footprint to reach some 5,900 stores by fiscal 2033, 4% lower than our prior estimate of 6,200. While Dominos aspiration of 7,100 stores globally is unchanged, the timeframe to reach this target is now uncertain. Previously, Dominos intended to hit the milestone by fiscal 2033.

Our reduced store rollout forecast for Dominos by fiscal 2033 lowers our fair value estimate by 5% to $58 per share. Recent challenges, including weak trading conditions in some markets, are souring investor sentiment. Although the recent pace of its network expansion has proved to be too ambitious, we believe Dominos longer-term growth potential is largely intact.

Neighboring stores could capture some of the sales lost from identified store closures. Still, we expect a greater distance to customers, and hence higher delivery costs, to reduce the profitability of those sales. Closing loss-making corporate stores improves overall earnings in isolation. However, we expect foreign-exchange headwinds from a weaker Japanese yen and greater marketing expenses in the short term to weigh on earnings. We reduce our fiscal 2025 earnings per share estimate by 3% to $1.83 per share.

Business strategy and outlook

Domino's Pizza Enterprises is the Australian master licence holder of the Domino's Pizza brand. It also has operations in New Zealand, Japan, Singapore, Malaysia, France, Germany, Belgium, Luxembourg, Taiwan, Cambodia, and the Netherlands.

The stock suits investors seeking exposure to the food and beverage sector. Management is active, importing marketing strategies from the United States, or creating new ones, and applying them to local trends in individual markets. Management has adapted to market trends by refreshing the product range, including healthier ingredients and gourmet styles, and transitioning to online ordering.

As a master franchisee, Domino's has limited capital requirements, which means royalty payments it receives in the future should continue to be paid as partially franked dividends. This makes returns on invested capital very attractive. The shares are currently yielding just under 3%.

Brand and scale are key competitive advantages warranting a narrow economic moat rating, and future growth prospects are significant. Despite significant growth during recent years, Domino's is by no means a mature business. Australia can still increase its store base by about one third in the next few years, and European growth is much more substantial, with potential to more than double the existing store base to around 2,900 outlets during the next decade.

Risks include a change in consumer taste for pizza as a food category and growth execution risk, particularly with differences between Australian, Asian, and European business environments. Good management can navigate these changes. McDonald's modified its menu in response to an increasingly health-conscious society; we see this as a perfect example of a food business changing with the times. We assign the shares a Morningstar Uncertainty Rating of High

Economic moat rating

We believe Domino’s warrants a narrow economic moat, sourced from intangible assets and cost advantages. Intangibles are derived from very strong global brand recognition. Domino’s was formed in 1960 and now extends to over 80 countries, with over 16,000 stores.

Intangibles also stem from internally generated intellectual property, with the firm a leader in restaurant logistics and technology tools that build and maintain customer engagement and loyalty. The majority of its global sales are sourced from digital channels. In Australia, over half of those digital sales come from its mobile app. Domino’s investment in streamlining its cooking and fulfilment process makes it the "go-to" location for individuals who covet the fastest and most reliable service.

We see durable cost advantages in advertising, as Domino’s gains far greater leverage from above-the-line advertising than smaller peers. Being one of the largest operators in each market means the firm can advertise at a lower average cost per outlet than smaller peers. This helps elevate and keep the brand top of mind for consumers—for example, Domino’s Australia has over 1 million likes on Facebook.

High brand awareness, longer trading hours, and sophisticated home delivery capabilities means Domino's stores have high sales productivity. This enables the firm and franchises to rent stores in better locations than less productive smaller pizza restaurants. We anticipate this as conducive to market share growth over the longer term.

Operating one of the largest global pizza franchises allows Domino’s to pool resources and outspend competitors on innovation. Technology innovation improves convenience, which next to value is the key sales driver. The technological platform is shared globally and spans: a digital loyalty program enabling electronic redemption of "reward pizzas"; electronic customer profiling; geotracking of pizza being delivered to homes; and customer geotracking to have pizza ready just as they enter the store. Other benefits in recent years of Domino’s innovation team include high-speed ovens and a re-engineered fulfilment process that appear best-in-class.

Detailed monitoring of every aspect of the ordering, cooking, fulfilment, and deliver processes means bottlenecks and downtimes are minimized, enabling Domino’s to offer faster delivery times than competitors. Delivery times in Australia average 20 minutes, with the largest competitor, Pizza Hut, reportedly sitting at around 30 minutes.

The firm's large network gives it some cost advantages in the procurement of consumables. It also increases the proximity to markets and therefore improves customer convenience.

Terms used in this article

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.