FTSE 250 stock Domino’s Pizza Group (LSE: DOM) has been a brilliant long-term investment.
The takeaway group’s share price has risen 15-fold over the last 20 years, as the business has become a near-universal presence on UK high streets.
Super profit margins
Like many of the biggest fast-food brands, Domino’s operates a franchising system. Most of its 1,300+ UK stores are operated by franchisees. They set up and run the stores, and pay Domino’s a royalty on all their sales.
In return, the franchisees get to use Domino’s brand, sell its products, and benefit from its marketing system.
The beauty of a franchise model is that companies can roll out a large store network with very little capital investment. This can lead to wonderful profitability.
Domino’s is a good example. The business typically generates an operating margin of about 20%, with returns on capital employed closer to 30%. These exceptional figures support strong cash generation. Domino’s hasn’t cut its dividend for 20 years.
Domino’s secret sauce
It would be logical to think that most of Domino’s own revenue comes from its franchise royalties. But this isn’t the case.
Over the 12 months to June 2023, Domino’s generated £655m of revenue, but only £84m of this came from franchise royalties – about 13%.
More than £455m of the group’s revenue (almost 70%!) came from its supply chain business. This operation sells franchisees pretty much all of the food and consumables they need to operate their stores and produce pizzas.
Source: Domino’s Pizza Group plc
This business model is known as vertical integration. Domino’s owns the whole process, from making dough in factories to delivering pizzas to customers.
This approach gives the company close control over its product, service quality, and pricing. It also allows Domino’s to keep the profit margin that would otherwise be earned by external suppliers.
New CEO has strong track record
Domino’s has suffered a high level of management turnover in recent years, but newish chief executive Andrew Rennie seems a strong appointment to me. Rennie has worked in the Domino’s ecosystem for 30 years, including 10 as a franchisee.
This experience may come in useful, as the company’s relationship with its franchisees hasn’t always been happy. The two sides have disagreed on profit sharing in the past, slowing new store openings.
Domino’s earnings growth has also slowed in recent years. In a recent presentation by Rennie, he admitted that earnings per share last year were only 5% higher than in 2018. Not ideal.
The right time to buy?
Domino’s third-quarter trading update revealed that like-for-like sales rose by just 3.7% during the period. Management warned of “an uncertain market”.
Cost-of-living pressures could continue to put pressure on spending for a little longer. But I think Rennie will gradually return Domino’s UK operations to growth, while also looking after its franchisees.
The shares are currently trading on 18 times 2024 forecast earnings, with a 3% dividend yield. I reckon Domino’s looks fairly priced at this level, but I might be interested in buying the stock on any future dips. Right now, I think there are probably better choices elsewhere in the UK market.
The post Forget franchise royalties, FTSE 250 stock Domino’s Pizza Group generates almost 70% of its sales from this hidden business appeared first on The Motley Fool UK.
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Roland Head has no position in any of the shares mentioned. The Motley Fool UK has recommended Domino’s Pizza Group Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
