Domino's Pizza Takes Whole Slice Of Japan
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Domino's Pizza Enterprises ((DMP)) will acquire the Bain Capital stake in the company's Japanese venture, as Bain intends to exercise a put option to sell its minority (25%) stake by August. The joint venture was established in September 2013 with Bain holding a put option to sell its stake after three years and Domino's Pizza a call option to buy the stake after five years.
Morgan Stanley does not believe consensus estimates reflect the accretion in FY18 which occurs with 100% ownership of the Japanese business, while the earnings multiple is not demanding. As of the first half, Domino's Pizza valued the Japanese put option liability at $50.5m. Based on Morgan Stanley's FY18 forecasts for Japanese operating earnings, the 25% stake equates to $10m in net profit in FY18.
Assuming the company will fund the acquisition with debt, this would deliver 5% accretion to the broker's FY18 forecasts for earnings per share. With 100% ownership the company is fully able to drive profit and the broker expects the operating earnings (EBIT) margin in Japan to increase to 22.2% by FY20 from 11.8% in FY16.
Domino's Pizza generates around 60% of its earnings from offshore and, in the current environment, this is important. As consumers typically trade down in tough times, the broker envisages little leverage to a weakening Australian consumer environment. Morgan Stanley is also attracted to the company's long earnings growth trajectory, driven by technology upgrades and a tripling of the store numbers over the next 10 years.
UBS expects the acquisition price will be around $50m, in line with the balance sheet value of the Japanese put option liability. The broker observes negative sentiment around Australian franchisee profitability and wage underpayments are a weight on the stock, but considers these issues are overstated.
Morgans assumes a $52m tag for the Bain put option and estimates the deal to be 3-4% accretive to earnings per share. The broker also assumes further adjustments such as working capital requirements will be made to the final price, yet tempers underlying growth forecasts for FY17 and beyond because of lower same-store growth assumptions, higher depreciation and updated foreign exchange forecasts.
The broker continues to believe the company will deliver solid growth in earnings per share over the next 3-5 years. Morgans now incorporates a price/earnings ratio in its valuation methodology versus pure discounted cash flow previously. As a result, the target drops to $65.62 from $82.38 and, as the stock is trading within 10% of the target, the rating pulls back to Hold from Add.
Opportunity In Europe
Morgans assumes same-store growth in Australia of 14.0%, Europe 3.5% and Japan 1.0%. As Europe cycles the World Cup in June and Ramadan is in this month the broker suspects this geography is unlikely to reach the bottom end of growth guidance ranges, although a stronger margin may be offsetting this.
UBS, nonetheless, believes the market is materially undervaluing the long-term opportunity available for the business by the transfer of its Australian model to Europe, specifically Germany and France. The broker estimates European revenue for the business will overtake Australasia in 2021, yet calculates the market is valuing the region are just half that of Australasia.
The share price should over time more accurately reflect this opportunity as momentum builds through the second half and beyond, the broker believes. While European margins are not expected to reach those of Australasia by 2021 the gap is expected to close materially.
UBS notes the company intends to deliver the results of its Australian franchisee audit in June. The company has flagged that the majority of future store growth will be store splits. UBS expects two thirds of incremental store growth will be via splits versus 30-40% currently.
The issue has raised concern among investors as co-locating stores creates a drag on overall sales. UBS, noting a similar strategy adopted by Domino's Group in the UK, concludes that, while splits are riskier than greenfield expansion, the impact moving forward is likely to be modest and attractive to franchisees.
Splits are beneficial to Domino's Pizza as it charges a 7% royalty and 3% margin, on UBS estimates, on food costs. The broker calculates this will created incremental drag in FY18 via cannibalisation and margin headwinds, as the company provides incentives for franchisees to split.
Nevertheless, UBS considers the net impact is more than factored into estimates and forecasts long-term Australasian operating earnings (EBITDA) margins of 42.8%, around 220 basis points under management's targets. The broker also estimates that the company can reach a 10% share of Australasian takeaways by 2025.
UBS believes the company is high-quality and deserves to trade at a premium to peers given its superior growth outlook. The company has beaten guidance seven or eight times over the last eight years by an average of around 5% and made a number of transformational acquisitions in Japan and Germany.
There are three Buy ratings on FNArena's database and three Hold. The consensus target is $67.60, suggesting 15.8% upside to the last share price. Targets range from $49 (Deutsche Bank, yet to comment on the Bain update) to $80 (Morgan Stanley).
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