The Moat Show Ep. 4: Domino’s Pizza with Morningstar's Sean Dunlop

On The Moat Show, we uncover the companies with economic moats, one stock at a time, by bringing on analysts from Morningstar to share their in-depth insights with you.

The views and opinions expressed herein are those Sean Dunlop of Morningstar as of 8/16/2023, and are not intended as financial advice, a recommendation to buy or sell any securities mentioned, or any call to action. Actual future performance of any securities mentioned is unknown. Certain statements may constitute forecasts, projections, or other forward-looking statements which are valid as of the recording date, for illustrative purposes only, subject to change without notice, and do not necessarily reflect those of VanEck or its employees.

CHELSEA: Well, I hope you're not hungry when you're watching today’s episode for the Moat Show, because we're covering Domino's. We have on Morningstar's Equity analyst, Sean Dunlop. Welcome, Sean.

SEAN: Thanks for having me.

CHELSEA: Sean, would you be able to start us off by giving us some background on Domino's history as a company?

SEAN: Absolutely, yeah. A lot has happened since the firm was founded in Ypsilanti, Michigan, in 1960. Tom Monaghan, Domino's founder and CEO, built the business out of a converted Dominick's pizza restaurant, opened a handful of units before starting to franchise the late 1960s. Fast forward a few years. Domino's opens up its first international store in Canada in 1983. And a little more than a decade later, they hit 1000 international units. Tom sells the business in 1993 to Bain Capital, who takes it public in 2004. And this is where the story really gets interesting. Domino's struggles with declining traffic, with consumer price sensitivity going into the Great Recession, and and they start cutting corners to save costs. So they invest a lot less in operations. They start using cheaper ingredients and consumers really notice. So the firm starts flailing in 2006, 2007, 2008 with declining quality. Guests are defecting from the brand and we find ourselves in a little bit of a freefall. But then in 2009, the firm scrapped its recipe entirely, launched a new and inspired pizza marketing campaign built around “new sauce, new crust, new cheese still around,” I think was the money line. So they invest heavily to make stores look a lot more inviting. You can now see into the kitchen. They invest heavily in digital tactics and they completely re-imagine the chain. And it works. And it works better than we've seen any brand turnaround, really, in the restaurant industry. After this, Domino's strings together 41 straight quarters of positive U.S. comparable store sales growth basically ten years. So all that to say certainly have been some bumps along the way. But the firm has very much rebranded itself as a technology chain that sells pizza and boasting and things like order tracking, omnichannel, ordering access. And now roughly 75% of sales come through those digital channels.

CHELSEA: What do you think made them take that step into investing in technology post 2009 with, you know, major developments such as the Pizza Tracker? They seemed to be the first one to really dive into online ordering first versus the traditional way of, you know, calling up, your local pizza joint. Is there is some sort of like insight they recognize before everyone else into, like, where technology was headed?

SEAN: Yeah, I think you could you could make that argument. Now, Dave Brandon, obvious, is an excellent CEO, Patrick Doyle, who followed obviously an excellent and somewhat visionary CEO in the restaurant industry. The pizza industry has historically been really phone-in heavy. So you think about people calling in an order on a Friday or Saturday night getting the pizza delivered. It's always been off premise heavy. But as you work into 2007, 2008, 2009, there are a couple factors in play here. So, number one, we sort of we've had the iPhone moment. People are just starting to adopt this. We're just starting to see 3G and 4G in mobile ordering become little bit more accessible. Consumers are starting to interact that way with restaurant brands and the industry hasn't yet reacted. It's typically very slow moving. Secondarily, Domino's really didn't have anything to lose. So you're looking at stringing together, really bad comparable store sales numbers quarter to quarter to quarter, and investors are getting quite tired of it. So they kind of kind of burned the plow and invested heavily in a lot of these technology features that that they really conditioned consumers to expect.

COULTER: Wow, that's a really pretty incredible story. Anything about the transformation of, you know, of pizza joints from the many years ago to today and where we've arrived and where we come from... The one question I have is I imagine the pizza restaurant industry can be intensely competitive. If you think about it, there is a number of options out there for consumers to choose from. But can you explain a little bit about how Domino's is able to stand out from these competitors? And also, how has it achieved one of Morningstar's most exclusive ratings? It's your wide economic moat rating.

SEAN: Yeah, great questions, Coulter. It's it is a really competitive industry. I mean, you think there are so many independent pizzerias. It's one of the quick service restaurant acoustic categories that has the highest independent restaurant concentration. People like Variety. They like trying new and different shops. It's also very promotional. Consumers on average get about a 20% discount from the sticker price when they buy pizza. So that's certainly a factor. And as you think about economic moats, particularly brand intangible assets being sort of things that confer pricing power, it seems almost counterintuitive that you could have a company carve out a wide economic moat in this industry. Now, with that said, you know, Domino's sells one in five pizzas that are sold globally and they're an extremely profitable chain. They do $17.4 billion in systemwide sales. So there are a number of factors that start to distinguish the brand over time. To answer your first question directly, it is pretty unusual to see a wide economic moat in the restaurant industry. As you think about the U.S. restaurant space, there are 860,000 restaurants. So, we obviously cover a number of restaurants that would be narrower, wide moat operators, but the proportion is really quite low. It's a very competitive industry. It's an industry market by type margins. You're often a price taker. There are zero customer switching costs and there are very low upfront costs to open a restaurant. So the way that we think Domino's kind of distinguishes itself is a couple of fold. So you can access Domino's almost any way you can think of. You can order in your car, you can order on your phone, you can use your loyalty program. Now you can use Uber Eats. So access is a really big point because you think about pizza, it's very much a convenience driven order a lot of situations. It's “can I get this in 30 minutes or less?” And Domino's really owns that niche. Now what that does is it drives transaction volume. So Domino's is able to sell so many pizzas out of a box that they can offer quite a bit lower pricing than you see at a number of competitors and still earn the same or better margins. That comparable store sales momentum ultimately drives a higher level of sales per store, which is a big a big feature in our economic moat framework. So from the perspective of an operator if I open a new Domino's restaurant, I get my money back within three years and that's about as compelling of a return as we see in the restaurant industry.

COULTER: Well, that was fascinating. So, really there is a big relationship between the branding and sort of the moat factor that you guys are viewing and then as well as value that that helps drive even for the franchisees who are receiving some of their money back sooner than other options might afford them.

SEAN: Absolutely. I mean, for perspective, you know, the Burger King unit in the United States today, you're probably looking at getting your money back in 10 to 12 years, which in many cases is longer than your initial franchise term. So it makes it much easier for Domino's to grow units, to continue to grow market share, to lean into this fortressing strategy where they try to build up really critical mass in the pizza market on a city by city, region by region basis.

COULTER: And you sort of mentioned that recently or just in your last comment there about the region. I do know that international business is a big part of Domino's, revenue streams. Can you talk a little about their footprint, you know, abroad?

SEAN: Yeah, it's really easy to think of Domino's as being a very U.S. centric, very US focused brand. And in terms of revenues, that's true. But if you think about systemwide sales, the total pizza dollar sales that they generate, most of those actually happen outside the United States. So Domino’s has roughly 20,000 total stores and 13,500 of those are outside the United States at roughly 65% of its footprint. So it's actually the international portability is an extremely important component of this Domino's narrative. Another way that we think about moats in the restaurant space is the relationships that a firm maintains with master franchisee partners. So as a for instance, if I'm working with Jubilant FoodWorks in India and they sell the Domino's brand, then jubilant is usually contractually prohibited from working with the Pizza Hut or Papa John's. So it's a little bit of a of a zero sum game. And Domino's maintains relationships with a lot of really big, well-capitalized, often private equity firms or publicly traded firms that are managing individual markets like the enterprises in Australia or Japan, obviously Jubilant in India and so on. That create pretty compelling barriers to entry for competitors. Now the last point that we'd make on the international market space, it's very interesting because Domino's doesn't want to necessarily own the process of developing a menu for regional tastes or different marketing expectations or regulatory barriers. They'll typically outsource that through what's called the master franchise arrangement. So they don't usually touch the market much beyond maybe providing a little bit of e-commerce support or some help sourcing equipment or things to that effect. And they end up only earning about 3 to $0.04 per dollar of sales abroad. So it's almost exclusively it's almost pure profit, but it's only about six and a half percent of their consolidated revenue, about 25% of their operating income comes from international markets.

CHELSEA: Sean, you mentioned Pizza Hut and Papa John's. Would you say those are Domino's, two biggest competitors, domestically and abroad?

SEAN: Yeah, it's a really interesting question, Chelsea. That's probably what I would have said if you asked me five years ago, but I would say as I see sort of five big competitors for Domino's today. So you've got the big national multinational pizza chains that you would think of. You've got your Papa John's, you've got your Little Caesars, you've got Pizza Hut, but now increasingly you've got delivery aggregators like Uber Eats or DoorDash. They're competing in that category. And in an environment like we see today, we've actually got frozen pizza, grocery stores and stores that are competing pretty meaningfully. Walmart, for instance, saw a 29% year over year growth in frozen pizza sales during the first quarter of this year.

COULTER: Well, I know you sort of mentioned this earlier in all of your previous responses, but Uber and sort of the massive popularity around these sort of, marketplaces where people can access easily on their phones. And I know a partnership was announced between Domino's and UberEats just not too long ago, and it seemed like it was received positively by the market. So I kind of want to get your views on that partnership. And how do you see that changing or adding to it as it pertains to Domino's, their business?

SEAN: Yeah, it’s interesting. So, Domino’s obviously was one of the firms that held out for a really long time from these aggregator platforms. They wanted to be very cognizant of their customer experience. They wanted a Domino's employee to be the one delivering your pizza, sort of as you minimize the time between order and getting an order out the door and to your doorstep, because customer satisfaction in the space correlates very strongly with how hot pizza is when it arrives. Now we're sort of in this environment where the delivery aggregators have reached a reasonable degree of scale. They account for about 18-- well, delivery as a category is about 18% of total U.S. restaurant sales In terms of scope. Uber Eats now operates across 27 markets, which is roughly 70% of Domino's footprint. And then in terms of incrementality, you know, these are customers that are historically a little bit more affluent, a little bit less price sensitive. Domino's obviously is a company that competes a lot on price on perceived value. So it's not their typical, their historical customer base. And so finally, as these things sort of all came to fruition and as they're able to broker a little bit better of a data arrangement, an arrangement with Uber Eats, that's somewhat bespoke, it's a little bit custom in that they actually still fulfill the delivery for all of these orders. It's more like a think of it, more as a demand aggregator than a fulfillment model. Begin to look a lot more salient for them. Now, obviously the market liked it quite a bit. They've got it for quite a while. I do think for Domino's, that impact is going to be relatively muted for a couple of reasons. For starters, Domino's core customers a lot more interested in value for the money, and a lot of those offers are still going to sit in the firm's piece of the pie loyalty program. They're still going to sit in the firm's own website. So most of those compelling value offers are going to be available. on the marketplace. And then secondarily, Uber Eats only has about 20% to 25% market share among delivery aggregators in the U.S. So even if they're able to capture ten, 15, 20% share of pizza sales on Uber Eats, you're still only looking at maybe a 1 to 1 and a half percent bump to two Domino's comparable store sales. So it's interesting. It makes sense at this juncture, but I'm not sure it's going to be as financially material as the market thinks.

COULTER: Another thing that you mentioned, we referenced value and relative value. And you know, when you're going to feed a family of four or five, you know, pizza oftentimes can kinda provide that value if you're looking for that. So I think one of the questions that I have for you and it's been a topic that's had a lot of conversation over the last year or two is sort of inflation and rising cost. And we've seen commodity costs go up. We've seen labor costs go up.

COULTER: So how has Domino's and how has that been handled generally within the restaurant and the pizza industry? And does Domino's wide economic moat, does that provide them any sort of protection on the margin front or give them any sort of advantage, you know, compared to their peers?

SEAN: Yeah, no, it's a good question. It's been a really tricky environment for restaurants. So you've seen, as you look back to call it, February 2020, hourly labor costs are about 25% higher and commodity costs are about 25% higher. So even as these restaurants have been able to grow same store sales at a 6 to 7% annual clip, which is as best as good as we've seen ever over a three year period, you're still seeing margin contraction. You know, as you look across our restaurant coverage, restaurants are seeing margins at about 2.4% lower than they were pre-pandemic. Things are starting to ease a little bit. Don't look now, but cheese costs have come down a lot, wheat costs have come down a lot, obviously with a large degree of uncertainty. And so we're starting to see that recovery. The challenge for a firm like Domino's is that because they compete along the lines of value, because consumers are thinking about what you're getting for the price, it's a little bit more challenging for them to raise prices than what we've seen a Chipotle or what we've seen at a Starbucks. So in the long run, I think Domino's will have done well by raising prices below inflation and by continuing to drive transaction market share gains. But in the near term, that has driven restaurant margin contraction. That's driven a little bit of angst among franchisees and obviously among investors earlier this year, although that seems to have abated a little bit. We would think of the wide economic moat for Domino's as their ability to continue to drive traffic, comparable store sales growth and eventually recover that margin. But they are probably in a little bit more of a difficult spot than firms that are very price led.

COULTER: That makes sense. Are there any other beyond the rising price? And then perhaps you know how they handle that going forward? Are there any other potential headwinds that might be, you know, the front of mind for you and that investors should be thinking about today as well?

SEAN: Yeah, for a company like Domino's, its position in the United States is pretty, pretty well entrenched and the growth narrative there is solid but unspectacular. The big uncertainty for a lot of these global restaurant chains is how portable their concepts are going to prove. And a lot of the key foodservice markets abroad. So you think about the UK, you think about a growing market like India or growing market like China, where a decent amount of the firm's growth narrative is tied what they're able to continue to generate there. Obviously the consumer spend a larger portion of their total income on food and on dining out as they feel the pressure from inflation in nondiscretionary spending, like in housing and transportation and food cost in the grocery store, the way that they react might be a little bit different than in the United States. So for instance, in the UK, we see very strong negative comps for most restaurant chains. Even with the trade down effect. And that's something that investors should keep an eye on. But by and large, you know, Domino's system, the best unit economics, the best return for franchisees in our coverage. And we think that the narrative moving forward is pretty durable.

CHELSEA: Sean, Domino's is pretty forward looking in their pizza tracker tool. Have they launched any new tech experiences recently or have they mentioned any new tools related to AI or robotics?

SEAN: Yeah, it's a good question. They're always tinkering in that. And that's good because, you know, you have to take ten shots for one of them to come off. And in a lot of these cases, most recent actual product launch that they had was the ability to pinpoint delivery. So imagine that you're having a picnic here on the Chicago lakefront. You could just drop a pin and they deliver the pizza there, which is which is pretty interesting. But elsewhere there have been piloting things like drone delivery, like automated vehicles through partnership with Nuro, which is a low speed vehicle manufacturer. They've got a number of those projects burning in the background. So I guess we'll see what comes next.

CHELSEA: Well, we saved the best question for last. Do you have any favorite items on Domino's menu?

SEAN: Oh yeah, their fetta and spinach specialty pizzas is pretty fire. As a restaurant analyst, I... I try to do my best to order periodically from the companies that I cover to keep an eye on some of these trends. And that one’s pretty good. I will say, probably need to cover a few more restaurants like Sweetgreen and Cabo and a few less like Domino's and Papa John's.

COULTER: I can imagine the that the diet isn’t always the best thing when you're covering some of these companies in the fast food restaurant chain business. So…

COULTER: Yeah, got to exercise well.

CHELSEA: Coulter, what about you?

COULTER: Yeah, I was gonna say, I know, I know within my household, within the Regal household, the parmesan bread bites are always a fan favorite, so.

CHELSEA: I like This stuffed cheesy bread. For me, it's sort of tastes like it's like childhood a bit. But it's interesting that all of us didn't have a pizza as our favorite item on the menu.

SEAN: Yeah, well, hope they're listening in and they can adjust the menu accordingly.

COULTER: Well, great. I mean, I think it's been an interesting and perhaps even mouthwatering conversation for sure. So with that, I think it might be time to conclude and perhaps grab some lunch. Sean, thank you for sharing both your time and your insights here with us today. You know, we appreciate it .

SEAN: Thanks for getting me.

COULTER: And thank you to all of our viewers as well. See you next time on the Moat Show.

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