When thinking about successful restaurant businesses, names like Chipotle Mexican Grill and Starbucks probably immediately pop up on investors' minds. Both are consumer favorites that have been thriving for quite some time. And what has bolstered their competitive positioning in recent years is just how beautifully they have integrated technology into their operations.
But with a market capitalization that is about one-fourth of the Tex-Mex chain and one-tenth of the coffeehouse giant, Domino's Pizza(NYSE: DPZ) is an under-the-radar restaurant stock that investors might want to take a closer look at in 2023.
Adding digital toppings to pizza
Domino's instituted a now-celebrated turnaround plan more than a decade ago to address slumping sales that focused on improving the recipe for its pizzas, which was clearly the lowest-hanging fruit the leadership team could've focused on. Directly addressing the problem worked, as the business became the biggest pizza chain by systemwide revenue in the U.S. in 2017.
But the reality is that Domino's product still isn't really that much different than other major pizza chains, like Papa John's or Yum! Brands' Pizza Hut. In the quick-service restaurant (QSR) market, pizza is really just a commodity. This means that what Domino's actually sells is not dough with sauce and cheese, but accessibility and convenience.
Bolstered by digital investments made throughout the past several years, Domino's made it an incredibly easy and frictionless experience for its hungry customers to order pizza for either carry-out or delivery. The company lets consumers order in a variety of ways, even with emojis on Twitter. Domino's has its own self-driving delivery fleet, and it doesn't outsource delivery to third-party apps. And the business has lots of employees working in data and software functions. The result is an enterprise that has created a tasty recipe that mixes tech and pizza.
This digital strategy has worked extremely well, as revenue and diluted earnings per share (EPS) have skyrocketed at compound annual rates of 10% and 23%, respectively, between fiscal 2011 and fiscal 2021. And shares of Domino's are up 670% over the past 10 years, even after dropping 39% in 2022. Investors would've loved to take a big bite out of that opportunity if they could go back in time.
An expensive pie
Despite its historical success, Domino's has been dealing with a slowdown. In the most recent fiscal quarter (third quarter of 2022 ended Sept. 11), same-store sales in the U.S. were up just 2% year over year, with international same-store sales down 1.8% (on a constant-currency basis). What's more, higher costs have pressured margins, hurting profitability in the process.
Management has pointed to the current macro picture as reasons for Domino's challenges. They believe that the bounce-back of in-person dining has been hurting carry-out and delivery food businesses. Moreover, inflationary pressures can discourage customers from ordering meals for delivery, as this option comes with added fees and tips. Consequently, people might be more inclined to make food at home. These trends help to explain why the stock was down so much last year.
But there's little risk that Domino's will be able to endure the ongoing near-term challenges. The company generates lots of free cash flow, to the tune of $280 million during the first three quarters of fiscal 2022. Its footprint continues to expand, with 225 net new locations in the latest quarter. And the brand is still popular with consumers. "We delivered around one out of every three pizzas in the United States before the pandemic, and we deliver around one out of every three pieces today," said CEO Russell Weiner on the Q3 2022 earnings call.
This is a durable business that isn't going anywhere anytime soon. However, investors still might want to think twice before taking a bite out of this stock. As of this writing, shares trade at a price-to-earnings ratio of 29. While this is a slight discount to the trailing five- and 10-year average valuations, I don't think it makes Domino's a screaming buy right now.
According to Wall Street consensus estimates, the company is projected to increase revenue at a compound annual rate of 6.1%, with EPS rising at an average rate of 12.5%, between fiscal 2022 and fiscal 2026. To me, this doesn't justify paying for an elevated P/E of 29.
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Neil Patel has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Chipotle Mexican Grill, Domino's Pizza, and Starbucks. The Motley Fool recommends the following options: short April 2023 $100 calls on Starbucks. The Motley Fool has a disclosure policy.