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Dominos Pizza Competitive Advantage

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Finding a company with Durable Competitive Advantage: Domino´s Pizza Group plc Value Investing. Autumn 2013

Author: Jero R. Marin. September 2013 Introduction Domino´s Pizza Group PLC (DPG) is the UK and Ireland's leading pizza delivery company and holds the master franchise to own, operate and franchise Domino's Pizza stores in these markets and also in Germany and Switzerland. It is a company based in UK and it is totally independent from the US Domino´s Pizza Corp with which it just holds an agreement to use the Domino´s brand name. With a Gross profit margin of 36.6%, a Sales compounded average growth rate in the last 5 years of 15.9%, and a Return on Equity of 48.6% it is worth a thoughtful analysis to determine

Finding a company with Durable Competitive Advantage: Domino´s Pizza Group plc

whether this company has really a sustainable competitive advantage. The stock performance in recent years has been spectacular after going from 200p in 2009 to 600p at last close:

1. Screening Process and Competitive Advantage “signals” Using a financial database we have first determined what parameters should be entered to screen candidates that may have a durable competitive advantage. We have decided that, in terms of financial parameters, a mix of revenue and profit margin growth along with a high Return of Equity could make a good starting point. These are the parameters used for the screener (see ex.1 for details and number of active companies that match each criteria): 1. 2. 3. 4. 5. 6. 7. Market cap >= 500 million USD EPS yearly Compounded growth Rate (past 5 years) >= 12% Sales yearly Compounded growth Rate (past 5 years) >= 10% LTG_CM >=15% ROE 5years average >= 20% ROA 5years average >= 8% Gross Margin yearly compounded growth Rate (past 5 years) >= 10%

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Finding a company with Durable Competitive Advantage: Domino´s Pizza Group plc

Parameter 2 secure that we filter companies that are growing in sales (which is a parameter that is difficult to distort by accounting policies) but at the same time parameters 3 and 7 corroborate that this growth is not at the expense of squeezing margins. Parameter 4 includes the consensus Long Term growth rate to filter at a first attempt those companies which are in industries that are growing but are not expected to keep the pace of growth. Parameters 5 and 6 forces the screener to filter those companies which are growing but over a reasonable asset base and not on top on excessive investments or by borrowing massively. In summary I understand that this mix of parameters are a good quantitative estimation of what a competitive advantage should be based on. 2. Screening results The screener has shown 14 European companies that matched all the parameters (see Ex.2 for full disclosure). The next step I´ve taken has been: identify those companies with a business model I think I can understand. It would be impossible to assess the existence of a durable competitive advantage if we are out of our “circle of competence”, which is defined by the type of business models that we , from our expertise, are able to understand from a “five forces” framework. In this sense, Dominos Pizza Group PLC is a company with a business model understandable by this analyst. 3. Quantitative evidence of Sustainable Competitive Advantage 1. Rates of growth in sales, gross profit margin and ROE. In Ex.3 it is quite clear that DPG has been able to grow in sales and profit margins and maintain a high ROE: a. From these growth rates in sales and profit margins we can deduct that the company has been able to identify a market niche (see industry map in Ex. 6) and capture not only a significant part of the growth of this market but also the fact the it´s increasing profit margins means that it is having a significant pricing power over this market. b. A high ROE with a reasonable high ROA means that the company is achieving this growth with an efficient use of the capital employed. 2. Increasing market share relative to the whole Quick Service Restaurants and Restaurants & Bar sector in the UK during the last 3 years. As shown in Ex. 4, has been growing relatively more than the market size, so although still very low, its market share of the whole low serviced restaurant industry has grown.

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Finding a company with Durable Competitive Advantage: Domino´s Pizza Group plc

4. Sources of Competitive Advantage This appears to be a high growth segment (see Ex.6 for an industry map), Pizza Restaurants, in which Domino´s and Pizza Hut , the two main player (see Ex.7) are positioned somehow differently. Domino´s pizza has a profile more in the “Delivery pizza” sub-segment and Pizza Hut is more focused on the Pizza Restaurant sub-segment. It seems that the competitive position they are enjoying is based in a high capacity to capture their share of growth in this market AND also they appear to gain an advantage over potential entrants and small operators. Therefore it seems reasonable clear that the main sources of Competitive Advantage are: 1. Economies of Scale: As the number of franchises growth, many fixed costs are spread over a higher revenue base so this might be one of the reasons for the expanding profit margins. 2. Network Effect: As more franchises are open, as Pizza is often consumed in multiple social events, more people are introduced to the product and the more barriers of entry are created. 3. Brand: Domino´s Pizza is already in the market for more than 40 years so it has built a brand easily recognizable and trustworthy for customers and not less importantly: to potential franchisees. 4. Efficiency: The company, over the years, has developed a very well engineered, refined and documented set of procedures that lead to a high level of efficiency in their operations. Is the company going to be able to maintain its competitive advantage? The sources appear quite strong. In my view, a good framework to assess the sustainability of a competitive advantage can be built on this question: would a competitor with free access to capital to invest, at a very low interest rate, erode the market share of Domino´s Pizza? Let´s study some scenarios : 1. Opening as many Pizza stores as Domino: First, this business requires local knowledge of the areas where every franchise is open so despite having capital to open tomorrow the same number of stores as Domino´s it wouldn´t work. So, the process of finding adequate franchisees would take much longer.
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Finding a company with Durable Competitive Advantage: Domino´s Pizza Group plc

2. Creating a brand: it would require a huge investment but anyway until gaining economies of scale (point 1) the profit margins would be very low. 3. Efficiency: Efficiency alone would not be able to facilitate an adequate level of profit margin in a reasonable time horizon to justify staying in this market unless the competitor or entrant could gain economies of scale and brand recognition. Moreover, Dominos , after 40 years may have obtained a extremely high level of efficiency already. 5. Conclusion I believe it´s quite clear Domino´s has a sustainable competitive advantage, firstly reflected in its high rates of growth in sales and profit margins while maintaining a high level of ROE and ROA. It´s strategy is well positioned within the sub-segment of Pizza Restaurants in the market of Lower Serviced Restaurants. The sources appear well embedded in the economies of scale, brand image and efficiency that does not appear to be easy to erode so I think could be sustained or even amplified in time for quite a long period.

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Finding a company with Durable Competitive Advantage: Domino´s Pizza Group plc

Ex. 1 Parameters in screener

Value Investing

Finding a company with Durable Competitive Advantage: Domino´s Pizza Group plc

Ex. 2 Screener Results (Filter applied for Only European Companies) Market Ratios

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Finding a company with Durable Competitive Advantage: Domino´s Pizza Group plc

Fundamental Ratios

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Finding a company with Durable Competitive Advantage: Domino´s Pizza Group plc

Ex. 3. Summary of most significant lines of growth and profitability

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Finding a company with Durable Competitive Advantage: Domino´s Pizza Group plc

Ex. 4. Estimation of Market size of Low Serviced Restaurants and Market Share for Domino´s Pizza Group Plc in the UK* (International companies with presence in the UK accounted for the revenues produced in UK only)

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Finding a company with Durable Competitive Advantage: Domino´s Pizza Group plc

Ex.5 Profitability of firms within the industry

Value Investing

Finding a company with Durable Competitive Advantage: Domino´s Pizza Group plc

Ex. 6. Industry map

Ex. 7

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