Why Domino's Brightest Days are Ahead

Domino's Pizza  is a common name. But for those who are not familiar, Domino's is one of the world's largest pizza makers. Founded in Michigan in 1960, the company operates 10,566 pizza stores -- 4,939 stores in the U.S. and 5,627 stores internationally -- in over 70 countries worldwide. 

The pizza turnaround
Despite its status as the worldwide leader in number of pizza stores, Domino's had its struggles prior to 2010. Domino's food was considered "mass-produced" and akin to tasting cardboard; not what most restaurants are looking to hear from their customers. The stock also reflected Domino's lousy operations -- the stock was down nearly 10% between its 2004 IPO and February 2010. Domino's had thousands of stores around the world but a growing reputation of poor food, lackluster service, and bad marketing were killing its business.

In March 2010, J. Patrick Doyle, who has been with Domino's since 1997, was selected to serve as President and Chief Executive Officer. Doyle immediately began to lead the charge on addressing Domino's problems "head-on." In a project dubbed "The Pizza Turnaround," which began in 2009 with a $75 million marketing campaign, Domino's revamped its food offerings by adding more handmade pizzas, using fresher ingredients, and developing a new store design.

The new Domino's store design attempts to make the customer experience in Domino's more interactive and places focus on its handmade pizzas. Doyle explains that the new design is similar to the "old pizzeria tradition" by "putting these great handmade pizzas up front and center." 

Between 2008 and 2012 Domino's had the lowest American Customer Satisfaction Index or ASCI score, a flat 77%, when compared to other pizza competitors such as Papa John's Pizza , Little Caesars, and Yum! Brands' Pizza Hut. This year, however, Domino's has seen its customer satisfaction score increase 500 basis points to 82%. Today, Domino's score is on par with its primary competitors, meaning Domino's is now tied for the lead in customer satisfaction among pizza makers.

In other words, the Pizza Turnaround campaign is working. Doyle's leadership has played a major role in the turnaround within a relatively short period of time (all you marketing majors, take notes). This quick and significant shift in brand culture and perception, which is still in its infancy, makes me think Domino's brightest days are ahead.

What about the financials?
A brand recovery is great, but it doesn't mean much if it is not accompanied by earnings growth and cash flow generation. We know the brand image is improving under Doyle's leadership, but what do the numbers look like?

Domino's net income increased 9.33% in 2010, 16.6% in 2011, and 6.23% to $112.4 million in 2012. In the first three quarters of 2013, Domino's increased net income by 23.91% to $98.32 million compared to $74.81 million last year. Domino's profit margin has increased to 8% from 6.6% year over year. 

Since 2010 Domino's has added 1,215 new stores. It's heavily franchised -- only 3.69% of Domino's restaurants are company-owned -- compared to Papa John's, who owns 16.55% of its stores. This helps explain the 7.66% profit margin of Domino's versus the 4.8% profit margin of Papa John's. Franchising minimizes costs and boosts margins, especially in the short-term, but it also results in less accumulated revenue compared to company-owned stores.

In the third quarter, Domino's saw domestic same-store-sales increase at a 5.4% clip, versus 3.3% last year. This reaffirms that the Pizza Turnaround is beginning to have a noticeable impact on both customer satisfaction and sales growth. Domino's saw international same-store-sales increase 5% in the third quarter.

Domino's weakest point is its load of long-term debt, which currently stands at $1.52 billion. This is an especially hefty number considering Domino's has a measly $32 million in cash on its balance sheet. A high amount of debt does not spell automatic doom for Domino's, but it means there is extra pressure on the company to produce sufficient and expanding cash flow. 

In 2012, Domino's increased operating cash flow 13.19% to $176.32 million. So far in 2013, Domino's has managed to produce $84.29 million in free cash flow. It is worth noting that operating cash flow has only increased 3.18% to $104.58 million. Results from the upcoming fourth quarter will help us determine if Domino's is capable of continuing to mark solid increases in cash flow production, as it has managed to do over the past several years. Between 2010 and 2012 operating cash flow increased 25.5%.

Even so, Domino's is generating sufficient cash flow to settle short-term obligations. This year, in fact, Domino's has repurchased $76.89 million in common stock (at an average price of $59.34) and issued $23.22 million in dividends. 

My preference would be for management to use cash to pay down debt and reinvest in the business, but management is evidently intent on buying back shares and rewarding shareholders with a dividend. The fact that the company has been buying back stock in such heavy doses could signify that management is confident in the present value of the company when considering its long-term prospects.

It is important to note that we are only seeing the beginning of the Pizza Turnaround's success. With notable financial improvements simultaneously occurring with the Pizza Turnaround, Domino's represents a compelling opportunity for patient long-term investors. 

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The article Why Domino's Brightest Days are Ahead originally appeared on Fool.com.

Fool contributor David Kretzmann owns shares of Domino's Pizza. You can follow David on his Foolish discussion board, Pencils Palace, or on Twitter @David_Kretzmann. The Motley Fool owns shares of Papa John's International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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