Domino’s Stock Should Come With a Buyer Beware Sign

The valuation on DPZ stock at $280 simply makes no sense

DPZ Stock Should Come With a Buyer Beware Sign

Source: Mike Mozart via Flickr

For the past several years, streaming giant Netflix (NASDAQ:NFLX) and pizza giant Domino’s (NYSE:DPZ) have rallied side by side as the at-home economy has grown in popularity. Put simply, consumers are staying home more often than they used to. That means more binge-watching Netflix shows and more binge-eating Domino’s pizzas, which are conveniently delivered.

But, the so-called “Netflix and Chew” growth narrative hit a road bump recently. A few days ago, Netflix reported its first quarterly subscriber miss in several quarters. NFLX stock plunged in response. A few days later, Domino’s reported slower-than-expected sales growth in its earnings report. DPZ stock took a leg down in response.

NFLX stock bounced back. Will DPZ stock do the same?

I’m not so sure. The “Netflix and Chew” narrative has been a strong one for several years. But, I think that narrative is coming to a close soon. The one thing that united NFLX and DPZ stock was the fact that Domino’s had perfected the delivery model. Thus, when consumers were sitting at home watching Netflix, Domino’s was the go-to food option.

Now, though, the fast-casual market has changed. Every restaurant has delivery capability thanks to delivery services like Postmates and UberEats. That is not good for DPZ stock, which is priced for perfection that almost assuredly won’t happen.

As such, DPZ stock looks due for more pain ahead.

Here’s a deeper look.

Domino’s Reports Slowing Growth

Domino’s second quarter numbers weren’t bad. They just weren’t up to par with historical standards.

Earnings topped expectations. Revenues missed expectations. Domestic comparable sales growth was 6.9%. That is slower than the year-ago quarter’s 9.5% comparable sales growth rate. It is also short of the 7.5% to 12% range that Domino’s domestic comparable sales growth has fallen in for the past several years.

Meanwhile, international comparable sales growth was 4.0%. That is below the consensus expectation for 5.3% comparable sales growth and just narrowly inside of the 3.4% to 7.8% range that Domino’s international comparable sales growth has fallen in for the past several years.

In other words, the international business is doing better than the domestic business. But, both businesses are slowing from their multiyear trends.

This makes sense to me. The single biggest headwind for DPZ today and going forward is the introduction of delivery services like Postmates and UberEats. In essence, these services mean that traditional fast-casual giants like McDonald’s (NYSE:MCD) and Jack in the Box (NASDAQ:JACK) now have delivery capability.

That is bad news for Domino’s.

Inevitably, this leveling of the delivery playing field will hurt DPZ stock. The popularity and reach of delivery services is only growing.

For example, GrubHub (NYSE:GRUB) just announced intentions to expand its delivery network in 17 states. As these delivery services grow in popularity and reach, DPZ’s competitive advantage in delivery will be eroded more meaningfully, and growth rates will come down.

Domino’s Stock Is Priced for Perfection

The big Domino’s growth slowdown is already happening to some degree. And it will continue to happen over the next several years.

Thus, when looking at management’s five-year model calling for 3-6% domestic comparable sales growth, 3-6% international comparable sales growth, and 8-12% global retail sales growth, it is safe to assume that growth will shake out in the low end of those ranges.

That implies 8% revenue growth over the next five years. Coupled with healthy margin expansion, that should lead to somewhere between 15-20% earnings growth.

That is healthy growth. But, it isn’t healthy enough to support DPZ stock’s 42x trailing earnings multiple. A 42x multiple on a 20% or lower earnings growth narrative seems too rich.

Indeed, I can’t really see DPZ stock being worth much more than $220 today. Best-case scenario, I see Domino’s earning profits of about $16 per share in five years. A growth-average 20x forward multiple on that implies a four-year forward price target of $320. Discounted back by 10% per year, that equates to a present-day value for DPZ stock of just under $220.

Bottom Line on DPZ Stock

DPZ stock has been propped up strong tailwinds in the delivery space. But, as delivery becomes more of the norm in the fast-casual space, that big delivery tailwind for Domino’s will moderate.

As this tailwind moderates, growth rates will come down, and the bottom will fall out on DPZ stock’s supercharged valuation. As such, don’t be surprised if this stock struggles in the back half of 2018 as low growth weighs on a big price tag.

As of this writing, Luke Lango was long MCD.

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