Insights

Domino’s Has Unappetizing News for Investors

Investors had low expectations heading into Domino’s (NYSE: DPZ) second-quarter earnings report. But the pizza delivery leader still announced some surprises that show mounting challenges for its business.

Sales are still declining in the core U.S. market and are now falling in the international division as well. These drops imply a tougher competitive environment and struggles in passing along sharply rising prices.

The pizza giant’s growth thesis isn’t broken. Domino’s is aggressively expanding its store footprint, for example, and still boasts some of the highest cash returns for franchisees in the industry. But this latest report points to a difficult few quarters ahead for the business.

Sales trends

Comparable-store sales fell for the second straight quarter in the U.S. segment. That result was slightly worse than expected and marked just the third time in the past decade that the pizza chain failed to boost year-over-year sales in its home geography.

Management highlighted inflation and financial stimulus payments in the year-ago period as key factors contributing to the slump. Labor shortages also played a big role, with Domino’s struggling to find enough delivery drivers even as wages increased. A dramatic 15% spike in input costs also made it harder for the chain to keep prices down.

“Our results,” CEO Russel Weiner said in a press release, “faced challenges consist to those I outlined back in April.”

Weaker earnings

Domino’s did what it could to support profit margins in a tough selling environment. It charged franchisees more for key inputs like dough and cheese, and the chain slashed administrative expenses. It also raised average prices across most of the menu.

Yet operating profit still fell to $343 million, or 16.5% of sales, compared to $377 million, or 18.7% of sales, a year ago. Net income declined to 9.3% of sales from 11.6%, too.

Cash flow remained in solidly positive territory, reflecting the chain’s usually efficient operations. Its focus on take-out and delivery options keeps maintenance and labor costs low and allows Domino’s to open many locations in a given metropolitan area without hurting sales or profits for the region.

Still, annual free cash flow trends have been declining since peaking in late 2021. That trend continued in Q2 as the business faced new cost pressures.

Looking ahead

The growth comparisons will continue to ease through late 2022, which means Domino’s will likely return to comparable-store sales growth in both the U.S. and international segments.

On the other hand, cost pressures aren’t easing, and management now believes prices will have to increase 13% to 15% for the inputs it supplies to franchisees, up from the prior forecast of around 10% to 12%. Domino’s also lifted its estimate of the financial drag from currency exchange rate swings.

The chain isn’t pulling back on key investments, including plans to open more stores as it moves toward 20,000 global locations. It has added 1,200 new restaurants in the past full year, with about 200 of those locations arriving in the mature U.S. market.

It’s unclear yet to what extent the sales declines in that geography reflect a loss of competitive edge as rivals pour into the home delivery space. Until investors have more answers on that point, the fast-food stock might continue to underperform the wider market.

Demitri Kalogeropoulos has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Domino’s Pizza. The Motley Fool has a disclosure policy.

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