Dominos Pizza Inc (DPZ) — Q2 2018 Earnings Call Transcript

Thank you, Emily, and hello, everyone. Thank you for joining the call today about the results of our second quarter. Today's call will be the first one featuring Ritch Allison, who became CEO officially on July 1. Ritch will be joined, as usual, by Chief Financial Officer, Jeff Lawrence. As you know, this call is primarily for our investor audience, so I kindly ask all members of the media and others to be in a listen-only mode. And in the unlikely event that any forward-looking statements are made, I refer you to the safe harbor statement you can find in this morning's release and the 8-K. We will start with prepared statements from CFO Jeff Lawrence, followed by CEO Ritch Allison, followed by analysts' questions. With that, I will turn it over to CFO, Jeff Lawrence.

Thank you, Tim, and good morning, everyone. In the second quarter, our positive global brand momentum continued as we once again delivered great results for our shareholders. We continue to lead the broader restaurant industry with 29 consecutive quarters of positive U.S. comparable sales and 98 consecutive quarters of positive international comps. We also continue to increase our store count at a healthy pace. Our diluted EPS, as adjusted, which excludes the impact of our recapitalization completed during the quarter, was $1.84, which is an increase of 39% over the prior year quarter. With that, let's take a closer look at the financial results for Q2. Global retail sales grew 12.6% in the quarter. When excluding the favorable impact of foreign currency, global retail sales grew by 11%. This global retail sales growth was driven by an increase in same-store sales and the average number of stores opened during the quarter. Same-store sales for our domestic division grew 6.9%, lapping a prior year increase of 9.5%. Same-store sales for our international division grew 4%, rolling a prior year increase of 2.6%. Breaking down the domestic comp, our U.S. franchise business was up 7% while our company-owned stores were up 5.1%. These comp increases were driven by higher order counts and also ticket growth, as consumers continue to respond positively to the overall brand experience we offer them. Our Piece of the Pie loyalty program also continues to contribute meaningfully to our comps. On the international front, all four of our geographic regions were again positive in the quarter, with our Americas and Asia-Pacific region leading the way, and our same-store sales performance for the quarter was driven entirely by higher order counts. On the unit count front, we are pleased to report that we opened 43 net domestic stores in the second quarter, consisting of 44 store openings and one closure. Our international division added 113 net new stores during Q2, comprised of 148 store openings and 35 closures. On a total company basis, we opened 156 net new stores in the second quarter and 905 net new stores over the last 12 months, clearly demonstrating the broad strength and outstanding four-wall economics our brand enjoys globally. Although we are generally pleased with our continued store growth, we recognized that our store growth internationally is slower than we expected for the first half of this year. We do not believe there is any structural or material market-specific reason for this net store growth result in the first half of the year, and we reiterate our global net store count guidance of 6% to 8% annual growth over the next 3 to 5 years. Turning to revenues. Total revenues were up $150.8 million or 24% from the prior year quarter. As a reminder, we adopted the new revenue recognition accounting standard in the first quarter of 2018. As a result, we are now required to report the franchise contributions to our not-for-profit advertising fund and the related expenses gross on our P&L. Although this did not have an impact on our reported operating or net income in the second quarter, it did result in an $80.9 million increase in our consolidated revenues. It is important to note, although these amounts are included in our financial statements, they are restricted funds that can only be used to support the Domino's brand and are not available to be used for general corporate purposes. The remaining $69.9 million increase in revenues resulted primarily from the following. First, higher supply chain center food volumes driven by strong U.S. retail sales resulted in higher supply chain revenues. Second, higher domestic same-store sales resulted in increased revenues at our company-owned stores as well as increased royalties and fees from our franchise stores. Store count growth also contributed to the increase in royalties and fees from our domestic franchise stores. And finally, higher international royalty revenues from higher retail sales as well as the positive impact of changes in foreign currency exchange rates. Currency exchange rates positively impacted international royalty revenues by $1.1 million versus the prior year quarter due to the dollar weakening against certain currencies. For the full fiscal year, we continue to estimate that the impact of foreign currency on royalty revenues could be flat to positive $4 million year-over-year. As you know, there are many uncontrollable factors that drive the underlying exchange rate, which does make that a harder part of our business to predict. Moving on to operating margin. As a percentage of revenues, consolidated operating margin for the quarter increased to 37.7% from 30.7% in the prior year quarter. This increase resulted entirely from the recognition of domestic franchise advertising revenues on our P&L from the new revenue recognition accounting guidance I mentioned previously. Supply chain operating margin was negatively pressured by delivery and labor cost, while company-owned store margins were positively impacted by lower insurance expenses and sales-based transaction fees as compared to the prior year quarter and were partially offset by higher food and labor costs. Let's now shift to G&A. G&A cost increased $6.5 million as compared to the prior year quarter, which is net of the expense reclassification for certain advertising costs we mentioned on the Q1 call. This net increase resulted primarily from our planned investments in technological initiatives, including e-commerce and the teams that support them. Please note that the company receives fees for technology from franchisees that are recorded separately as franchise revenues. Moving down the income statement. Domestic franchise advertising costs were $80.9 million in the second quarter. As a reminder, we are now showing domestic franchise advertising in our revenues with an equal and offsetting amount of expense in our operating costs. Interest expense increased $11.5 million in the second quarter, driven by increased net debt from our most recent recapitalizations. Our weighted average borrowing rate in the second quarter decreased to 4%. Our reported effective tax rate was 15.1% for the quarter. This was primarily due to the lower federal statutory rate of 21% resulting from federal tax reform legislation enacted at the end of 2017. The impact of tax benefits on equity-based compensation also resulted in a $6.9 million reduction in our second quarter provision for income taxes. This resulted in a 7.6 percentage point decrease in our effective tax rate. We continue to expect that our tax rate, excluding the impact of equity-based compensation, will be 22% to 24%. When you add it all up, our second quarter net income was up $11.7 million or 18% over the prior year quarter. Our second quarter diluted EPS, as reported, was $1.78 versus $1.32 last year, which was a 35% increase. Our second quarter diluted EPS as adjusted for the 2018 recapitalization transaction was $1.84 versus $1.32 last year, which was a 39% increase. Here is how that increase in diluted EPS as adjusted breaks down. Our lower effective tax rate positively impacted us by $0.23, including a $0.28 positive impact from tax reform and a $0.05 negative year-over-year impact related to lower tax benefits on equity-based compensation. Lower diluted share counts, primarily as a result of share repurchases, benefited us by $0.21. Higher net interest expense resulting primarily from a higher net debt balance negatively impacted us by $0.09. And most importantly, our improved operating results benefited us by $0.17. Now turning to our use of cash, including the use of proceeds from our recapitalization transaction. During the second quarter, we repurchased and retired approximately 906,000 shares for $219 million at an average purchase price of approximately $242 per share. Year-to-date, we repurchased and retired approximately 1.35 million shares for $320 million at an average purchase price of $236 per share. We also used cash to repay $490 million of our 2015 note in connection with our recapitalization and we returned $23.5 million to our shareholders in the form of a $0.55 per share quarterly dividend. We continue to invest heavily in technology and have also increased the level of investment for supply chain capacity, primarily for our new U.S. supply chain center scheduled to open later this year. Given our current outlook for the U.S. business, we are pulling forward additional supply chain capacity building investment into 2018. This includes work to begin building two additional U.S. supply chain centers, which we project will be completed over the next 18 to 24 months. As a result of this acceleration, we now estimate our gross capital spending for the full year 2018 to be approximately $115 million to $120 million, up from our previously communicated $90 million to $100 million range. All in all, our strong momentum continued, and we are very pleased with our results this quarter. And with that, I will turn it over to Ritch.

Thanks, Jeff, and good morning. I'm excited to be with you all on my first earnings call as CEO, and I am particularly pleased to be reporting a very good quarter as the momentum in our business continues to remain quite positive, thanks to our strong fundamentals and a steady, proven strategy. Before digging into the specifics around the quarter, there are two things I'd like to acknowledge. First, I'd like to pay one more respectful farewell to my predecessor, Patrick Doyle. It's a little odd for all of us on quarterly earnings day to look around the room and not see Patrick, but his legacy and contribution toward this wonderful organization will not be soon forgotten. For me personally, I am grateful for his influence and mentorship and my progression toward the honor of succeeding him. Thank you one more time, Patrick, for all you did to make this an outstanding business and a great place to work. Secondly, I want to express my gratitude and excitement to continue working even closer with our incredible group of franchisees. During my transition, I have heard from many of our international franchisees, with whom I have worked very closely over the last seven years. I have also really enjoyed getting to know many more of our U.S. franchisees. It is energizing to trade thoughts around how we can continue to maintain our incredibly strong alignment and our shared commitment to industry-leading store-level economics and cash-on-cash returns. During my seven years leading the international business, this was a top priority for me and it will continue to be going forward as we lead this business into its next phase. We placed major emphasis on ensuring our franchisees' success, and we promise to continue to listen, to be collaborative, and to remain as strong of a partner for you as any in the industry. Strong alignment and performance is a great segue into our discussion of the second quarter, one that was very solid across all areas. During the quarter, we officially surpassed the milestone of 15,000 stores worldwide and retail sales growth continued its tremendous momentum. I am particularly pleased with the performance of our U.S. business, led by outstanding same-store sales and yet another quarter of solid sustained momentum around unit growth. Industry-leading unit economics, a focused fortressing strategy, and a committed franchisee base once again contributed toward our balanced formula for growth in the U.S. The rapid growth of our U.S. business has driven record-level volumes in our supply chain centers. With volumes up more than 50% in just the last five years, it is time to accelerate our investments in supply chain capacity, both to serve current demand and to support our growth plans going forward. We are on track to open a new supply chain center in Edison, New Jersey later this year. We will also accelerate work in the second half of the year on two additional supply chain centers. In addition to these three new center projects, we are increasing our investment to enhance capacity in several existing centers. We will continue to invest in the growth of our business going forward and we'll provide specific CapEx guidance for 2019 in January. The international business had a good quarter with top-line comp performance within our 3- to 5-year outlook and positive results from all four regions. I continue to be pleased to see our same-store sales growth being driven solely by order growth. We have a collection of top-notch master franchisees who are continuing to learn from insights and global best practices, focusing on value and emphasizing the importance of growing transactions, prioritizing traffic over ticket, and avoiding the price take trend that we see taking place throughout most of the industry. As Jeff touched on, our international unit growth has admittedly been a bit slower than our historic norms during the front half of 2018, but I continue to stress my confidence and expectation that this will normalize on a full-year basis. Last month, we welcomed another new market into the Domino's family. Kosovo celebrated the grand opening of its first Domino's location in mid-June and set a new Domino's European record for opening week volume. We are excited to deliver hot, made-to-order pizzas helped by strong digital ordering capability to the people of Pristina. Domino's is truly a global brand and this was on full display during our biannual worldwide rally event held in Las Vegas just two months ago. We hosted nearly 9,000 Domino's franchisees, general managers, and team members from six continents and more than 70 countries. The interaction I was fortunate enough to have with our many global operators was truly inspiring. Our attendees learned and grew through connecting, networking, and best-practice sharing, reminding us all that we are truly a global system with so much in common, most notably our commitment to helping one another reach success. It was another forward-thinking quarter on the technology front as our Domino's Hotspot's ordering platform got officially up and running. We are very pleased with the launch and customer reception and most importantly, the participation and execution of our U.S. franchisees, store team members, and drivers in making this a successful start to a unique, collaborative, and clever digital platform. We now have over 200,000 Domino's HotSpots delivery locations available nationwide, and I hope customers will continue reaching out to suggest new potential locations and can do so by visiting dominos.com/suggestahotspot. We continue to demonstrate our ability to invest and innovate in a flexible manner to maintain our unquestioned digital leadership position within this category. Getting a lead is one thing, keeping it is another. And that demands an aggressive and nimble mindset around investments toward this area. Expect that to only continue going forward. In closing, it was an excellent second quarter. There's a reason that, in addition to being quite humble, I come into the position with utmost confidence in the continued potential for this business. I inherit an outstanding leadership team and smart, dedicated, motivated corporate team members here in Ann Arbor and throughout the world. The momentum around this brand and all that it has come to stand for has never been stronger in its nearly 60-year history, and I now have the opportunity to work even closer with the best group of franchisees in the restaurant business. We are incredibly committed to their success and we'll remain aligned, focused, and marching in unison toward our shared goal of dominant number one. Thanks again, and we will now open it up for questions.

First question, just you mentioned the loyalty program continues to be one of the largest tailwinds to your domestic comp. This is a program you launched, I think, in September 2015, so can you just help us understand what about this program almost three years later is still contributing so much to your growth trend? And I have a follow-up.

Yes. Brian, the program continues to gain active membership. We'll update you on those membership numbers again in January, as we did last January, but our program just continues to resonate with our customers, and we continue to see nice, solid tailwind from it.

And just my follow-up, maybe for Jeff. The international business, after a stretch of very steady margins here, you did see a pretty big decline this quarter and it looked like it was mostly because of G&A which went up a lot. Can you just unpack the drivers of the international margin this quarter and help us understand maybe how these dynamics unfold from here?

Yes. I mean, first thing is we had some FX settlements. Even though we were benefited on the top line during the quarter in royalty revenues from FX as it started to turn and people were paying their bills, that pressures us a bit on the G&A line for the international division. The other one, quite simply, is that we continue to invest in the capabilities of the team members that are in the field right now, partnering with our master franchisees to grow the brand. So again, other than that, you normally get some variability, a little higher, a little lower, but those are the two things that I'd point to for this quarter.

A quick one, really, on store level margins. From disclosures in the Q, it looks like labor costs are actually leveraged in the quarter, which is certainly a divergence from trend. Is there anything you would call out that was sort of onetime in nature about that? And is that going to pick up the decrease in insurance costs year-over-year or is that separate?

And you're speaking of the corporate stores, Karen?

Yes.

Yes. So corporate store labor for the quarter was actually up 0.5 points to 30% of sales, and primarily that's labor rates. Now partly a function of some minimum wage increases we've had in the business this year and partly because the economy is humming and some of our stores we're paying a little bit more to attract, retain great team members. We are doing a better job with efficiency with the labor hours that we have in the store and we're getting some leverage because ticket and sales continue to go up, but it was not enough to overcome the labor rate increase. And that's why you see that 50 basis point increase in corporate store labor this quarter over last year's quarter.

And then one of the things that came up on the call last quarter was starting to test fully automated phone order taking. Maybe just give us an update on sort of how that test is going and do you have any initial thoughts on when sort of earliest time to market?

Sure. Karen, we've got that automated phone ordering. We've done phone ordering in about 20 of our corporate stores that we're testing, and we are continuing to learn at a very rapid rate. I don't have any update for you right now on the timeline for a broader rollout, but the program is moving along at or better than our initial expectations.

First question is on the international unit growth. And I know you both expressed confidence that this would reaccelerate and I assume you have reasonably good visibility into that, but was there any one factor or region that would have driven that slowdown? I mean you're in 70 countries, so it's a little bit surprising that they would all slow down at once.

Yes. Matt, it's Ritch. Yes, it's interesting, no real single market or region driving the near-term slowdown. We have had, over the course of the last year, we've had some leadership changes in a number of markets. And frankly, some markets just absorbing what was a record amount of growth across 2016, 2017. I mean, if you think about it, we opened more than 1,900 net new international stores during that 2-year period. So sometimes, markets just need a little time to absorb the impact it did have on the people and their organization. But as we take a look forward, our confidence is really grounded in the fact that we still have very strong unit-level economics across these markets, and that is ultimately what drives store growth over time. So we feel good about that and we also have some visibility into the store pipeline through signed leases and things like that. So when we take a look at it, still very confident in the 6% to 8% global net unit growth that we have put out there as our guidance for the 3- to 5-year horizon.

On the company-owned margin side, was the decrease you noticed in food related to actual food price inflation, or was it more about labor and the supply chain? Also, what was the overall change in the commodity basket?

For corporate stores, it was mostly up due to the prices that the supply chain centers are charging the stores, and there were various fluctuations with commodities going up, down, and sideways. Overall, it was up, though not significantly, with the basket increasing by around 4% quarter-over-quarter.

I have two questions. The first is that the story for Domino's in the pizza category over the past several years has been the big three or four taking share from everybody else. But recently, it seems like Domino's has taken share from the big four players. Does that increase the urgency to maybe pull forward or accelerate unit growth from here? And then my other question is just on CapEx. And I know you guys don't want to guide next year, but any early read just on if there's new material step up around supply chain investments or not? I'm sure you guys have a read into how much more you need to add to the supply chain next year and just directionally kind of where we should expect that number to go.

Greg, first on share, we see an opportunity, as we've communicated in the U.S. business, we see an opportunity for an 8,000-store Domino's business potential within the next 10 years. We've had success gaining share. And while a lot of that share has come from the locals and the regionals, as we look forward, we see an opportunity to take share broadly across the industry, and that confidence leads to our expectation that we've got strong unit growth potential in the market.

And then, this is Jeff. On the CapEx question, we're going to update our 2019 figures in January. We'll base our information on that. However, I can tell you that the costs for building the second and third centers after New Jersey will be significantly lower than the New Jersey build. We'll provide specific numbers about that when we share our 2019 guidance. This year, we're just getting started, but we'll have more details in January, so you'll have a good reason to attend our Investor Day.

Just a quick question on domestic comps. Last quarter, you talked about the strength of delivery and that growth rate actually outpacing carryout. So I'm curious what those two growth rates may look like if you could speak directionally to that this quarter here in the U.S.

Yes. We're not going to speak specifically to the composition of growth across delivery and carryout, but both were growing during the quarter. We emphasize delivery last quarter, just given the discussion that we had been having around aggregators. But don't expect going, forward, that we'll break that comp down across delivery and carryout.

Fair enough. And Ritch, just given you've been focused on the international business for a while now. And now thinking about things, obviously, much more broadly, is there anything in the U.S. that strikes you as either an opportunity or even where we might see you focus a little bit more intently than we've already seen in the past? And I don't know, supply chain might be the answer or if there could be something else.

Yes. A couple of things there. One is that the strategy that we are now pushing forward in the U.S. around fortressing is actually something that a number of our international markets had been doing for some time. So there was some learnings that came out of our ability to carve out territories from existing stores and drive overall retail sales growth in the U.S. market that respond out of the efforts of some of our high-performing international master franchisees. A second area, and it relates to some of the supply chain investments that we're talking about, it has been a number of years since we opened a new supply chain center in the U.S. And as we move forward in building out with that additional capacity, we're taking a lot of the learnings that we've gained over the last decade in the international business as we built dozens of supply chain centers, employing some more advanced production techniques and technology in those centers. So we'll continue to look for opportunities to transfer learnings and best practices back and forth between our U.S. and our international businesses.

First, regarding the domestic business, could you discuss the acceptance of the HotSpots? Has there been an immediate uptake, or is it more of a novelty that people will adapt to over time? Additionally, how do you ensure that it doesn't affect the speed of service? You can envision a situation where drivers are searching for someone, which could take longer. How do you address this to prevent that from happening?

We cannot provide much insight on the uptake of HotSpots since it is primarily a Q3 initiative. We have been rolling it out over the past month. Generally speaking, we view HotSpots in a similar way to our AnyWare platforms. It offers our customers another option to access our services anytime and anywhere. Regarding the speed of service, HotSpots are located within the delivery areas defined by our franchisees. Customers can request them, but it is the franchisees who select the delivery areas. These locations are often well-known landmarks, which tend to be easier to locate than a residential address, such as a beach, baseball field, or park, making them familiar within the community.

Got it. That's helpful. And then just another on the domestic comps. So one is that the gap between domestic company-operated and franchise, again, continues to favor franchise the last couple of quarters maybe the simplest comparisons, but is there any other element in there? And maybe in answering the question, has fortressing accelerated, for example, in company-operated markets prior or ahead of franchise markets? Or maybe you could just talk about where you are in fortressing markets generally in the U.S. right now.

Yes. So John, it's a good question. And yes, when we look at our corporate store growth in the U.S., basically, all of the stores that we're opening in our corporate store business are splitting territories, so there is a bit more of downward pressure on the comp from those splits. But consistent with what we've been talking about, the strategy is really around growing retail sales within that footprint and expanding the sales for households in each of those territories. So when we take a look at those openings, we're not only looking at the sales and economics potential of the new store that we're opening, but also looking broadly across the market and trying to drive sales and profitability at that level.

A couple of questions. First, on the domestic business. If I look at the domestic franchise revenue growth, it was quite a bit below the system sales or retail sales growth this quarter. So I know you had an accounting change, maybe that was part of it, but can you talk about why the franchise revenues lag the retail sales growth this quarter?

Yes. David, this is Jeff. I think it's a couple of things. The comp flow-through in the technology revenues that we get track the way we would normally expect it, but there were a couple of things that might be mucking up your model a little bit. One is a reclassification of some technology fees out of domestic into international. That might be doing it. And the other thing that we disclosed in the quarterly report we filed this morning is a reclassification out of franchise revenues into the advertising fund revenue line item. So those two things taken together, my guess is, will make up most of your difference there.

And Jeff, was that reclassification a catch-up adjustment from previous quarters or was it entirely related to this quarter?

It was related to this quarter. But when you compare it to last year at this time, you'll get a little bit of wonkiness there.

I wanted to revisit the supply chain investment for a moment. Jeff, what has shifted in your perspective on the supply chain that prompted you to be more proactive in advancing the investment this year? What has changed since the Investor Day in January that makes you want to take a more aggressive approach to the investment?

Yes. I mean the first thing is our U.S. operators in the field and our marketing and technology teams just continue to put up amazing growth. And when we look at what capacity we need to keep up with that growth, but also to hopefully continue the acceleration and unit count growth in the U.S. business. These are centers we knew we were going to have to build, probably over time. But as we did almost 12%, 11%, 12% retail sales growth again in the second quarter for the U.S. business and most of that again is volume and traffic-driven, it simply accelerates what we knew we had to do already. Again, we're just going to get these things going. They have a long lead time, 18 to 24 months is what I said in the prepared remarks. But we view this as a front-footed, a smart investment, kind of a good CapEx problem, and we're going to get great, fresh, high-quality dough out to our stores that we have today, but also make sure we can get the capacity for the stores we're going to open up over the next one to five years. That's really important to us. We're excited to make these investments, and more importantly, our franchisees are excited that we're making these investments.

Peter, I'll give you just a little bit more color as well in addition to what Jeff just said. If you look back over the last five years, the volume that is running through our existing supply chain center network in the U.S. is up more than 50%. So the team there has done a great job of absorbing what is a phenomenal increase in demand within the existing footprint, but we are now at a point where you start to get inefficiencies and diseconomies of scale in some of these centers when you get capacity up past a certain point. So we're both trying to absorb some of the demand that we've already driven, create a little bit of model preparing ourselves, as Jeff said, for the future growth in our business going forward. It's also, at this point in time, with the after-tax return on our investments, it's better this year than it was last year, so it gives us another opportunity to continue to invest.

Great. I have one more question. I know you have been focusing more on the carryout business. Given that you've been more creative and focused on this in the first half of the year, what does the data show regarding the carryout business compared to the delivery businesses? Is carryout still a distinct occasion from delivery customers? Are you still seeing unique guests for carryout, or are you noticing more crossover from delivery customers to the carryout business?

We still view them as two distinct occasions with some overlap, which is why we consistently market to both. Throughout the year, our ads are running on TV, featuring messages aimed at the delivery segment and others focused on carryout. As we noted in January, this important insight has bolstered our confidence in our fortressing strategy. The new stores we open allow us to reach carryout customers that were previously inaccessible, as carryout customers generally won't travel as far for a pizza as we do to deliver.

I just had a couple of follow-ups. One was on the domestic fortressing strategy. Ritch, how many stores opening this year are part of that strategy, and is there a geographic region of the country where the strategy is focused? It would seem like targeting markets where competitors were weaker would make sense.

Yes, we are continuing to increase the number of units that are opening. Regarding our distribution across various regions in the U.S., I believe that over the last two years, we opened just under 300 units in split territories. This sometimes means dividing one store's territory in half, or reallocating areas from several stores to form a new trading zone for a new store. We evaluate this on a market-by-market basis, running our models to assess the potential incremental sales from the new store and how it will impact the existing stores.

Two questions. First, Ritch, regarding the international business, you've mentioned that all four regions are performing positively. Looking back over the past few years, we have seen strong comparable sales growth. However, in the last six or seven quarters, your performance appears to be within the long-term guidance range or slightly below it, in contrast to the previous 12 quarters where you consistently exceeded the high end of your 3% to 6% long-term guidance. Are we now experiencing a new steady state where most of your key markets have matured, making the long-term guidance more fitting, or are there structural changes occurring that might be influencing this? You mentioned that no markets are significantly deviating from your comparable sales, but I’d like to hear your thoughts on whether the 3% to 6% growth rate is likely to be maintained compared to the previous period of strong growth.

Yes, Jeff, as we look ahead, the range of 3% to 6% is what you should keep in mind. We've experienced a significant increase in unit growth in our international business over the last seven years. Similar to our U.S. business, many of our new store openings, especially in mature markets, have been splits or carve outs from existing store territories. This does apply some downward pressure on overall same-store sales comparisons, but we pursue this strategy to drive retail sales growth. In the second quarter, despite the impact of foreign currency, we achieved 10.6% retail sales growth in our international business, which is at the upper end of our long-term range. Therefore, that’s how you should perceive it. There are various business dynamics at play, including some countries where we are still relatively underpenetrated, while growth in more mature markets will primarily come from these carve outs.

Got it. And then my follow-up, also, just on the international front. I'm just wondering, in your new seat, whether there's anything you consider doing differently as you think about international. I know in the past it often came up a lot about the royalty rate and how to determine country by country. I'm just wondering, how often is that rate reviewed or is there options for negotiation? Obviously, the international franchisees are doing so well, or which ever considered taking an equity stake in any of these businesses, or should we just assume kind of steady as she goes?

Yes. Jeff, we don't have any near-term plans to make changes in strategy for that business. We feel good about the way it is structured today. The master franchise business model is a model that we still believe is the right way to grow the Domino's Pizza business.

I have a couple of follow-up questions. Regarding the supply chain investments, I'm trying to understand the impact on margins. Are you indicating that this will immediately benefit margins by improving capacity and efficiency at your plants? Or will there be a delay before these improvements in capacity utilization translate into better supply chain margins, potentially benefiting us in the future?

Yes, great question, Matt. We aren't currently providing specific guidance on margins for any of our businesses, including the supply chain. However, I can share that the opening of the New Jersey Center involves significant expenses due to increased capacity. The second and third centers will require considerably less capital expenditure than the New Jersey Center, but they still represent a substantial investment. We aim to leverage these new centers and some new technologies to enhance our transportation capabilities by being closer to customers in these locations. Our goal is to offset the costs associated with building these centers. In terms of operating margin, we're currently at around 11 percent, with 10.7 percent reported this quarter. I don't anticipate it reaching 15 percent or dropping to 7 percent, so I expect it will remain within a reasonable range for the industry. Ultimately, we must build this capacity to ensure we can deliver fresh products to our existing stores and those we plan to open in the future.

That's a good problem to have, though. So I guess if you're looking at the franchise perspective, are their margins going to get better and potentially from some new capacity that you're bringing on or new abilities that your capabilities are doing at these facilities?

Yes. One of the advantages of having strong franchise relationships is that we share in the investment and profitability of our supply chain centers in the U.S. and Canada. This creates a true partnership from which we both benefit significantly. In terms of franchisee profitability in the U.S., 2017 marked a record high, which supports the growth of these units. No matter the challenges we face regarding food, labor, insurance, rent, or any other capacity-related issues, we need to grow to overcome any potential financial challenges. We have successfully done this for an extended period, and our franchisees understand that. We are committed to growing together, presenting a significant opportunity for us. As we stated, we are a leading player in the U.S. pizza industry, and there is much more opportunity ahead, which we will pursue alongside our franchise partners.

Okay. Did the World Cup have any impact on the international side of the business in terms of same-store sales or development? How should we view that impact since it didn't occur last year?

So World Cup, for us, was a Q3 event, so we won't comment any on sales impact from that on this call.

Would it be correct to assume it's a positive, historically?

We're not going to touch on it.

I believe most of my questions have been covered. I would like to revisit HotSpots. It’s still quite early, as you mentioned, Ritch, and I see it more as a Q3 platform. What insights do you have so far regarding whether those orders are cannibalizing existing sales or if they are entirely incremental? Any early details you can share would be appreciated.

Yes, it is still too early for any quantitative measures. As we discussed, it's mostly a Q3 event. However, having 200,000 of these set up already indicates strong consumer interest and the fact that our franchisees have really embraced it. We are excited about how it fits into the AnyWare platforms. Our main message is that we want to be the pizza provider for our customers anytime and anywhere they want to access us.

Makes sense. And then just one quick follow-up on HotSpots. I mean, is there an opportunity to expand the delivery territory? If a franchisee, obviously, can move out into a territory that isn't covered by another Domino's franchisee, is there the ability to do that set up HotSpots outside of their actual delivery area?

We're really focused on these HotSpots within our current delivery areas, and here's why. Venturing outside these areas might seem appealing because it could bring in additional orders, but delivering pizzas farther from the store poses challenges. In fact, we are moving in the opposite direction by tightening our delivery territories over time. When we talk about fortressing, it means we are reducing the size of our delivery areas to better tap into the carryout business in new locations. Additionally, by having tighter delivery areas, we can deliver food to customers more quickly, encouraging repeat business and reducing the delivery costs associated with each order, which ultimately makes those delivery orders more profitable.

At this point, I think a couple short ones. Firstly, there was a slight uptick in international closures in the second quarter and I think there was in the first quarter as well. Is there anything you need to think about the rate of international closures? I mean is it just modernization of the system? You see better locations elsewhere like you saw in the U.S. a decade or two ago or is that happening in specific markets?

Yes. We're not particularly worried about any structural issues. Although there has been a slight increase in closures compared to historical data for an individual quarter, when we look at the trailing 12-month run rate and consider future projections, we don't identify any significant structural problems. Over time, markets may close some locations as trading areas evolve and new opportunities arise, but there is nothing noteworthy related to specific markets or trends that I would emphasize.

Okay. And then, secondly, you touched on market rates kind of driving up your own labor cost. But the question was around availability, specifically around delivery drivers. I mean, whether in the U.S. or a market like the U.K., are you seeing any acute pockets of demand for your drivers where you feel execution has been affected? In other words, do you think the current employment market may actually be constraining your ability to execute to some extent?

John, we certainly have open positions across the U.S. and in many markets around the world with the growth of our business, but not at a level that has constrained our growth or caused any major service deficiencies. With unemployment at the current levels in the U.S. and some international markets, it is a very competitive labor market, just as it is a competitive market at the customer level as well.

Just on the theme of fortressing your markets. Can you talk a bit about the value proposition? It seemed that the context or the promotional levels that we're seeing from Domino's and your top branded competitor in contrast with the rising menu prices from independent pizza players. I asked this question in the context that the last two years we haven't really seen much consolidation of the market, at least on the delivery side. It seems like most of your market share has come from the other big two. Are we seeing a change this year and are you seeing more value-driven or price-driven transactions?

We have consistently focused on providing value over time. We are now in our ninth year at the $5.99 price point, which has become closely associated with Domino's in the minds of many customers. We are maintaining our emphasis on this for delivery while also offering a competitive value on the carryout side, specifically the $7.99 large, three-topping pizza. We are actively pursuing market share in both areas. Regarding our strategy of fortressing, it is crucial for both business segments. The carryout business tends to grow when we open new stores. To stay competitive at the $5.99 delivery price, we must continue to improve our efficiency. By tightening delivery territories, we can operate a more efficient and cost-effective business model while still delivering great value to our customers.

Got it. Just a quick follow-up. We've seen a bit of a drop in your core commodity cost. Do you expect that to impact the spot chain restaurant margins or do you plan to reinvest?

For the store level food basket, we were actually up in the quarter. For our franchise and our corporate-owned stores, food is down a little bit. And supply chain, as a result of procurement savings just benefiting from the scale that we have, certainly, as a number one player, that's getting better, not worse. But we've given guidance this year of the 2% to the 4% for the basket going up and we're not changing that.

I have two follow-up questions. First, you mentioned the importance of being competitive and providing value. One of your major competitors appears to be facing difficulties, so I anticipated that you might experience an increase in market share. While a 7% comparable sales growth is commendable, I expected there might be more opportunity to capture market share. Are there other competitors also focusing on value, which may be affecting the traffic distribution? My second follow-up pertains to the supply chain.

I won't comment on what our competitors are doing in the marketplace. Our primary focus will remain on providing value for our customers and ensuring that we deliver strong unit level economics for our franchisees. The market share will settle where it does over time. If we manage the aspects within our control effectively, I believe we will continue to capture market share across the industry.

Okay. And then just on the supply chain, I guess, philosophically, it seems like owning the supply chain is sort of sacrosanct. But not every franchise business owns their supply chain, in fact, it's more of the minority and it does have a dampening impact on operating margins and returns. So I guess I was wondering if there's an opportunity or if you have ever considered outsourcing it. Other big systems seem to be able to control quality and consistency across the franchise base without necessarily owning it from the supply chain.

Yes. Sara, when we think about it, really, the core of our product offering is that fresh dough that we produce ourselves with our proprietary formula and that we distribute out to our stores. And there are certainly capital implications to doing that. We are going to have to invest to continue to expand that network, but we feel so strongly about the quality of our product and in controlling the quality of that product that we're going to produce that dough ourselves. And I'll also tell you that I think one of the key elements of the value proposition to our franchisees is the very high level of service that they get from an integrated supply chain where we bring that fresh dough and the other products and materials that they need to their stores increasingly three times a week for most of them. So it's a great service for our franchisees in addition to being a key part of the customer value proposition. And then, of course, finally, the great thing about it is it does deliver a significant level of profitability to the business.

Just first on international same-store sales. The number now trending more within your long-term guidance and I believe you said earlier it was driven by order growth. I'm just looking back historically, you are outside of that 3% to 6% long-term range. I'm just curious to know what the composition of the comp growth has been, perhaps, now relative to the past. Meaning, order growth versus ticket growth and how that's evolved.

John, it can ebb and flow some over time. In the first half of last year, it was more driven by ticket than it was orders. This year driven, we're very happy to say exclusively, by order count growth. Over time, what we look for in the business, and this is no different in our U.S. business, we look to drive the majority of our same-store sales gains over time through order count growth. That is the only sustained way to grow the business, over time, is through transaction growth. There are times when brands will grow their same-store sales through pricing increases and that can sometimes work in the short term, but rarely works over the long term in terms of being able to sustain the growth in the business. When you look back at 98 consecutive quarters of positive same-store sales gains, we would not have been able to do that in the international business without driving significant order count or transaction growth over time.

And I know you're pleased with store level returns in the international markets, but has that come under a bit of pressure with perhaps a shift in that comp growth more towards the traffic and away from the ticket?

No. We still feel very good about where we are on cash-on-cash returns at the store level in our international markets. Again, things will ebb and flow over time in individual markets, but we've been pretty strong and steady there when you take a look at it across the board.

From Maxim Group. I don't want to beat the international piece of the business to death, but as I recall about one year ago, there were some concerns about the rise of third-party aggregators. There hasn't been as much talk about it now. But since we were lapping that, and maybe the lap hasn't been as much as had been suggested, can you tell me if there's been anything that you're seeing outside the U.S. that maybe there's a new competitor or maybe one of those competitors is gaining momentum in these markets. Can you flesh some insight into that?

Steve, we don't have anything new to add beyond what we've previously discussed. We haven't observed any significant new entrants in that market, nor have we seen any substantial evidence suggesting that the business's economics have changed.

Well, thanks, everyone. We look forward to discussing our third quarter 2018 results with you on Tuesday, October 16.