Dominos Pizza Inc (DPZ) — Q3 2018 Earnings Call Transcript

Thanks, everyone, for joining us. Today's call will highlight the results of our third quarter and will feature commentary from Chief Executive Officer, Ritch Allison, and Chief Financial Officer, Jeff Lawrence. I just said, Ritch Al, I should have said Ritch Allison, sorry. CEO Ritch Allison and CFO, Jeff Lawrence. This call is primarily for our investor audience, so I kindly ask that all members of the media and others be in a listen-only mode. A friendly reminder to our analysts: We have asked you to stick to one question on this call because we want to give all 19 of you the chance to participate. We will provide each of you the opportunity for in-depth one-on-one calls later today and tomorrow. In the 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. In addition, please refer to the 8-K to find disclosures and reconciliation of non-GAAP financial measures that may be used on today's call. With that, I would like to turn the call over to Jeff Lawrence.

Thank you, Tim. And good morning, everyone. In the third 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 30 consecutive quarters of positive U.S. comparable sales, and 99 consecutive quarters of positive international comps. We also continue to increase our global store count at a healthy pace. Our diluted EPS was $1.95, which is an increase of 53.5% over the diluted EPS as adjusted in the prior year quarter, which excluded the impact of our recapitalization completed in 2017. With that, let's take a closer look at the financial results for Q3. Global retail sales grew 8.3% in the quarter. When excluding the negative impact of foreign currency, global retail sales grew by 10.4%. This global retail sales growth was driven by increases in same-store sales and the average number of stores open during the quarter. Same-store sales for the U.S. grew 6.3%, lapping a prior year increase of 8.4%. Same-store sales for our international division grew 3.3%, rolling a prior year increase of 5.1%. Breaking down the U.S. comp, our franchise business was up 6.4%, while our company-owned stores were up 4.9%. Both increases were driven primarily by higher order counts in addition to some ticket growth, as consumers continue to respond positively to our overall brand experience. Our Piece of the Pie loyalty program once again contributed meaningfully to our traffic gains. Our international comp for the quarter was driven entirely by order count growth. During the quarter, comps in our Asia-Pacific and Americas regions were strong. And while still positive year-to-date, the comp in our European business was slightly negative for the quarter. Our teams on the ground are working hard with our European franchise partners to regain comp momentum. Our retail sales growth in Europe remains strong due to healthy store count growth, and we remain optimistic long-term in the business there. On the unit count front, we are pleased to report that we opened 59 net U.S. stores in the third quarter, consisting of 61 store openings and two closures. Our international division added 173 net new stores during Q3, comprised of 192 store openings and 19 closures. On a total company basis, we opened 232 net new stores in the third quarter and 920 net new stores over the last 12 months, demonstrating the broad strength and attractive four-wall economics our brand enjoys globally. Turning to revenues, total revenues were up $142.3 million, or 22% from the prior year quarter. This amount includes 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 third quarter, it resulted in an $82.5 million increase in our consolidated revenues. It is important to note these amounts are included in our financial statements, but they are restricted funds that can only be used to support the Domino's brand. The remaining $59.8 million increase in revenues resulted primarily from the following: First, higher food volumes driven by strong U.S. retail sales resulted in higher supply chain revenues. Second, higher U.S. same-store sales resulted in increased royalties and fees from our franchise stores, as well as higher revenues from our company-owned stores. Store count growth also contributed positively to these increases. Finally, higher international retail sales resulted in increased international royalty revenues, though partially offset by the negative impact of changes in foreign currency exchange rates. FX negatively impacted international royalty revenues by $1.9 million versus the prior year quarter due to the dollar strengthening against certain currencies. For the full fiscal year 2018, we now estimate that the impact of foreign currency on royalty revenues could come in near the low end of our prior 2018 guidance of flat to positive $4 million. As you know, there are many uncontrollable factors that drive the underlying exchange rates, making this 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 37.6% from 30.8% in the prior year quarter. This increase resulted entirely from the recognition of domestic franchise advertising revenues on our P&L from the new accounting guidance mentioned previously. Supply chain operating margin was negatively pressured by delivery and labor costs, though procurement savings partially offset these margin pressures. Company-owned store margin was negatively impacted by higher food, labor, and insurance expenses compared to the prior year quarter. G&A cost decreased by $1 million as compared to the prior year quarter. This decrease resulted primarily from a $5.9 million pre-tax gain on the sale of 12 company-owned stores, as well as a $4 million impact from the adoption of the revenue recognition guidance primarily related to the reclassification of certain advertising expenses. The full-year G&A cost for 2018 is estimated to be near the low end of the range of $370 million to $375 million. Keep in mind, G&A expense for the year can vary based on performance versus plan, affecting variable performance-based compensation expenses. Domestic franchise advertising costs were $82.5 million in the third quarter. Interest expense increased by $800,000 in the third quarter, driven by increased net debt from our most recent recapitalization. Our reported effective tax rate was 15.3% for the quarter, down significantly from the prior year. Lower federal statutory rates resulting from tax reform legislation at the end of 2017 primarily drove this change. When you add it all up, our third quarter net income was up $27.7 million or 49% over the prior year quarter. Our third quarter diluted EPS was $1.95 versus $1.18 last year, marking a 65.3% increase. Now, turning to our use of cash. During the third quarter, we repurchased and retired approximately 397,000 shares for $109 million at an average purchase price of approximately $275 per share. Year-to-date, we've repurchased and retired approximately 1.75 million shares for $429 million at an average purchase price of $245 per share. We also returned $23.2 million to our shareholders in the form of a $0.55 per share quarterly dividend. All in all, our strong momentum continued and we are very pleased with our results this quarter. And with that, I'll turn it over to Ritch.

Thanks, Jeff. And good morning, everyone. I'm very pleased with our third quarter performance, and I'm extremely proud of our great franchisees and operators around the world, particularly within our U.S. business, who executed at high levels during the quarter. Our focus on global retail sales growth and franchisee economics continues to shape our steady, long-term strategy and approach. My first three months on the job have only reinforced my point of view about what it takes to succeed in this business. The brand with the best people, the strongest franchisee relations, a focus on forward-thinking innovation, and most importantly, the courage to take smart risks and tackle the steep hills needed to create meaningful change and improvement will win. I'm proud to lead an organization that continues to play the long game with this winning approach. Focusing first on U.S. business, it was an outstanding quarter, with strong retail sales growth driven by a solid balance of same-store sales and unit growth. The launch of Domino's Hotspots and the Paving for Pizza program both generated terrific attention and are two examples of how we continue to make news for the brand in unique ways. We see these as more effective than the limited-time offering product of the month approach, which differentiates us from others not only in pizza but across the QSR landscape. We continue to drive healthy traffic and order counts, and as always, remain focused on our strategy and execution rather than specific competitive or macro factors. For years, we've stressed the importance of franchisee profitability and cash-on-cash returns as important drivers of long-term growth for Domino's or any restaurant brand. Store openings are an evident measure of the health of cash-on-cash returns, but it is also essential to take a look at the rate of store closures. I'm pleased to note that year-to-date in 2018, we have only closed seven stores in the U.S. while opening 140. I credit the efforts related to sales and efficiencies made by our team and our franchisee base toward industry-leading unit economics, keeping stores open and profitable. I'm pleased to report that during the quarter, we opened our new state-of-the-art supply chain center in Edison, New Jersey, the first Domino's U.S. supply chain center to open in more than a decade. I am happy to see us making progress on these efforts to expand capacity. And as Jeff mentioned earlier, we will continue to address needed efficiency improvements as we invest toward upgrading capabilities within our centers. I'd also like to call out an event during the quarter that makes a big statement about the strength of the Domino's brand. Stan Gage, a former member of the Domino's leadership team, left Domino's and then became a 12-store franchisee in the Carolinas. Stan, in a familiar Domino's story, started as a driver more than 30 years ago and worked his way up through the company. Most recently, he ran our company-owned stores. This not only shows one more outstanding talent joining our nearly 800 franchisees in the U.S. but also demonstrates ultimate confidence in the brand. Many of you have told us we make this look easy at times, but the retail sales results, franchisee energy, and momentum within our U.S. system don't come easily. They require hard work every day. This collective energy and drive motivates me and my leadership team each day. Turning to international business, we had a good quarter, generating strong retail sales growth and improving store growth trends across all regions. Three of our four regions delivered positive same-store sales, with Europe being the exception. While we have work to do in a few key markets, I remain very pleased to see our international same-store sales growth driven by order growth. Our master franchisees continue to perform at a high level with excellent unit economics. We have the best master franchisee partners in the restaurant business, and we will continue to work closely with them in driving home elements from the proven playbook used in the U.S. across many other markets, including customer insights, franchisee alignment, technology innovation, and a clear focus on value and transaction growth. We are a work-in-progress brand and will never stop in our quest to achieve a dominant number one position in every market where we compete. On the technology front, our Hotspots program was featured prominently this quarter. Beyond any initial sales expectations, I am most pleased with the remarkable engagement we've seen from this program among our customers, franchisees, and the media. Hotspots received significant attention due to its uniqueness within our industry. I couldn't be prouder of the execution by our franchisees and operators as they deliver delicious Domino's Pizza to parks and beaches and over 200,000 Hotspots across the U.S. Not all technological innovation is television commercial worthy, and some behind-the-scenes innovations are as valuable as anything else. We continue to consider technology when discussing operational efficiencies with our franchisees, innovating to support their needs wherever possible. Recently, we've incorporated voice and mobile capabilities into some of our store-level activities, including inventory management. These launches can also drive value. We strive to create a better experience in our stores, utilizing technology to benefit our franchisees, managers, and store team members. In closing, I am pleased with our third-quarter results. I'm proud to be part of a brand with a winning attitude, strategy, and people who are undoubtedly the best in the industry. This gives me the utmost confidence that we can maintain our energy, momentum, and success.

Thank you. Good morning, guys. First question is just when you look at the U.S. business and you look at the fourth quarter last year, comps of 4% in Q4 last year, was still obviously very solid, but it also was a very clear temporary slowdown that we saw in the business. Can you just remind us what drove that temporary slowdown last year so we can better understand the fourth quarter this year? Was it mostly driven by external issues or internal issues in the fourth quarter last year?

Brian, we were pleased with the fourth quarter last year; the 4.2% was within our three to five-year outlook we've been giving you guys for quite some time. We didn't see any material challenges back then that gave us cause for concern. When we take a look at the momentum in the business this year and on a multi-year stack looking backward, we're very pleased with the performance.

Okay. And just in the international business, I know your Australian franchisee is going to be doing a conversion. How do you expect that to impact the international openings over the next few quarters?

We are in the midst of a conversion with our partner Domino's Pizza Enterprises of Hallo Pizza in Germany as we speak. So, Brian, that is a work in progress, and conversions have been happening for several months now, continuing in the months to come. We won't comment on any specific unit count impact as it's an ongoing process.

Hi, thank you for taking my question. This is the first quarter in a while that we've noticed only a moderate increase in year-over-year supply chain costs. Is there anything specific you could highlight that is contributing to this trend? Are you beginning to see changes in freight or shipping costs, and could you provide any insights on that?

Yes, Karen, it's Jeff. In supply chain, we've really taken our role as the franchisor seriously. We're investing materially as you know, both in capability building and capacity building. As Ritch mentioned in his prepared remarks, we were excited to get our first supply chain center open and running in Edison, New Jersey. It's a great division. People are working hard and our franchisees need that comfort that we're going to continue providing them high-quality safe food supply so that they have the confidence to continue to grow. We'll continue to invest in more capacity and capabilities over time. We raised our guidance on CapEx for 2018 to reflect the optimism in the U.S. business for supply chain centers two and three as well. There's lots of opportunities for improvement.

Hey. I got two questions for Ritch. One is just a clarification. I think you said 3% to 5% long-term algorithm. I think you meant 3% to 6%; just maybe you clarify that. The other question I had was just on the European sales and what the reason for the pressure there is, and I guess what you're doing right now to address that market and maybe sort of bend the arc back?

Sure, thanks Greg. Yes, you are correct, 3% to 6% is our three to five-year outlook. First, around the business in Europe, our three other regions were very strong in Q3, but within the Europe region, we've got a couple of markets where we've got some improvements to address. Some of those are short-term, and some of those will take time. When I take a look at the business there, the issues we have are largely in our master franchisees' control, and we share a joint commitment to take whatever steps we need to get the business back to the performance on comps that we're all used to. If you look at it holistically in Europe, I still feel very positive about our overall market position. We still have strong cash-on-cash returns across the region, and our retail sales growth performance has still been quite solid even in the face of a quarter where we didn't achieve the comp result that we'd like to see.

Hi, good morning. My question is on domestic unit growth. I think this is maybe the seventh year in a row where the pace of growth has increased, and I think that's probably an outcome of your fortressing strategy. Just wondering if you would expect that pace to continue to move higher as we move forward? Is it possible, in your view, that we could see domestic growth in line with your long-run target for global unit growth outlook?

Sure, David. We're pleased with what has now been a multi-year acceleration of the pace of unit growth in the U.S. The strategy of fortressing and driving retail sales growth plays a significant role in that. We've seen consistently improving store-level profitability, which drives confidence in the franchisee base to build new stores. When we estimate that the U.S. within a 10-year horizon is an 8,000 store business, we're optimistic about forward growth.

And Ritch, maybe a related follow-up. Are you seeing any signs of concern among the franchisees related to the overall labor environment? I know the cash flows are still quite good, but is there any sort of pause or concern you're seeing anywhere in the system in the U.S. on development?

Labor is tight in any business in the U.S. today, and we're no exception. Unemployment has been under 4% for a while, but our franchisees are making it happen. Our drivers, due to their busyness, help us. When we look at a driver’s income at a Domino’s Pizza relative to delivering or driving for some other businesses, it's very attractive. Labor pressures are on the minds of our franchisees, but the strong labor market also drives sales of pizza.

Hey, guys. Thanks for taking my question. This is actually Hugh on for Will this morning. I think this is really the first full quarter with the Hotspots now in. Can you provide any learning from the program and maybe any color on the adoption or top-line contribution from this program?

Hotspots has been fun for us. It's another one of our platforms aimed at making Domino's accessible to customers anytime and anywhere. I'm most pleased about the engagement we've seen on this platform. It starts with our franchisees who have set up these 200,000-plus Hotspots. The customers have been excited about the program, and it also attracted terrific media attention. So overall, we're quite pleased with the program.

Good morning. Questions on G&A. When you back out that $5.9 million gain you had in the impact of ASC 606, your G&A dollars were up about $10 million in the quarter. Is that just a normal G&A increase or is there some sort of lumpiness in the quarter that should go down? And just to confirm, the full-year guide on G&A reflects that gain, meaning you went a little bit higher given that would have been an offset?

Yes, Matt. The $370 million to $375 million remains our guide, and that's inclusive of the noise you see, including the gain. We're guiding to the low end of that range in part because of that gain. So it compensates for that a little. We'll continue to give you one-year guidance on G&A because we are in such a dynamic environment. Any one quarter could have bounce-around things like this, but we're still maintaining that range. The key point is that our increases continue to go into strategic areas such as marketing, analytics, and technology that drive profitable sales for franchisees.

Thanks very much. Could you just talk a little bit about the U.S. competitive environment? It's not lost on you or anyone on the call that one of your key competitors ceded some share this quarter, but it's hard to see if you actually got a benefit or how much that benefit is? So can you talk about the overall U.S. competitive environment and changes, specifically with that comment on the competitor that's losing share?

Yes, John. We're in a very fragmented category. If a competitor donates share, it doesn't simply fall into our pocket. We've got to earn it. Sometimes, that share doesn't fall solely into the pizza category either. The impact on the overall landscape is not as heavy as some might assume. We need to stay focused on our competitive strategy rather than getting distracted by short-term pros and cons from a specific competitor. If we can continue to provide value to our customers and deliver solid unit-level economics to our franchisees, we believe we can capture more share over time.

Great, thanks. Yes, I want to circle back on the category as well. Can you talk a little bit about the growth of the pizza category? Have you seen that growth moderate or accelerate at all? And then anything you can discuss on the closure rate of some of your competitors primarily the independent operators? Are you still seeing closures accelerating in the system?

Peter, first on the overall market, we aren't seeing significant swings on what is steady, low single-digit growth of the category in the U.S. and globally. We believe it continues to grow in that 3% to 5% range, so no significant change. Regarding closures, we've reported a very strong unit-level economics helping our franchisees maintain confidence keeping stores open. Seven closures across the entire U.S. year-to-date. I don't have specific comments on closures at competitors, but over time, it follows unit-level economics. If players struggle to generate returns at the unit level, that drives closures or openings.

Hi, thank you. Ritch, you mentioned both value to customers and unit economics to franchisees, but I think sometimes in other systems we see those in conflict. Could you just address how your franchising about value and consistency in that $5.99 price point? Are there offsets you're finding? Is it a mixed sort of fixed amount?

Sure. The key word is consistency. We've maintained our $5.99 mix-and-match offer in delivery for about nine years now and for multiple years kept our $7.99 offer in our carry-out business. The consistency is critical because it's difficult to offer low price points if you’re not driving volume growth over time. Transaction count growth correlates with sales growth and profit growth. We've seen steady results in the U.S. and other large international markets, attributing that to transaction count and consistent value.

Thanks. Ritch, I had a follow-up regarding labor. Several restaurant companies have stated they're having difficulty fully staffing the restaurants in the current market. Are you able to monitor whether franchisees are staffing properly? Can you tell us whether customer satisfaction or drive time performance has changed much in recent quarters?

We don't monitor franchisee staffing at the local level; they are independent business owners. Service remains critically important to us and contributes to our fortressing strategy, getting stores closer to customers improves service while allowing drivers to execute more runs per hour. Happy customers also contribute to more tips, aiding in retaining delivery drivers. We haven't seen a decline in customer satisfaction.

Hi. Chris' second question was about third-party delivery providers. a) Do they have a bigger impact on demand? And b) How do we model out the increased labor costs from the growth of these providers?

Hey, Alton. It's Jeff. On aggregators, we don't have much more to add than what we've been saying for the last 18 months to two years. It's more about what we're doing. Our strategies are great execution in over 90 markets around the world. We're hitting global retail sales growth with great flow-through to the bottom line. I expect we will continue to grow regardless of aggregators.

Great, thank you. Question on unit growth. The last couple of quarters we’ve been sitting in the 6% range, which is lower half of your 6% to 8% annual guidance. Last quarter, there was talk about International potentially not meeting expectations. Could you discuss if the third quarter results saw the uptick you anticipated, or if there are regions where international growth may be more modest?

Well, thanks, Jeff. 6% to 8% unit growth outlook is a three to five-year range. Specifically regarding the third quarter, we were pleased to see an uptick in international growth with 173 net units. We're optimistic about the growth. The solid unit economics across international business encourage growth, and we believe our balanced portfolio will continue driving unit growth in the 6% to 8% range.

Hey, thank you. Good morning. Just bigger picture on international—what are the contributions from your core market versus some of your younger markets that were launched in the 2013-2015 period? Which markets may surprise us and accelerate versus those where growth might level out? Regarding your commitment with master franchisees, is there a threshold for underperformance that would induce you to step up with capital support?

Sure, Jeremy. Over time, we’ve had good balanced growth from long-established core markets and newer or emerging markets. Strong store growth from places like the UK and Australia has driven significant growth. Meanwhile, newer markets like India and Brazil have also seen growth, and that balance helps us consistently drive unit growth in the 6% to 8% range. Our partnership with master franchisees allows us to work collaboratively, taking shared learnings from our experiences, but we are less focused on direct financial support and more on driving unit-level economics together.

Hi, thanks. Ritch, you mentioned in your prepared remarks about taking risks and climbing steep hills. I thought that was interesting. And then Jeff, you mentioned looking at G&A one year at a time while also discussing accelerating strategic investments. How should we think about future G&A spend? Are you looking to spend more to achieve growth or seek to leverage the current spend?

Yes, John. The key is that we want to invest for growth. We’re not going to take our foot off the gas and just hope that things improve. We want to make targeted investments where we believe they can drive great franchise economics and consumer experience. We’re not limiting ourselves to a fixed percentage of revenues for G&A. Instead, we’ll continue being proactive, taking smart risks to achieve growth.

Thanks; good morning. As you think about building traffic over the next couple of years, how do you envision the balance between building frequency of existing guests versus accelerating growth in new customer visits? How do you go about identifying those groups and encouraging them to become loyal customers at Domino's?

The primary opportunity is to continue driving frequency among existing customers. Our Piece of the Pie rewards program was developed to specifically drive frequency. We see significant opportunity here. Additionally, attracting new customers is vital, so we aim for trial and reduce the barriers for those who may not have ordered before. Introducing new products, such as salads, helps attract customers to our brand. But I still believe there’s a lot of opportunity in frequency growth.

Thanks for taking the question. First, a clarification. There was roughly a 50 basis point headwind to U.S. same-store sales from the hurricanes last year. Is that correct? Is there one from Florence this year? And is there any level of U.S. market share where you’d consider monetizing the technology platform to other operators outside your franchise base?

Hey, Jon. This is Jeff. Last year and this year, we did not see material benefits or detriment to the U.S. comps because of weather, including hurricanes. If we see measurable impacts in the future, we’ll point it out, but for us, it wasn't a factor last year or this year.

Regarding market share, it's worth noting that as the market leader, we still only sell about one in six pizzas sold in the U.S., and one in fifteen sold outside the U.S. There’s significant headroom for growth. Our benchmarks show that in other QSR segments, the leaders often have 25% or higher shares. Our focus is on continuing what we do well. With over 300,000 people globally in the Domino's system, we'll keep targeting growth without distraction from monetizing capabilities for other brands.

One comment on your commodity outlook. Just want to see if there has been any change to that, and whether you're seeing trends heading into 2019?

Yes, Stephen. Our guidance for 2018 is a 2% to 4% increase on the food basket that our U.S. franchisees are expecting, which we’re not revising at this point. Year-to-date, we’re in that 3% to 4% range. Our franchisees have done a great job executing at the local level. No change to food basket guidance for 2018. We’re not giving commentary or guidance for 2019 today.

Thanks, everybody. We look forward to seeing many of you at our Investor Day on Thursday, January 17, following the ICR Conference. We also look forward to discussing our fourth quarter and full year 2018 results on Thursday, February 21st.