M&C Report takes a closer look this morning’s full-year results from Domino’s Pizza Group and talks to chief executive Lance Batchelor about trading across its different regions, trialling a new look, growth in digital sales and health issues. New look The chain is currently trialling a more, modern look across four of its sites, including units in Wantage and Billericay, which Batchelor hoped would allow the brand to “breakdown barriers” with consumers and take it away from fast-food perceptions. These sites will include some seating where appropriate. He said: “The look and feel of the sites is constantly evolving and the brand is currently undergoing a step change around the world. We want the consumer to be able to see what goes into making their pizza. Therefore with these new sites there is more glass, some seating and more wood finishing, which we hope will encourage customers to stop and see that our pizzas are custom-made, hand-made and that there is less of a fast-food feel.” Batchelor said that the initial impressions from these trial sites had been encouraging and that the group hoped to convert a further 40 to 50 sites in the UK to the new look this year, while also introducing it into Germany and Switzerland. UK In the UK, the company opened 57 (2011: 58) new stores in 2012, ending the year with 727. Batchelor remains confident that 1,200 stores is viable by 2021, and said the chain’s property and franchise development teams were working hard at identifying optimal sites with its franchisees, finding stores and gaining planning permission. He said: “Our franchisees demonstrate a real appetite for more stores and we intend to carry on opening at a similar rate. Our UK commissaries produce our fresh dough and distribute the food materials needed to our franchisees. As the volume builds, we need only minimal extra headcount in a world class efficient commissary such as Milton Keynes. In addition our procurement team can use our scale to buy better, and to protect against commodity price risks. “Our 124 UK franchisees are at the very heart of this business. We work with them every day, hand in hand. They now have an average of about 6.3 (2011: 5.7) stores each. Stores are showing improving sales, operating efficiencies and in turn improving profitability faster than the rate of sales growth.” Digital Online system sales increased by 46.3% to £268.6m (2011: £183.6m) with online sales accounting for 55.7% of UK delivered sales (2011: 44.3%). Of this, 19.7% of online orders were taken through a mobile device (2011: 10.1%). The group is investing an increasing proportion of its £24m budget on targeted digital campaigns. Batchelor said: “Customers who order online have a higher net promoter score, i.e. they recommend us more often. They themselves order more often, and spend more. Importantly a web transaction generates higher margins for our franchisees, because they do not need to incur labour costs to answer the phones. This has saved franchisees many millions of pounds which can be invested into new store openings, for example. Finally a digital customer is a customer with whom we have a one-to-one relationship. This often allows us to market directly to them, and indeed by year end we had over three million customers who had agreed to allow us to communicate with them via email etc.” Batchelor believes Domino's is far ahead of any of its UK competitors in this field; and intends to continue exploiting this strategic advantage. “How far can it go? About three quarters of our sales are delivery, and in theory all of these could eventually migrate,” he said. “Currently many customers still use the phone to order, but the world is changing: some of our franchisees are now actually reducing the number of phone lines into their stores, as they see ever more web orders. One store has even removed the phone number from its menus and seen no decline in sales.” An important and dynamic subset of the company’s digital channel is mobile, which grew in 2012 by 195% to reach 19.7% (2011: 10.1%) of all digital sales. Batchelor said he could envisage more sales coming from pre-ordering channels. He said: “Coming from a mobile industry background myself, I can say that this is no accident, but a direct result of our time and energy in this area. We now have sales channels for all the major mobile operating systems (iPhone, iPad, Android and Windows 7) as well as recently refreshed apps which have scored significantly higher on customer ratings than our competitors. Our iPhone, Android and iPad mobile ordering apps won the Best Food & Cooking award in the Carphone Warehouse Appys 2012, which celebrate development and innovation in app technology. Mobile is set to grow rapidly as a proportion of sales; and we will stay ahead of the curve. It is a real competitive advantage for Domino's that we are fully accessible wherever and whenever our customers want to order a pizza.” By year end the chain had reached 747,000 (2011: 330,000) Facebook Fans in the UK and 68,000 followers on Twitter (2011: 18,000). Health Batchelor said that the group could hold its head high on the health issue. He said: “We have signed up to the Responsibility Deal, with calorie counts on our website, banning trans fats, reducing salt and offering low fat pizzas. However, our consumers see having a pizza as a treat, our low calorie options only account for 2% of orders. Our customers are ordering from us every 37 days on average, and they are not eating on their own, with a large pizza being eaten on average by 2.2 people. Republic of Ireland Despite the tough economic environment, like-for-like sales, in Euros, stabilised at -0.2%. Batchelor said: “Irish sales are 31% down from the peak in 2007 but despite this, only one of our 49 Irish Domino's stores has ever closed. Our ecommerce business continues to grow at a strong rate and is now at 30.4% of all delivered sales, up 20.2% year on year. Mobile incidence is particularly strong at 19.6% of all ecommerce sales. “We have been particularly encouraged by the growth seen from extended trading hours, with sales post midnight up 60.4%, in part benefitting from the communication of Late Night opening on TV. Ireland however continues to be a very tough trading environment. We have worked closely with our Irish franchisees during the last year and I have been really impressed with their tenacity. After almost four years of an Irish downturn, only one of the 49 Irish Domino's stores has closed. Our competitors have suffered much more. “No one can confidently predict the turn of the economic tide in Ireland, but when it comes, Domino's Pizza will be ready and waiting. In the meantime the stores there continue to generate some of the best operational metrics anywhere in the world.” Germany The group now has 18 sites open in Germany and said there is a full pipeline of planned openings in 2013. Batchelor said that the rapid pace of growth in the country had been “challenging but hugely exciting”. He said that the stated target of 400 sites in the country within 10 years was now seen as no more than “a sensible line to start with”. He said: “In the past year we have seen our first franchisee run stores and we have several more coming aboard in the next few months. Our confidence in and enthusiasm for the German opportunity has grown steadily with more on the ground experience. Ourearliest Berlin stores saw their like-for-likes grow by 19.3% and 24.1% respectively in 2012 as we learned ever more about menu and marketing preferences in Germany. Other key indicators look good too - our first three franchise stores in the West have achieved average weekly unit sales (AWUS) of over €12.2k in Q4 with one store now regularly achieving an AWUS of €18k and our new flagship corporate store in Dusseldorf opened in November and achieved sales of over €18k in its first week. It is still early days, we still have much to learn, but we are seeing some really encouraging numbers.” The group expects to add 18 more stores in 2013, doubling the German footprint to 36 stores. This is an acceleration in the store opening programme compared to the 14 stores in the master franchise agreement. Batchelor said: “As a result of the accelerated store opening programme and further investment in the central resources to support this growth we are expecting marginally higher losses in 2013 and 2014. We are still on track to reach profitability by the end of 2015.” Its main rival has 180 sites in the country. Its Berlin commissary was relocated and substantially upgraded in 2012 and now has capacity to supply at least 50 stores. Batchelor said the fact that company is set to build a commissary in the west of the country in the coming year, which will add capacity for 100 more stores, demonstrated its commitment to its expansion there and the opportunities it believes there is in terms of store numbers. Switzerland In the second half of 2012, the company acquired the master franchise agreement for Domino's Switzerland, and took over operation of the 12 stores there. It said that the business had suffered from “systemic under-investment and lack of scale”. Batchelor said: “We strongly believe Switzerland can eventually host at least 50 stores and make solid profits. We expect it to be operating profitably by the end of 2014 and we have already begun the process of updating the stores, systems and menus, with an immediate rise in sales.” Other international opportunities With the Swiss deal, the company also obtained the rights to operate and franchise Domino's Pizza stores in Luxembourg and Lichtenstein. It also holds an option to acquire the master franchise agreement for Austria before the end of 2014. Batchelor said: “We will keep all those opportunities under review. Along with the four markets we already operate in, this represents even more international opportunity ahead.” Banking facilities During the year the group successfully re-financed its £25m five year facility at “very competitive interest rates”. During this process the facility was increased from £25m to £30m. The company said this enabled it to have the additional flexibility to take advantage of further international growth opportunities and acquire Domino's Switzerland. At 30 December 2012 the Group had a total of £53m of banking facilities of which £8m was undrawn. The main facilities are a £30m five year facility and a £13m seven year term facility which attract an interest rate of LIBOR plus 135bps and 50 bps respectively. Commodity prices The company said that 2012 saw continued pressure on certain commodity prices (in particular wheat and milk prices). Wheat prices rose by over 40% due to the droughts in America and Australia and the flooding in the UK and Northern Europe. It said: “This had a further knock on effect on the price of feed which adversely impacted the price of chicken, pork and beef. Milk prices were impacted by the aforementioned as well as the lobbying for increases in the base milk prices paid to farmers. The group was further impacted by the removal of the quota subsidies in force in Portugal relating to our tomato growers, which substantially increased raw material prices for our pizza sauce.” Lee Ginsberg, chief financial officer, said: “The group's continued focus on its strong long term relationships with our key suppliers and taking advantage of its buying power, enabled us to mitigate the resultant impact of these commodity price increases by securing longer term fixed price contracts and forward buying in advance of the price increases taking effect. An example of the benefits of our long term partnerships with our suppliers was their ability to project the potential increases in the wheat markets and for the group to take advantage of weaknesses in the markets to buy forward its flour supply. “This proactive policy enabled the group to mitigate the increased pricing to franchisees significantly over the year, protecting not only their margins and ours but also the suppliers. Overall in 2012 the entire food basket only saw an aggregate increase of 2% over 2011 which was a satisfactory outcome given the upward pressure on commodities.” Analyst reaction Douglas Jack at Numis said: “2012 PBT, at £46.7m, was ahead of our forecast (£46.0m) and consensus (£46.3m). In the UK, Domino’s generated 17.2% earnings growth from 5% LFL sales, 50bps margin growth and 57 new openings. Trading in Europe is strong, such that expansion there will now accelerate. We are upgrading our forecasts slightly, despite increased European infrastructure investment. This year, LFL sales should benefit from higher advertising, 1-1 smart marketing and further new product launches. “Trading in Germany is strong, with Berlin LFL sales up c.20%. Also, a number of the franchisee new stores and the Domino’s flagship corporate store are generating similar sales to new sites in the UK. Thus, Domino’s will increase infrastructure investment to support stronger expansion. Our forecasts anticipate PBT growth accelerating, even though they still, very cautiously, assume UK margins fall. “Net debt/EBITDA is 0.4x and is forecast to fall to zero over the next three years due to strong cash inflow even after £10m of annual share buy backs and expectations of a 50% increase in dividends over the next three years. Against this backdrop, we would build positions ahead of growth accelerating from 2014E.” Wayne Brown at Canaccord Genuity said: “Current trading has slowed from LFL sales of +5% in Q4 2012 to +1.6% in the first 7 weeks of 2013. Whilst the statement highlights adverse weather as a key reason for this slowdown, past experience would suggest that snow has played to the strengths of the Domino’s model. Comparatives become increasingly tough in 2013 with LFL sales in H1 2012 of +5.2% (UK +5.7% and IRE +2.9%). “We see a number of headwinds in 2013: (1) tough comparatives, (2) input cost pressures which could place further pressure franchisee profitability, (3) the growing importance of area splits to drive volume growth and (4) the growing importance of new products (14% of sales in the UK came from new products up 11.4% in 2011) is likely having a negative margin impact. Despite our cautious stance, we remain strong believers in the model but note that the slow down in margin progression and the low level of share buy backs in 2012. We also feel that the improving performance in Germany is encouraging and whilst we should get more detail at the analyst meeting, we forecast start-up losses up until 2015/16. “The shares are trading on 26.0x 2013E PE for c13% EPS growth. On an EV/EBITDA basis of 16.6x, this represents an EV/store of >£1.1m (some 5.5x the average store cost). We feel the shares have been resilient but with the lack of upgrades we see the rating as fully valued.”

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