Domino's IPO: Hot or Cheesy?


By Edward Popper Two years ago, when the word on the Street insisted that Domino's was planning to go public, investors caught the whiff of something tempting (see BW Online, 8/8/02, "Domino's Next Delivery: An IPO?"). Now, finally, it's official. In a May 19 Securities & Exchange Commission filing, the second-biggest U.S. pizza chain announced that it'll sell 24 million shares at between $15 and $17 per share. A spokesperson says Domino's expects to make the offering by mid-June. Sure, everyone likes pizza -- but investors who smell a sizzling deal might want to peek inside the box before taking a big bite, analysts say.

Founded by Thomas Monaghan and his brother, James, in 1960 (Thomas traded a VW bug for his brother's stake early on), Domino's rapidly expanded into a global franchise that now boasts 7,400 franchisee- and company-owned stores. There was bump in the growth curve during the early 1990s, but Monaghan turned it around before selling all but 7% of his stake in 1998 to an investor group controlled by Bain Capital. Monaghan now devotes most of his time to conservative causes, and Bain controls Domino's with 49% of its voting stock and an unspecified number of nonvoting shares.

Domino's and its domestic franchisees have spent a hefty $1.2 billion on advertising over the past five years, the company estimates. New products also have boosted sales in recent quarters. The Cheese Steak Pizza has done well, as have other new products, such as cinnamon balls and Cheesy breads. And special offers, such as two-liter Cokes for 99 cents with pizza orders, have kept Domino's customers coming back for more, notes Richard Baldwin, a high-yield bond analyst with Moody's Investors Service.

Management "has been able to maintain the sales excitement, so people don't get tired of Domino's and continue to make purchases," Baldwin says. "And they seem to be getting a good return on their advertising."

EATING OUT. Under the management team installed by Bain and led by CEO David Brandon, revenues hit $1.3 billion in 2003, up 4.6% from the year before. On average, Domino's sales have seen 4.6% annual increases since December, 2000 -- 3.5 percentage points faster than the overall pizza-delivery business.

The restaurant industry, moreover, may be due for an upturn. "Coming out of a rough economy, people have a little bit more spending money, and they're spending it not only in the retail sector, but also in restaurants," says Sidoti & Co analyst Dennis Joe. Still, investors will want to take a close look at Domino's before gobbling up the shares.

With enviable 4% growth in international same-store sales, which accounted for 31% of total franchise-outlet sales in 2003, Domino's is outpacing the rest of the industry. In the U.S., where Domino's has over 19% of the pizza-delivery market, same-store sales jumped 1.3% in 2003 and 2.6% in 2002. Those gains may not sound like much, but they're well ahead of No. 1 Pizza Hut and No. 3 Papa John's (PZZA), which both saw decreases in domestic same-store sales from 2001 to 2003, according to Joe. He adds that the majority of fast-food outfits suffered declines until the last quarter of 2003, when the trend began to show signs of reversing.

CHEESE CRUNCH. The worry in Domino's case is that same-store sales at company-owned stores, which account for 28.2% of revenue, were flat in 2002 and shrank by 1.7% in 2003. Analysts couldn't explain the drop-off, and Domino's management is restricted by the SEC from commenting while the IPO is in process.

Domino's faces other challenges that could cut into earnings. According to Joe, cheese prices, a key operating cost, have increased by 93%, to $2.17 per pound, since April of last year. The price escalations resulted from a culling of the national dairy herd as farmers took advantage of higher beef prices to sell cows for slaughter. Since it will take time to replenish the herd, cheese prices are liable to stay high for a while. In the cutthroat pizza-delivery business, where it's hard to raise prices without losing market share, higher costs are hard to pass on to consumers.

Also a cause for concern is Domino's long-term debt, which ballooned from around $640 million in 2002 to over $982 million at the end of 2003. According to Baldwin, most of the new debt comes as the result of a recapitalization last June, which funded a $400 million payout in shareholder dividends. But prospective IPO investors could end up being adversely affected by the payout.

INSIDE OUT. The latest SEC filing says Domino's intends to use $136.7 million of the IPO proceeds to pay down $125.5 million of the remaining $403 million in public debt that comes due in 2011. Still, increased interest expenses resulting from the higher debt levels cut Domino's margins in 2003, when profits fell to $38 million, down 36% from $60.6 million in 2002, according to Domino's 2003 SEC filings.

That was the first annual earnings decline since Domino's began filing with the SEC in 1999, when the outfit first issued public debt. The pressure on earnings will increase if interest rates rise, as many economists expect.

Some Domino's followers were also concerned to learn that corporate insiders intend to reduce their stake by as much as $249 million in the IPO. "If it's such a wonderful offering, then why are the insiders getting out?" asks David Menlow, president of IPOfinancial.com.

Of course, it's not that unusual for insiders to cash out of a private company when it finally goes public. And Menlow says he thinks Domino's name recognition will probably make the offering a success. "People will have a warm and cheesy feeling about the offering," Menlow says. "It will be a comfortable name for IPO investors" to buy into. Still, prudent ones will probably be taking a close look at the details before ordering up any Domino's shares. Popper is a freelance writer living in New York


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