Domino's: Right company, wrong time

The pizza chain's Q3 earnings look great, but the stock is overbought however you slice it.

By InvestorPlace Oct 17, 2012 11:38AM

Image, Baker copyright Blend Images, SuperStockBy James Brumley


iplogoThere's little doubt about why Domino's Pizza (DPZ) shares soared Tuesday. The company posted some very compelling third-quarter results. The questions investors should be asking are: Why were the results so strong? And are the numbers sustainable? 


If it was just a fluke, then the already overbought stock might be something to avoid rather than bite into.


The bad news is there were special circumstances behind Q3's earnings. The good news is it might not entirely matter.


First things first

Domino's Pizza -- the nation's second-largest pizza chain -- posted earning of 43 cents per share last quarter on $378.1 million in sales. Income was up 22% compared to the year-ago quarter, and the top line grew a tad from the Q3 2011 figure of $376.3 million.


Perhaps more telling than any other measure, however, is the 3.3% improvement in domestic (U.S.) same-store sales, and the 5% improvement in same-store sales for its international units.


What gives? Although it didn't offer any specifics, the company noted this summer's Olympics drove heavy sales, as fans opted to not leave their televisions sets … not even to cook.


It's not hard to believe, and to the average thinking investor, the stock's pop in the wake of solid numbers would be a perfect exit opportunity, locking down the gain-in-hand. Yet, for traders looking further down the road, Domino's Pizza isn't exactly the one-hit wonder it's being made out to be this week.


For starters, it's surprisingly competitive with the nation's No. 1 pizza name, Pizza Hut -- owned by Yum Brands (YUM) -- and No. 3 player Papa John's (PZZA), as well as the country's top non-pizza names like McDonald's (MCD) and Wendy's (WEN).


More specifically, Domino's might be more investment-worthy than the bulk of its peers, for a couple of reasons.


But why?

Just in the interest of fairness, Domino's Pizza isn't going to look as strong on paper as, say, McDonald's, because no other restaurant chain in the world can look as strong as McDonald's. The folks working under the Golden Arches have mastered the art of buying in bulk and then distributing the goods where they're needed.


That's why McDonald's margins are so wide, at 30.6% on a trailing basis. No other restaurant comes close, though Domino's comes closest with a trailing operating margin of 16.2%. For comparison, both Papa Johns and Wendy's boast tepid operating margins of only 7.3%.


It's only one aspect of Domino's financial statements, but it's easily the most important one in the restaurant business. In fact, gross margins usually are the make-or-break element in the industry. If nothing else, DPZ shareholders can take solace in a strong margin figure.


For Domino's, though, wide margins mean so much more. It's that strong margin cushion that has given the company the flexibility it has needed to make the march into international markets where growth has started to outpace U.S. growth.


It's not even just that, however, that has been fueling the pizzeria's success.


While menus matter, restaurants -- and quick-service restaurants in particular -- tend to have more faith in their menus than what actually matters to consumers. By and large, consumers select a fast-food restaurant based on convenience and price rather than flavor. Domino's still is obliged to compete on price, and to the extent menus do matter, Domino's is firing on all cylinders.


One recent example is major traction with its new pan pizzas, which were unveiled after the end of last quarter (well after the Olympics were over) to an amazingly receptive consumer crowd. That hits Pizza Hut's pan-pizza fare right where it hurts the most, and should set up solid Q4 numbers. Moreover, Domino's has introduced those new items at a key price point of only $7.99 for a medium pie … competitive with the price of two meals at McDonald's, and very competitive with slightly higher priced Wendy's.


Again, when operating margins are wide, you can afford to do that.


Looking ahead

As tempting as it is for traders and long-term investors alike to jump on the bandwagon after Tuesday's 7% surge, it might be the worst time in the world for either group to step in. This is a short-term pop that wasn't mean to stay in place.


Although Domino's is a great company, it's a great company for reasons that don't inspire big, rapid moves. In fact, a frothy valuation of 24 times trailing earnings could be more scary than inspirational at this point.


After a pullback when the price is on a more stable foundation again, long-termers can wade in, having faith that the tightly run ship will keep sailing in the right direction. Such a pullback might materialize by the end of the week.


As of this writing, James Brumley did not hold a position in any of the aforementioned securities.


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