Based on continuing evidence of slowing sales trends in two markets, we are turning bearish on DPZ over the TRADE (3 weeks or less) and TREND (3 months or more).
Only three years ago, the Street was worried that DPZ’s balance sheet had too much leverage. The liquidity crisis at the time definitely amplified those fears but the fact remains that deteriorating fundamentals for a heavily levered company can have a severe impact on the financial health, and value, of that company. We’re not drawing any conclusion that DPZ sales are falling dramatically but industry data from Sales Trac Weekly Data suggests that pizza sales are underperforming in the U.S. for the first two months of 2012 and this morning’s release from Domino’s Pizza UK & Ireland was not encouraging for the global business. The timing of this slowdown is also interesting given the recent recapitalization that the company undertook along with the payment of a special dividend.
Domino’s new debt structure means that the company is less levered at 5.4x debt-to-EBITDA versus 6.8x in 2007. With respect to the company’s adherence to the terms of its debt covenants, the company said on a recent conference call regarding the recap that “we estimate our EBITDA would have to drop by over $100 million, or global retail sales would have to decrease by over $1.8 billion versus the levels that we achieved in 2011 before the covenant would be at risk of breaching its primary financial covenants.” There is a significant amount of financial flexibility in the company’s capital structure but sales softening may heighten the standards to which investors hold the company from a leverage perspective.
Through the first two months of the year, we are seeing pizza category sales growing 3-4% (sequentially down from 4Q trends) with sales trends turning negative during the last few days of February. We are assuming that the category was negatively impacted by weather during 1Q as consumers are have been out and about more than during a typical January/February period. We will get more data next week regarding March trends but elevated gas prices and continuing warm weather may lead to further disappointing data.
Today, Domino’s Pizza UK & Ireland reported slightly different same-store sales at +3.5% versus 4.2% in 2011. Importantly, management hinted at further disappointment possibly coming in the second quarter results, saying, “We may have a softer comparative for the second quarter of the year”.
There is a lot of noise within sales trends this quarter with the weather impact and various calendar shifts that have impacted some company’s reported results. We are withholding judgment at this point until we gain further conviction but there is evidence of the underlying trend moderating, at least from the strong acceleration that was seen in 4Q11.