Conclusion: Although DPZ posted strong results for 3Q10, the sustainability of the current trends and the company’s ability to better leverage top line growth are key issues going forward.


DPZ is trading well today, outperforming the restaurant space on the back of good earnings results from this morning.  While the results were strong, particularly on the top line, some questions arise going forward regarding the sustainability of their margin growth.   Recurring, diluted EPS growth for the quarter was 59% versus the third quarter of 2009.  Driving this growth was domestic company same-store sales growth of 11.8% and domestic franchise same-store sales growth of 11.7%.  On the negative side, gross margins declined by about 40 bps year over year.  This was the first compression in gross margins since 3Q08. 


The 10-Q provides some detail on the underlying dynamics of the margin compression.  In the section titled, “Domestic Company-Owned Stores Operating Margin”, it is stated that “as a percentage of store revenues, food costs increased 3.2 percentage points to 28% in the third quarter of 2010…due primarily to higher cheese and meat prices, a slight increase in the product costs for our improved pizza” and lower mix.   Insurance costs increased 1.9 percentage points to 5.4% as a percentage of store revenues.  On the conference call this morning, management mentioned insurance costs “as well as higher overall commodity cost” as being largely the cause of the margin decrease. 


While a minor point, by the way this was communicated; it seemed that management was implying that insurance costs were more of a factor than food.  In reality, food costs have increased far more on a year-over-year basis.   To that end, food costs have increased as a percentage of sales each quarter to date in 2010 where as the company had been able to leverage its insurance costs prior to 3Q10.  Management likely highlighted the higher insurance costs as they were less expected and potentially one-time in nature.  Higher commodity costs, however, were expected; though the YOY increase in food costs as a percentage of sales accelerated during the quarter to 320 bps from 190 bps and 150 bps in 1Q10 and 2Q10, respectively.  Although the company continued to get leverage on its labor and occupancy cost lines, it was disconcerting to see margins decline with comparable sales growth up 11.8%, particularly knowing that same-store sales growth will not be up double-digits forever.  Going forward, it will be interesting to see if DPZ can more successfully leverage its top line growth.  This will become especially important in 2011 when facing difficult same-store sales comps and facing commodity cost headwinds. 


DPZ will lap its first quarter of positive domestic company-owned same-store sales growth in 4Q10 (after eight quarters of declines).  The YOY impact on margin from higher cheese prices should decelerate in 4Q10, however, as cheese prices had already started to climb in 4Q09 with the average cheese block price per pound up about 24% from the 3Q09 level.  During 3Q10, the average cheese price increased nearly 29% YOY to $1.53 per pound, but if you assume prices hold relatively stable in 4Q10, cheese prices would only increase about 3% YOY, which should relieve some pressure on margins.  That being said, management also pointed to higher meat costs as an issue during the third quarter.






Howard Penney

Managing Director

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