The Results Look Good if You Ignore 2 Big Problems

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

As fast as a company can seem to offer good value, that value can disappear. This seems to be the case with Domino's Pizza (NYSE: DPZ). About three months ago I wrote about how Domino's impressed me with their earnings report. While it has been clear for a while that the company is either at or near saturation on the domestic front, it may be years before they reach saturation overseas. While the company continues to show good growth internationally, there are two big worries from the current quarter that investors need to be aware of.

Well Known Competition

Domino's faces significant competition from the likes of Papa John's, Pizza Hut, which is owned by YUM! Brands (NYSE: YUM), and even the ubiquitous McDonald's (NYSE: MCD). Generally speaking, ordering pizza from Domino's is a cheap way to feed a family, and this is the same market that would buy a pizza from Pizza Hut, or order their meal off the value menu at McDonald's. In addition, both YUM! Brands and McDonald's are well known for their overseas expansion plans. Each company operates thousands of locations overseas that compete with Domino's over 5,000 international stores.

What is pretty impressive about Domino's is its relative strength, particularly based in its operating margin. YUM! Brands is nowhere close to Domino's by this measure, and reported an operating margin of less than 15%. By comparison, McDonald's sports an operating margin of over 31%. Meanwhile, Domino's increased its operating margin from 27.5% last year to 29.5% this year. This strong operating margin helps the company generate cash flow and earnings growth.

Impressive EPS Growth And Free Cash Flow

Domino's EPS increased nearly 23%, and same-store sales were up 3.3% domestically and 5% internationally. If you exclude foreign-currency impact, international same-store sales increased by double-digits. This international trend matched strong growth last quarter when same-store sales were up 6.7%, and currency-adjusted they increased 13.8%. In the last nine months, the company generated over $86 million in free cash flow and used about $42 million to repurchase shares.

Domino's has consistently repurchased shares and now has retired over 5% of their diluted share count in the last year. Even though it sounds like the company is doing everything right, there are two problems.

Problem #1 – Slow Organic Growth

Though international sales growth has been strong, there are some issues. Last quarter, international same-store sales and foreign-currency adjusted growth were both stronger than the current quarter. On a sequential basis, the company's international same-store sales growth dropped from 6.7% to 5%. In addition, even though now just over half of the company's stores are international, total revenues increased just 0.5%.

New store openings internationally increased by just 2.41%, and on an annualized basis this represents less than 10% new store growth. Even if the international division grows new stores by 10%, this is only half of the company, and domestic stores are staying relatively flat. This indicates that new store growth overall might be 5%. Same-store sales increased 3.3% domestically, and 5% internationally, which means average same-store sales might increase by 4% on average.

With 4% average same-store sales growth and 5% new store growth, total revenue growth should be closer to 9%. With the company increasing overall revenue by 0.5%, there is a clear disconnect between the numbers. Also, as I mentioned before, Domino's has already increased its gross margin to 29.5%, just short of McDonald's' 31%. It is highly unlikely that Domino's can continue to increase its operating margin significantly, and a lack of margin expansion would cause earnings growth to slow as well.

Problem #2 – A Weaker Balance Sheet

An even greater concern for investors, believe it or not, should be Dominos' balance sheet. The company already operates at a disadvantage because they carry a significant amount of long-term debt. In fact, the improvement in Domino's operations should allow the company to improve their balance sheet, but the opposite has occurred. In a continued trend, the company's cash and cash equivalents have dropped and long-term debt has increased.

Last quarter, cash was down on a year-over-year basis, and long-term debt increased. This quarter, the same problem reared its ugly head with cash down from $142.90 million to $95.46 million. At the same time, long-term debt rose from $1.45 billion to $1.54 billion. Given the company's strong cash flow, it seems Domino's might consider slowing down its share repurchases and use these funds to improve the balance sheet.

Conclusion

Domino's has benefited from a strong resurgence domestically and big growth internationally. However, Domino's will not be able to enjoy this growth forever. Domestically the concept seems to have reached saturation, so same-store sales growth is about all investors can expect from this division. While new international store growth can continue for years, same-store sales growth is beginning to slow down. When you combine these factors with the company's steadily weakening balance sheet, you get a dangerous combination.

Given the fact that competitors YUM! Brands and McDonald's both pay dividends that Domino's does not, this is yet another reason to consider switching to these other options. Last but not least, Domino's sells for almost 21 times forward earnings projections, which is far above projected growth of less than 13%. Investors should probably consider taking profits in Domino's before all of these factors cause a negative surprise.

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MHenage owns shares of McDonald's. The Motley Fool owns shares of McDonald's. Motley Fool newsletter services recommend McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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