3 Risks This Pizza Company Should Worry About

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When you evaluate a publicly traded business it’s always important to look at the risk factors section of the company’s Form 10-K. Weighing the risks of a particular company can help you determine its investment worthiness. Looking at the risk factors section in the form 10-K of pizza chain Domino’s Pizza (NYSE: DPZ), three risks stand out as the most worrisome for the company and its investors.

Competitive landscape

“The quick service restaurant pizza category is highly competitive and such competition could adversely affect our operating results.”

A quick look in any small town and you see any number of pizza restaurants. Domino’s Pizza and its franchisees currently operate more than 10,000 stores globally. The store counts of rival chains Papa John’s (NASDAQ: PZZA) and Yum! Brands’ (NYSE: YUM) Pizza Hut clock in at around 4,000 and 13,000 restaurants respectively. Yum! Brands enjoys greater ubiquity, giving it more purchasing power and greater brand recognition.

According to Yum! Brands latest form 10-K Pizza Hut commanded a leading market share in the United States owning approximately 16% of the market. With aggressive overseas expansion it looks like Pizza Hut will continue to dominate.

Papa John’s has nimbleness and a good balance sheet going for it. Its small size means plenty of room for expansion. Papa John’s increased its revenue 10% versus 8% for Yum! Brands, and 2% for Domino’s in 2012.

Piles of debt

“Our substantial indebtedness could adversely affect our business and limit our ability to plan for or respond to changes in our business.”

As of the end of 2012, Domino’s owed $1.5 billion in debt. Domino’s accumulated this debt through various recapitalizing efforts and imprudent payment of special dividends. Its operating income only exceeded interest expense by about three times. The standard rule of thumb for margin of safety resides at around five times interest expense. Any significant rise in interest rates could hamper this company’s ability to find more debt financing. Moreover, this leads to the third risk.

Papa John’s long-term debt to equity ratio stands at 51% of stockholder’s equity whereas Domino’s debt exceeds assets.

Exposure to bad times

“Adverse economic conditions and the global debt crisis subject us to additional risk”.

Any major global about face in the economy can cause cash flow to decline and consequently the ability to pay off interest expense resulting in a default. The various global debt crises in the European nations could leave Domino’s, in particular due to its debt, vulnerable to this possibility. The current economic recovery going on right now in the U.S. could serve as a buffer.

Conclusion

In summary, look for Yum! Brands, Papa John’s, and Domino’s to continue to expand and cut into each other’s territory. Keep an eye on Domino’s debt and make sure rising interest rates don’t affect this company. An economic pullback and the Avian Bird flu scare will certainly serve as friction for Domino’s future profitability in the Chinese markets. Economic recovery in the United State should serve as a counterbalance to some of this friction. However, unless Domino’s pays off some of its debt you should look elsewhere for a better investment.

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William Bias has no position in any stocks mentioned. The Motley Fool owns shares of Papa John's International. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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