Domino's Pizza Boosts Taste, and Sales Follow

BOSTON (TheStreet) -- A last-place finish in taste tests last year persuaded Domino's Pizza (DPZ) to remake its recipe. Customers like the new Domino's, and investors should too.

The chain was founded in Ypsilanti, Mich., in 1960 by brothers Tom and James Monaghan. Tom quickly bought his brother's half of the business and began a two-decade expansion of franchise and company-owned stores outside Michigan and into Canada. Bain Capital bought 93% of the company in 1998, but lessened its holdings in 2004 when Domino's went public. Bain still ranks as the company's largest shareholder, with a 14% stake.

The NYSE offering forced executives to cater to a new ownership's demands, chief among them a focus on quality. The menu was expanded to include appetizers and desserts, but patrons' lingering dissatisfaction with pizza quality nagged. Then came that taste test.

Despite financial success and the rank of No. 2 U.S. chain-pizza franchise, Domino's listened. It decided the recession presented an opportunity for self-improvement, and it was right: This year the company achieved an astounding 14% jump in quarterly same-store sales following the worst business contraction since the Great Depression. As of January, when Domino's celebrated its 50th anniversary, the company ranked as the No. 1 pizza-delivery business in America.

First-quarter profit inched up 3.2% to $25 million, but per-share earnings remained flat at 41 cents. Revenue climbed 18% to $381 million. The operating margin extended from 14% to 15%. Domestic same-store sales gained 14% on improved consumer spending.

A turnaround in the pizza business requires a lot of dough. Fortunately, Domino's had the balance sheet and ingredients to execute. A self-deprecating advertising campaign encouraging new taste tests of Domino's pizza appealed to diners, who felt their criticisms had been heard and acted upon. The new pizza has been met with analyst and customer praise.

It helps that pizza is one of the most resilient restaurant businesses -- both popular and cheap. NPD estimates that each American man, woman and child consumes roughly 46 slices -- or 23 pounds -- of pizza a year. And it costs an average of $25.19 to feed a family of four on quick-service pizza, compared with an average $49.94 at a casual-dining restaurant.

But those same factors help local pizzerias as well. They hold a dominant market-share position, with an estimated 55% of the national market. Because of the advantage of economies of scale, which gives Domino's franchises lower ingredient costs than local eateries, there is plenty of room to expand market share within the U.S.

And the rest of the world is still catching on to the delights of pizza to go, which is why Domino's is reinforcing its focus on international expansion. The chain has had some success overseas, with international same-store sales increasing 4.2% in the first quarter and, excluding currency effects, sales abroad jumping 12%.

Domino's is running a shareholders' deficit and carries $1.5 billion of debt, rendering its financial position less than appetizing. Management is committed to decreasing leverage, though. In the latest quarter, debt fell by 9.9%. Liquidity is adequate, reflected in a $114 million cash balance. Also, Domino's has been profitable for nine consecutive quarters, so shareholders' deficit will eventually reverse.

Its stock has surged 56% in the past 12 months, doubling the gain of the S&P 500 Index. Its beta, or market correlation, of 1.3 accounts for a portion of outperformance, though. Of researchers covering Domino's, four rate its stock "buy" and eight rank it "hold." Citigroup ( C) offers a target of $17.50 and JPMorgan ( JPM) predicts a price of $17, both implying a return of more than 40% in the months ahead.

The stock offers a compelling bargain. It trades at a trailing price-to-earnings ratio of 8.2, a price-to-projected-earnings ratio of 8.5 and a price-to-cash-flow ratio of 5.5 -- 88%, 69% and 53% discounts to respective peer averages. These discounts seem illogical when considering that Domino's growth rates and margins are superior to those of competitors.

-- Reported by Jake Lynch in Boston.

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