Domino's Pizza franchise system under spotlight

Sue Mitchell
Jul 11 2016
For a company’s whose raison d’etre is selling what has become a consumer staple – pizza – Domino’s Pizza Enterprises has been one of the most surprising success stories on the market in recent years.
Sales have risen five-fold since its 2005 float, earnings are up seven-fold, and the shares are trading at 30 times their issue price of $2.20.
Most brokers expect further gains over the next 10 years as the franchised pizza chain consumes a bigger slice of the $14 billion fast food market in Australia and pushes aggressively into markets in Europe and Japan.
Domino’s share price performance reflects this optimism – at $67 the shares are among the most expensive on the market, trading at a staggering multiple of 78 times forecast 2016 earnings per share.
The profitability of Domino’s Australian franchisees, which is tracked through compulsory monthly reporting, is at record highs across the network, according to the company.
But not all Domino’s franchisees are happy and doing well.
Domino’s chief executive Don Meij has lauded recent initiatives such as $5 every day pizza and Project 3/10 (three minutes in the oven, 10 minutes to your door), saying they have helped grow same-store sales and take market share from rivals such as KFC and Pizza Hut.
But some franchises say they can’t make money selling pizza for $5 or rushing to get pizzas delivered in 10 minutes.
“We don’t make any money on $5 pizza – the value pizza used to be Tuesday only, now it’s Monday as well,” one franchisee told The Australian Financial Review last week.
Even $11.95 pizzas are not generating good returns: “There are so many discounts it’s hard to say where we make money.”
“The 3/10 policy sounds very good but it’s an impossible model,” said another franchisee. “The loading time alone takes eight to 10 minutes.”
Domino’s says these franchisees are in the minority and if they aren’t coping it must be their fault.
The company owns and operates about 64 stores in Australia and New Zealand and franchisees own around 606.
The company-owned stores and select franchisee stores are used to test and benchmark new concepts such as $5 pizza and Project 3/10 to make sure they are feasible before they are rolled out across the network.
Domino’s concedes that $5 pizza and 3/10 deliveries place added pressure on franchisees and forces them to work harder. However, it suggests that if franchisees are taking eight minutes to load pizza for delivery it’s a sign they’re not as efficient as they should be, pointing to the 60 stores that are now capable of delivering in 10 minutes.
Another policy that is causing concern among franchisees is that of “splitting” stores or opening new stores in a franchisee’s territory.
The policy is aimed at grabbing a bigger share of the local market and making it easier to deliver within the promised 10 minutes.
With almost 700 stores in Australia and New Zealand, there’s a Domino’s in almost every catchment, and much of Domino’s new store growth comes from splitting stores.
Domino’s says new stores are not opened in existing catchments if the franchisee is reluctant to expand. It points to the number of new stores opened – 58 in Australia and New Zealand in 2015 and a similar number in 2016 – as evidence that franchisees are willing to invest.
“The majority [of franchisees] take the opportunity,” a company spokesman said.
But some franchisees say they’re spending almost $500,000 to open new stores, only to find that weekly sales are falling well short of forecasts and the network average, which is around $19,000 a week.
After paying 7 per cent of sales as royalties, 6 per cent of sales on marketing, plus rent (to Domino’s), utilities, ingredients (purchased through Domino’s) and ovens (bought from Domino’s), they are struggling to make a return even after putting in 60 to 70 hours a week.
Some disgruntled franchisees have likened the store split policy with that at Pie Face, where new stores cannibalised sales at existing stores rather than growing the market.
Domino’s suggests struggling franchisees are a small minority, pointing to record system profits.
“In any system there are people who are not aligned with the strategy or disgruntled or they’re not executing at a certain level,” a spokesman said.
Franchisees disagree, claiming that there are as many as 30 stores for sale in Sydney alone, many of which have been on the market for 12 months.
Domino’s website shows just 13 stores officially for sale in NSW, 18 in Victoria and 18 in Queensland. However, many stores change hands between franchisees without being publicised for sale.
Soon franchisees will face new pressure on margins when they have to start paying staff penalty rates under a new enterprise agreement under negotiation between the parent company and the Shop, Distributive & Allied Employees’ Association.
In a timely report last week, Deutsche Bank analyst Michael Simotas pointed out that Domino’s, under an enterprise agreement that expired three years ago, doesn’t pay weekend penalty rates stipulated in the award.
Domino’s is not alone. Hungry Jacks, (owned by Domino’s chairman and largest shareholder “Hungry” Jack Cowin), Pizza Hut and McDonald’s have also managed to trade away penalty rates under enterprise agreements struck with the SDA several years ago.
However, Deutsche Bank says Domino’s pays a lower base rate than its major rivals.
Simotas estimated that the introduction of award penalty rates could lift wage costs in Domino’s Australian operations by 14 per cent, or $32 million, crunching Australian system profits – the profits of both the franchisor and the franchisees – to the tune of 24 per cent.
Deutsche believes the system profit in Australia is around $132 million, assuming a 50/50 split of the profit pool between the parent and franchisees.
“Based on our estimated $32 million cost increase, this would mean the average franchisee profit would halve if they funded it all themselves,” Simotas said.
Some of the poorer performing stores would become loss-making, forcing Domino’s to provide support, just as Harvey Norman was forced to support struggling franchisees during the global financial crisis by reducing rents and marketing fees.
Meij, who was taking advantage of the blackout period to take a rare holiday when the Deutsche Bank report was released, confirmed that the impact of reintroducing penalty rates would be “material.”
However, he rejected Deutsche Bank’s claim that Domino’s would have to help franchisees absorb the extra costs, by, for example, cutting royalties or marketing costs.
He said the parent company had been preparing for the increase in labour costs by introducing initiatives aimed at increasing productivity and improving franchisee margins.
These initiatives include GPS Driver Tracker, which uses GPS technology to find the fastest delivery route for drivers, electric bikes, project 3/10, new pricing models and other initiatives that have yet to be unveiled.
Domino’s ANZ managing director Nick Knight has been on the road in the past few weeks explaining to franchisees how the new initiatives will more than offset higher wage costs.
The company says the “roadshow” has been well attended and well received by franchisees.
However, if some franchisees are already struggling to make money selling $5 pizzas and achieving 10-minute deliveries, higher wages will only further crimp profits.
If franchise margins come under pressure franchisees may become less wiling to invest in new stores, ovens and refurbishments and the whizz-bang technology that has helped fuel Domino’s strong sales growth.
“If franchisee profits fell significantly, even if they were still viable, appetite for this investment would likely reduce,” Simotas said.
A fall in franchisee profitability could also affect the value of new franchises.
This in turn would crimp growth in Domino’s ANZ revenues, which are derived from company-owned store sales, royalties and revenues from new stores, ovens and ingredients.
A franchise system is only as strong as its franchisees.
Domino’s needs to make sure that gains from cheaper pizzas, faster deliveries and splitting stores do not come at the expense of franchisee returns and that the burden of extra costs is shared.
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