The market has a love-hate relationship with Domino’s Pizza (DOM). After its third quarter trading update, investors and analysts alike are split over whether it is bouncing back from weak sales growth or if it is still struggling.

News that Domino’s delivered like-for-like UK sales growth of 8.1% in the 13 weeks to 24 September triggered a 10% rally in the shares on 10 October.

But we are not convinced that the pizza delivery firm’s troubles are over. Increased competition and sluggish growth in the UK delivery pizza market are obvious headwinds and are compounded by a consumer spending squeeze.

When Domino’s first floated on AIM in 1999, investors were drawn in by its rapid growth prospects which could be delivered without having to overspend.

The company, which holds the master franchise to the UK and some other European countries, mostly operates through another layer of franchising, where individual store owners pay upfront for a license and then deliver an ongoing share of sales as well as buying their ingredients from the company. According to the 2016 annual report, out of more than 1,000 stores only 16 were directly run by the company.

We will explore why some analysts are optimistic on a potential turnaround and why we are convinced by those who argue that Domino’s is not a good investment.

Who is confident on Domino's outlook?

Among a sea of bears, there are a couple of bullish voices including Peel Hunt analyst Douglas Jack.

He argues that self-help initiatives such as new technology, lower pricing and stronger advertising should benefit Domino’s in the last quarter of this year and first half of 2018.

The importance of this emphasis on innovation is reflected in a 17.4% build in online sales in the most recent period, representing 75% of total sales (which Domino’s calls system sales).

Domino’s says its new advertising campaign ‘The Official Food of Everything’ has helped drive this increase in online sales, flagging a record 200,000 online orders – or 140 a minute on the last Saturday in September.

Numis analyst Richard Stuber, who is also a fan, says sales growth of 11.6% implies Domino’s is gaining market share in a delivered pizza market that is growing at 4% based on consultancy Parthenon’s forecasts.

Stuber hiked his pre-tax profit expectations by 1% to £88.7m this year and raised earnings per share (EPS) expectations to 14.5p.

 How relevant is the overseas operation?

Overseas, the London-listed Domino’s is performing well with like-for-like growth rising 20.4% in Switzerland, driven by lower menu prices while sales in Norway jumped 14.6% in the 13 weeks to 24 September.

However, the overseas business only represents approximately 8.7% of overall group revenue.

Langton Capital analyst Jack Brumby argues that while overseas sales are growing, it will be ‘some time before they make a telling contribution’.

With the shares trading on 21.9 times forecast earnings, Domino’s is not cheap and Brumby says investors are paying a high price for future growth.

On the reverse side he acknowledges it is cash-generative with a strong brand and high-margin business model.

Why new stores could cannibalise sales

One of the biggest issues Domino’s faces is oversaturation in the market and intense competition, which it hopes to tackle through increased price discounting and new store openings.

The company is on track to open 90 stores in 2017, with 58 already opened so far. Investec analyst Karl Burns is not convinced that new store openings are necessarily good for business.

The issue with Domino’s expansion is that it is focused on existing trading areas instead of new geographic territories, meaning two separate branches could compete for the same customers.

In August, the company acquired a 75% stake in 25 existing Domino’s stores in London for £24m, but Liberum analyst Wayne Brown says it paid ‘a very high price tag’ to gain this exposure.

According to Brown, if the stores contributed approximately £0.5m at the busiest time of the year between August and December, this suggests a profit of £1.5m to £1.6m for the full year.

Brown is not convinced the deal was the right move, regardless of valuation, as the stores are underperforming and flags Domino’s ‘chequered history’ with direct ownership of its outlets.

In the early 2000s, the business found it difficult to make money from its UK stores due to poor management, leading to its decision to sell them back to franchisees, says Brown.

Was sales growth all that impressive really?

Liberum is dismissive of the latest sales growth and argues nothing has changed as it was driven by adverse weather and weak comparatives instead of a strong trading performance.

Sales growth was partially supported by a gross margin investment of up to £4m in July and this strategy in the future could lead to further margin pressure, according to Brown.

Berenberg’s Ned Hammond says Domino’s did not rule out absorbing more costs for franchisees too and points out like-for-like growth may not necessarily lead to higher profits.

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