28/07/2016: Should you short Dominos Pizza?

28/07/2016: Should you short Dominos Pizza?

Scott Schuberg:

We've got a cracker the first one from Darren. I'll read it out and I'll tell you why I like it. His question is in regards to Domino's Pizza.

 

Shannon Rivkin:

It's a great question.

 

Scott Schuberg:

Yes. It's stock ticker is DMP. Darren says he finds it difficult to understand the benefits in purchasing a stock at a P/E ratio in excess of 80 times. Understandably, the stock has had a remarkable rise to fame with incredible capital growth on little or no news. He says excluding the recent demise of Eagle Boys this week, so it was submitted last week, probably. And I find it difficult to understand what forces drive it in a positive direction so strongly. I currently hold a short position on this stock which is a source of frustration and confusion and he'd appreciate our comments.

 

 

Firstly, thank you very much for the question. Thank you for being so open in talking about the fact that you've got a position against this stock which gives us some more texture to talk about your situation. In particular, I'd probably say the first thing please never do is value a stock based solely on its last 12-month price-earnings ratio. If I had a business that baked bread and I filed my last year's earnings and then all of a sudden, I get a new customer in China and my sales double, that 12-month trailing earnings expressed against the price of giving you that P/E ratio can be incredibly ...

 

Shannon Rivkin:

Misleading.

 

Scott Schuberg:

Misleading.

 

Shannon Rivkin:

Well, I wanted to say, sorry to interrupt. The market doesn't price in the past or even the present. It prices in what's going to happen in the future, so to some degree what happened in the past is irrelevant. To Scott's point, what happened last year for his baking bread business is irrelevant. If the market knows that there's a new Chinese supply that's coming online, or sorry, client, then that will be factored into the stock price.

 

Scott Schuberg:

Yes, and my ability of having grown earnings the years before this Chinese buyer came along is also incredibly relevant. When particular events come up and stocks suddenly grow by 20%, 30%, 40% per annum with their earnings, there's something going on there that justifies a re-rating in the market.

 

 

Now, with regard to Domino's. It's FY15 earnings per share was $0.72. Forecast to be around a $1.05 for FY16. A huge jump, an uplift in profits. If you look at average earnings on this stock, I know you say there hasn't been a lot of news out, but really if you're an analyst and you're looking at this stock, all the news you want to see is their incredible organic growth, little bit of acquisition there, but bottom line, their earnings growth has been phenomenal. On that basis, there's an incredibly good stream of news that's come out from this company for years now. It's no longer some fresh market darling. This has been loved for the market for quite a good time now for good reason.

 

 

I'd probably say, what you want to look at, yes, the history of its earnings growth. How reliably does this company find new ways to increase its sales and maintain and lower its costs relative to those sales, and therefore get an uplift in earnings year after year. How good is its track record in doing that? Then you want to listen to the analysts and figure out its ability to continue doing that. What you end up getting close to is a price-earnings growth ratio rather than a price-earnings ratio. What that price-earnings growth ratio is looking at on average, how quickly does the stock grow its earnings per share, and puts that in a relevant ratio that makes the P/E on its own, the trailing P/E look a little irrelevant.

 

 

Now, if we put all that aside and look at its forward earnings. As I said, basically, you could probably bring that P/E down to about 40 times and it's still not cheap and on that basis, you want to then get a sense of, 'Okay, if it's still very expensive, then it means the market's still quite optimistic about them being able to grow the business in the future beyond just the next year's forecast earnings. Because If you look at the next year's forecast earnings, sometimes they're pretty solid.

 

 

A stock like this is highly analysed and therefore, you don't bank on the next year's earnings, but you bank on the fact that this is a company with a reliable board that puts out reliable forecasts and earnings guidance.

 

Shannon Rivkin:

Not reliable, but ultraconservative. They keep smashing it out of the park.

 

Scott Schuberg:

Yes. These guys aren't a bunch of morons who sprout the stock. They just put in great results and talk about what they're going to do for the next year. It is a good one in that regard and then when you go further out, obviously the risk of those earnings missing becomes greater. Listen, yes, there are risks that this stock could fall because if they make one misstep and all of sudden the market feels very differently about their ability to grow earnings at 30% to 40% per annum, then there will be a very quick re-rating.

 

Shannon Rivkin:

The downside could be severe.

 

Scott Schuberg:

Absolutely. Yes, really severe. What I'd ask you, Darren, is on balance. Have a think about your evidence for that case. What's the evidence that they will keep growing their earnings? Will they have done a very good job historically and on that basis, there are some analysts out there who like the stock and think it will keep going. There's a bit of a market consensus that there's a trajectory of earnings there. What's the evidence that it won't happen? I guess there's not a lot aside from the fact that exponential growth doesn't last forever.

 

 

At some point, this company probably will lose its much loved CEO and have a structural change and something gives and all of a sudden earnings flatten out, but when that will be, I really have no idea. The other risk in taking a short position on a stock like this ... These guys, yes, it's called Domino's Pizza. Is it renamed now?

 

Shannon Rivkin:

Enterprises.

 

Scott Schuberg:

Yes. Okay. They're trying to get away from the idea that it's just a pizza related business. They want to be a food delivery business, so they're incorporating a whole bunch of other stuff. This is a sector that's very trendy around the world at the moment. It's a big company now, $6.5 billion or so, so it's not an easy takeover target. Nonetheless, it is one that is a potential takeover target for foreign investors and therefore taking a short position in a stock that's a high growth stock that the market loves, which means any bidder would have to make significant premium bid to the closing share price could put you in a position where you wake up one morning and you've got no opportunity to close your short position other than 30% or 40% higher than where it closed yesterday. Keep that in mind as a risk as well.

 

 

Listen, this thing could come out tomorrow with something bad and the price could rollover like you want it to, but another tip would be to if you insist on taking short positions, that's certainly not a bad thing, if you want do your analysis. Maybe look for a trend that sees the market falling back out of love with a stock like this. It's very dangerous buying on momentum because there's no real price signal yet that the market's going to come around to your thinking.

 

 

Even if you have to wait for this thing to turn and fall 15% or 20%, so see a significant fall before you put on your short, at least you’re getting into a short position while the market is starting to change its opinion about this stock. Domino's is a straight line. Obviously, there's been peaks and troughs, but pretty much a straight line over the last 12 months, probably the last 24 months.

 

 

It's a stock that I'd look at as a chart and say, 'Listen, it may be on my expensive radar, but I'd sure as hell never put a short on it yet until I see evidence that the market's falling out of love with it.'

 

Shannon Rivkin:

Look, I might just add a couple of things because I think Scott's covered it a lot and I think he's made a few good points. The one thing I'll say is because of the technology side of it, I think this is a business that still has so much potential in it. In Australia, they've been able to increase their market share because they have such a better technological offering than everyone else. Can that be expanded into other things like burgers and etc.? Probably, so there's probably room for them to actually make solid market share grabbing acquisitions in Australia.

 

 

What they've done. What, better really than anyone in Australia has been able to leverage what they have, which is great technology. Overseas, make great acquisitions in Japan, great acquisitions in France. What they've been able to do is start to increase the market share over there in countries, as well, where pizza isn't that popular at least compared to the US and Australia. If they continue to make great acquisitions and leverage what they're doing here, I think the sky's the limit.

 

 

That's why it looks expensive, but if they continue to have the same sort of earnings growth they've been showing, continue to make great acquisitions, I just don't see why it can't keep going. I'm with Scott in that, yes, I like the logic of a short position because it is expensive and when things turn, there could be great downside on there. But until that point, you're betting against the momentum of this business.

 

 

Right now, I think that's a very dangerous thing because the stock could go a lot higher before any issues start to arise.

 

Scott Schuberg:

Yes. Thank you for sharing.

 

Shannon Rivkin:

Great question.

 

Scott Schuberg:

Great kind for a conversation like that, Darren, which anyone can transpose of in many other kind of topics and situations.

 

Shannon Rivkin:

Oh, yes. We talk a lot about high P/E stocks that we love and would love to own. The risk we just said is why we don't just buy them, just saying that they're great businesses. Just seeing a high P/E usually means it's a high volume business and all things being equal, we'd love to own the majority of them.

 

Scott Schuberg:

Yes.

 

This video contains general advice only

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