The profitability challenge
Returning to margins, the Q3 restaurant earnings cycle felt like a roll call on the topic. There was a definitive change in management tone, however, toward commodity inflation among multiple restaurant and food distributors. Although Saleh doesn’t expect commodities to deflate meaningfully in the near future, he is confident the rate of inflation has begun to moderate, which could translate into real deflation later in 2023 or early 2024. US Foods (overall inflation moderated from 15 to 12 percent in Q2) and Performance Food Group reported center-of-the-plate deflation, while Texas Roadhouse (cut Q4 commodity outlook in half to 4.5 from 9 percent, mostly on moderating beef prices), Chipotle, and Wingstop (wing prices down 43 percent) all cited moderating trends, if not full-on deflation, in certain areas.
The package of commodity inflation, labor battles, and other inflationary heat, like utilities and supplies, led to 420 basis points of restaurant-level margin contraction in 2022 for the brands Saleh’s BTIG covers. “While we believe that restaurant margins always recover to historical levels through pricing, commodity deflation, efficiency and the like, this recovery takes time, and development tends to follow the same directional trend as margins, and unit economics.” To reiterate, margin recovery unfurling across 2023/2024 would lead to “significant unit growth” in 2024/25.
Similar to the field, Saleh feels Domino’s commodity basket inflation peaked in Q2 2022 and has softened since. For the full year, he projects the basket to increase at least 13 percent, including low double-digits in Q1, 15.2 percent in Q2 (the high level), and about 13 percent for the balance of the year.
Yet projecting 2023, Saleh said Domino’s could experience low-single-digit commodity inflation, which would be more than offset by the mid- to high-single-digit pricing already in place. The result? An expansion in margins.
Cheese, proteins and cardboard (boxes) are the most meaningful input costs for the company, Saleh added. Year-to-date, cheese (about 35 percent of commodity basket) is up about 4 percent, declining to $2.07 per pound recently from a peak of $2.40 in the spring. “While cheese is a very volatile commodity that is nearly impossible to predict, it has hovered above $2 per pound nearly all year, and has rarely [last 10 years] been above $2.35 per pound,” Saleh added. “If cheese prices revert to the mean, Domino's could experience significant moderation in its commodity basket.”
Concerning proteins, or toppings in Domino’s case, there’s been widespread reports of chicken prices easing, as well as beef, and even pork. Saleh expects chicken prices to continue their downward trajectory into 2023, adding Domino’s Specialty Chicken platform as well as its pizza topping costs, and moderation in other options like pepperoni.
For the past five years, Domino's has averaged 22.6 percent restaurant-level margin, varying about 50 basis points on average. Saleh projects company-owned restaurants margins of 14.7 percent in 2022, more than 800 basis points below their historical average over the past decade. Looking ahead to 2023, he’s forecasting a 200-basis point improvement, but notes the figure “could be much higher,” especially if Domino’s does decide to pull the price trigger on the $7.99 carryout offering.
The wider look
Broadly speaking, as inflation has ebbed somewhat, restaurant pricing in Q3 was at seemingly all-time highs with chains like McDonald's and Wendy's sitting around 10 percent, and Chipotle at 13 percent, Saleh pointed out. According to Black Box Intelligence, average checks rose 8 percent sector-wide in recent months. Saleh said “evidence is building that commodity prices are rolling over for the first time in several years, which could bring some welcome margin relief next year, and cause restaurant operators to ease off the incremental price hikes.”
As for development, Saleh said restaurant growth nearly always follows the directional trend of unit economics. Over the past six months, he’s held conversations with franchisees across multiple concepts, and there’s been a clear, pessimistic tone on development, Saleh said, as commodity and labor inflation took their toll on margins. He hypothesizes franchisee EBITDA margins are down 300–350 basis points in the past year, and well off their recent peak of 13.5 percent. Couple that with rising construction costs and cash-on-cash returns have potentially been cut by a third in the past two years. That’s the heart of why Saleh feels development won’t tick up in 2023 for most, but should accelerate as margins ultimately recover.
For Domino’s specifically, Saleh targets $1.3 million franchise average-unit volumes in 2023, down less than 1 percent versus 2021 and up 13.5 percent compared to 2019 as Domino’s has held sales volumes, mostly, in face of the driver shortage.
Across quick service, the decision to slow development and turn focus on recovering margins has been evident. At Wendy's, unit growth targets were trimmed to 2–2.5 percent from 5–6 percent at the beginning of the year, Saleh shared, while Papa Johns reduced its unit opening guidance for the year to 240–260 units from 280–320 previously.
“A recurring theme of franchise checks we have conducted in the second half of the year has been waning enthusiasm for new unit development compared to 6–12 month ago,” Saleh said. “The combination of restaurant margin degradation, persistent labor challenges. and higher developments costs [typically up 15–30 percent versus 2021] has significantly changed the calculus for new unit returns and led many to reprioritize new units in favor of existing ones.
Domino’s domestic franchisee development slowed to its quietest pace since 2015. The brand hunkered on pricing and worked to attract more drivers. “We believe franchisees are hesitant to build new stores as they struggle to staff their existing restaurants,” Saleh said. “That said, we believe the recent price increases implemented on the Mix and Match menu, and the additional pricing we expect them to take next year should help margins recover, and eventually translate to unit growth.”
Domino’s opened a net of 24 U.S. shops in Q3, pushing its domestic count to 6,643. The growth is a steep slowdown from last year, when the U.S. segment opened a net of 45 units. CFP Sandeep Reddy owed the sluggish movement to delays in permitting and construction. But he added in Q3 those headwinds were temporary, and once Domino’s gets past them, he’s confident the pizza chain will reach its long-term of 8,000-plus stores in the U.S.
Back on the Domino’s projection
Saleh called Domino’s a “secular market share gainer in the pizza category.” Indeed, despite all the aforementioned delivery challenges, Weiner said in Q3 the brand “delivered around one out of every three pizzas in the United States before the pandemic, and we deliver around one out of every three pizzas today.”
The reasons are nothing novel. Domino’s digital ordering, national marketing, and value have been difficult for peers to rival for going on a decade now. Strengths across these buckets have driven considerable increases in retail sales, market share, and unit economics as Domino’s climbed atop the country’s pizza chart. The brand closed 2021 with U.S. systemwide sales of $8.641 billion and 6,560 locations—a gain of 205 net, year-over-year. Pizza Hut reported results of $5.5 billion and 6,548, respectively, which was a net decline of 13 from 2020. Little Caesars followed at $4.185 billion (estimate) and 4,181 units, with Papa Johns next at $3.486 billion and 3,164 units.
“We believe management's more aggressive pricing posture over the past three quarters and anticipated future pricing should not only drive margin expansion, but should allow them to better compete for driver availability,” Saleh said of Domino’s outlook.