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Earnings wrap: The a2 Milk Co, Domino's Pizza

Glenn Freeman  |  22 Aug 2019Text size  Decrease  Increase  |  
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Domino's (ASX: DMP) shares remain undervalued despite a softer outlook flagged during fiscal 2019 results, and A2 Milk's (ASX: A2M) 41pc revenue growth warrants a fair value upgrade, say Morningstar analysts.

Morningstar tips Domino’s margins to recover

A largely disappointing fiscal 2019 result from Domino's Pizza (ASX: DMP) has nonetheless left Morningstar only slightly cooler on the company's prospects over the longer term.

Equity research director Johannes Faul says Domino's $1.65 in underlying earnings per share met his expectations, "but there were a few disappointments only partially offset by the highlights".

Faul has downgraded his fair value estimate by 2 per cent to $52 a share – from $53 – reflecting a drop in EPS estimates of 9 and 10 per cent for 2020 and 2021.

"But outer years’ earnings are less affected, because we anticipate margins to recover as corporate stores are converted back into more profitable franchised stores," Faul says.

Trading at $43.20 at midday, Domino's share price remains about 17 per cent below Morningstar's fair value estimate, despite the downgrade.

Signs for optimism include strong sales in Japan, which for years has underperformed. Same-store sales grew 8.4 per cent, almost double Morningstar's forecast of 4.8 per cent growth "and much improved on the flat to slightly negative growth seen over the past three years," says Faul.

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Lower-than-expected growth in store numbers during the year, particularly in Australia and New Zealand, was a key miss for the fast-food retailer, which opened 179 new stores globally versus its target of 200.

In Australia and New Zealand only 6 new stores were opened.

This is despite this Australia/NZ being Domino’s largest and most profitable region, comprising 40 per cent of group sales and 45 per cent of total earnings before interest, tax, depreciation and amortisation.

"The rollout of new stores stalled predominantly in Australia and New Zealand, where only 6 net new stores opened," Faul says.

Domino's said it was operating a higher mix of Australian and NZ corporate stores after 22 underperforming franchisees were removed amid allegations of underpaying staff.

"We have identified some of those franchisees who have demonstrated they no longer had the passion or capability to execute successfully as we grow," Domino's Australia and NZ chief executive Nick Knight said on Wednesday.

Domino's faces a class action lawsuit in Australia that claims, among other things, that the company and its franchisees systemically underpaid workers for five years – claims company management rejects.

"We believe that the entitlements of franchisee workers were governed by our enterprise agreements and that we have at all times acted in accordance with those enterprise agreements," the company reiterated on Wednesday.

In any case, Morningstar doesn't view this as a substantial threat to profits, with Faul indicating even the worst-case outcome for Domino's only represents around 3 per cent of his fair value estimat.

Online delivery operators such as Uber Eats and Deliveroo pose a more serious, but not insurmountable, threat to Domino's.

"We don’t expect this to impede Domino's ability to expand its Australian network stores to 1,000," says Faul, who notes management didn't call out "delivery aggregators" as a headwind in sluggish ANZ store sales growth in fiscal 2019.

In a report published last month, Faul said he believes expansion of the "Internet of Food" still leaves room for Domino's to expand "just at a slower rate".

Full analyst report: Domino's Pizza takes near-term hit in ANZ for long-term gain; FVE lowered to $52

A2 Milk's better margin outlook prompts upgrade

Morningstar has shrugged-off the share price dip that accompanied A2 Milk's result for fiscal 2019 yesterday, when the Kiwi company posted a below-consensus 41 per cent jump in revenue.

A2 shares are still up more than 30 per cent for the year, trading at $13.83 at 1pm Thursday, but down from the historical highs of around $16 seen in late July.

Morningstar Australasia director of equity research, Adam Fleck, lifted his fair value estimate to $14.20 a share, from $13.60, on the expectation of improving EBITDA margins over the longer term.

The company yesterday flagged higher costs linked to marketing, personnel and customer analytics – part of building its brand positioning – would remain elevated for longer than previously expected.

"Nonetheless, we expect these investments will benefit the firm over the long run.

"We’ve reduced the magnitude of these improvements, and now assume margins rebound to 32 per cent versus 35 per cent previously. But we expect these investments will result in slightly higher revenue growth through fiscal 2029," says Fleck.

Morningstar has reduced its shorter-term forecasts, including lower EBITDA margins – though improving top-line growth partly offset due to continued strength of US liquid milk sales and the benefit of improved marketing.

"In all, our projected EBITDA for fiscal 2020 falls to NZ$472 million, from NZ$495 million," Fleck says.

Sales of infant formula, particularly into China, remain the primary revenue contributor for A2 Milk, and Fleck expects this will continue after a "robust" fiscal 2019.

Revenue from infant formula leapt 47 per cent year-on-year and he anticipates market share in China to reach almost 8 per cent in fiscal 2020.

Fleck sees A2's infant formula sales in China climbing at a 16 per cent compound annual growth rate over the next decade, revenue growth of 30 per cent and a long-term market share target of 15 per cent.

"A2’s marketing investments, combined with continued successful navigation of an ever-changing Chinese regulatory environment and product launches to reach a broader range of children, support our forecast," he says.

US sales grew 160 per cent to NZ$34.6 million, although the segment posted an earnings loss of NZ$44 million in fiscal 2019, as A2 invested in distribution and brand awareness.

In the long-term, Fleck expects EBITDA margins from the US liquid milk business to surpass 10 per cent, "but we've pushed back our assumed breakeven point to fiscal 2023 from fiscal 2021".

On the downside, management yesterday revealed it would exit the UK liquid milk business because there was more opportunity in greater China and the United States.

Pointing to this example, Fleck cautions that A2's growth in China and the US may not be replicated in all markets where it has a presence.

If the increased investment in marketing in the US and China fail to boost profit margins beyond current levels of around 28 per cent, all else being equal, Fleck says Morningstar's fair value estimate for A2's share price could come off by 10 per cent.


is senior editor for Morningstar Australia

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