Company finance fundamentals and applications

Company Finance

Domino's UK & Ireland has succeeded admirably during the economic downturn, largely due to the actions of management. The company "monitors its cash resources through short, medium and long-term forecasting" (2009 Annual Report). This allows the company to borrow funds where needed and to make strategic moves such as share buybacks at times when these moves are most affordable. Domino's bought back £10.6 million worth of shares in 2009. It also increased its cash position in advance of this; as the buyback remains a liability on the books the cash position had to be increased to make the buyback (2009 Annual Report). The company faces low operational risk with regards to economic downturn -- Domino's benefits from people spending less eating out and more eating at home. The company continued to expand during this time and restored its gearing level to more historic norms from a low in 2007 (Domino's Investor Relations, 2010).

Scenario planning also played a significant role in the company's success. The company has maintained focus on delivering value to customers, including new store growth to increase market share and reduce delivery times, and the introduction of a new mobile unit (Domino's press release, 2009).

Whereas some firms may prepare for divestitures in economic downturn, Domino's expanded operations. The company added 55 stores in 2009 and launched its new mobile units (2009 Annual Report). This pace of expansion is expected to continue through the next decade. The company cited increased availability of "good properties at sensible rents" that emerged as a result of the downturn (no author, 2010). With strong profits, including an 8.4% increase in same store sales, there is little reason for stakeholders to lack confidence. Domino's exceeded expectations for the year comfortably (RTT News, 2010).

2. Dividend policy at Domino's UK is oriented towards the payment of dividends when possible. The company believes that paying dividends, reinvesting earnings and making share buybacks are a three-pronged approach to building shareholder wealth. Domino's keeps a low gearing ratio as well, in order to retain its ability to grow slowly and organically.

In 2009, Domino's paid a dividend per share of 5.90p on earnings per share of 10.86p, indicating a dividend payout ratio of 54%. The payout ratio has steadily increased over the past five years, as it was 51.8% in 2007, 49% in 2006, 45.7% in 2005 and 39.3% in 2004. During that time, Domino's has held its gearing ratio relatively steady at either 0.3 or 0.4, except for one exceptional year at 0.1. This indicates that the company is committed to paying back its shareholders, rather than taking on debt. It also indicates that Domino's UK is in a strong financial position as not only does the company not need debt in order to finance its growth but it can also grow rapidly without compromising dividend payments.

Normally, a firm that is growing rapidly will retain most of its earnings in order to fuel that growth. In lieu of retained earnings, debt financing is required in order to grow. That the gearing has not increased indicates that Domino's is using retained earnings to fuel growth. The company has taken a conservative approach to growth, however, and is therefore able to grow using retained earnings while still plugging more money back to the shareholders. The company has routinely engaged in share buybacks in order to enhance shareholder value, and this was the situation again in 2009 with a buyback of £10.6 million worth of shares at the end of the year.

This strategy has been a success. Coming on the heels of another excellent year in 2009, Domino's double its shareholder equity from £12.7 million to £21.5 million in 2009. In addition to the dividends, the company's shares have generally seen strong growth as well. A sharp growth pattern in the early 2000s lead to a stock split in 2007 (Patel, 2007), after which the company's shared have grown slowly but steadily from 250p to the current level of 339p (London Stock Exchange, 2010).

The company's strategy with regards to building shareholder wealth has been successful because it recognizes the balance between growth and returning value to shareholders. Many firms predicate their entire shareholder wealth strategy on growth, but Domino's understands that with slower growth they can build their market presence without taking on too much leverage, and without compromising the shareholders. They recognize that although their particular company has the opportunity to grow, they can best manage their growth by doing it slowly, choosing the right locations and the right franchisees. This more conservative growth trajectory means that the company can not only be restrained in its use of leverage but does not need to keep excessive amounts of cash on hand. By slowing the growth via new stores, Domino's is able to also focus on growing its same-store sales. It has been able to record strong same store sales growth for each of the past five years. As a result, the company has driven good value from its existing, mature, operations. As with any mature company that makes money in almost all economic circumstances, once growth objectives have been achieved, the best value in reinvesting the capital is in returning that wealth to the shareholders. Many of Dominos' strategies, from the split to the buybacks to the steadily increasing dividend payout ratios have been oriented towards enhancing shareholder value.

3. The credit crunch has had little impact on Domino's UK. The company finances the majority of its growth with retained earnings. Moreover, its profits have grown throughout the economic crisis, so there is little cause for a lender to have trouble with the company. Because of this success, the company has remained well within its debt covenants. For example, it is required to maintain a debt-to-EBITDA ratio is 2.5 and the current ratio is 0.5. The company acquired non-recourse loans at a rate of 0.5% over LIBOR, which does not indicate that the company saw its cost of debt increase as the result of the credit crunch. Management feels that no new debt will be required to finance the firm's expansion program though 2017 (2009 Annual Report).

One of the ramifications of Dominos' ability to continue to grow throughout the entire economic downturn is that the company has experienced strong stock growth during that time. The company consistently grew in terms of the number of stores, in terms of same store sales, in terms of dividend payout and in terms of profits. If the efficient market hypothesis holds, strong performance should result in strong stock performance as well, regardless of the prevailing economic conditions. For a time in 2008, however, this did not take place. As a result, Dominos' stock was undervalued in the market for a while. When the company reported stronger than expected earnings, the market began to see the value in the company and the share price has increased rapidly since that point.

The stock market appears to have reacted quickly and irrationally, maybe not with respect to the FTSE 100 but with respect to Domino's Pizza UK & Ireland. The company's stock traded downward beginning in the spring of 2008 and dropped sharply at the end of June. From there, the stock remained at 20% below spring of 2008 levels until the beginning of 2009. This decline roughly tracked a similar decline in the FTSE 100. This decline was irrational in light of the company's earnings over that period. The market expected that Domino's would fall, mostly because it expected almost every company to fall. In fact, the market was ignoring the underlying business fundamentals. Domino's, being a low cost provider in an industry expected to see consumers scale down their spending, can reasonably be expected to benefit from economic downturn.

The company increased its dividend in its half year report in 2008. Despite the 42.1% increase in the dividend, the market knocked the share price down. Management was obviously confident about its future earnings, but the market was not. When earnings exceeded expectations at the end of 2009, the company's shares began to move sharply upward. At that point, the FTSE 100 continued to slide downward. The divergence that should have occurred throughout the latter half of 2008 finally occurred in early 2009. Since approximately March 2009, Domino's performance has mirrored that of the FTSE 100. The magnitude of the growth, however, is higher for Domino's, which is now nearly 60% over its starting point two years ago. The FTSE 100 is still under water. This is more accurately reflective of the actual market performance of both the company and the index. It appears that while the market reacted irrationally in the middle of 2008 it has finally reacted rationally with regards to the performance of Domino's. If anything, the fact that Domino's has been one of the few success stories through the recession has convinced the market to slightly overvalue the stock.

4. It can be expected that Domino's UK is fairly valued in the market today, if the efficient market hypothesis holds true. With Domino's UK, the company has in its annual report and in its press releases outlined its future expansion plans. There are figures readily available with respect to trends in its same store growth and with respect to its dividend policy. All of these factors should, in theory at least, be included in the current share price. The first step in valuing the company will be to ensure that this is the case.

Given that the price of the company today is expected to be the fair value of the company's future earnings, an acquiring firm would need to consider in its valuation the worth of Domino's as part of its operations. Thus, a bid would need to be done on the belief that its acquisition of Domino's would make Domino's more valuable than it already is. This is the concept of synergy, defined as "the specific increases in performance beyond those already expected for companies to achieve independently" (Sirower, 2000).

As such, the potential acquirer would need to evaluate the Domino's business in conjunction with its own. If the acquirer believes that it can help the franchisees run their operations better than they are currently doing, this may result in greater payments to head office. There may be opportunity to tie up two different fast food brands together to create synergies. This tactic has been used in the industry before, such as the creation of Yum Brands in the U.S. Or the tie-up of Wendy's and Tim Horton's in Canada. Driving value in an acquisition often comes down to analyzing strategic synergies and exploiting those. The premium that the acquirer is willing to pay is reflective of those synergies.

When such synergies fail to emerge, shareholder wealth is destroyed rather than created in the course of the merger. Evidence shows that upwards of 60% of mergers ultimately fail to enhance shareholder value (Tetenbaum, 1999). Synergies often come down to operational synergies or marketing synergies. Valuing these is a rough science at best. There are some precursors to merger success, however. As noted, the acquirer should be a fast food company, as complementary operations increase the opportunity to cost savings and co-marketing efforts (Larsson & Finkelstein, 1999).

The valuation of the company to be purchased, therefore, needs to take into account the odds and magnitude of synergy derivation. A company should not pay on the basis of the best case scenario as they will almost surely overpay. The acquiring firm should make an estimate based on past acquisitions and the synergies those were able to generate, and should also take into account the result of other merger and acquisition activity in the industry.

In addition to operational synergies, there are also marketing synergies. The examples listed above both showed that complementary product lines can help to drive increased business to the company. Acquiring Domino's, for example, would give a firm access to over 500 retail locations and would give it high profile sponsorship partnerships, in addition to festival access currently enjoyed by the mobile Domino's units. A path marketing analysis can help the acquiring firm understand what synergies may be available and how they might be achieved, including the exploitation of captive sales gaps, tangible product gaps, price gaps, distribution gaps and promotion gaps (Weber & Dholakia, 2000).

Once the different synergies and their potential value is estimated, this will provide a ballpark for the potential synergy value of the acquisition. The acquiring firm would then set this level as the ceiling for its bid. The reason for this is because while many acquisitions deliver synergies, they reduce shareholder value because the synergies fail to exceed the synergy premium paid at the time of the acquisition (Eccles, Lanes & Wilson, 1999).

A final step that must be considered by the acquiring company is the degree of financial synergy that will result from the transaction (Damodaran, 2005). In this situation, Domino's has both stable cash flows and from that a low cost of capital. The acquisition of Domino's therefore could lend financial stability to the acquiring firm and lower its cost of capital. The financial benefits of the merger must include these aspects in the synergy premium. With a lower cost of capital, all of the firm's cash flows become more valuable. The opportunity may exist to restructure the acquiring firm's existing debt as well, again lowering its costs. There are considerable financial synergies that would be gained from purchasing Domino's UK.