Why Does Warren Buffett See Opportunity in This Highly Valued Pizza Giant?

Ninety-four-year old Warren Buffett is still investing, but the biggest news he's made this year has actually been his massive stock sales and the rising cash pile at his conglomerate Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B).

But Berkshire hasn't only been selling stocks; it's been buying some too, even if the buys have been in more modest amounts.

In its recent 13-F filing, Berkshire disclosed a new $550 million stake in Domino's Pizza (NYSE: DPZ) bought in the third quarter. It's an interesting buy, as the pizza chain's shares appear more expensive than the typical Buffett stock.

But that's only at first glance. Here's the Buffett-esque case for buying Domino's now.

A P/E of what?

At first glance, Domino's looks too expensive to be a Buffett pick, at 28 times earnings. That being said, the purchase was likely made at somewhat lower levels, with Domino's valuation bottoming out at just under 25 times earnings during the summer.

That's still higher than the typical P/E ratio at which Buffett buys a stock. And while the purchase could have been initiated by one of Buffett's two younger investment managers, Todd Combs and Ted Weschler, both "Todd and Ted" also share Buffett's strict value investing discipline.

Image source: Getty Images.

But it may not be high for Domino's business model

Even though Domino's valuation seems high, its asset-light business model has allowed the stock to sustain a high-looking valuation for years.

You see, Domino's has a highly franchised business model. In fact, 98.6% of Domino's restaurants are franchises. In that type of model, Domino's takes franchise fees and a small margin selling pizza ingredients and equipment to franchisees. In addition, Domino's outsources all international development to large master franchisees, who manage entire or large parts of overseas markets.

Because franchise fees are tied to revenues, not profits, and franchisees need to consistently buy supplies, there is very little "risk" in Domino's earnings stream compared with other companies that bear 100% of their overhead costs.

That's why Domino's and other franchise-heavy restaurant businesses tend to trade at high P/E ratios. So while Domino's stock fell to "only" 25 times earnings, that was actually close to a decade-low valuation for the stock:

DPZ PE Ratio data by YCharts

Why Domino's sold off in Q3, and why Berkshire may have pounced

The Berkshire buy likely came after Domino's second-quarter earnings release, after which the stock fell about 20% to levels more than 25% below its 52-week high. With the stock down that much and at a historical trough valuation, Buffett or his managers likely smelled opportunity.

But that would depend on the reason for the sell-off, and whether or not it was warranted.

The big negative on the second quarter release was that Domino's lowered its outlook for international store openings this year, after it became clear its largest master franchisee, Domino's Pizza Enterprises, which operates many several big markets in Europe and Asia, was closing more stores than anticipated. So, while Domino's had initially forecast 1,100 global net openings, it cut that figure to 825-925 for this year.

At first glance, that doesn't seem like a big enough deal to warrant such a sell-off. The lower openings target actually reflects increased closings in a couple select geographies, while gross openings continue apace. And Domino's still maintained the same overall 7% revenue and 8% operating profit growth guidance for the year. This was due to the fact that the closed restaurants were low-revenue and under-performing stores to begin with. So, while the headline net openings number is now lower, it shouldn't make for a big difference to this year's results, according to management.

Meanwhile, Dominos sees lots of room to grow

The growth hiccup mainly happened in the markets of Japan and France, but those aren't the biggest growth opportunities for Domino's. Internationally, Domino's sees the potential for 40,000 restaurants, far higher than the 14,000 it currently has, with major growth opportunities in India and China.

Even in the U.S., management sees the potential to continue taking market share. Management sees the company growing same-store sales at 3% over the long term, with 175 new domestic stores to be opened over each of the next few years, adding to that growth. That should be enough to continue taking market share, given the quick serve restaurant (QSR) category is only projected to grow 2%.

On the third-quarter call, management said that even after Domino's impressive share gains over the past decade and becoming the largest pizza chain in the U.S., its market share still remained just under 25% of the U.S. pizza market. CEO Russell Weiner noted that in other types of retail categories, the dominant player can be as much as 50% of the market. So, that is where Domino's thinks it can grow.

The current adverse retail environment may also be advantageous in accelerating those share gains. The QSR industry is in a slowdown after years of cumulative inflation has pinched consumer budgets. But Domino's generally has a low-cost value product, often delivered within 30 minutes, and its scale gives it an advantage over rivals. These competitive advantages could enable Domino's to take even more share over weaker or more expensive competitors in a soft restaurant market.

A quality company at a fair price

While not a bargain-priced deep-value investment, Domino's is a high-quality company trading at a fair price. While the stock has appreciated since Berkshire's likely buy, it's still well below its all-time highs, and could make for a strong buy -- even today.

Don’t miss this second chance at a potentially lucrative opportunity

Ever feel like you missed the boat in buying the most successful stocks? Then you’ll want to hear this.

On rare occasions, our expert team of analysts issues a “Double Down” stock recommendation for companies that they think are about to pop. If you’re worried you’ve already missed your chance to invest, now is the best time to buy before it’s too late. And the numbers speak for themselves:

• Nvidia: if you invested $1,000 when we doubled down in 2009, you’d have $350,915!*
• Apple: if you invested $1,000 when we doubled down in 2008, you’d have $44,492!*
• Netflix: if you invested $1,000 when we doubled down in 2004, you’d have $473,142!*

Right now, we’re issuing “Double Down” alerts for three incredible companies, and there may not be another chance like this anytime soon.

See 3 “Double Down” stocks »

*Stock Advisor returns as of November 25, 2024

Billy Duberstein and/or his clients have positions in Berkshire Hathaway. The Motley Fool has positions in and recommends Berkshire Hathaway and Domino's Pizza. The Motley Fool has a disclosure policy.