Domino's Pizza - 2nd Serving
Following up on Domino's, a look into how it's unit economics give it a competitive advantage
So last week, I took a look at the core business model of Domino’s Pizza. A quick review — it’s a franchise model that does a good job in allocating the fees from it’s franchisees to cover corporate technology development along with Sales and Advertising spend. This leaves it to concern itself primarily with General Expenses, as the franchisees take care of Capex for their stores.
However there were two key areas that we didn’t get into. These are important key areas, because they are the future of fast food/fast casual. I’m talking about unit economics (cost of goods sold) and delivery economics. Particularly delivery economics are an important one to keep in mind, because this is one of the key factors that is affecting the restaurant industry due to the emergence of delivery platform aggregators.
Let’s start by looking at unit economics. When you think about food, not all food is made equally. For example, consider a McDonald’s burger.
You’ve got your bun, cheese, beef, lettuce, tomatoes, onions, sauce, ketchup, mustard and if it’s a combo potatoes and gallons of oil. Of course proteins and vegetables are typically the primary driver of food expenses in the restaurant industry.
Now consider Domino’s unit economics….
Flour, yeast, tomato sauce, cheese, and a smidge of oil. As you can imagine, the unit economics of a Pizza are much better than those of a burger. Except for soft drinks. Coke from a machine, or coffee with breakfast provides fantastic unit economics leading to high margins.
However on a whole a franchisee for Domino’s will get a better margin out of an order than a franchisee for a McDonald's. That’s why feeding a family of 4 at Domino’s is cheaper than feeding a family of 4 at McDonald’s (unless you load up on 0 margin items like the dollar menu) with no drinks.
On a corporate level if you look at the margins between Domino’s and McDonald’s you will see that McDonald’s has much higher margins, but not because the business is cheaper to run, rather because McDonald’s franchise model has significant economies of scale. In addition to a higher initial fee for new franchises, McDonald’s franchises pay around 15% of sales in fees and rent (similar to Domino’s). But McDonald’s scale lets it less than 12% of revenues in SGA expenses. Domino’s is around 2x that amount. So scale matters.
Domino’s also deals with a cost that historically McDonald’s hasn’t until recently — delivery costs. Let’s talk about those costs and how the rise of menu aggregators is changing the landscape.
Because Pizza has low costs of goods and travels well, historically Pizza chains have been able to offer delivery as an add-on convenience service. However recently platform aggregators have been able to onboard franchises that historically don’t do delivery by leveraging their delivery networks and trying to pass those costs down to the customers by slowly increasing the price of these services as they scale and lock down markets.
While Domino’s has been resistant to using these platforms, they aren’t immune to the presence of them. Specifically because these platforms can create competition for two valuable resources — delivery drivers and eat-at-home buyers. One key advantage of the platforms is that their drivers are classified as subcontractors and not as employees. That mean’s there are a few major differences when it comes to two major expenses. Insurance and wages.
Most Personal Auto Insurance policies do not cover delivery drivers for an Uber Eats or for a Domino’s Pizza. One insider estimated that only 10 to 15% of Domino’s delivery drivers get the proper insurance coverage. Because of this the company has to acquire it’s own secondary policy. Since their drivers are employees, they can’t chance an accident. The insider estimated that this generally runs about 5 to 10k per store.
Door Dash does have a 1M Commercial Auto Policy, but unlike Domino’s which is expensed at a franchise level, Door Dash is purchased at a corporate level. I’d imagine Uber Eats does something similar. While the exact amounts they spend on this are unknown, it’s a reasonable bet that these aggregators that purchase as a corporate entity will end up having lower insurance rates if for nothing else due to the power of scale, whereas Domino’s Franchises even at a corporate negotiated discount rate, may face higher costs due to it’s more fractured purchasing model (i.e. each Franchise buying for itself increases business costs). Even if the costs are similar, it’s undisputable that the platform aggregators have a simpler corporate structure to navigate.
Also worth considering is wages and how those are effected by classifications. Again because Driver’s are employees at DPZ, they must be paid minimum wages. In some states the wage structure is complicated. When making deliveries they are paid tip wages, when in the store, they must meet normal minimum hourly wage requirements. Historically one way a less forthcoming driver could boost his salary is by not reporting his cash tips. The company would then have to increase his hourly wage to meet the legal requirement, while the driver pocketed the cash. The increase in electronic tips has changed that. It’s harder for drivers to push down their tip wages with more consumers buying online. This lowers wage costs for Domino’s. However it also lowers an incentive for drivers to drive for Domino’s.
Delivery aggregators don’t have to deal with these issues, although they are under fire about employee/subcontractor classifications in numerous jurisdictions. That being said, the increased flexibility that these drivers have working for a Door Dash or Uber Eats along with comparable wages is leading to more drivers switching to drive for the delivery platforms. Generally at the moment there is a shortage of delivery drivers. This shortage has exacerbated the turnover of drivers which was already at 2/3 drivers per a Domino’s insider. One big question to think about is how changes in immigration could affect this? A major shift in policy could increase the legal drivers in the population and workers in the work force. Both of which could help fill the shortage.
One potential advantage for Domino’s is the inferior quality of the delivery from an aggregator. Aggregators aren’t employees, they don’t have brand loyalty and they don’t have a boss who they have to respond to. When your Uber Eats gets delivered cold it’s hard to figure out who was at fault in the system. Was it the platform? The restaurant? The driver? You for ordering a burger that was +3 miles from your house? You can’t choose your driver, so you just don’t pick that restaurant next time or you switch to a different platform. Either way the driver can switch platforms too, and if he flirts for 5 minutes with the cute hostess, you are going to have soggy fries again.
Pizza is a known commodity, and Domino’s knows how many deliveries they can make at one time (no more than 2), at what time the quality begins to degrade (20 minutes in the hotbox is the max), and how many deliveries they can reasonably do in an hour (4 is a good goal). This is why Domino’s the parent company prefers and promotes opening up new stores as opposed to having stores with extremely high volume. The greater the spread, the better the service, the greater the experience will be for the consumer. Herein lies the wisdom of having low capital requirements for a new store, and a quick payback period (3 years). If one franchise owner balks at opening a new store in his hot zone, someone else may be happy to do so.
It remains to be seen whether Domino’s will resist the calling of the food delivery platforms. In NYC, during the heart of the pandemic, one insider estimated that aggregators boosted demand by as much as 15% for the stores. However corporate as of now is willing to sacrifice that demand by keeping control over the brand and the deliveries.
Recently corporate announced a new agreement with Walmart where Domino’s will be opening up shop inside of select Walmart’s (McDonald’s and Walmart are ending their relationship). Worth thinking about is if this could lead to any synergies? Order your groceries and tack on 2 pizza’s for curbside pick-up? Curbside pick-up could be a game changer for the industry. Many people don’t have an issue with driving to a restaurant. Sadly however they do have issues with waiting 15 minutes in the drive through, or worse, having to get out of their car and actually interact with people to pick up an order. Full disclosure, I’m probably one of these people!
What is the future for Domino’s? I think it’s bright. Especially when you look at the potential for automation. I’ll cover that in part 3. Here’s a quick summary of parts 1 and 2:
-Domino’s is a franchise model.
-They try to make opening a Domino’s affordable, and only allow individuals experienced in the Domino’s way to be majority owners of a franchise.
-They have a strict allocation of fees from franchisee’s which cover advertising, research and development expenses.
-Pizza has great unit economics, which can be leveraged to include delivery. Delivery comes at a cost in terms of complicated wages and insurance requirements.
-Delivery is also being challenged by a new breed of delivery platforms. This adds some uncertainty to the future.
-A high quality delivery experience is a fundamental pillar of Domino’s operating strategy.
In the next article I’ll go over how Domino’s has been able to drive superior stock returns over the past few years. I’ll also explain while I don’t feel the same levels of returns should be expected, but why I still think the business is a good, old-fashioned compounder worth holding in most portfolios. Finally, I’ll discuss why automation could drive even further improvements in their unit economics along with solve some pain points in their delivery costs.