It’s been a rough year thus far for the restaurant industry, with a pullback in traffic, higher costs due to commodity/wage inflation, and a challenging environment for some companies from a traffic standpoint.
The result is that much of the group has become un-investable, and some names are looking worse by the month, including Red Robin (RRGB), which will post its third straight year of heavy net losses in FY2022.
Given this backdrop, the best strategy is to focus on the industry leaders and those with proven business models enjoying unit growth and still enjoying strong restaurant-level margins.
However, in a sector where there are still several names with these attributes, it’s tough to decipher which are the best to own. In this update, we’ll compare newly public restaurant operator First Watch (FWRG) with long-time franchiser Dominos Pizza (DPZ) and see which is the better name to own in the current environment.
Scale & Business Model
Dominos and First Watch are akin to David and Goliath from a scale standpoint, with Dominos being the largest pizza company globally with ~19,300 restaurants and First Watch being an emerging breakfast chain with ~450 restaurants.
The differences in the business model are also night and day, with Dominos being a 98% franchised model with a significant international footprint and First Watch being a primarily company-owned company model, with just 22% of its restaurants being franchised currently.
While Dominos’ operators have seen some headwinds due to elevated cheese prices and difficulty securing drivers from a margin standpoint, Dominos is more inflation-resistant than First Watch, given its franchised model where operators bear the brunt of higher costs.
The good news is that First Watch still has very respectable restaurant-level margins, even if they dipped 440 basis points in the most recent quarter. Besides, this margin erosion was largely due to a conservative pricing approach to maintain its value proposition. Plus, as its alcohol mix grows and it’s rolled out to 100% of the system, we could see some additional benefit from a margin standpoint.
That said, Dominos is the clear winner from strictly a margin standpoint, with 30% plus gross margins and double-digit operating margins vs. First Watch at 21% and 4%, respectively, on a trailing-twelve-month basis.
Domino’s Pizza - 1 / First Watch - 0
Unit Growth & Positioning In A Recessionary Environment
Moving to unit growth, First Watch is the leader by a wide margin, with considerable white space (~450 restaurants in 28 states vs. ambitions of up to 2,500 restaurants) and consistent double-digit unit growth rates. Meanwhile, Dominos has continued to grow at an impressive pace given its scale but will be lucky to grow at 5% this year and 4% next year.
However, from a positioning standpoint, pizza tends to hold up better than casual dining occasions, given its relatively low average check to feed the family, the ability to skip tips to keep checks low when picking up, and convenience. In fact, Dominos started paying guests for picking up earlier this year with a $3 tip in the form of online credit.
That said, First Watch’s traffic is clearly suggesting a different story, with it being one of the only brands industry-wide to see positive but high single-digit traffic growth in Q2 (8.1%). This suggests that First Watch’s differentiated menu might make it more recession-resistant than some of its casual dining breakfast peers.
It’s also possible that its breakfast daypart might be stickier, with it being a tradition for many families to go out for breakfast on weekends without breaking the bank vs. a higher check dinner occasion.
So, with better unit growth and what appears to be similar positioning in a recessionary environment due to recent traffic trends, First Watch wins in this category.
Domino’s Pizza - 1 / First Watch - 1
Finally, from a valuation standpoint, Dominos is not cheap at first glance, trading at ~22x FY2023 earnings estimates in a recessionary environment with some margin compression. That said, Dominos has historically traded at 27.8x earnings (15-year average), and even using a 5% discount to this multiple (26.4 x 27.8) places a fair value on the stock of $393.40.
Meanwhile, First Watch trades at 47x FY2023 earnings estimates, and while a premium valuation is justified, this is not cheap when the S&P-500 (SPY) is in a cyclical bear market, and growth stocks are being taken down due to multiple compression.
So, while I think there is some upside for FWRG long-term as its earnings play catch-up, DPZ is the more attractive bet from a valuation standpoint.
Domino’s Pizza - 2 / First Watch - 1
Dominos and First Watch both make excellent buy-the-dip candidates, but neither are in low-risk buy zones just yet, even if Dominos is the better restaurant stock to own on the above criteria, slightly edging out the newly listed and high-growth breakfast concept, FWRG.
However, if we were to see DPZ decline below $292.00, or FWRG below $14.20, I would view pullbacks to these levels as buying opportunities.
For now, I see safer bets elsewhere in Retail, such as Capri Holdings (CPRI), which trades at less than 6.5x FY2023 earnings estimates.
Disclosure: I am long CPRI
Disclaimer: This article is the opinion of the contributor themselves. Taylor Dart is not a Registered Investment Advisor or Financial Planner. This writing is for informational purposes only. It does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Taylor Dart expressly disclaims all liability in respect to actions taken based on any or all of the information in this writing.