I was halfway between Sydney's CBD and my office in Pyrmont when I realised my taxi driver was crying.
He'd picked me up from a meeting and asked what I had been doing. When I told him I covered the retail sector for The Australian Financial Review he asked whether I wrote about Domino's.
The taxi driver was a Domino's franchisee. He'd sold his home for $410,000 to buy his first Domino's franchise in Sydney's west for $700,000.
Several years later he was convinced by Domino's to open a second store nearby by "splitting" his franchise.
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The theory is that new stores enable franchisees to increase their share of the local market by reaching new customers and cutting down delivery times.
That's when it all went pear-shaped. Related Quotes
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Both stores are now struggling and weekly sales have fallen from about $26,000 to $14,000, or $728,000 a year, well below the network average sales per store of $1.4 million a year.
"It's put a lot of pressure on my family," the taxi driver said, tears sliding down his face.
Splitting stores is the main way Domino's grows sales and market share in Australia and New Zealand.
Domino's plans to open 400 stores in Australia and New Zealand by 2025, lifting its network from 800 to 1200, mainly by encouraging existing franchisees to open a new store in their existing territory. Most of the new stores will be in Australia.
http://www.copyright link/content/dam/images/h/0/z/e/s/a/image.imgtype.afrArticleInline.620x0.png/1524992087409.png In the first half of 2018, Domino's opened 25 stores in Australia and New Zealand, 75 per cent of which were via store splits and 96 per cent of which were by existing franchisees or their store managers. This followed the opening of 66 new stores in 2017.
The theory is that new stores enable franchisees to increase their share of the local market by reaching new customers and cutting down delivery times.
But store splits are emerging as a major source of grief amongst Domino's franchisees as competition and costs rise. Not all splits succeed
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Domino's opened 25 stores in Australia and New Zealand in the first half of 2018. Luis Ascui
"It's the biggest problem we're seeing with the brand at the moment," said franchisee advocate Michael Fraser, of Franchise Redress. "We get calls fairly regularly about this kind of problem."
Some franchisees who agree to split stores struggle to generate sufficient new sales to cover the cost of opening and operating a second store. While they don't pay goodwill on the second store, there's the cost of rent, ovens and other equipment, and labour.
Franchisees who baulk at splitting stores become targets for audits, Mr Fraser says, and when discrepancies are found, they come under pressure to sell, often at a huge discount.
The stores are often subsequently acquired by Domino's "favoured" franchisees and multi-store operators, including joint venture partners.
Mr Fraser claims one store doing sales of around $30,000 a week, or $1.56 million a year, was sold to a favoured franchisee for $350,000, when it should have fetched more than $600,000, based on historic benchmarks.
Domino's stores usually change hands between 22 and 28-times average weekly sales, depending on whether they're renovated and the circumstances behind the sale (i.e. if a franchisee is terminated). Franchising under fire
Details about the pressures facing Domino's franchisees are expected to emerge at the parliamentary inquiry into franchising, which was called last month following a spate of scandals involving Domino's, Retail Food Group and 7-Eleven.
Submissions close on May 4 and hearings are expected to commence in late May.
Store splits aren't only a worry for Domino's franchisees – they're also a concern for Domino's investors.
In a report earlier this month, Credit Suisse analyst Grant Saligari cast doubt on Domino's long-term store forecasts, saying it was "unlikely" to reach 1000 stores in Australia because store splits did not stack up for franchisees.
Dr Saligari analysed Domino's footprint in Victoria, where the chain currently has the lowest number of stores per capita (113 for a population of 5.79 million vs 227 for a population of 8.19 million in NSW).
Credit Suisse estimated that franchisees who split their territory in Victoria would need to generate an incremental 50 per cent increase in sales to maintain earnings and a 70 per cent increase in sales to maintain returns.
The bank's analysis was based on average profitability figures provided last year by Domino's. Figures released by Domino's last August showed the average earnings (EBITDA) per store in 2017 were $133,700, down from $134,400 in 2016. About 45 stores were unprofitable and needed assistance in 2017, up from 21 in 2016.
Credit Suisse says that to achieve 50 to 70 per cent sales growth, a new store would need to grab 40 per cent of the walk-in or pick-up market and about 30 per cent of the delivery market.
"When you take into account there are existing operators already getting walk-in trade, to get 40 per cent share would significantly increase competition," Dr Saligari told the Financial Review.
"It's not as if there's latent demand where people haven't got access to pizza ... it becomes a market share tussle," he said. New competitors
With aggregators such as Menulog, UberEats, Deliveroo and Foodora making it easier for independent pizza stores (as well as cafes, restaurants, fried chicken shops and hamburger joints) to deliver food, Domino's is facing a significant step up in competition in the online/delivery market.
Dr Saligari said if store splits didn't stack up in Victoria, they were unlikely to be viable in states such as NSW and Queensland, where Domino's market penetration is much higher.
"If Victoria could only sustain a 15 per cent increase in the number of stores from the present base, the growth implied by Domino's 1000-store target for Australia would appear to be too high to be achieved from the other states alone," the report said.
Domino's rejected suggestions franchisees were reluctant to split stores, pointing to the number opened in 2017 and the first half of 2018.
"Domino's franchisees are more frequently targeting increased store penetration for the simple reason that this increases their revenue and profit," a spokesman said.
"Franchisees are investing in their business because, with the detailed data they have available, they have decided their return on investment supports this decision," he said.
While Domino's did not comment on the metrics in the Credit Suisse report, it said the experience of franchisees in these areas, where delivery guarantees of less than 15 minutes are common, is that faster delivery times leads to heightened customer satisfaction and more frequent deliveries, increasing profitable sales.
The spokesman rejected suggestions franchisees are pressured to split stores – saying splits are only "recommended" when modelling supports it – and denied franchisees are pressured to sell stores when they choose not to split.
"A franchisee who chooses to split their territory may do so either by themselves, with a business partner, or sell the rights to all or part of their territory, at commercial terms, for another franchisee to open a new store," the spokesman said. "Should the franchisee choose not to split their territory, it will not proceed." Targets in question
If Credit Suisse's analysis is right and Domino's fails to reach its 1000-store target, its growth prospects will be lower and it will become more reliant on Europe, where performance has been patchy in the past despite a string of acquisitions.
Credit Suisse has downgraded its growth forecasts for Domino's ANZ and estimates that about 75 per cent of earnings growth out to 2025 will come from Europe, where Domino's is converting recently acquired chains to the Domino's banner and rolling out digital innovations.
Domino's shares have fallen as much as 37 per cent this year and the stock is the second most shorted on the ASX, with 17 per cent of shares sold short last week compared with 10 per cent a year ago.
Any sign of weakness in Domino's store rollout in Australia – and any adverse publicity stemming from the franchising inquiry – will inevitably put more pressure on the share price.
As for my taxi driver, he was due to meet Domino's and was hoping they would buy back his stores. I hope he gets a fair price.
DMP Price at posting:
$42.50 Sentiment: Sell Disclosure: Not Held
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