Podcast: Wayne Jones

I spoke with Wayne Jones, co-founder and portfolio manager of the Ganes Focus Value Fund, on the recent travails of Domino’s Pizza Enterprises, including its difficulty getting to critical mass in France and Germany; wrongly betting that the boom in sales during COVID lock-downs signalled a permanent change in consumer habit; and the complexity of managing its global portfolio, especially given the flurry of recent acquisitions in Denmark, Taiwan, Singapore, Cambodia and Malaysia.

This transcript has been lightly edited for clarity:

Graham: Hi everyone! Welcome to the Longriver Podcast. My name is Graham Rhodes, and I'm delighted to welcome today Wayne Jones, co-founder and portfolio manager of the Gaines Focus Value Fund, a Brisbane-based investment manager. Wayne and I connected several years ago when he reached out to me to talk about Domino's Pizza Enterprises, the Australian Master franchisee of the Domino's brand. Wayne, welcome to the podcast. It's great to have you here.

Wayne: Morning Graham, and thanks for having me on your podcast.

Graham: Before we begin, I need to make a quick disclaimer. Nothing we talk about today is financial advice and shouldn't be taken as such. Please do your own research. With that, Wayne, why don't you tell us a bit about yourself?

Wayne: I'm an accountant by background. I've loved the share market for a long time. Like everyone, I bought some shares when I was young and lost money. But then I found Buffet in about 1990 through the John Train book. Started investing, started the fund in 2002. And yeah, that's how it's worked. I also have business interests as well. So when Warren Buffet says he's a better investor because he's a businessman and a better businessman because he's an investor, I totally resonate with that. I get to see things in my businesses that I can apply to investing. Yeah, that's pretty much how it's been going.

We've got a 20-year track record of just shy of 12% per annum, beating the Australian Index. So I'm measured against the ASX 300, and I'm beating that by about two and a half percent over the last 20 years. So yeah, it's been, it's worked out quite well. It's been a lot harder to beat the index than I ever thought when I started. I'll say that 20 years later. But yeah, that's, and my philosophy has evolved a lot over the last 20 years.

When I first started, I was a very valuation-driven investor. I was looking for 50 cent pieces, sort of thing. And as soon as I got to a dollar, I sold them and moved on. These days it's much more about finding founders and holding things for the long term. Domino's squarely fits in that sort of wheelhouse. And it's a fairly concentrated portfolio by most people's standards as well. Yeah.

Graham: I think what strikes me when I look at the Gained Focus portfolio is the collection of gems that you've built there. I'm guessing most people outside of Australia won't have heard of most of these businesses, but they're global franchises, you know, and they're diversified across industries and geographies as well. And when you and I talk about Domino's, I can tell that your knowledge of that company has just compounded really well over time. So I was wondering if you could just share with us how you've built your circle of competence and how you've found this collection of gems.

Wayne: I look at it like doing a jigsaw puzzle. When a fund manager says, "Oh, interest rates are gonna go up, so we're not looking at interest rate-sensitive stocks," they take a macro piece of information and then try to find a stock to fit that macro. I look at it more like a jigsaw puzzle where I've started in the bottom left-hand corner, and Buffet calls it his work of art. You're just looking for another piece of, "Okay, I've got a piece there, where's another piece of this that will fit next to that?" And it's just a compounded process where you build the jigsaw puzzle out. You don't go, "Oh, there's a piece over there. I think that's the sky, that'll go over there." You don't get any economies of scale trying to pick up disparate pieces of knowledge in that sense.

So it means that it limits what I can look at. I had a fund manager the other day calling me up, wanting to talk. He said, "Oh, look, I'll show you my top 10 if you talk to me about these stocks." And he went through his top 10, and I said, "I don't know any of those." Whereas, I don't own as many things, and the knowledge just compounds over the years.

When you are learning a language, the way the language seeps in is that you are relating things that you already know to what you're learning. You don't go and learn a new word that has no relevance to you. You can go and learn that, but you'll forget that word three days later. Whereas, if you learn words that you already know and they relate to the concepts, you build the language layer by layer. You know what I'm saying? There's a theory called comprehensible input that it relates to. Yes. So when I look at comprehensible input, and as I say, I was watching someone doing a jigsaw puzzle and thought, "That's actually the way I learn." Yeah. Adding bits to the bits I know. And that's how I find stocks.

Graham: Yeah, I totally get that. I describe it as adjacencies, so I just happen to learn a little bit here, which leads me to there, which leads me over there. And I could never have told you how this journey would unfold in advance, but it has, and that's where I am. And my circle of competence, it's not really even a circle, it's got a lot of jagged edges, where my interests have taken me and sometimes they connect and the circle expands that way. So let's get into Domino's then, Wayne. I was wondering if you could begin by telling us about the company and your own experience with it.

Wayne: Sure. Okay. So Domino's floated here back in 2005. The business had been around in a couple of various iterations before that, but there was a company here in Brisbane called De Silva's Dial-A-Pizza. Dom May was working for that as a delivery driver. He ended up becoming a franchisee, and then they took over the Domino's brand. They floated the business on the ASX in 2005. They had around 330 stores at that stage, making about 10 million in profit. Then in 2006, they wanted to expand into Europe. When they started, I think the shares were $2.20 at the float price, and the company was valued at about 130 million.

When they announced they were going to expand into Europe, the share price fell because there's this belief in Australia that our domestic companies go offshore to die. So I went and saw Dom, and I said, "What's going on with this European expansion?" And he said, "Look, Wayne, Domino's brand, Domino's is a 50-year-old brand. I'm just taking it off to France. I'm not inventing anything here." So on that basis, I started buying in 2006. And they went along very nicely. 

Being a value investor at the time, by about 2010, the share price had tripled and I thought, "You beauty!" and I sold them. However, that turned out to be a huge mistake because the shares went on to reach about $80 each. Then they started expanding into other countries. They acquired stores in France, Belgium, and the Netherlands, paying around $15 million for 150 stores. In 2014, they expanded into Japan, acquiring a 75% interest. In 2016, they entered the German market, purchasing over 200 stores. And just recently, in 2022, they expanded into Taiwan.

In total, they now own about 13 territories offshore, and their revenue has grown from around 200 million to an estimated 4 billion. However, the past six to twelve months have been challenging for them, as they were a significant beneficiary of the COVID-19 pandemic but not so much anymore.

Graham: Let's go back to the basics, though. Tell us about how the business works. You have Domino's Pizza in America, who then franchises the name and, I guess, the technology to Domino's Pizza Enterprises in Australia, and they, in turn, franchise it to their own franchisees. So can you help us understand a bit about the business and what makes Domino's special?

Wayne: Okay, so yeah, Domino's Pizza Australia has a master franchise agreement, an MFA, with Domino's Pizza in the US. It usually goes for 10 years with 10-year options. After that, they pay a royalty on their network sales to DPZ. And then they collect a royalty from their local franchisees in each territory.

When they started, they were collecting, oh, I'd have to look at my notes again, but I think it was around 7% from the local franchisees and passing 2% of that on to the US. I believe those terms have now changed, and I think it's close to the 4% or 5% that they pass on to DPZ now.

They used to run some company stores at the time, so if they saw a territory they wanted to be in, they would just go and build the store, open it, run it, and then wait for the franchisee to come along, rather than just looking for franchisees to open stores. A typical store costs about $350,000 to $300,000 these days, about $380,000 to build, and typically, the average store would make about $110,000 to $120,000 EBITDA.

Now, that's an average across thousands of stores. Some of the best stores in the group would make way more than that, and then there would be a whole bunch of stores that don't make that. It's a pretty marginal game for them. In Australia, it's actually very dense. Now we've got a pizza store for every 35,000 head of population. It's way less dense than that in the offshore markets.

Graham: I was just going to add, I think one interesting thing that I understand about these people, Jack Cohen and Don Meij, the CEO, they've been long-term investors and participants in the QSR (Quick Service Restaurant) industry, haven't they? Like Jack Cohen built Hungry Jack's in Australia before pivoting into pizza, and Don Meij obviously started his career as a university student delivering pizzas before becoming a franchisee owner and hugely successful in his own right. So I think it's interesting that these guys are quite scrappy, and you know, maybe you can add to this, but it sounds like the Australian pizza market was originally quite competitive, but they led a consolidation of that market.

Wayne: Yes, as you say, Jack Cowen, who's the current chairman of the board and a 25% shareholder in the business, he put $400,000 into Silvio's Pizza in about 1990. And that shareholder is now worth well over a billion dollars. He started off here in Australia with Hungry Jack's, but he also owns the KFC franchises.

When they floated, he had to have his shareholdings in a blind trust because of the competition between KFC and Domino's. At the time, the major player in Australia was Pizza Hut, but Pizza Hut had a dine-in model, while Don and Jack could see that the world was going to move to a takeaway model.

So when they opened stores, they only opened up 100 to 120 square meters with no dine-in capacity at all, whereas Pizza Hut stores were much larger, around 300 to 350 square meters, with room for dining in. It was a very different business model. Both Domino's and Pizza Hut had about 40% market share at that time. However, when Domino's floated, I would estimate that they now have a 70% to 80% market share because another player called Eagle Boys, which had 150 stores, no longer exists.

Don brought a high-volume mentality to the Australian market, and he is taking the same approach to offshore markets—low prices, high volume, and a very marketing-driven business model. Jack Cowan is one of the most underrated success stories in Australian business. He is a Canadian who came to Australia in the early '60s and got involved in the QSR industry. He couldn't invest in Domino's initially due to competition with KFC, so he had to hold his shares in a blind trust.

Domino's CEO, Don Meij, is a charismatic leader who knows the business inside out. He's personally involved in every aspect, even down to the smallest details. I remember once he showed me how to cut a pizza, explaining that doing it a certain way saves three seconds. He understands the ups and downs of the business, and even during a rough patch, he remains optimistic, saying, "You have bad patches, and that's just the way it is."

Graham: One of the things that makes Domino's special, in my opinion, is having a CEO who has the freedom to think long term. Don and Jack have known each other for over 30 years, and Don has generated significant wealth for Jack. This relationship has given Don the freedom to think about how to build the business even better over the next 10 or 20 years.

Wayne: Absolutely. Jack Cowan understands the ups and downs of business. When I spoke to him at the end of last year, he acknowledged that they were going through a tough period, but he said, "I've been around for a long time, and you have bad patches. That's just the way it is."

Graham: Pizza itself is such a versatile concept, isn't it? You start with the dough, and then you can have an endless variety of crusts like Italian thin, cross pan, or stuffed crust. And the range of toppings is almost infinite, right? The menu is incredibly versatile, appealing to a wide range of people. One thing that Domino's excels at is reducing delivery times. Could you tell us more about how they've achieved that?

Wayne: Absolutely. Pizza's key ingredients, flour and water, give Domino's a slightly higher gross profit margin compared to burger chains because there's less protein involved. So they have a slight edge there in terms of profitability.

Another interesting aspect is that everyone likes pizza. I once heard a psychologist talk about it. When you're in a group and discussing dinner options, if someone suggests fish and chips, there might be someone who doesn't like fish, or if someone suggests Indian or Indonesian cuisine, there might be someone who doesn't like spicy food. But no one ever says, "I don't like pizza." It's a universally accepted food that can be customized with different toppings to suit individual preferences. That's the beauty of it—universal acceptance and customization.

Don Meij, Domino's CEO, isn't competing with small artisan pizzerias. He's up against fast-food giants like KFC, Hungry Jack's, and McDonald's. He once told me that their typical customer is a young male who decides on pizza just 15 minutes before eating. It's a spontaneous choice. On the busiest night of the year, the State of Origin football match, people gather at someone's house and enjoy pizzas together. And guess what? The second busiest night is also the State of Origin match. That's the appeal of pizza—it's universal.

Graham: And when they manage to bring down delivery times to below 20 minutes, customer satisfaction skyrockets, leading to a surge in orders, right?

Wayne: Absolutely. Speedy delivery has been crucial. They have always maintained control over their delivery network and never relied on aggregators to deliver their pizzas. Pizzas are ideal for delivery as they stay warm and intact during transportation. Moreover, they introduced the pizza tracker, inspired by Uber's technology, which allows customers to track their pizzas. Everything they have done focuses on enhancing the customer experience. They are even using artificial intelligence to predict customer preferences. If you always order a pepperoni pizza, the moment you log in, they'll start preparing one for you, reducing the overall preparation and delivery time.

Around four or five years ago, they implemented a strategy called "Fortress" where they aimed to split territories and get closer to their customers. So, as you mentioned, once delivery times drop below 18 minutes, customer satisfaction soars.

Graham: Yeah, can we discuss the franchisees for a moment? One of the great advantages of a QSR business like Domino's is its ability to expand using other people's finances. However, the challenge lies in keeping the franchisees motivated, excited, and willing to invest. You've been following the company for almost 20 years. How were they able to convince so many individuals to join the Domino's franchise? Did their success attract more success? Please share your insights.

Wayne: Absolutely. I believe part of the reason lies in Don, a charismatic CEO who started as a pizza delivery person and now leads the company. This success story is not unique in the industry. For instance, David Burgess, who currently oversees Australia, began his career in the business back in the nineties. Andrew Renny, who managed France for several years, is another example.

Domino's offers a clear career path within the company. Once you become a store manager, they provide assistance in financing your own store. They offer a two-year loan at bank rates, which is particularly beneficial for exceptional managers. Rather than approaching a bank for a loan, they can enter the franchise through Domino's support.

The goal is to encourage franchisees to become multi-store owners. Instead of having a group of individual store operators, Domino's aims to have franchisees like Don, who manage 10 to 12 stores. These successful franchisees contribute to the network's growth because they are already earning profits from their existing stores.

The payback period for a store is approximately three years, enabling franchisees to generate income and reinvest in expanding their store network. Domino's can find new franchisees through their employees in existing stores, but they also achieve store growth through existing franchisees who become multi-franchise owners.

Graham: Exactly. It's remarkable to see these franchisees operate like a dedicated army of entrepreneurs, allowing the company to delegate more autonomy and authority to them. They make important business and investment decisions, creating a fantastic ecosystem, don't you think?

Wayne: Absolutely. Consider this: if you come across an Uber driver who delivers random orders from different restaurants, it may seem ordinary. However, if you work for Domino's, you can start as a driver, progress to a manager, acquire your own franchise, and eventually own eight to ten franchises, each worth around $100,000 to $120,000. By the time you're 40, you could be earning a million dollars within Domino's. In contrast, as an Uber driver, there is a defined career path, and if you excel, you can achieve significant success. Many individuals have indeed thrived in that regard. I believe Domino's should emphasize this more in their communication. It sets them apart from other chains, especially for young people.

 Graham: Absolutely, the equity value is substantial. We've discussed the numerous advantages and smart strategies that help Domino's outperform its competitors. They have undeniably excelled in Australia, New Zealand, and the Benelux markets, where they have a dominant presence. However, when they expanded into France, around 2007, it seems they didn't achieve the same level of success. They struggled to gain critical mass and failed to gather enough momentum. Do you have any thoughts on the reasons behind this?

Wayne: Indeed, in 2006, Domino's started with 90 stores in France. They acquired another 90 stores in 2016, bringing the total to 180. Presently, they have nearly 500 stores, adding around 300 stores over the past 10 to 15 years. It's not a poor performance, but it's not outstanding either. As you mentioned, Benelux started with 60 stores and achieved similar growth without acquisitions, building organically. I believe the French culture may not embrace takeaway food as enthusiastically as some other cultures. The French Domino's advertisements focus on personality and unique names for their pizzas rather than straightforward descriptions. This may indicate a cultural difference in embracing takeout food.

Additionally, Germany faced even greater challenges. Despite having 80 million people, making it the fourth-largest pizza-eating market globally, Domino's entered in 2016 with an acquisition of over 200 stores and now has only around 400 stores. They struggled to gain traction, primarily due to advertising and the need for scale. Until they establish a substantial presence, localized advertising is ineffective. I agree that Domino's hasn't achieved the same level of success in these markets as they have in Australia or the Benelux region.

Graham: Could the difference in population density and suburban living between Australia and France or Germany contribute to the varying concentration of stores? This could affect delivery times and create a positive cycle where satisfied customers order more pizza, thereby incentivizing franchisees to open additional stores.

Wayne: That's a valid point. In Australia, approximately 85% of our population resides in capital cities. While we may not have the same density as European capitals, the rest of the country doesn't require store openings in remote areas with low population. In contrast, France has numerous small towns, and I imagine Germany faces a similar situation. So you're correct that achieving the same store density in those regions becomes challenging. As mentioned earlier, Australia boasts approximately one Domino's Pizza store for every 35,000 people, whereas in Germany, it's still one store for over 200,000 people, and France stands at around one store for 130,000 people. Although progress is being made, it's still a considerable difference compared to Australia or the Benelux region, which I believe has reached around 35,000 to 40,000 people per store.

Furthermore, in Germany, they seem to struggle in garnering support from existing store managers and franchisees. In contrast, France boasts the highest number of multi-store franchisees within the group. The average store count in France is over three, while in Germany, it's approximately 2.2. This indicates a lack of buy-in from existing franchisees, suggesting that they might not find it as profitable as their counterparts in Australia or the Benelux region.

Graham: Another change in Germany is that DMP recently acquired the minority interest previously held by Domino's Group in the UK. I wonder if that will have an impact. Perhaps they'll be even more motivated now to make it work.

Wayne: Actually, I didn't mention that earlier. Don also mentioned a similar situation in Japan. We had a minority interest shareholder, a private equity firm, who wouldn't invest any money. They acted as a hindrance to the business for several years. I wonder if Germany will face a similar situation now that they have eliminated that hindrance. With management control but limited capital expenditure, it becomes challenging. Every time you propose investing in something, they just want dividends. This can cause problems. I believe Japan will fare even better now that they have removed the minority shareholder. Hopefully, Germany will follow suit because it has been the biggest disappointment for the company.

Graham: You mentioned the high-volume mentality, which is a defining characteristic of Domino's. Has it been challenging to instill that mentality in new franchisees in Europe?

Wayne: Yes, that's one aspect. Additionally, in the early days, and I'm not sure if it still applies, Domino's franchisees wanted to choose cheaper locations to save on rent. However, Don always emphasized the importance of being on the high street, even if the rent was higher. He believed it was worth it for visibility. Convincing franchisees to take that entrepreneurial risk and invest more in prime locations was a cultural challenge. It seemed to be an issue for quite some time, though I haven't personally been to Germany, so I can't speak to that specifically.

Graham: I guess that's the flip side of having an army of entrepreneurs. Sometimes it can feel like herding cats. Okay, let's provide some context. In your recent shareholder letter, you discussed the challenges Domino's has been facing, despite your admiration and appreciation for the business. So what we're describing here are some of those challenges, right?

Wayne: Yes, and it's also the aftermath of Covid. When people couldn't dine in restaurants, they turned to Domino's Pizza. The company may have been lulled into thinking that this brought in a wave of new customers who would remain loyal, providing a new platform for growth. As a result, they increased store growth and marketing spending. However, when Covid restrictions eased, people preferred dining out or trying different options rather than having pizza at home. The post-Covid boom subsided, especially in Japan, where the development team aggressively opened new stores during the pandemic. Now they are facing the challenge of immature stores that take about three to four years to reach maturity. It will take another two to three years before these stores become profitable. We are currently going through a period of adjustment in Japan, and perhaps to some extent in France as well. We are waiting for these stores to mature, surpass the fixed cost base, and start generating profits again.

Graham: Yes, you can see that in the numbers. In the most recent reported results, the store count increased by around 50% compared to pre-Covid levels. They added approximately 1,500 stores, correct me if I'm wrong, Wayne. However, the revenue remained relatively flat, and profits were down, right?

Wayne: Profits were considerably down. Yes, they added 500 stores in Japan alone in the past two years. It's unrealistic to expect 500 perfect location decisions and 500 exceptional managers. Mistakes are inevitable in such expansion. Additionally, when the rules changed and people started dining out again instead of ordering pizza at home, the numbers suffered in Japan. Europe faced different challenges, including geopolitical situations, energy prices, and customer confidence. It has been a disappointing past two years, despite initial optimism that Domino's had captured the mass market. Just like with online retailing, where people predicted the demise of shopping centers, habits have shifted, and people have returned to shopping centers. The same seems to have happened with Domino's.

Graham: Exactly, it's like a head fake. People thought habits were changing, so investments were made accordingly. But in reality, people still want to go out, socialize, and not rely on pizza as their primary option within 15 minutes of deciding.

Wayne: Indeed, I had a couple of other companies in my portfolio that performed well during Covid, but I knew their success was temporary, and their numbers would eventually decline. I anticipated it. However, with Domino's, I think both the company and Don believed that these customers would continue to choose them. In their last full-year results, they had to acknowledge the need to reassess their Japanese business. They had been spending money under the assumption that these new customers would remain, but their buying habits changed. The company itself was somewhat deceived into thinking that these customers would stay loyal.

Graham: Yeah, it's interesting how the virtuous cycle of Domino's wasn't fully realized this time. We discussed earlier how more stores should lead to reduced delivery times, increased customer satisfaction, and ultimately more orders and revenues. It seems like that cycle didn't quite materialize.

Wayne: Exactly. It's surprising that the change in consumer habits wasn't as permanent as expected.

Graham: It surprised both Domino's and us, I believe.

Wayne: Yes, indeed. Personally, I think it could be attributed to cultural factors. In Japan and possibly in France, people tend to live in smaller houses and prefer going out to eat rather than staying home. Here in Australia, where houses are bigger and more spacious, staying home is not as much of an issue. The shift in habits caught the company off guard, and it surprised me as well.

Graham: Let's also touch upon the impact of inflation on Domino's and its supply contracts. Can you elaborate on that?

 Wayne: Certainly. Inflation has been a significant issue, particularly in Europe due to rising power prices. In Germany, they experienced inflation rates above 20% recently, leading to mature contract clauses being enforced on some supply agreements. For instance, the prices of cardboard boxes for pizza delivery soared. However, instead of passing on all these costs to franchisees, Domino's absorbed the expenses at the company level. This decision aimed to minimize the impact on franchisee profitability, even though other costs such as food supplies and power bills have also increased. This has had a substantial negative impact on the company, especially in Europe, over the past six months.

Graham: I believe passing on the cost increases to consumers through higher prices only worsened the change in habits. If someone was considering going out, they would be even more inclined to do so if the price of a delivered pizza increased by 20%.

Wayne: Apologies, you broke up again. Could you please repeat the question?

Graham: Of course. I was saying that the cost increases and subsequent price increases likely exacerbated the change in habits. If the price of a delivery pizza went up by 20%, those who were already considering going out would be even more motivated to do so.

Wayne: Yes, exactly. They found that their existing customers continued to buy pizzas despite the price increases. They adjusted their prices to account for the cost hikes and also introduced delivery fees, which were previously absent. This was an attempt to recoup the costs and maintain profitability for franchisees. However, it was the marginal new customers who were more price-conscious that abandoned them in large numbers. It's unclear where they went, whether they turned to McDonald's for burgers, started eating at home, or opted for restaurants. But it was primarily these marginal customers who were the first to leave.

Graham: Right. Now, let's discuss the acquisitions made by Domino's. Besides expanding store presence in France, Germany, and Japan, they also ventured into new territories during Covid, such as Denmark, Taiwan, Singapore, Malaysia, and even Cambodia.

Wayne: Yes, Denmark is a bit perplexing. It's a small area with a struggling business that continues to incur losses. I'm not entirely sure why they chose to enter Denmark. However, they made a more favorable acquisition with Taiwan, which had around 160 stores. They paid approximately 80 million for it in 2022. It's a well-managed business and should perform well. The purchase price was about 10 times EBITDA, so it seems they didn't overpay. In the recent announcement, they acquired businesses in Malaysia and Singapore. The previous owner, an entrepreneur, wanted to accelerate growth and needed capital, so he sold to Domino's while staying on to run the business.

Although I hope these acquisitions succeed, they may have come at an inconvenient time, considering the ongoing challenges in Europe and Japan. It will require Don to once again distribute his management team's focus across multiple Asian territories. Additionally, managing 13 territories with different languages and cultures poses its own challenges, particularly in marketing. However, it's worth noting that Taiwan is performing well, and all the acquired businesses are profitable. Malaysia has 240 stores, indicating scale, and Singapore has nearly 40 stores, suggesting similar potential.

While these acquisitions may dilute the management team's ability to address issues in Japan and Europe, they are not problematic businesses in themselves.

Graham: Yeah, one of the key aspects to consider is that different markets have different consumers and businessmen. However, what remains consistent about Domino's Pizza and its team is their high-volume mentality. They excel at conducting business in that manner and focusing on delivering increasing value to customers, incentivizing franchisees, and expanding anywhere. It's interesting to see that this approach has worked in some markets like New Zealand and the Benelux countries, but not in others. Now, I'm curious if they're taking on more than they can handle and if they can replicate their past success. Their track record is somewhat mixed.

Wayne: Yes, they've been doing this for 20 years, and the CEO, Jack Cowin, has remained the same. That gives me confidence in their ability to execute. I don't think Cowin would have approved these acquisitions if he didn't believe in them and if the numbers didn't support it. However, they now need to deliver the results that align with their narrative. In my update, I mentioned that I'm not buying more shares for now. I haven't sold any, but I want to see the numbers match the narrative. These new acquisitions should contribute to profits rather than add to existing problems, as not all acquisitions are successful. They need to prove that they made the right choices with shareholders' money.

Graham: Absolutely. One thing Don does exceptionally well is motivating people. If you listen to the earnings calls or meet him in person, you can feel his magnetic charisma. He always leaves you with a sense that this business is destined for greatness. Their long-term targets reflect that ambition, starting from 2,000 stores and increasing to 2,500, and now 3,000 stores. The target keeps growing, but the timeline gets pushed back slightly. It could be a way to motivate employees, but as shareholders, we should be cautious not to be overly swayed by it.

Wayne: I agree. Personally, I don't pay much attention to those targets. I see them more as marketing tools for analysts and investors. It's not a metric or a slide I dwell on. Looking at Australia and Benelux, they have a store for every 40,000 to 50,000 people, while Germany has one store per 200,000 people. This indicates that they have room to double their network if they can gain momentum. So when Don says he wants to double the stores, it shows there's a market for it. Whether they achieve it in eight, ten, or fifteen years is uncertain. But his target of growing the store network by 5% to 8% or 8% to 10% is plausible. Personally, I would be satisfied with 4% or 5%. If they achieve that growth rate alongside consistent store sales growth and price increases, they will generate double-digit profit increases for the foreseeable future. I don't focus too much on those graphs showing the number of stores they aim to have. The reality is they went from 300 stores to nearly 4,000 stores, so I have no doubt they can go from 4,000 to 7,000 stores in the future. That's not in question, in my opinion.

Graham: Yeah, I agree. It's true that the markets they've recently acquired, especially the larger ones, are still in the early stages of growth, right?

Wayne: Yes, if we look at the USA, which is obviously the most mature market, they have around 60 to 70,000 people per Domino's store. Australia has performed very well compared to the USA. Even if we aim for a ratio of around 100,000 people per store, many of these countries still have a long way to go in terms of market potential.

Graham: Absolutely. Hopefully, that virtuous cycle can start showing itself again, where higher revenues lead to increased marketing spend, attracting more customers and franchisees, resulting in quicker orders and so on. You mentioned this as a period of indigestion, where they've had a lot on their plate and faced significant changes in recent years. How do you think they will navigate through this?

Wayne: I believe they have to provide value to those who have already tried their product. They need to emphasize the value proposition to these customers. Additionally, their competitors who haven't raised prices despite increased costs will eventually have to make that adjustment. I don't personally go to McDonald's, but I've heard that their prices have recently increased. So it's clear that some competitors will need to follow suit. I think Domino's acted too quickly and aggressively. They need to let the rest of the market catch up and then find a balance that aligns with customer comfort. It will require a bit of trial and error, but Domino's has a wealth of knowledge about customer behavior and ordering patterns through their data. If anyone can do it, I believe they can. I don't think the model is broken. The quick-service restaurant (QSR) model is here to stay. The key is to make customers choose Domino's over the competition next door or down the road.

Graham: Absolutely. And what about the franchisees?

Wayne: Don recognizes that franchisees need to make money because their success is essential for opening new stores. I believe around 85% to 90% of new store openings come from existing franchisees. So franchisees are as important to Domino's as the customers ordering pizzas. Don ensures they are taken care of and tries to keep them profitable. If we saw a change in the narrative or a decline in the number of stores per franchisee, that would indicate a problem.

Graham: Yeah, I can imagine that achieving the desired level of store growth in the next two or three years might be challenging for them. It seems like some franchisees may have overextended themselves or faced difficulties during the Covid period. What do you think?

Wayne: Yes, I agree. In the next year or two, it might be a bit harder for them to make franchisees profitable as quickly as they hope or as the market expects. However, that doesn't mean it's impossible. Domino's is known for periods where they don't do much for a couple of years and then suddenly show a 50% increase in profits. There's something about their business that works in that manner. It can be a bit inconsistent. So it wouldn't surprise me if they experience a couple of years with flat or unpredictable earnings, followed by a pleasant surprise of significant growth, say 50% or 60%.

Graham: That's interesting. What causes that inconsistency?

Wayne: I'm not sure. It could be due to marketing efforts or fluctuations in consumer confidence. It has happened at different times, and I can't pinpoint the exact reason.

Graham: That's intriguing. Okay, another thing that surprised me was their equity raising last year. How is their balance sheet, and what are your thoughts on that?

Wayne: The level of debt in the business has been increasing due to the acquisitions they've made. I believe they're up to around $800 million or maybe even $900 million in acquisitions. Since they pay out most of their profits as dividends, they have to borrow money for these acquisitions. The debt level is higher than I would prefer, and it exceeds the debt levels of other businesses I own in the fund. It's one aspect I'm not fond of regarding the business. However, it generates a significant amount of cash, so it's not close to breaching any covenants. If they ever needed cash, they could raise it through the market. But it's not my preferred way of running a business. Sometimes you have to tolerate certain things, and the increasing debt level is one of them. I believe it's now around $600 or $800 million. Keep in mind that this is a business with a total value of over $4 billion, so it's not exceptionally high. Most of the businesses I own generate cash and never need to borrow money.

Graham: Yeah, if you look at DPZ in America, it seems they've used their balance sheet to leverage up and buy back shares. That's one approach. And as you mentioned, Domino's Pizza Enterprises in Australia has used that money differently. They did have a small buyback, but most of it was allocated towards acquisitions.

Wayne: That's correct. The majority of the funds were used for acquisitions. They did have a small capital return where they didn't reduce the number of shares available but returned money to shareholders through a capital reduction. They have also conducted some share buybacks, although it hasn't been a significant focus. Don's main priority is to grow the business. On the other hand, DPZ has embraced a more financial engineering approach, believing that continuous share buybacks add value. It's interesting to note that when Domino's went public, they had around 5,000 stores, and now they have over 7,000 stores—a growth of approximately 50%. In comparison, Don has achieved a tenfold increase in store count during the same period.

Graham: Yeah, absolutely. But perhaps as the master franchisee in an already mature market, DPZ didn't have the same opportunity to reinvest as Don did in Australia. Don, starting from a smaller base and expanding into various territories, had more room to effectively utilize the funds.

Wayne: That's correct. Australia is a highly mature market, and when I initially bought into Domino's, it was because it was a good business in Australia with potential for growth. However, anyone considering investing in Domino's now recognizes that it's not primarily about the Australian market but rather about expanding and thriving in offshore markets. While the Australian market remains profitable, it has reached a mature stage, similar to where DPZ currently stands with its business.

Don had a choice to make when he was growing Domino's Pizza. He could either stay within the confines of Australia and introduce additional franchise brands, as the Mexican Domino's franchisee did, or he could remain solely focused on Domino's and venture overseas. DPZ opted for the latter, urging Don to remain a pure play Domino's operator while providing offshore markets as opportunities. This differs from the approach taken by the Mexican business, which primarily remained within Mexico but introduced different franchise brands. We have witnessed a similar scenario here in Australia with a company called Retail Food Groups, where managing multiple brands has resulted in a disastrous outcome, as conflicting tensions arise within the business.

Graham: It definitely adds more complexity, doesn't it?

Wayne: Yes, it certainly does.

Graham: I'm glad you brought up that point because I was curious, now that Domino's Pizza Enterprises has evolved into more of a global story rather than just an Australian one, how do you, as an investor in Brisbane, stay informed and confident in your understanding of what's happening in Hamburg, the suburbs of Paris, or Nagoya in Japan?

Wayne: Yeah, that's right. The business definitely has added complexity now. I find myself spending more time reading the results than I used to, trying to work my way through it. It's clear that we rely more on management, and I'm comfortable with that. They seem very transparent. They hold investor days both locally and internationally, and they make a lot of that information available online. Even if you can't attend an investor day in person, you can still watch it online. So the business complexity has increased, and you have to analyze the numbers to see if they align with the narrative they're presenting. Additionally, I speak with other investors to gather their insights and knowledge.

Graham: Absolutely. I'm also curious, given your long history with the business as an investor, how do you differentiate between a period of temporary difficulties, like indigestion as we described earlier, and a fundamental change that suggests things won't go back to the way they used to be? How much time do you give it, and what would it take for you to change your perspective?

Wayne: Well, I think it would probably take a year or two, depending on the circumstances. If, for example, Don were to suddenly resign without a clear reason, that would concern me. Or if they unexpectedly sold a territory, I would question what's happening. Similarly, if they keep promising that next year will be better, but the results continue to worsen, it raises red flags. So it depends on the type and significance of the event. For instance, there's a company here in Australia called Magellan Financial Group, a fund manager that was once highly regarded. Suddenly, the CEO resigned without explanation, the founder went on extended leave, and they started selling the businesses they had acquired. That entire story has now changed. So in such cases, when the reason for investing in the first place no longer exists, it would prompt me to reassess. It really depends on the severity of the event.

I asked Domino's about their entry into Taiwan, considering the tensions between China and Taiwan from my perspective in Australia. I expressed concerns about the potential risks, but they didn't seem to share the same level of worry. These are the types of considerations I keep in mind. However, it takes me some time to evaluate and adjust my perspective. I've owned businesses in the past where problems arose, and I knew it would take a year or two to address them, although it usually ended up taking longer than expected. My business experience helps me navigate such situations. I'm not just seeking shares that constantly increase in value with each profit report. I'm comfortable with businesses having challenging periods. In fact, that's often when you find opportunities to buy good quality businesses. I try to purchase them when there's some negative news affecting their price. That's when they become reasonably valued or even cheap, in my opinion.

Graham: Absolutely, I couldn't agree more. It's great that you have practical business experience because not many people do, and it seems like you truly understand that progress doesn't always happen in a straight line.

Wayne: That's right. I've had experiences where things didn't go as planned. For example, I had to do a property redevelopment for a business I owned. They estimated it would be offline for three months, but it ended up taking six to nine months. Many customers left because it was inconvenient to deal with during that period. So I know that the best-case scenario rarely happens. I believe the same applies here. While some people may expect customers to quickly return, I don't anticipate it happening that fast once they've been lost. However, I do believe they will eventually come back. If franchisees can stay profitable, they will continue operating, and if it remains a good investment, people will invest in it. Domino's even provides loans to franchisees and they repay them over time. The model is still intact and effective, it may just take a bit longer than expected. In the stock market, everyone wants instant results, profit upgrades, and flawless businesses, but that's not the reality.

Graham: Absolutely, I completely agree. However, as you mentioned earlier, we are in a phase where management needs to demonstrate positive results and assure us that they are back on track and overcoming these challenging times. From my perspective, I would actually prefer to see store count remain stable for the next two to three years. I hope they don't make more acquisitions or purchase additional territories. Instead, I would like them to focus on consolidating their existing operations.

Wayne: Yes, I'm on the same page. I would be disappointed if they borrow money to buy more territories. I don't think they would do that. I hope they didn't overpay for Taiwan, similar to the situation with the share price. It surged because we anticipated a large customer base. I also hope they made prudent decisions with the new Asian acquisitions. By the time they made those acquisitions, the COVID wave had started to recede. So, like you, I would prefer to see them strengthen the balance sheet, reduce debt, and have franchisees open new stores independently. Even if the store rollout is slower, as long as it's organic and doesn't strain the balance sheet, that's what I'm looking for. If it means a 3% to 4% growth in store rollout, I'm content because it will ultimately translate into future profits.

Graham: Absolutely. It's crucial to ensure that everyone in the system is satisfied and making money. And I genuinely believe that focusing on markets like Germany, France, and Japan will create more value for the company over the next decade compared to Cambodia. Let's concentrate on these strong markets for now.

Wayne: Japan has surprised me. When they entered Japan in 2014, I couldn't imagine Japanese people eating pizza, but it has been incredibly successful and is performing really well. It has been a pleasant surprise for me. I initially thought France and Germany would be the major successes, but I was mistaken. I would much rather see them concentrate on Japan, which has a large and densely populated market, allowing for excellent store metrics. They should also focus on Taiwan and perhaps Malaysia now that they have entered that market, as it is a sizable market. I would be satisfied with that approach. They might make additional strategic acquisitions within those markets, but in terms of France and Germany, I don't think there are any significant store networks left worth acquiring. There are mostly small networks with 20 or 30 stores. It would be more beneficial to grow organically, even if it takes a bit longer.

Graham: Absolutely. The success of the Benelux markets can be attributed to their small size and high population density. It allows for the establishment of a dense store network, delivering an exceptional customer experience. Domino's shouldn't try to conquer the entire German market all at once. I don't believe that's their strategy. Instead, they can select specific areas and focus on opening numerous stores there to create a virtuous cycle of success.

Wayne: Exactly. That's where you get the most value from your marketing efforts. They allocate around 10% of their revenue to marketing. Starting in one corner of the country and gradually expanding is more effective. When they went public, they didn't have any stores in Melbourne. It was mainly a Brisbane and Sydney story. They entered Melbourne after going public. So starting in a small area, rather than having a few stores in each town or capital city, is better. Having a hundred stores in a concentrated region and then expanding gradually across the country provides better advertising efficiency. It's also important for their commissaries, where the dough is made and distributed to stores in Europe. Having a cluster of stores around those central locations makes operations more profitable and cost-effective.

Graham: Yes, I agree. Instead of focusing on the overall store count in France, it's more useful to consider the store count in specific regions and how that's developing, along with the density in those areas.

Alright, this is probably a good point to wrap up. It has been a fantastic conversation with you, Wayne. One final question: If people want to learn more about you or the Gaines Fund, where is the best place to find you and get in touch?

Wayne: To get in touch, I maintain a relatively low profile on social media. You can visit the website at Gaines Capital, g-a-n-e-s. The "n-e-s" stands for the last initials of my last name, Jones. So it's gainescapital.com.au. All my fund updates are posted there. I typically write an update every three months, which is usually about four or five pages long. I aim to help unit holders understand what's happening with the businesses we own in the fund, as well as discuss my investment philosophy. I don't usually provide monthly updates since there isn't enough significant activity to warrant it. I'm also somewhat active on Twitter, but not extensively.

Graham: I highly recommend your newsletters. You've discovered some real gems, and many of them are strong global franchises that people outside of Australia may not have heard of otherwise. So I encourage everyone to visit your site and learn more. It has been a real pleasure, Wayne. Thank you once again for your time, and thank you to everyone for tuning in to the Longriver Podcast.