Domino’s Pizza’s share price will heat up again – here's how to play it

Investors have lost their appetite for Domino’s Pizza chain, but the shares are cheap, says Matthew Partridge.

With the exception of China, most of the world has returned to something approaching the old pre-Covid normal. While this is cause for celebration, some of the companies that have flourished during the pandemic have seen their share prices deflate. 

Domino’s Pizza Group (LSE: DOM), the UK master franchise of the US takeaway pizza chain Domino’s Pizza, is a good example. The shares went up by almost 30% in the 19 months from January 2020 to July 2021, as people switched from eating out to staying in. It then saw another near-30% leap in a matter of weeks at the end of last year, when it looked as if yet another lockdown might be on the cards. However, after hitting a peak of 473p at the end of the year, it has since lost a quarter of its value.

Of course, it isn’t just the fear that people will ditch takeaways for restaurant meals that is causing the slide in the share price. There are concerns that higher ingredient costs may depress margins, while there is always the risk that consumers struggling to deal with inflation may decide they can do without a regular takeaway. 

Customers may also be looking to tighten their belts in other ways, thanks to the recent introduction of mandatory calorie labelling on food as part of an attempt to get people to consider healthier options. These are all valid concerns.

Maintaining the number one spot

Still, it’s important to remember that Domino’s isn’t just a typical pandemic stock. Indeed, even before Covid-19 appeared, the company had built an impressive record and was maintaining the number one pizza delivery spot in the UK and Ireland. Between 2016 and 2019 it grew sales by 40% and profits by a whopping 161%. At the same time, it maintained large operating margins of just under 20%, and a return on capital expenditure of roughly 30%. All this has enabled it to keep debt low, while steadily increasing its dividend. Domino’s has a clear strategy for continued growth. As well as opening more stores, it plans to boost sales by further improving the online platform, which already accounts for over 90% of sales, and by cutting delivery times, which are already lower than most major competitors. It will also be focusing on the in-store collection market, which has done well from the removal of restrictions. 

The firm is also responding to changing trends by expanding the range of pizzas on offer, especially in terms of vegan and vegetarian options. Lastly, it is also putting more cash into growing its German venture, which has already seen success. Despite all this it still trades at a modest 16 times forecast 2023 earnings with a dividend yield of 3%.

Given that Dominos’s shares are currently slightly below both their 50-day and 200-day moving averages, I wouldn’t immediate go long. Instead, I’d wait until they reach 375p before pulling the trigger, then I’d go long at £7.50 per 1p with a stop loss of 240p. This gives you a total downside of £945.

How my tips have fared

Over the past six weeks, my four long tips haven’t done very well, with three out of the four positions falling in price. Construction firm Morgan Sindall has fallen from 2,431p to 2,155p, supermarket J Sainsbury has declined from 259p to 237p and Airtel Africa dipped from 152p to 146p. Online retailer Asos is now at 1,418p, well below the price of 1,800p at which I said you should go long. The only exception is National Express, which rose in value from 230p to 251p. Overall, my four long tips are making a net profit of £2,650, down from £3,423.

The good news is that five out of my six short tips have also declined in value. Cinema chain AMC declined from $15.86 to $15.26 and marketing software group HubSpot fell from $459 to $380. Remote medicine stock Teladoc slumped from $65.55 to $35.73, and DWAC, the company behind Donald Trump’s social-media “empire” slipped from $68.91 to $47.91. Digital currency exchange Coinbase fell from $177 to $121. Overall, my six short tips are now making net profits of £5,312. This means that my short and long tips are making combined profits of £7,962, up from £7,011 at my last update at the end of March.

I now have four long tips (Morgan Sindall, Airtel Africa, J Sainsbury and National Express) as well as six shorts (Teladoc, HubSpot, AMC, KE Holdings, DWAC and Coinbase). I also have two pending long tips (ASOS and Domino’s Pizza Group). I’m going to raise the stop loss on Morgan Sindall to 2,100p (from 2,000p); on J Sainsbury to 200p (from 175p); and on Airtel Africa to 115p (from 110p). I would also lock in more profits on my shorts by cutting the price at which to cover the Teladoc short to $100 (from $135); HubSpot to $500 (from $771); DWAC to $55 (from $142); and Coinbase to $175 (from $275).

Trading techniques: merger arbitrage

Elon Musk’s decision to buy Twitter at $54.20 is good news for those who bought into the company when its shares were trading at a low of $31.20 just a few weeks ago. This isn’t unusual: an acquirer almost always has to offer a substantial premium over the market price to take a company over (known as a control premium). For example, a 2020 study by accountants Deloitte found that the average premium in US takeovers was a whopping 55% between 2017 and 2019. During the same period the premium for non-US deals was a smaller, but still useful, 15%.

There are several ways to trade takeovers. The most speculative is to buy into a likely target in the hope that it will be subject to a takeover offer. Another strategy is to buy the shares of firms that are already subject to an offer, in the belief that the deal will go ahead. (If you don’t think the deal will go ahead, you would short the shares instead.) Since there’s always a chance that the bid could unravel, the share price will usually be below the offer price – unless the market expects a higher offer – so the trader will make a small profit when the deal closes. 

This is known as merger arbitrage. When the company doing the deal is paying in its own shares, a refinement of this strategy is to buy the shares of target while shorting the shares of the acquirer. By doing this, you can eliminate the effect of market movements on returns from the trade, making the outcome solely dependent on whether the deal goes through. A 2005 study by Ben Branch and Jia Wang of the University of Massachusetts at Amherst found that between 1994 and 2003, simple market arbitrage strategies produced excess returns of 6.3% a year.

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