#2 Investment Pill | Domino's Pizza Nordic Black Swan

The unnoticed black swan of the American pizza franchise giant

Author

The Octopus Value Investing
December 03, 2023

I have lately been looking into Domino’s Pizza (ticker $DPZ) and I realized none of the research articles I read so far mentions among the potential risks the lack of control of the company over franchisees to ensure they follow the prescribed procedures.

Hence, I have decided to write an investment pill related to Domino’s Pizza retreat from Denmark back in June 2023. A decision which has its roots in a black swan event back in 2018 and which left me without my part-time job after roughly 2 weeks onboard!

Black Swan Theory

The black swan theory, popularized by Nassim Nicholas Taleb, refers to the occurrence of unpredictable and highly improbable events with potentially severe consequences. These events, often deemed impossible or extremely unlikely based on past observations.

The theory challenges the conventional notion of predictability and highlights the limitations of relying solely on past data to predict future events. It emphasizes the existence of unknown unknowns, events that lie beyond our current understanding and cannot be accurately anticipated.

Black swan events are characterized by three key factors:

  1. Surprise: They are unexpected and occur without warning, shattering our perception of normalcy.

  2. Impact: They have a significant and often widespread impact, disrupting established systems and norms.

  3. Rationalization: After the event occurs, people tend to rationalize it, making it seem less surprising in hindsight.

The black swan theory serves as a reminder that we must remain vigilant, adaptable in the face of uncertainty and well prepared for the unexpected.

Figure 1: “The Black Swan”, a book by Nassim Taleb in which he delves into the realm of unpredictable events.

Domino’s Pizza

Domino's Pizza is a global pizza delivery company that operates a franchised business model. The company generates revenue through the following sources:

  • Franchise fees: Domino's charges franchisees an initial fee to open a store, as well as an ongoing royalty fee based on a percentage of sales.

  • Company-owned stores: Domino's also operates a small number of company-owned stores for testing the new products and strategies. They also generate revenue from the sale of pizza and other products.

  • Supply chain sales: Domino's sells ingredients and other supplies to its franchisees, which generates additional revenue.

  • Other income: Domino's also generates revenue from other sources, such as advertising and rent.

The company's franchised stores are responsible for most of the day-to-day operations, which allows Domino's to focus on its core competencies of marketing, supply chain management, and technology. This is important for the case covered

The Nordic Black Swan

During the last years Domino’s Pizza has faced problems in some of its franchise networks across some European countries. In 2022, Domino’s Pizza left Italy after failing to materialize their expansion plan. Back in this summer, Domino’s Pizza announced it was shutting down its 27 stores in Denmark. However, the retreate from the Scandinavian country was different from the one from Italy where they failed to establish in the country which invented pizza. So what happened in Denmark?

Well, what happened in Denmark was a black swan, one of those unpredictable events with severe consequences. But the black swan didn’t occur in 2023, but in 2018! We have to go back to the 27th of September of 2018 when the Danish TV2 channel published an “Operation X” (link in resources section), a story exposing Domino’s food fraud in the country.

Operation X is the story about Domino’s Pizza Scandinavia (company managing the Danish franchises) systematic bad practices. The investigators were able to persuade the Danish Veterinary and Food Administration to inspect all Domino’s Pizza shops in Denmark. The findings were devastating, 21 out of 30 shops inspected received some sanction. Food expiry date manipulation was systematic across the franchisees and there were severe hygienic deficiencies (poor cleaning, rat droppings, etc).

Since Operation X release, media coverage was very negative, the company’s reputation deteriorated and customers loyalty evaporated. According to a study of consumer advocacy group Forbrugerrådet Tænk, customer satisfaction with Domino's Pizza Scandinavia plummeted following the Operation X scandal. The study found that only 20% of consumers were satisfied with the company's food quality and cleanliness, compared to 60% before the scandal.

The decline in consumer confidence translated into a significant drop in sales. Domino's Pizza Scandinavia's sales fell by over 30% in the year following the scandal. The company's market share also declined, as many consumers switched to other pizza chains. The company was also fined DKK 400 million (approximately €53 million) by Danish authorities for tax fraud and was also required to pay back taxes and interests.

Finally, Domino’s Pizza Scandinavia filed for bankruptcy in March 2019. A couple of months after the scandal Domino’s Pizza Enterprises (largest franchisee of Domino’s excluding the USA; ticker DMP) bought the company, placing its focus on rebuilding a trustworthy brand. However, after approximately 3 years, the company decided to retreat from Denmark back in June 2023. Domino’s Pizza Enterprise estimates $16 - $20M of operating loss (roughly 13% of DMP 2022 operating income) per year caused by the Danish franchises.

Summary and learnings

One of the main learings from this story is how a bad culture can ruin a great business. The reputation loss and customer distrust were caused to the brand instead of only impacting Domino’s Pizza Scandinavia (the only one covered by Operation X investigation).

There are no Domino’s Pizza stores in Denmark while in Malmö (Swedish city at the other side of the Øresund strait from which 100k Swedes cross to Copenhagen for work everyday) there are still 6 Domino’ Pizza shops.

Figure 2: Domino’s Pizza shops in the Swedish city of Malmö.

Hence I think two things this story teach us about black swans events are:

  • They will come in the most unexpected way. Denmark is a country with high hygiene standards (Denmark’s main export are pharmaceutical drugs in fact). Moreover, all shops had previously been awarded with green smileys from the Danish Food and Veterinary Administration.

  • The extent to which a black swan event is impacted is also unknown. It impacted a franchise business in a small country. What if it would have occurred in a larger market?

Hence, I always try to have in my portfolio companies with:

  1. Difficult/unlikely to disrupt business models.

  2. Diversifed operations. Not necessarily diversify thorugh the addition of more companies to my portfolio but by adding companies with varied customer base and geographies.

  3. As asset-light as possible. It is easier to repurpose people than machines and softwares.

  4. Strong culture that will allow its workforce to navigate uncertain times and tackle difficulties.

Hope you enjoyed this newsletter a little out of the usual research topics but I thought it was quite interesting to put in writing, analyze and learn this memory which at first sight might seem not quite related to the investment world.. Please leave a comment, gie it a like and share!

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