Even before Warren Buffett gave up on showing long term book value progression in his Annual Shareholders letter, others were noticing that price / book had a problem. According to a paper by OSAM there are currently over 100 companies in the US with negative book value.
To me, it is the qualities that book value can’t capture that matter. There are spectacular rewards for getting it right. For instance two companies. Same sector (food delivery). Same brand. But different countries: one has increased in value by 100x over the last 2 decades, the other is down 90% peak to trough. Both were listed on the UK stock exchange by the once venerable, now defunct stockbroker Seymour Pierce where I used to work.*
No equity, but worth over £1bn
Starting with £10,000 that’s the difference between £1,000 and £1m. For two companies operating with exactly the same brand. Even more interestingly the successful company has a negative tangible book value. That is, after deducting intangible assets (like goodwill) from shareholders equity, the company has no accounting equity value at all.
As Jonathan Haskel and Stian Westlake point out in their book “Capitalism without Capital” it is extremely hard to value intangible assets, because their value is wildly uncertain.
Traditional accounting assumes there is some relationship between the amount of money you put into a business and the returns that you eventually get out. But within a modern economy this is less true. There is a huge divergence between sunk costs (which accounting can record) and future prospects (where accounting fails dismally). With intangible investments if things go wrong, the recovery value is dismal (shares in https://myspace.com/ anyone?). But compared to a company with lots of tangible assets, like property, plant and equipment, the upside is much greater too.
Many think that this just applies to technology, but it’s equally true of more mundane parts of the modern economy, like pizzas. Because the brand that has seen such a wide divergence in performance is Domino’s Pizza.
One brand, many companies
First though a digression is necessary to understand how it’s possible to have more than one company listed on the stock exchange with one brand. Normally it’s the other way round, for instance Lloyds Bank, owns Halifax, HBOS and Bank of Scotland brands (bank brands are fairly worthless) but Lloyds bank is the umbrella organisation that you can buy shares in.
Instead Dominos Pizza was founded in 1960 in the US. But to expand overseas the company would sell its country Master Franchise Agreements to different entrepreneurs. The agreement gives the buyer exclusive rights to use the Dominos brand and operate the systems. They can also sub-licence to other franshisees in the area. To ensure quality the franchisees have to stick to the ingredients and supplies that are agreed, and operate the systems that Dominos has developed and knows work well. So Dominos Pizza Inc is listed in the US, but companies operating exactly the same brand are listed in the UK.
It is Dominos Pizza Group UK which Seymour Pierce listed 20 years ago on the London Stock Exchange, and it is DP Poland which Seymour Pierce listed in 2010. Dominos Pizza Group UK has increased from less than 3.5p in December 2000 to almost 400p halfway through last year (adjusted for share splits). In fact, the UK business paid a dividend last year of 9p (over £40m), compared to the total value of the company (market capitalisation) of £25m when it was listed by Seymour Pierce in 1999.
That is, say you spent £10,000 on shares at the end of 2000 (the very peak of the internet bubble) and tucked them away, not only would you be sitting on a huge capital gain, but you would also now be receiving around £25,000 in dividends.
DP Poland has not faired nearly so well. Seymour Pierce helped the company to raise £6m at 50p per share in 2010. But it still hasn’t generated a profit and it doesn’t look like it will do in the next few years, almost a decade after listing. But investors are still prepared to put money into the business, most recently £5m at a much reduced 6p per share.
The comparison isn’t completely fair to DP Poland, because the UK business was established in 1985, and had time to mature only coming to the stockmarket almost a decade and a half later. This is important, because in the early years Domino’s Pizza tends to be unprofitable in countries because stores cost money to open, there are central costs not covered by economies of scale. It is worrying though that even after 10 years the business is not profitable though, and that is reflected in the share price decline.
Waiting for the right moves
I’m not sure when the turning point will come, or if it will come at all for the Polish business. Breakeven always seems to be in the medium term, I’m fairly sure the original investment case was not based on making more than 10 years of losses. By my count after all the capital raisings over £30m has been poured into the business over the last couple of years, versus a market cap of £22m and negative retained earnings of £20m.
In the mid 1990s (ten years after the business opened its first store) the UK company was profitable and had opened over a 100 stores, versus 64 for the Polish business now.
But more significantly I went back and looked at what management were saying before the UK business share price really took off. Perhaps it is the benefit of hindsight but the UK business seemed to have a much better story than the Polish business now. Remember this was the time of the internet bubble, but if you’d have suggested that the best way as a shareholder to benefit from the internet would not be a banking new entrant (remember Egg?) or online travel agents (lastminute.com?) but Ryanair and Dominos Pizza, people would think you were crazy. But not so crazy now.
The interesting thing was the Dominos Pizza UK management spotted the opportunity, and wrote about it.
We consider that the growth of e-commerce will have a fundamental effect on our business in two different ways – how we advertise our offering and how we receive orders. Traditionally, the most cost-effective medium has been direct mail (e.g. leaflets) and to this end we printed over 90 million pieces during the course of last year. However, due to the relatively low cost of this form of marketing, it is increasingly being employed by virtually every food delivery company resulting in what we feel is an increasing customer fatigue of this medium. Furthermore, the only means by which we could receive customers’ orders were either personally at the store or over the telephone.
E-commerce has transformed this environment. We can now provide full menu information to every home in the country capable of accessing the Internet or receiving digital television via satellite and cable and at a fraction of the cost of direct mail. We can receive orders back from our customers (in our delivery areas) using any of these new sales channels and fulfil those orders in 30 to 40 minutes. This ease of ordering and most importantly the almost instant fulfillment capability is second to none and is why we believe e-commerce represents such an exciting opportunity for us. We also have a distinctive advantage as very few competitors have the scale, geographic spread and infrastructure to capitalise on these opportunities.
In addition to the ecommerce opportunity, management could sponsor The Simpsons and create national brand awareness. A single local pizza company just couldn’t compete with that.
Of course the Polish company is also talking about online ordering, but now they are warning that the technology trends are not in their favour, blaming the cumulative impact of delivery aggregators’ advertising spend on the company’s disappointing performance. These delivery aggregators offer customers a choice of restaurants in one app.
That is the trouble with intangible assets, as Haskel and Westlake point out that their value can be contested. If you have a piece of equipment you own it, and can operate it yourself to bash widgets. If you have an online platform, customers might stay but they might leave for something better.
I don’t have a high conviction about the Domino’s Pizza either way. I notice that the UK business share price has also fallen in last year, probably driven by concerns about this new form of competition. I just know that brands are hard, and their value waxes and wanes with wild Mandelbrot style uncertainty. My thinking is that there are more clues in the text of the “story” management tell in the financial text, rather than just a focus on the numbers in the balance sheet.
I will leave you with this graphic from www.visualcapitalist.com showing how global brands have grown and shrunk over the last 2 decades this link is fascinating, and perhaps a little bit scary.
The photo is from Poznan, Poland – no idea if it’s Dominos though.
* Seymour Pierce floated a couple of hundred baggers. Dominos Pizza, but also ASOS. You may be wondering why the stockbroking firm didn’t take shares in some of the companies that it was IPO’ing and hold on for the ride, watching their value rise a hundred fold. The answer is that Seymour Pierce management did think of that – but were not very clever about it. Instead of holding shares in successful companies like Dominos Pizza or ASOS, they took shares in a speculative oil company, called Resaca Exploitation, that failed a couple of years after they IPO’ed it.