DP Eurasia (DPEU) – Don’t throw the baby out with the bathwater

Why now?

In CY18, the Turkish Lira depreciated ~40% against the USD. This nosedive was driven by a number of factors: 1) investor fear that
Turkish companies are over-levered due to years of runaway borrowing, 2) US-Turkey trade tensions (e.g. doubling of tariffs on Turkish
steel and aluminum) and 3) truly comical “market-stabilizing” interventions by Erdogan (e.g. making his son-in-law the finance minister
or re-assuring citizens that while “overseas investors had dollars, Turks had Allah”). Yearly inflation increased from ~10%-25% during
Jan ’18-Sep ’18, thousands of firms applied for bankruptcy protection and the economy is expected to shrink by 2% in CY19.
Unsurprisingly, DPEU has fallen a whopping ~51% (GBP terms) in CY18 and ~30% since listing in Jul ‘17.

Investment Thesis

DPEU offers the greatest growth potential and the cheapest valuation among all Dominos sub-franchisees listed globally. Consider
this: DPEU’s LTM EBITDA is ~1/3 that of Jubilant Foodworks (Indian Dominos sub-franchisee) and yet its enterprise value is less than
1/10 that of Jubilant. Skeptics will argue that being cheaper than an Indian consumer stock doesn’t count for much as Indian consumer
stocks routinely trade at 40-50x trailing earnings despite demonstrating high single digit EPS growth due to non-fundamental factors
such as the perception of being “defensive” plays or MNC parentage premium. However, DPEU trades at a ~40% discount (on a NTM
EV/EBITDA basis) to a comps set comprising of all publicly-listed Dominos franchises. On an EV / store basis, DPEU trades at a ~75%
discount to peers ($0.4m vs $1.7m comps set average). There are 4 reasons why DPEU could trade at such a steep discount to peers:

Slower Growth Rate & Shorter Runway Relative to Peers (NOT TRUE)

DPEU is the fastest growing sub-franchisee among all its listed peers. On a LTM basis, DPEU’s historical 1-yr and 3-yr local currency
CAGR is 30%+ (~2x listed Dominos peers). While part of the higher local currency revenue growth can be attributed to inflation, DPEU
is growing materially faster than peers primarily due to:

 Base effect: At 724 outlets (CY18E estimate), DPEU is at least 30% smaller than its nearest peer (Jubilant – 1141 outlets, DP
Enterprises – 2393 outlets, DP Group – 1103 outlets). While DPEU’s long-term store count CAGRs are comparable to peer
store count CAGRs, its 1-yr store count CAGR (~13%) is ~2x peer average. When forecasting revenue growth due to store
additions, 1-yr CAGRs are more germane relative to long-term CAGRs as they take base effect and geographic saturation into
account.
 Store Maturity: ~27% of DPEU’s stores are under 2 years old and ~13% are under 1 year old. The relative immaturity of DPEU’s
Russia store estate will help it sustain higher than steady-state like-for-like (“LFL”) sales growth. This is reflected in Russia
revenue data as DPEU’s LFL growth rate has not fallen below 15% since it began Russia operations in 2013.

While near-term growth prospects are sanguine, the long-term growth potential is even more attractive due to the scale of DPEU’s
Russia operations. Dominos has a smaller footprint in Russia (179 units) than it does in the Netherlands (232 units), Saudi Arabia (~250
units) and UK (1000+ units). In fact, Russia is only ~2.5x the size of Ireland (75 units) despite a ~29x larger population! Given the scale
of Domino’s operations in other countries, it seems safe to assume that DPEU can at least double or triple its existing Russia store
count, if not hit long-term management guidance of 900 stores.

Inferior Margin Profile & Capital Efficiency (NOT TRUE)

Dominos sub-franchisees globally follow different business models ranging from 100% franchised (Dominos UK) to 100% corporate-
owned (Dominos India). This means that EBITDA margins are not a fair proxy to compare profitability across business models as a
100% franchised store network will incur lower operating overhead. EBITDA as a % of system sales (“system sales” is defined as net
revenue per outlet) is a more relevant metric as it measures profitability as a % of every sale made to the end consumer. One would
expect Jubilant to generate highest margins per system sales as its stores are 100% corporate-owned but it is surprisingly Turkey
(DPEU’s home geography) that generates the highest EBITDA margins on system sales among all its listed peers. Russia’s EBITDA
margins trail peers but an apples-to-apples comparison is hardly relevant as Russia is still scaling up (~61% FY15-18 store count CAGR).
While DPEU RoCE trails pure 100% franchised operations such as Dominos UK, the business still has attractive unit economics (2-3
store payback) and Turkey RoCE comfortably exceeds 20%. Consolidated RoCEs lag peers not because of inferior margins or inferior
unit level economics but because Russia (~34% of FY18 system sales) is still scaling up. Not only is DPEU’s unit level capital efficiency
comparable to peers but a lot of incremental growth going forward will be driven by franchisee stores (sub-franchisees accounted for
44% of Russian stores in FY18 vs 18% in FY17) implying high incremental returns on invested capital and steady RoCE improvement in
the coming years.
Management Issues (NOT TRUE)

DPEU was founded by Aslan Saranga (still owns ~5.6%) in his 20s. Starting with one store in ’96, he has scaled DPEU to 700+ outlets.
He is well-regarded within the Dominos ecosystem and he sits on the Domino’s Pizza General Management Council (comprises of the
CEOs of the top 10 countries in the global Domino’s network). Although he sold half his stake during the IPO, he has been a net buyer
of shares after the recent drawdown and desk research indicates that he remains fully committed to the business. The senior
management in Turkey have spent an average of eight years with the group (low churn!) and have been hired from major multi-
nationals (e.g. Pizza Hut, Pepsi). DPEU’s largest shareholder is Turkven (PE fund that acquired a majority stake in ’10) who still hold a
~43% stake, who has been a net buyer recently and control 3 board seats. Management and insider shareholders appear to be
committed, competent and most importantly, have significant skin in the game.

Macro instability (TRUE)

Turkey’s economic woes have hit DPEU really hard. Rampant inflation hurts consumer purchasing power (affecting volume growth),
FX devaluation poses currency translation risks as DPEU is listed in the UK (financials are presented in GBP) and rising debt costs hurt
earnings directly. DPEU’s CY18 debt bore a 25% interest expense. To put this in perspective, destitute farmers in India have cheaper
access to credit than one of the world’s fastest growing publicly-traded Domino’s franchisee.

Expected Upside

Since macro instability hurts DPEU and is a risk that cannot be controlled, the best time to enter this stock is after a macroeconomic
shock. I won’t dwell on when, how and if the Turkish economy will recover as I don’t have the expertise or the arrogance to make such
bold predictions. My upside math is predicated on DPEU continuing to meet its operating targets:

- 15% system sales CAGR for the next 4 years. As of FY18E, Russia accounts for ~34% of system sales. If management triples its
store count over the next 5 years (25% store count CAGR), Russia system sales will show at least 25% CAGR (likely higher due
to inflation and LFL growth as stores mature). Historically, system sales have grown at least 1.5x faster than estate growth.
Assuming Russia shows 25% CAGR, Turkey will have to show 8% 4-yr CAGR for overall system sales to compound 15%. Turkey
has shown 12%+ CAGR over the past 1, 3 and 5 years giving me confidence that my topline growth assumptions are not
unreasonable.
- DPEU is expected to earn a 9.3% EBITDA margin (as a % of system sales) in FY18. While Turkey’s EBITDA as % of system is
~11.5%, Russia lags considerably at ~5%. I am forecasting that consolidated EBITDA as a % of system sales improves by only
60 basis points despite ~2.4x growth in Russia system sales and a ~1.7x growth in total system sales with a growing
proportion of incremental stores coming via the sub-franchisee route. If we look at historical adjusted EBITDA margins as a
% of system sales (this excludes non-recurring items such as IPO expenses), they have improved far more drastically relative
to my forecast. During FY14-17, adjusted EBITDA as a % of system sales improved from 5.3% to 11.3% as system sales grew
~1.7x. I sense-checked my margin assumptions not only by looking at historical base rates but by also doing a bottoms-up
study of cost line-items. For e.g. central overheads are ~11% of overall system sales (~20% in Russia, 9-10% in Turkey). If
Russia grow topline by ~2.7x, it is hard to imagine that overhead costs as a % of system sales won’t start approaching Turkey
levels and that alone is enough to meet my modest margin expansion forecast.
- DPEU’s Turkish has a whopping 25% interest expense. Management expects to pay back this debt completely in CY19 but I’m
assuming that this debt is paid over the next 4 years. This means that interest expense will fall 50% over the next 4 years
- No macro mean reversion which provides currency translation benefits given that DPEU is listed in the UK

These assumptions result in net income growing ~8.5x from 13m lira in CY18 to ~102m lira in CY22. Using a 25x NTM multiple (comps
and DPEU both trade at 30x NTM PE today) on FY22 earnings, we arrive at a FY21 price target - GBP 2.06 (21% IRR). I want to highlight
that my topline growth and margin expansion are far less bullish relative to sell-side estimates. I am able to arrive at a higher price
target despite less aggressive operating forecasts because: 1) time-arbitrage, 2) I’m assuming DPEU meets its guidance to pay down
debt vs assuming that DPEU issues a dividend with surplus cash instead of repaying 25% yielding debt and 3) DCF-based forecast that
extrapolates current macro-pessimism by using an elevated WACC.

Risks

Excluding unavoidable macro risks, the following risks need to be monitored closely:

1. Turkey and Russia franchise health, growth rates

2. Management debt repayment progress over FY19
3. Turkven’s stake sale process as this could create an unnecessary overhang on the stock