If We Save Pizza, We Save America

America loves pizza. If we assume that pizza follows a traditional “Pyramid of Quality” ratio, which posits that there is always more bad than good, then the world of pizza can be split into five sections.

Garbage Pizza is the quality of a school lunch cafeteria. Corporate Pizza is the major chains (Domino’s, Little Ceaser’s, etc.). Other Chains include the smaller regional and fast casual pizzerias. Good Pizza is worth going out of your way for. And finally, Prestige Pizza is “the best” pizza according to your snobbiest food friend.

Another way to look at this is as a five-star rating system. For every five-star review you should have three four-star reviews, five three-star reviews, seven two-star reviews, and nine one-star reviews (it’s actually pretty easy to avoid Garbage Pizza, so unless you’re in middle school you should be able to avoid one-star pizza).

If we believe The Pyramid of Quality ratio there should be seven times as much “Corporate Pizza” as “Prestige Pizza.” If the whole triangle represents the 100 acres of pizza America eats every day then Prestige pizza would represent 4 of those acres, or 4%, and Corporate Pizza would be 28 acres, or 28% of all pizza consumed.

According to PMQ.com the four pizza company giants (Domino’s, Pizza Hut, Papa John’s, and Little Caesar’s) own 25.17% of all pizza stores. (This is 2.83% off what is predicted by the Pyramid of Quality for Corporate Pizza.) But those same four companies represent 39% of all pizza sales.

One might assume that the reason why there is such heavy supply of Corporate Pizza is that people like Corporate Pizza, and vote with their dollars. But the consumer doesn’t like Corporate Pizza. Online reviews prove it:

• Yelp: Domino’s in Boston 2/5
• Yelp: Domino’s in San Francisco 2/5
• Yelp: Domino’s in Houston 2/5
• Serious Eats: A bad review
• Trustpilot: Domino’s in the UK 1.7/5
• Consumer Affairs: The whole chain 1/5

There are positive reviews out there, but we can assume people have an accurate understanding of low quality pizza.

The reason people are buying so much poor quality pizza is because Corporate Pizza has easy access to credit and can outspend everyone else. Access to credit is the fuel for the Corporate Pizza growth machine and it’s working great for them! Domino’s Pizza ($DPZ) is up over 500% over the last five years:

The success of Domino’s has been credited to their transformation from pizza company to tech company. According to PMQ.com:

About 50% of Domino’s sales now come through its digital ordering channels, and studies show that online customers tend to spend more on their orders. Plus, as Domino’s CEO J. Patrick Doyle told investors in late 2014, digital ordering leads to a higher volume of orders from repeat customers.

In a 15 part series the Market Realist highlights Domino’s debt:

Domino’s Pizza has high leverage compared to many of its competitors. Its net debt-to-EBITDA ratio is 3.91x compared to an industry average of 1.6x based on 12 restaurants. Papa John’s has a net debt-to-EBITDA ratio of 1.33x, and Pizza Hut’s parent, Yum! Brands, has a leverage ratio of 1.20x.

Douglas Rushkoff points out that the growth rate of a company is determined by its debt structure. And the story of Domino’s is all about debt.

We have to go back to the year 1998 when an investment funds group associated with Bain Capital LLC completed a recapitalization deal to acquire what is now Domino’s from then-owner Thomas Monaghan and family. The company went public with an IPO (initial public offering) in 2004.

The company debt came due in 2007, but it underwent another recapitalization transaction with the issuance of $1.7 billion in debt. The latest recapitalization transaction happened in 2012, leaving the company with $1.57 billion in debt. This debt obligation is coming due in 2019, when the company may go for yet another round of recapitalization. –Market Realist

Rushkoff calls this “the growth trap. And it’s what all these giants companies are in, because they’re obligated to grow by what their debt structure demands rather than by the demand of their market.”

“At the end of the day, any place where there is a screen you should be able to order Domino’s.”

CEO J. Patrick Doyle

Domino’s uses massive financing to fund the technology that enables growth. This raises the stock which allows more borrowing and the whole cycle starts again. As CEO Patrick Doyle says, “Domino’s benefits from scale.”

Corporate Pizza is less about pizza and more about the process behind pizza (otherwise known as, “economies of scale”). Their revenue is generated largely from logistics. “In terms of revenue, the supply chain is Domino’s Pizza’s (DPZ) most important segment. In fiscal 2014, it contributed 63%, or $1.26 billion, toward the company’s total revenue,” explains Market Realist.

Public companies take on the costs of generating the financial data investors need to analyze and understand risk. Institutional money isn’t concerned about the quality of the pizza, just the financial performance of the company. The stock of Domino’s pizza is mostly held by institutional investors who do their research and then invest millions of dollars.

Two Sigma Investments purchased $92.1 million of DPZ over the previous quarter. They “use artificial intelligence and other advanced technologies to look for meaningful patterns in the world’s data. Then we use these insights to create investment strategies.” What if an investment firm wanted to look for meaningful patterns in Prestige Pizza instead of Corporate Pizza?

Applying an investment strategy requires standardized information. Independent pizzerias don’t have the capability to regularly release their finances in a standardized format and on the low end a financial review is estimated to be $2,000-$10,000 depending on the company size, complexity of the business, and how well records are being kept.

For a fund to invest $92 million in Prestige Pizza it would have to overcome some massive hurdles. A fund would likely choose a fixed-income loan instead of an equity investment because Prestige Pizzeria isn’t a high growth enterprise. Assuming the average Prestige Pizzeria wants to borrow $150k (to finance a new $60k pizza oven and a commercial kitchen renovation, for example) the fund would need to make 613 loans. Some of the companies they review will not meet their investment standards (a 2013 survey shows that only 39% of businesses with less than $5 million in revenue were approved for a small business loan), but we’ll assume the fund is full of experts and only had to review 1000 pizzerias to find their 613. At $2-$10k per company, it would cost no less than $2 million just to produce the financial data necessary to analyze their risk (information that public companies are compelled to provide to the market at no cost).

The expense of determining the risk of privately held companies keeps the majority of institutional money in public markets. That’s bad for pizza, and ultimately it’s bad for America!

Access to capital, especially access by privately held companies, is a component of job and economic growth. Despite the attention stock market performance receives, researchers at the Pepperdine University have noted “the relationship between public stock returns and real economic activity has been shown to be weak, at best.” Instead, they say, “GDP growth in highly developed economies is significantly driven by the private sector and by entrepreneurial activity in particular.” –Forbes

The public markets are designed to facilitate investment, that’s where the majority of capital is invested. All those public companies, regardless of industry, are actually in competition with one another for the same investment dollars. They use the capital to reduce that competition through mergers and acquisitions.

The M&A market is booming: A record $1.1 trillion of U.S. deals were done during the first half of 2015, according to Dealogic. –CNN Money

Most M&A deals fail, but consolidation reduces the competition and fewer public companies means more investment dollars for the survivors. Of course that’s not so great for investors.

You don’t have to be an economist to predict what would happen to pricing in any marketplace when there is a shrinking number of buyers and an increasing number of sellers. –The D&O Diary

With the majority of investment dollars being put into a shrinking number of companies and the knowledge that GDP growth is driven from entrepreneurs in the private sector these “pizza problems” are in fact America’s problems.

The long tail of independent “pizza” has been too costly and difficult for institutional money to access. Although public markets are engorged with capital, real growth opportunities lie within the private markets. New regulation has been passed to encourage more investing in private companies but a lot of work needs to be done to standardize information, enable diversification, and entice institutional money to allocate money to small and medium sized businesses. As more investment dollars to flow into the long tail of the economy, private markets generate increasing profit opportunities for institutional money, help shrink the credit-gap faced by private companies, and may yet pull the entire economy out of the growth trap.

When institutional money is equally distributed among the entire Pyramid of Quality, consumer preference will become the key driver of market share.Prestige Pizza and Good Pizza return to their rightful share of pizza sales. And we’ll all be eating better pizza as a result.

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