Domino's Facing Liquidity Challenges From Lehman Fallout

(MoneyWatch)  Domino's Pizza, after reporting disappointing sales and a drop in third-quarter profit, reported Tuesday that its ability to draw upon its variable funding notes had been sharply reduced from $90 million to an estimated $21.7 million -- after Lehman Brothers, the primary provider of those funding notes, declared bankruptcy. Despite the fact that operating margins remain under pressure from higher commodity (from wheat to dairy), labor, and delivery (fuel) costs, CEO David Brandon said in a conference call with analysts that management "was losing no sleep, had no concern about its liquidity, and had significant cash balances" and ample ongoing cash flow from operations to fund its day-to-day operations for the forseeable future.

Yet an analysis of the company's third-quarter 10-Q filing for the period ended September 7 shows a leveraged company struggling to maintain liquidity and capital spending needs:

"Historically, we have operated with minimal positive or negative working capital, primarily because our receivable collection periods and inventory turn rates are faster than the normal payment terms on our current liabilities. We generally collect our receivables within three weeks from the date of the related sale and we generally experience 40 to 50 inventory turns per year. In addition, our sales are not typically seasonal, which further limits our working capital requirements. These factors, coupled with significant and ongoing cash flows from operations, which are primarily used to service our debt obligations, invest in our business and repurchase common stock, reduce our working capital amounts. As of September 7, 2008, the Company had approximately $34.9 million of cash held for future interest payments, $26.4 million cash held in interest reserves, and $10.0 million cash held for capitalization of certain subsidiaries for a total of $71.3 million of restricted cash."

In actuality, less total restricted cash ($71.3 million), pre-paid expenses ($10.6 million), and restricted advertising fund assets ($19.7 million), working capital plummets from $84.4 million to a deficit of approximately $17.3 million. According to the aforementioned filing notation, negative working capital is nothing more than a speed bump for the pizza delivery operator. These are not however, historical times -- and as the credit crunch intensifies, Domino's will likely need to seek alternative financing:

1. Domino's preference would be to keep its relationship with franchisees focused on being the franchiser rather than their bank, but given the current lending environment has effectively shut down, Brandon admitted that the company would consider making short-term capital available to top-tier franchisees looking to purchase faltering operations.
2. Free cash flow, defined as operating cash flow minus capital expenditures, fell 49 percent year-on-year to $26 million, at nine-months ended September 7. Going forward, liquidity could deteriorate further, due to an expected $1.0 million hit to fourth-quarter earnings from a stronger U.S. dollar on foreign operations (41% of aggrgate sales), continued volume weakness in the domestic market, and a higher effective tax rate.
3. The company services about $1.7 billion in debt.

In charge of an empire that sells more than a million pizzas a day, Chief Executive Brandon emphasized that "cash remains king" in today's uncertain market conditions. That said, the pizza delivery king will also need to sell plenty of its new $4.99 Oven Baked Sandwich to bring in the needed dough.

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This post first appeared in BNET's 10-Q Detective.