Dunkin’ Brands Group (NASDAQ:DNKN)
Q1 2014 Results Earnings Conference Call
April 24, 2014, 8:00 a.m. ET
Stacey Caravella - Director of Investor Relations
Nigel Travis - Chairman and CEO
John Costello - President of Global Marketing & Innovation
Paul Carbone - CFO
John Ivankoe - JPMorgan
John Glass - Morgan Stanley
Andy Barish - Jefferies
Michael Gallo - CL King
Joseph Buckley - Bank of America Merrill Lynch
David Palmer - RBC
Matt DiFrisco - Buckingham Research
Alton Stump - Longbow Research
Jeffrey Bernstein - Barclays
Jeff Farmer - Wells Fargo
Will Slabaugh - Stephens
Steve Anderson - Miller Tabak
Good day, ladies and gentlemen, and welcome to the Dunkin Brands first quarter 2014 earnings conference call. [Operator Instructions] I will now turn the call over to your host, Stacey Caravella, director investor relations. Please go ahead.
Thank you, operator, and good morning, everyone. With me today are Dunkin' Brands' Chairman and Chief Executive Officer Nigel Travis and Dunkin' Brands' Chief Financial Officer Paul Carbone, each of whom will speak on today's call. Additionally, Dunkin Brands President of Global Marketing and Innovation John Costello is here, and he’ll be available for questions during the Q&A session at the end of the call.
Today’s call is being webcast live and recorded for replay. Before I turn it over to Nigel, I'd like to remind everyone that the language on forward-looking statements included in our earnings release also applies to our comments made during this call. Our release can be found on the website investor.dunkinbrands.com, along with any reconciliation of non-GAAP financial measures mentioned on the call with their corresponding GAAP measures.
Now, I'd like to turn the call over to Nigel Travis.
Thank you, Stacey. Good morning everyone, and thank you for joining us for today’s call to discuss our first quarter 2014 results. Let me start by saying we’re happy that spring is finally here. It seemed for many months that the winter was never going to end, and it’s not just here in New England, but across many parts of the U.S.
The record-setting snow accumulation and cold temperatures significantly impacted both Dunkin Donuts and Baskin Robbins in the U.S. during the quarter, and though we’re disappointed, we’re certainly not alone in this as most of the broader retail sector felt the impact from weather as well, and certainly that’s true when I look at some of the other reported comp numbers that we’ve heard about this week.
Even with the difficult start to the year, we’re confident we will achieve our targets for the full year, and while the weather disrupted sales in our restaurants, we still achieved strong restaurant growth in the quarter, adding 69 net new Dunkin Donuts in the U.S.
We continued to successfully execute on our long term domestic growth plan for Dunkin Donuts, and we’re excited to announce that we expect the first traditional restaurant to open in California by the end of 2014, which is ahead of the original expected date. We had previously said 2015.
During the past quarter, I visited several of our western markets and saw firsthand the outstanding quality of operations and franchisees that are so critical to our success in that part of the country. What is impressive is seeing the results of our five development strategies, which are, and I’d like to remind you, firstly, highly effective real estate selection; secondly, an operations focused culture - and some of those franchisees really ooze operations; the impact of national media; a focus on beverages; and of course choosing highly qualified franchisees.
Later on this call, Paul Carbone will discuss in detail the unit economics of the cohort of Dunkin restaurants that opened in 2013, and I’m happy to report that the cohort achieved 25% unlevered cash on cash return. This is the fourth straight year that the new store openings hit this target.
The quarter saw the launch of two exciting and highly anticipated initiatives. First, the DD Perks rewards program, which launched on January 27, when our guests nationwide began to enroll in the program and earn points for every Dunkin run. The rollout has gone incredibly smoothly, from the technology backbone to the operations in our restaurants, to our guest reception of the program. The Dunkin Donuts Perks program now has more than 750,000 members, and marketing for the program only began in early March.
Second, the launch at the beginning of April of online cake ordering for Baskin Robbins U.S. is off to a great start, and I believe this will be a transformative initiative for the business, not only in the U.S. but someday perhaps globally. I’ll talk about both programs in further detail later on.
Now let me talk in greater detail about sales in the Dunkin Donuts U.S. business in the first quarter. The business delivered 1.2% positive comp store sales growth. We estimate approximately 200 basis points of negative impact from weather in the quarter.
There were two main factors that drove this significant impact from weather. First, the geographic concentration of our stores in the Northeast, which is the region with the worst weather. We were up against more disruptive storms and unseasonably cold temperatures compared to last year. Based on our records, we had 39 days of snow in the Boston and New York markets in the first quarter.
Secondly, the day part that we predominantly operate in is in the morning. Breakfast is very much a ritualistic occasion. It’s what makes this day part such an appealing one in the QSR industry. But when our guests’ normal morning routine gets disrupted by things such as store closings and office closing, as a result of snow and bad storms, we lose their visit on that particular day, and that visit, in most cases, is not recoverable.
As a result, we saw a transaction decrease in the quarter, and that decrease was just under 100 basis points. However, we do not want to harp on the weather. We’ve learned that what we need to have is better programs for the winter, and we’ll do so in the future, using the learning from this year.
On the positive side, the Dunkin Donuts performance in the first quarter was stronger than the performance of the remainder of the sales tracked weekly quick sellers restaurant participants, as measured by the MPD Group. Additionally, major markets that saw little to no weather impact delivered very strong results. For example, the Miami and Tampa markets had mid-single digit comp store sales growth throughout the quarter.
And we’re encouraged by the fact that across the system, we continue to see gains in both the number of units sold per transaction and the price per unit sold in each transaction. Price was below 100 basis points in the quarter. From a category perspective, we saw good results in iced coffee, hot and iced espresso, donuts, and both morning and afternoon sandwiches. The combination of core category momentum and limited time offer product news continues to provide a sound platform for long term growth.
Putting weather aside, there are other headwinds facing our franchisees. First, there’s continued economic uncertainty with QSR customers. Secondly, increased competitive activity in the breakfast and coffee categories. And finally, the legislative impact from issues such as minimum wage and healthcare.
To combat these ongoing real challenges to our franchisees, our number one focus is driving comp sales, since that flows through to the bottom line of our franchisees, given our very high product margins. To drive comps, we remain focused on great operations and customer service in our restaurants, leading product marketing and innovation, and the addition, of course, of our DD Perks loyalty program.
I must say, we’re very excited by the start of DD Perks. As I said earlier, we now have more than 750,000 members, and while it’s still the early days of the program, weekly spending of Dunkin Perks members is higher than Dunkin card holders who have not joined the Perks program.
We would love to share greater detail about the program, but we feel we need to give the program a full year before discussing it in depth, so that we can fully understand the impact of Perks to the business and what it can ultimately mean for long term growth.
We have set a target of 2.5 million members by the end of the year. We developed this goal based on our own internal projections and by analyzing what other loyalty programs have accomplished. Reaching our year-end target will mean that our loyalty program has grown faster in the first 10 months than the programs of anyone else in our space, and we will have accomplished this with significantly fewer outlets than the robust loyalty programs that we benchmarked against.
As I said earlier, despite the tough start to 2014, for Dunkin Donuts U.S., we continue to expect to achieve 3% to 4% comp store sales growth for the full year. As an update on a topic we’ve discussed in the past, I’m pleased to report that we’re also making substantial progress in our studies of the current sandwich station - I actually saw the new version yesterday, and came as well as very excited by it - and secondly, ways to maintain and enhance speed of service as we continue to aggressively grow that part of the business.
And also on operations, the Dunkin Donuts U.S. business again hit an all-time high guest satisfaction score during the quarter.
Let’s now move to Baskin Robbins U.S. The segment had its fourth straight quarter of positive comps and ended the first quarter with 0.5% comp growth. Obviously, the stone cold temperatures present challenges for an ice cream business.
As you’ve heard me talk before, one of the ways we believe we can mitigate the weather impact is by driving cake sales, because birthdays, holidays, and celebrations take place no matter what’s happening outside. In fact, driving cake sales globally is a major strategic focus for us, and I’ve set the goal of growing from more than 13 million cakes sold around the world annually to 20 million sold in the future.
We have several initiatives underway to help us achieve this goal, including online cake ordering in the U.S., enhanced cake designs, which is a global initiative for us, and cake delivery, which we’re beginning to test in a few markets outside the U.S.
As I referenced earlier, we launched online cake ordering nationally a few weeks ago, and it’s off to a good start. Our franchisees are very enthusiastic about it, as they understand that a $25 cake sale can have outside positive impact to their profitability when you consider an ice cream cone typically sells for about $3. I’ve personally seen what online ordering did to revolutionize the pizza industry by driving average ticket up, and I believe we can see the same effect for ice cream cake sales.
Let me now turn to international. As we’ve discussed in previous quarters, comp store sales growth for Baskin Robbins International is largely driven by the performance of our restaurants in Japan, and similarly, on the Dunkin side, comp store sales growth is highly affected by the performance of our restaurants in Korea.
We are working hard with our joint venture partners in both countries to accelerate sales growth, but it will take some time and Japan in particular has been difficult for many QSR brands. We are pleased with the performance of the brands in many other regions of the world. Importantly, for Dunkin Donuts, we continue to open new restaurants in Germany and the U.K. and we’re excited by the starts in both countries. In fact, one of our new franchisees in Germany opened their first store in Munich just a couple of weeks ago, and it’s surpassed $40,000 in sales on the first day and close to $250,000 for the week.
Yes, you did hear that number correctly. In these markets, we’re seeing very early success from the migration of the strong disciplines that we have seen to be very successful in the U.S. The brand reception in Germany has simply been outstanding, and reaffirms our strategy of targeting high GDP countries. In fact, our teams recently began recruiting franchisees for Austria, Holland, Belgium, Denmark, and Finland.
Lastly, before I turn it over to Paul, I’m delighted to say that I recently agreed to extend my employment contract with Dunkin Brands through the end of 2018. I’m extremely proud of everything we’ve accomplished over the past five years. We have two tremendously powerful brands, enormous global growth potential, a talented management team, and most importantly, world class franchisees.
I’m really looking forward to the next five years with Dunkin Brands, much of which will be driven by technology initiatives such as Perks and online ordering, which truly does give us true access to one to one marketing.
With that, I’ll hand it over to Paul.
Thanks, Nigel, and good morning everyone. Typically, around this time of year, at our investor day, we share the unit economic performance of the traditional Dunkin Donuts restaurant that we opened up during the previous year in the United States. This year, we’re holding our investor day later in the fall, on September 17. Given this, I’m going to cover the highlights of the performance of the 2013 cohort of new restaurants on today’s call, and we posted a presentation to our investor relations website that provides more detailed information.
Nigel stole the headline from me, but I’ll reiterate the point, because it’s important. We’re proud to report that the 2013 cohort of new restaurant openings delivered 25% unlevered cash and cash returns to our franchisees, the fourth year in a row that new restaurants achieved this target. Our steadfast focus on franchisee profitability is the backbone of our long term plan to have more than 15,000 Dunkin Donuts restaurants in the U.S.
The highly compelling returns of a Dunkin restaurant are attracting highly qualified new and existing franchise operators to grow with the Dunkin Donuts brand and enabled us to achieve 5% net unit growth in 2013.
Now, let me walk you through the performance of the traditional restaurants of our franchisees opened in the western emerging markets in 2013. New restaurants in the western emerging markets continue to see strong top line sales, with average weekly sales of approximately $18,000 or average annualized unit volumes of $936,000.
The average cost to build a new restaurant in these markets was about $460,000, up slightly from 2012, driven primarily by the addition of the digital menu boards which are now a standard as part of the Fresh Brew store design that we rolled out last year.
Another factor driving up build cost is that our franchisees are building more standalones and drive-thru locations in the western emerging markets. This is great news in terms of the overall quality of new assets coming into the system.
Franchisees are seeing on average EBITDA of around 12%, which is up slightly from 2012 as COGS have come down. Additionally, sales of high-margin products, like differentiated beverages and breakfast sandwiches, are up year over year, and also helping to drive profitability across the system, and particularly in the western emerging markets.
And same as the entire cohort, new restaurants in the combined western emerging markets are seeing, on average, 25% unlevered cash and cash returns. We’re very pleased with the performance of the new restaurants opened in 2013. Obviously, we face a challenging first quarter, which for many of our new restaurants marked the first full quarter of operations, given that we had so many opened in the fourth quarter of last year. But overall, it was another strong year of unit economics for new restaurants.
As Nigel said earlier, our franchisees are facing some headwinds in 2014. Because of the strong returns of Dunkin restaurants, we feel our system is well-positioned to handle these challenges. However, we’re working hard every day to help our franchisees mitigate these headwinds. Part of this is the great work done by our franchise owned purchasing and distribution cooperative, which is delivering on the commitment to flat national pricing by the end of this year.
There’s more detail on new unit economics from the past five years in the presentation that we posted to our investor relations website this morning. I encourage you to follow up with Stacey and me with any questions after you’ve had time to further review the data. We’re also close to sharing with you the BRUS unit economic data, which is looking promising, although our sample size is small.
So now let me move on to our first quarter development results. In the first quarter, our franchisees opened 69 net new units versus 78 last year. Just as a reminder, last year we had the highest number of openings in Q1 since 2018. The year over year decrease in net openings is a timing issue between quarters, and not an indication of a slowdown in the development pace. And it was on plan with our internal expectations. We remain very confident in our full year target for Dunkin Donuts U.S. of 380 to 410 net openings in 2014.
By region, 30% of the Q1 net development was in the core market, 32% in established markets, 22% in emerging markets, and 16% in western markets. Our franchisees completed 94 remodels during the quarter.
Now to Baskin Robbins U.S. development. Baskin Robbins U.S. franchisees added one net new unit during the first quarter, versus two net new units last year. And as a reminder, our target for full year development for Baskin Robbins U.S. is 5 to 10 net new units.
Baskin Robbins International added 52 net new restaurants versus 34 last year. This growth was primarily in Europe. And Dunkin Donuts International had net 26 closures in the quarter versus six net closures last year. The closures in the first quarter this year were driven by closings in the Philippines that we discussed when we provided our full year guidance for Dunkin International.
Without the Philippines, the segment would have had 14 net new units. We do not expect as many closings in the Philippines in Q2, and we believe Dunkin International will have positive net development in the second quarter. And we continue to expect to open 300 to 400 net new units for our international businesses combined.
So now let’s turn to Dunkin Brands financial results. First, I want to address the G&A expense in the quarter. Beginning this quarter, we’ve changed the way we present certain income generating transactions that in the past were treated as a contra-G&A expense. We’ve now moved these types of transactions into other operating income net on the P&L.
This includes things such as the sale of land that we own. While transactions like these occur regularly, they’re not part of our core business model. And we’ve made this change to just provide greater transparency to our investor base.
As a result of this change in the face of the P&L, G&A growth for the quarter was above our full year guidance of 3% to 4%. But, let me reiterate, for the year, we still expect G&A growth of 3% to 4% inclusive of these types of transactions, even though they are now reported differently than in the past.
Revenues for the first quarter increased 6.2%, compared to the prior year period, primarily from the increased sales of ice cream products and increased royalty income due to the system wide sales growth. Operating income for the first quarter increased by $5.6 million, or 8.9% from the prior year, primarily as a result of increases in royalty income and the margin on sales of ice cream products.
Adjusted operating income increased $4.9 million, or 7%, from the first quarter of 2013, also as a result of the increases in royalty income and margin on sales of ice cream products. Net income for the first quarter decreased by $0.8 million, or 3.5%, compared to the prior year period, primarily as a result of the $13.7 million expense in loss and debt extinguishment, and refinancing transactions, compared to a $5 million loss in the prior period, as well as a $1 million increase in income tax expense.
The increases in expenses were offset by the $5.6 million increase in operating income and the $2.9 million decrease in interest expense due to the recent refinancing. Adjusted net income increased by $4.5 million or 14.4%, compared to the first quarter of 2013, as a result of an increase in adjusted operating income and a decrease in interest expense offset by the increase in income tax expense I spoke to earlier.
Diluted adjusted earnings per share increased by 13.8% to $0.33 for the first quarter of 2014, compared to the prior year period, as a result of the increase in adjusted net income and a decrease in shares outstanding.
The decrease in shares outstanding is due primarily to the repurchase of shares during 2013 and the first quarter of 2014, offset by the exercise of stock options. During the first quarter, we repurchased a total of 512,205 shares. The diluted weighted shares for the quarter were 108.0 million.
At the end of the first quarter, we had a debt to adjusted EBITDA ratio of 4.6:1. Our effective tax rate for the quarter was 39%. And lastly, during the quarter, we had $29.3 million in free cash flow. We ended the quarter with $202 million in cash on our balance sheet, and of the $202 million, $101 million represents cash associated with our gift card programs and marketing fund balances. We used $25 million in cash during the quarter to pay our Q1 tax dividend to shareholders and $22 million to repurchase shares.
And now I’d like to turn the call over to operator to open it for questions.
[Operator instructions.] Our first question comes from John Ivankoe with JPMorgan.
John Ivankoe - JPMorgan
First, Nigel, in your prepared remarks you said two interesting things I’d like to follow up on. Firstly, a new sandwich station I think you said you saw yesterday. What would that entail in terms of retrofitting the stores and what could that accomplish in terms of transactions per hour, overall throughput, speed of service, what have you? And then secondly, you mentioned all-time high guest satisfaction scores for Dunkin in the U.S., and could that translate to increased pricing at the franchise level, especially since traffic isn’t great, and your commodities like coffee and dairy are higher? What’s the attitude towards franchise pricing relative to those guest satisfaction scores?
On the new sandwich station, we’ve actually taken a fairly different approach to removing what some people see as a bottleneck, and we’ve actually employed two outside universities, which we also then had a group of internal people and franchisees working together. And what I saw yesterday was the result of that last group. We expect to have some pretty radical thoughts from the universities, and we’re effectively separating the three groups because we don’t want to, if you like, distort each’s radical thinking.
What I saw yesterday was like a double-side sandwich station, and what that does is it means that you can have far greater throughput. And that means that the drive-thru can be handled more satisfactorily, as well as in the store. The store I saw yesterday actually had very high volumes, 50,000, and they’re already seeing improved guest satisfaction scores as a result of the extra speed.
So we’re excited about it. It’s early days. We’ve only got two of these in test, one in Florida and one in Massachusetts. I don’t want to commit to what we’re going to do on investor day, but we’ll probably show you at least the video of it on investor day. I think the challenge that I saw yesterday is how to take this really exciting development and break it down and take some of the aspects of it and put it into smaller stores. That’s the real challenge.
But I think I came away yesterday excited by the fact that we can boost throughput. To answer your question, not sure what that means in numbers, but it is a big improvement, and obviously, that goes hand in hand with one of our core attributes, which is speed of service.
Going on to the second quarter, as you all know, I’m totally fixated by the fact that we’ve great operators. And you know, we push and push and push all the time to take our stores, on a store by store basis, a region by region basis, and nationally to reach higher numbers on every aspect of guest satisfaction.
Obviously, we’re in a highly competitive business, and if we can deliver great order accuracy, great guest satisfaction, that means that our customers will leave better satisfied. So that’s the focus. Whether it means that will translate to pricing, I doubt, because our view on pricing is to maintain our strong value proposition. Our franchisees, as I said, just about every quarter have done a great job in terms of keeping our prices low. In fact, price is below 1%. That’s been, if you like, the focus that we’ve had, and the franchisees have maintained that.
John, anything else on pricing?
As Nigel mentioned, we are very committed to our value position, where we have real flexibility as our continued rollout of differentiated products. So we combine great value on everyday items with the ability to, for our franchisees, price on differentiated products, for which there is no comparison. The two of those let us maintain our value positioning, but also help us grow profitable sales for our franchisees.
Our next question comes from John Glass with Morgan Stanley.
John Glass - Morgan Stanley
I wanted to ask about your comp store sales performance in the quarter and the guidance, because it hasn’t been changed. So even if you back out weather, your deceleration on a tier basis was somewhat pronounced. I wonder how much of that was that competitive activity in macro. Did you see it specifically around certain competitor promotions? Or are you just seeing that generally?
And you’d have to run four plus for the rest of the year to get to the low end of the guidance now, roughly that’s right. What gives you confidence you can get there? Are you seeing that excluding weather? Is that why you’re feeling that way? Or is it something else that has to change?
Okay, let’s first talk about the quarter. And as we’ve seen, and we actually allocated for the job of being the weather man, but I won’t bring him up now to talk about all the statistics. But you know, we still feel very good about the business. I think your math is about right, about 4%.
And I think John touched on some of the core elements just now. You know, we have this group of highly differentiated products. Sandwiches continue to do incredibly well. That’s why the sandwich station question that was asked previously was so important. So we’re very focused on that, we’re excited about what’s happening with beverages overall, and our iced coffee beverage numbers look outstanding. And we really think this is, if you like, a lead indicator, as there is a change in the demographics of the country.
In terms of overall comps for the year, our formula remains the same. Innovation. LTOs for adding to that is Perks. And I think Perks is allowing us to do true one to one marketing for the balance of the year. So that’s the overall view. Again, John, anything to add?
We think weather was a key factor in the first quarter. As Nigel touched on in his opening remarks, we do look at external and internal tracking of how groupings of our competitors are performing. And so we believe the best defense is a strong offence, and so we’re confident that we can continue to grow comps in the face of competitive activity.
When you look at our performance where weather was more normal, our comp store sales performance was stronger. And then finally, as Nigel touched on, we’ve got the combination of strong product innovation for the rest of the year, strong guest satisfaction, very motivated franchisees, and the growing impact of DD Perks, which, along with mobile, continue to grow at a very nice level.
And I think one thing we didn’t cover there is the competitive activity. Ever since I’ve been here, we’ve had strong competitive activity. I think it was actually my first year that McDonald’s first really got into coffee with McCafe. So we’re pretty used to that. We’ve obviously had other people coming on the scene in recent times. We feel they’ve had very little effect.
I mean, a franchisee actually shared with me a fascinating photo last week. He has a store right next to McDonald’s and McDonald’s had all this free coffee stuff. And we had a line out the door. This was an amazing picture, and I think it demonstrates the loyalty we have, which is reinforced by Perks. So we feel really good about the rest of the year, and it’s down to us to deliver on that number.
Our next question comes from Andy Barish with Jefferies.
Andy Barish - Jefferies
Wondering if there was a little bit of development slip. Just you talk about some renewal timing and the developing numbers overall. But did the weather have any impact, and thus a related fee impact in the first quarter?
Great question. Not really. Last year we had just a huge Q1. When we announced last year’s results, we said don’t expect this in the future. While we continue to try to even out the development by quarter, last year was an anomaly and one of our biggest quarters. So we were at or slightly above internal expectations for development. So the weather really didn’t have that much of an impact, or any impact certainly, on development vis-à-vis our internal projections.
And I think it’s interesting just on the development, what I’d say is that I’ve had two franchisees in the last two weeks come to me and say, “We want to be your biggest franchisee. We’re so excited about the future of the business, we think the stability of the management team, your focus on franchise relationships, your focus on franchise economics, and the exciting revenue growth that we’ve seen is something that really excites us. Can you give us more markets?”
So I know there’s been a lot of noise out there by various pieces of research. I think most of that in my view is complete nonsense. So we feel very good about our development and I think that’s supported by the unit economic numbers that we shared this morning, or Paul talked about. And I would encourage everyone to have those discussions with Stacey and with Paul, because I think all the indications that come out of those numbers are very positive.
Our next question comes from Michael Gallo with CL King.
Michael Gallo - CL King
I was wondering if we could touch a little bit on some of the changes you’re making internationally to Dunkin. Obviously you’re seeing terrific results in Germany. You’ve rationalized some lower volume doors, as you indicated earlier. So how should we think about that brand longer term? Obviously, it’s had a relatively small contribution to your overall performance, but it seems like if you can replicate what you’re doing in Germany, the potential for that is significant. So I guess Paul’s had his hands on the business for six months now, and I was wondering if you could give us some further into what you think the issues are and how you’re going to address them.
Let me talk about international in four bits. First, the joint ventures, which is really Korea, because we don’t have anything in Japan. Korea, we’re working hard. Korea is a very competitive market. It’s one that we’ve got great confidence in the management team there. You only have to see the spectacular results they’re having on Baskin to give us confidence on what they’re going to do on Dunkin. And they are. They have a very clear plan of how to revitalize their business in Korea. And the negative comps, as we said in our prepared comments, are very much down to Korea.
So that’s one segment. You then have what I call the very traditional segment, which is principally southeast Asia and a few other countries. I’m kind of excited about the influence that we’re having in those markets. It’s never going to have the true impact on cost or on our profitability, because most stores have very low AWS. The challenge for us is to take what is already very high franchise profitability, despite the low AWS, and add on some more sales or sales layers onto those businesses. And recently, we’ve launched in a number of countries what we call in America Bubble Tea. That’s been incredibly successful. The third challenge here is sandwiches.
So that’s, if you like, the traditional segment that goes back in some cases, in places like Thailand, Philippines, Malaysia, 30 years. You have the Middle East, which is actually the core profitability of international. And I’m really excited about what’s going on in the Middle East. I’ve been out there a couple of times in the last year or so. I’m out there again in June. I think we’re building a great business in the Middle East. And we actually looked earlier this week at some of their franchise economics. They’re off the charts. So that’s really exciting.
The real development, though, is we’re trying to replicate everything we’ve done in the U.S. in our newer markets in Europe. Germany’s very exciting, and I talked about that store, the second week was also $200,000. Saw that just before I came into this meeting. So Germany is something that we’ve got to make sure we resource out and support properly. The U.K. has started very well. We’ve now got three stores, Harrow, Chelmsford, and Cambridge. More on the [unintelligible]. We’re signing up franchisees at a good rate.
We will then go into these new markets. But what is core is they’re all higher AWS. We’re putting in all of the same elements of equipment that we have in the U.S. in terms of beverage and sandwich stations, which gives them the opportunity to have a high margin product. The Liverpool marketing deal that John did not only was a great deal, but the fact that Liverpool’s probably going to win the Premier League will give us even more publicity to it. So we feel that’s a great way to support new markets when they don’t have the kind of media dollars that we have in the U.S. So that was a terrific initiative.
And I think we’re over every detail. We look at all these stores every week, and we’re determined to make the high AWS markets incredibly successful as you see in Germany. And Brazil’s signed up ready to go later in the year. And having been to Brazil, I’m actually very optimistic, because Brazil has high pricing, and I think from memory, Subway in Brazil has an average price of like $12 per ticket. So that shows you’ve got real pricing power there.
So I think that covers the whole of international. And you know, it is a very small part of our profitability. It’s very frustrating, but I think we have a solid gameplan to get out of that smallness.
Our next question comes from Joe Buckley with Bank of America Merrill Lynch.
Joseph Buckley - Bank of America Merrill Lynch
Just want to go back to the pricing question. Given the run up in coffee costs and dairy costs, when do those higher costs hit your franchisee stores? And if that’s sooner rather than later, wouldn’t that lead to some greater pricing?
You may say that’s logical.
Let’s start with coffee, and you know we’ve talked about this. A franchisee owned distribution cooperative has done a great job and have locked in coffee prices through the end of the year. That’s actually lower in ’14 than ’13, so because of their buying, COGS has actually been a little bit of a positive on the coffee side.
Now, you know, they’re starting to buy into ’15. As you know, futures are higher. So the conversation now happening at the coop level and at the board level is do you start taking some of that price maybe in Q4 of this year and kind of feather it in? But COGS are still lower year over year based on coffee. We’re seeing obviously some impact to dairy.
But overall, COGS are in good shape for the franchisees. And you know, I think with the maniacal focus that management team has in conjunction with the leadership of the franchisees, we see for instance rising coffee costs as something that we can help the franchisees offset, not only through, as you mentioned, maybe some pricing, but importantly through better operations and taking other costs out of the system. You know, having flat national pricing by the end of the year is a huge win for the system, and will certainly help offset any commodities that we see occurring early next year.
And I think I’d just add to that. You and I were talking earlier today that if you compare many of the other QSR companies, they’ve got this huge push on beef and chicken etc. Our segment is relatively protected given the current commodity outlook. So I think even though a lot of people have got pressure, we’ve got small pressures. And as Paul says, we’ve got great plans to mitigate it.
Joseph Buckley - Bank of America Merrill Lynch
Paul, how are you thinking about the balance sheet? I think you mentioned the debt to adjusted EBITDA down to 4.6x. That’s kind of the low end of the range. How are you thinking about it?
First, I may get in trouble for letting you slip in the second question there. But what we’ve talked about is that 4.5 to 5.5 range, and like we’ve said in past quarters, we continually monitor the credit market. So the good news is, we were able to refinance and we have some of the least expensive debt at our credit rating out there. The bad news is, raising more debt at those low rates becomes harder.
So we continue to look at the market, we continue to test raising our leverage. I think that it is something that isn’t baked into any of our numbers, something that all I can tell you is we continue to look at and leveraging the balance sheet and returning cash to shareholders, short term and long term, is certainly a thesis that the management team fully believes in.
Our next question comes from David Palmer with RBC Capital.
David Palmer - RBC
I’ll just ask this one question to a previous question. I think John Glass asked it. But I think it makes sense on the face of it that the weather was a factor in the first quarter and DD Perks should be a ramping lift through the year, and you continue to do some good stuff with breakfast sandwiches and seasonal news.
But the leftover business, I think, that this company will have, and a lot of restaurant companies have had, is that the comparisons on paper look more difficult over the next two quarters. And so people are going to really wonder are you looking at numbers in an exit rate momentum in your business that’s making you feel like that 4% plus is happening already, such that you feel good that you could do that 3% to 4%. Perhaps you will want to comment on that.
I think I just want to harp back on the weather, and it’s interesting, if you actually look at our core markets and over 50% of our stores are in not just the development categorization of core, but if you take New York into account, over 50% of our stores are in that northeast corridor, despite all our efforts to push south and west. And if you take Boston, we had 22 snow days this year. New York had 17. Some of those days, people just don’t leave the house. And I think actually what’s happened, certainly happened here in Massachusetts, a lot of people [unintelligible] some more discipline, because people can work from home, schools are more disciplined. So people don’t leave the house. So you lose effectively whole mornings and whole days.
So the comparison with the first quarter going into the rest of the year, I think given what you say about the challenges of some of the comps from last year, we take that, but we haven’t got the problem that people can’t leave the house. And I think it’s difficult to stress how difficult that is for us to overcome. Because we can’t sell coffee online to them, and for them to drink. So there’s no other way of doing it.
So even though I understand the mathematical challenges you’ve got, and you put very nicely, I actually think we feel very good about the rest of the year. I think our plans are incredibly robust. I mean, Paul says we’re maniacal about the economics and that stuff. We’re probably even more fanatical about comps. And we talk about it every single day, and I think John’s got some of the most robust plans that we’ve had. We’ve got some great products, we’ve learned from previous years. So given the two years, challenges are high, I think I would put the first quarter as very weather dependent and then the rest of the year, I wouldn’t say it’s easier, but it doesn’t have the challenges of people not leaving their homes.
I think you’ve seen the comp store performance of many other people who have reported negative comps, and despite a heavy concentration of our business in areas more affected by the weather, we were able to generate positive comps. But you make a good point on the math. We’re very aware of the math. We build our plans week by week, market by market, so we know what the average weekly sales needs are. We think the product plans are stronger than ever, the marketing plans are stronger than ever. The operational focus is stronger than ever, plus the growing impact of DD Perks as well as the growing impact of our Dunkin mobile app, which continues to grow robustly as well. So you put those all together, and excepting the validity of your math comments, we remain very confident that we can deliver the guidance for the year.
Our next question comes from Matt DiFrisco with Buckingham Research.
Matt DiFrisco - Buckingham Research
I was just curious, also a little bit of a follow up on that discussion about comp. You mentioned 1% price in the quarter, or about 100 basis points I think is how you quantified it. Is that the pace you expect to have for the remainder of the year? I’m just curious if there’s any acceleration in that. And then just a similar question on cannibalization. I know there’s been a lot of concentration on the mix, and I appreciate you providing where the stores are opening, but it does seem like relative to the annual pace, you opened more this quarter in the core markets. You opened a little bit more, and the perception was in 2013 you exceeded your plans in the core market. Is there any change as far as cannibalization that you might be seeing in some of these older markets as well that could be resulting in a little bit more of the modest near term comp trends and improvement in the back half?
Good question. Let me start with where you ended. No, we’re not seeing any cannibalization impacting our comps. Let me start there. On pricing, pricing was significantly below 100 basis points for the quarter. And as you know, we think about pricing long term - and our long term model is 3% to 4% comp growth, so call it in the middle 3.5% long term - we see pricing about 100 basis points in there. So over the long term ex any significant commodity shocks or whatnot, we see it giving us about 100 basis points. On the development piece, we’re one quarter into the year, we’ve given guidance on kind of the ranges. Where we expect development to end on the net development between core, established, emerging, and western markets, we continue to believe that’s where we’ll end in those ranges.
We’re three months in, and I would take it as kind of like the costs, we’re moving towards the full year guidance of where ewe expect to be. So again, no cannibalization, no change in development. I think the two data points that we put out there this quarter, that the 2013 cohort of western emerging markets of 25% unlevered cash and cash returns, goes to speak of the strength of the business model and the demand. And then also, as Nigel talked about in his opening remarks, we are thrilled that we’re actually going to have some traditional stores open up in 2014 in California, ahead of plan. So certainly it shows the demand of the franchisees to open these units.
Our next question comes from Alton Stump with Longbow Research.
Alton Stump - Longbow Research
I just wanted to ask, on the weather comp in the first quarter, obviously I’m sure it’s as much art as science trying to figure out what the impact was. But my assumption was that in the coffee area anyway, in the core New England markets, that there’s not as much impact from weather on coffee versus the other food dominated QSR chains. So I guess what gives you confidence that we did indeed see something like that 200 basis point drag from weather?
Let me address it a couple of ways. First, on coffee not being impacted, it’s less about coffee not being impacted - you know, think about our business. Our business model in breakfast is great, because it’s very ritualistic, and it’s a low ticket. So back in ’08 and ’09, our worst comp performance was negative 1.3, because breakfast is one of the last things, because of the low ticket, people move away from.
But you know, how does weather impact a ritual business? And it’s on the other side. It impacts it greatly. So if you’re coming to Dunkin five days a week, and we have many guests in the northeast that come five days a week to get their morning coffee, and on Tuesday, schools are closed and offices are closed. But you came on Monday, and you’re going to come Wednesday, Thursday, and Friday. But I lose the Tuesday transaction, and for most people, while we would like it, on Wednesday they don’t buy two coffees.
So we lose that transaction forever, unlike maybe a lunch destination or a dinner destination, where you may have had plans that Tuesday, and whereas school was cancelled and work was cancelled, you reschedule for Thursday night, because you’re only going to go there once every couple of weeks. So a ritualistic business is impacted more by weather and disruption of the normal routines than a non-ritualistic business. On the flip side, it’s one of the last things people leave.
You know, on your question on the 200 basis points, we triangulate this three ways. We look at planalytics and weather driven demand. We look at performance in the markets pre-weather/post-weather, for a trend. And then we look at the relationship to those markets to other markets that don’t have weather. And we triangulate this, and that’s how we came up with the 200 basis points. And I’ll tell you in my many years in retail, because the data is there as well, we are the most sophisticated on weather impact, and I am very comfortable saying that weather gave us a couple hundred basis points of impact to the business.
And you could actually back that up even without our own data, by the fact that I think Yum! talked about 300 basis points and McDonald’s 1.4. So given our northeast propensity, I think that basically comes back to the number we quoted.
Our next question comes from Jeffrey Bernstein with Barclays.
Jeffrey Bernstein - Barclays
Actually, just two follow ups, one on the DD Perks. Obviously there are lots of benefits there. I’m wondering whether you can prioritize those. But just wondering, in addition to that, in the early learnings, now that we have three months in, I’m wondering whether anything surprised you thus far with the major launch, whether it’s reloads, redemptions, or things along that front. Just sort of what tweaks you might make a few months in.
And then separately, with California now coming at the end of the year, obviously getting close, I’m just wondering whether in your talks with franchisees - Nigel, you mentioned the headwinds that all your franchisees are facing, but California seems to be more unique in terms of the elevated real estate and minimum wage. I’m just wondering, do you do anything with those franchisees as they ramp up, whether it’s support or incentives or anything along those lines, as the date quickly approaches to help those California franchisees to deliver, especially when they open up at lower volumes and more donut sales.
You guys are getting really good at two questions. [laughter] So I’m going to let John answer the Perks question, and I’ll come back and talk about California. John?
In answer to your question, we are very pleased with DD Perks. I think it was a cross functional team that worked on this. When Nigel and I joined five years ago, we talked about the excitement of someday being able to do one to one marketing, and it’s pretty exciting to see that actually come. The first step to that was putting the technology into our restaurants.
I would say it’s going right on plan. No big surprises, but a couple of encouraging things. One is what a great job our restaurants and operations are doing adapting to the new technology. If you look at people using mobile and Perks in our restaurants, and through the drive-in, I think the combination of our crew and operators are doing a great job.
The other thing is we’re very encouraged, although we’re in the early days, at customer response to all of the various offers that we’re testing. We’re also very pleased with the technology. So I would say it’s very much on plan with no negative surprises, the positive surprises being what a great job our crew franchisees and operators are doing implementing it in store. Second, the responsiveness of our guests to the offers, and third, the speed with which both mobile and Perk enrollments continue to increase.
And just to add one thing, I was talking to someone outside of our business recently and they were commenting about what a great job we’ve done in making our perks program so simple. I mean, I don’t think anyone’s written about this, but it is so simple, and you get constant feedback about how you’re going to the next reward. It focuses people on a reward, which is what everyone wants, which is a beverage.
And this person was saying, you’ve avoided all the complexities that other programs have, and you’re getting the data and using it. So I have to say, John probably was a little bit modest there, because he’s right behind Perks. They’ve done a spectacular job on Perks, and we’re really happy with it.
On California, all the things that you said are right. California has high real estate, it’s got minimum wage effects. To be honest, we’ve got a lot of stores in California with Baskin Robbins. Minimum wage may well have a bigger impact, we think, on them, because they’re smaller than the Dunkin stores, and that’s something that we’ve talked very actively about with our franchisees in Baskin Robbins.
We always have a philosophy of attacking problems. Minimum wage is an issue that we’ve attacked. I’ve gone on public record as saying that it should be done a state by state basis rather than done federally. I’ve actually communicated that to the White House. And so we understand what’s going on, we have models. You know, Paul went into how we look at weather. We have models that we share with our franchisees about how to mitigate all these things.
So California, from a Dunkin perspective, A) I think we’re going to do really well, secondly, and it was in my comments, you may have missed it, I think we’re learning so many lessons market by market. I had a franchisee who has been in the west with us for some time say to me on the phone the other night, Nigel, I wish I was starting now, because what your team has done is learned so many things that would have made us even more successful. And I went through some of those lessons earlier.
So California is a microcosm of all that learning, plus some unique economic characteristics. But just to get rid of some myths, our franchisees are finding sites, they’re finding sites with drive-thrus. They’re signing sites with drive-thrus, they’re excited based on what they tell me about what they’re seeing, and I’ve had two franchisees saying, I fulfilled all my obligations, and I feel really good about California. So I couldn’t be more positive about California and overall, when I look back at the unit economics, we’re very positive about the fact that given our national awareness through all our advertising, people are just waiting for us to come to California.
Our next question comes from Jeff Farmer with Wells Fargo.
Jeff Farmer - Wells Fargo
Just keeping it on Dunkin Donuts Perks for a second, it looks like almost two years ago you guys had some pretty conservative adoption targets for the mobile app, and you blew through those pretty quickly. So I guess my question is, you mentioned a target of 2.5 million Dunkin Donuts Perks members by the end of 2014. Realizing that you can’t predict the future, but do you think that could also prove to be equally as conservative?
Goals are goals, and they’re to be achieved and beaten. And you’re right about the app, which has been phenomenally successful. One of the things we heard from investors over all of our meetings in the previous three months is they started comparing us with other people, I won’t talk about which companies, but you all know. And so we looked at that, and as I said in our remarks, if we hit 2.5 million, it would be the fastest growth of anyone in our space.
We’re well on the way to hitting that number. 750,000 after a tough couple of months of weather, and we’ve only really got going in March. You can do the math yourself. So the trajectory looks very good. So I think I feel good about the 2.5 million, and Jeff, I’ll let you decide whether we can beat it.
Our next question comes from Will Slabaugh with Stephens.
Will Slabaugh - Stephens
Wanted to follow up on the ticket. And you mentioned earlier about the lower ticket leading to frequency of breakfast, etc. Just on that topic, as you continue to evolve the menu, you see consistent ticket increases along with that willingness to trade to higher price menu items. Is there a point where you become concerned that your ticket could provide sticker shock to your customer? Or maybe just a little bit higher than what they’re used to? Or do you think we’re still quite a bit of a ways away from having to worry about that?
I think we do not see us anywhere near approaching sticker shock. As ticket continues to grow, we’re maintaining our value. Part of the growth is due to mix, meaning people are spending more to buy more differentiated sandwiches. Part of it is due to add-ons, where people are adding hash browns to breakfast and things like that, which remain a good value. So we relentlessly check that. We also do a very sophisticated pricing analysis on a DMA by DMA basis that involves business analysis, consumer analysis, competitive analysis. So we watch that area very very closely, and while ticket is increasing, we are not worried about sticker shock in the near future.
Our final question comes from Steve Anderson with Miller Tabak.
Steve Anderson - Miller Tabak
Very quickly, you talked about the SG&A and the removal of some of the operating income items from there. Aside from that, did you see any unusual SG&A expenses incurred in the first quarter?
No, we really didn’t. We’re generally on land from an SG&A growth, both for the year and our internal plan for the quarter. And as I mentioned in my remarks, the breakout of those transactions was from a transparency, just wanting to provide more transparency to investors and the Street in general.
So thank you very much everyone. And I appreciate your time today. What I’d like to say in conclusion is we feel that our business is in great shape, and I know our franchisees feel the same. We’re very excited about the fact that we continue to take market share. When you look at our forward track on development, and as I said, there’s been some stories to the contrary, we feel really good that we’re on track for hitting our goals for the year, and then further, faster growth in the future.
And I think what really does excite me, as John said, when I came here from Papa John’s, I was frustrated that we didn’t have the marketing capabilities to do one on one marketing. We now do. That is a very exciting development, and if there’s one thing you should take away from this quarter, it’s that we’ve now got marketing into a position where we can do that kind of marketing, which we’ve never been able to do before, and indeed, most people in the category can’t do.
So I’m excited, and I think we look forward to very exciting times ahead. Thanks for your time.
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