Dunkin' Brands Has Room To Run And Dividend Growth Investors Should Chase It

About: Dunkin' Brands Group, Inc. (DNKN)
by: Low Budget Dividend Investing

Dunkin' Brands has one of the most loyal customer bases in the coffee business.

The company's westward expansion efforts have been successful and there is still plenty of opportunity for more growth.

While Dunkin' Brands has only paid a dividend since 2012, it has grown steadily and looks set to continue growing for years to come.

About five years ago, when I was living in Iowa, Dunkin' Brands (DNKN) opened its first Dunkin' Donuts store in the state (this was, of course, before the company decided to rebrand as a coffee shop rather than a doughnut shop). As a native east coaster living in the Midwest, I only saw Dunkin' stores on my trips back east. Consequently, when Dunkin' opened that first store in Coralville, I excitedly visited the location in an effort to taste a little bit of home. In my excitement, I lost all motivation to adhere to a healthy diet and I decided to treat myself to a doughnut, ordering a Bavarian Creme to accompany my steaming cup of coffee. As I walked to one of the tables in the store, the elderly Iowan couple behind me in line decided, rather loudly, to try "one of those Barbarian Cream doughnuts he has." I chuckled at the malapropism, devoured my breakfast, and went home. After that first visit, and although I could easily have gotten a decent cup of coffee at any one of the many Caribou Coffee and Starbucks (SBUX) outlets scattered around the state, I would frequently forgo coffee at either of those chains in order to get a cup at Dunkin', even if it meant going out of my way.

What I did not recognize at the time was that, at the heart of this little vignette, was an investment opportunity. With the benefit of hindsight, two aspects of this story stand out to me as an investor. First, Dunkin's brand appeal was so strong for me that I made a point to drive a long distance to get a cup of coffee that reminded me of home. Second, if I had bothered to look beyond the elderly couple's lack of familiarity with a common doughnut filling, I would have recognized that a doughnut shop in and of itself was unfamiliar to many rural Midwestern residents. Indeed, had I known anything about Peter Lynch at that point in my life, I would probably have started buying shares right then and there because I would have seen a massive growth opportunity with my own two eyes. After all, how many companies can inspire the sort of brand loyalty that could get a displaced east coaster to drive sixty miles for a two dollar cup of coffee?

Today, as an income-oriented investor, I see the domestic growth prospects of Dunkin' Brands as a promising opportunity for dividend growth investors seeking to buy a high-quality company with strong brand recognition, substantial room to grow in a highly competitive market, and a clear pattern of steadily increasing shareholder returns.

Brand Loyalty and Recognition

As it turns out, my fondness for Dunkin' is hardly unique. In its most recent Customer Loyalty Engagement Index, for instance, Brand Keys named Dunkin' as the top coffee brand in both its out-of-home and prepackaged categories for the thirteenth consecutive year. I would suggest that Dunkin's high level of customer satisfaction and brand recognition will be key growth drivers as the company looks to expand its footprint beyond the confines of its home turf in the northeast.

Growth Prospects

As I see it, Dunkin' has two primary avenues for growth: the aforementioned geographic expansion and its menu offerings.

Domestic Geographic Expansion

While it has long been a fixture of the urban northeast, Dunkin' has only recently begun expanding westward.

Of the company's nearly 9,500 outlets, the highest concentration of stores, numbering just below 4,700, can be found in the comparatively compact Northeast region consisting of New England, New York, and New Jersey. An additional 4,100 or so stores are spread across the rest of the U.S. east of the Mississippi River while not quite 600 can be found west of that great waterway:

Source: Dunkin' Brands 2019 Q2 Earnings Presentation

Significantly, for investors, unlike the national chains such as Starbucks or McDonald's (MCD), Dunkin' has yet to saturate the western half of the United States with franchises. With the company's stated plans to open between 200 and 250 new outlets annually for each of the next three years combined with its intention to "accelerate growth to establish brand presence" in the under-served western region, Dunkin' is poised for substantial growth. In the second quarter of 2019 alone, Dunkin' Brands' licencees and franchisees opened 109 net new restaurants globally, the majority of which (46 Dunkin' locations and 43 Baskin-Robbins stores) are in the United States.

While the American West, with the notable exception of the California coast, is certainly not as densely populated as the northeast corridor, the region nevertheless contains such major urban centers as Houston, Phoenix, Denver, and Los Angeles. Even with 90% of those 600-750 planned store openings planned for the western region, that huge swath of the country will still only have roughly one quarter the number of Dunkin' stores as either the northeast or east regions, leaving plenty of room for aggressive expansion beyond the three-year period.

Menu Development

While Dunkin' is already the nation's top seller of total drip coffee, ice brewed coffee, donuts, and bagels, the company continues to reinvent its menu to better meet the tastes of its customers. Besides the company's recent high-profile decision to incorporate Beyond Meat (BYND) products into its breakfast menu, Dunkin' has introduced products such as egg white bowls, ham and cheese roll-ups, pretzel bites, Donut Fries, gluten free fudge brownies, an expanded espresso drink line-up, and a range of new coffee flavors modeled after popular candies or ice creams from the company's own Baskin-Robbins brand:

Source: Dunkin' Brands 2019 Q2 Earnings Presentation

Significantly, Dunkin' routinely evaluates product performance and prunes those products with lagging sales (such as the aforementioned brownie) from its menu. In doing so, Dunkin' not only manages to keep its offerings fresh, it also ensures both that customers will not be overwhelmed by a plethora of options (which makes ordering quicker and easier) and that employees will require less training to complete orders. By maintaining a slim menu with a small yet appealing rotation of newer items, Dunkin' balances brand-strengthening familiarity with customer-drawing novelty.

Financial Health and Present Valuation

In an article published in late June, another Seeking Alpha contributor called Dunkin' Brands "a very expensive company to buy at the moment" and argued that "[i]nvestors might pay a premium" for the company's rebranding efforts if they bought the stock at the time. In the time between that article's appearance and this writing, Dunkin's stock price has grown an additional 1.32%, leaving the stock with a forward P/E ratio close to 27:

Chart Data by YCharts

While Dunkin's forward P/E ratio is somewhat high, it nevertheless trails both Starbucks, whose inflated price I discuss in a previous article, and McDonald's:

Chart Data by YCharts

In the company's most recent quarterly report, issued earlier this month, Dunkin' did highlight declining Baskin-Robbins sales as one significant area of concern for investors. With a 1.4% decline in Baskin-Robbins comparable store sales weighing the company's earnings, the company shuttered some of its poorly performing ice cream outlets in an effort to minimize their impact on the company's bottom line. Likewise, those investors with a more bearish outlook on Dunkin' will likely point out that the company's diluted earnings per share for the second quarter dropped by 1.4% to $0.71.

On the other hand, bulls will likely highlight the fact that Dunkin's diluted adjusted earnings per share increased by 11.7% to $0.86 year over year while comparable U.S. store sales growth rose by 1.7% and revenues grew by 2.5%, which is consistent with the company's recent history of slow but steady growth on that front:

Chart Data by YCharts

So, while Dunkin' Brands may have a higher price than value-oriented investors might want to pay at the moment, the company's balance sheet is healthy and its outlook is bright.

What About the Dividend?

As a dividend investor, I tend to be most attracted to stocks with dividend yields that exceed the interest rates I could obtain with a less risky investment such as a CD, treasury bond, or high-yield savings account. At 1.83%, Dunkin's yield does not dazzle. However, as a dividend growth investor, I am intrigued by Dunkin's recent history of annual dividend hikes:

Chart Data by YCharts

In each of the eight years the company has paid dividends, Dunkin' Brands has increased payouts to shareholders. Starting with a $0.60 annualized payout in 2012, Dunkin' now pays $1.50 per share. While the growth rate has slowed somewhat in recent years, Dunkin's five-year compound annual growth rate is an attractive 12.83%. With a payout ratio of just under 53%, Dunkin' can easily cover its current dividend and, if the company's expansion efforts proceed as anticipated, it seems likely that shareholders can look forward to more dividend hikes in the future.

Parting Thoughts

While I do count myself among the people who think Dunkin' Brands is a bit pricey, I think the stock presents a promising investment opportunity for income investors. With a very high level of customer recognition and brand loyalty in its core northeast region, Dunkin' Brands is well-positioned for a successful westward expansion. Offering espresso drinks at a lower price point than competitors such as Starbucks and a menu that caters as much to vegetarians as it does to omnivores, Dunkin' can hold its own in a crowded fast food landscape. In rebranding itself as a coffee shop that also sells doughnuts rather than a doughnut shop that also sells coffee, Dunkin' is setting itself up as an indispensable part of its customers' daily routines rather than a place to pick up an occasional treat. Given that coffee is about as recession-proof a commodity as one can find, this rebranding strategy will likely keep Dunkin's cash registers ringing in good times and bad. With half a continent yet to be saturated with stores, it seems very likely that we will be hearing more and more of those resisters in the next few years. As an income investor, I see Dunkin' Brands as a solid opportunity to tap into that growing cash flow.

Disclosure: I am/we are long DNKN, SBUX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.