Dunkin's Story Isn't Over, But The Valuation Is Too Rich

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About: Dunkin' Brands Group, Inc. (DNKN)
by: Josh Arnold
Summary

Dunkin' continues to perform well operationally.

There is plenty of additional growth ahead.

However, the share price already reflects much of this.

Image source

Dunkin’ Brands (DNKN) has been on a tear in the past several months. In fact, it is up 35% just since the bottom set in late December of last year, and is up about 60% over the last two years. That sort of performance from a mature chain with thousands of stores is impressive, but it has also led to what I believe is an overvaluation of the stock. Dunkin’ has a lot to offer investors, and I certainly think the growth story is a long way from being done. In addition, Dunkin’ uses its considerable free cash flow to return cash to shareholders, but in my view, it isn’t enough.

Baskin-Robbins doesn’t matter

The Dunkin’ story is all about the firm’s namesake chain, Dunkin’ Donuts. The company has tried to somewhat disassociate itself from the donut connection with its brand, calling itself just “Dunkin’”, or on its store fronts, “DD”. That has been part of a deliberate strategy to move away from just selling donuts and coffee to grow the business; more on that in a bit.

Dunkin’ US makes up about 77% of company sales, while the Baskin-Robbins US business is just 6% of revenue. The international business is 17% of sales, so really, this is about the Dunkin’ US business.

Source: Investor presentation

This is prudent given the B-R chain is an also-ran in a very crowded ice cream landscape. Dunkin’, however, possesses scale and brand recognition to rival Starbucks (SBUX). The company has invested heavily in next-gen Dunkin’ stores, menu innovation, and improving the guest experience in recent years to further bolster its lead in the breakfast/coffee category.

Source: Investor presentation

Dunkin’ has 9,400 stores in the US alone, so it is not only widely recognizable and convenient for tens of millions of consumers on a daily basis, but it has scale that affords it certain supply chain advantages a smaller chain wouldn’t enjoy. You can read the list above, but essentially, Dunkin’ is number one or two in just about every breakfast/coffee sales category one could name in the US. Its relatively recent expansion into non-donut breakfast food items has been tremendously successful, and it is, of course, looking to build upon that success.

All of this has afforded Dunkin’ significant earnings growth in the years since it came public, growing earnings at an average annual rate of about 13% since 2012, which was its first full year as a public company. Part of that growth in EPS has come from significant share count reductions, the product of the company’s outstanding free cash flow. However, Dunkin’ is also just producing more and more earnings as it grows as it proves the concept can be scaled.

More growth is on the way

That profitable scalability of the business is key to Dunkin’s strategy and why one may want to invest in the stock. Despite the fact that Dunkin’ has 9,400 stores in the US, it has heavy penetration in some regions of the US, and virtually none in others. In other words, Dunkin’ is heavily concentrated today, relatively speaking, which opens up the possibility for meaningful store growth in the future.

Source: Investor presentation

Dunkin’s average store count per population in the US is one store for every 34.7k people. However, in the core Northeast, it is one store for just 9.3k people. That market is saturated, but if we look west, there are very few, if any, stores in most Midwest or Western states. That leaves an enormous blank space for Dunkin’ to continue to open stores indefinitely, and at a reasonable pace, for many years to come. While it is unreasonable to expect Dunkin’s store count to double or something like that, there is no reason to think it cannot handle at least a couple thousand additional stores in the US over time. The underpenetration of the western half of the US is Dunkin’s biggest opportunity to grow.

In addition to new stores, Dunkin’ is fixing the existing ones it already has via the next-gen store rollout. Many of Dunkin’s stores look outdated and don’t offer the best customer experience, including the enticement of impulse buys. The counters at these legacy stores are completely closed off and uninviting, as guests talk over what amounts to a wall to an employee that then picks what the customer wants from behind the counter. It is uninviting and unfriendly, but Dunkin’ is looking to change that.

The company’s new store design is the answer to this problem, and should help drive incremental growth over time.

Source: Investor presentation

Dunkin’ will not only fix the counter issue and make the stores more inviting, but it will install front-facing cases with the items available for purchase right in customers’ faces, not ten feet away where one has to squint to see the day’s offerings.

In addition, there will be a dedicated mobile pickup area, a key to the company’s digital strategy where it tries to increase convenience for the customer. Iced beverage taps will give a more upscale feel than the current, hideous pitcher system. In total, the stores will be more inviting and should help drive traffic and sales over time. The rollout is slow, but Dunkin’ should do well in the future as it rolls out this design across the country.

Growth at an unreasonable price

Dunkin’ reckons it can boost revenue in the low single digits on a comparable basis in the US, driving mid-single-digit total revenue growth through 2021.

Source: Investor presentation

In addition, it sees some measure of margin growth thanks to leverage on higher sales, as it has for many years. Coupled with the buyback, it seems reasonable that Dunkin’ would continue to produce high single-digit EPS growth for the foreseeable future. That’s outstanding, but keep in mind that the stock today is very expensive relative to this growth rate, and also its own historical valuations.

Below, I’ve charted the company’s average annual PE ratio and yield since 2012, and it shows how expensive Dunkin’ is today.

Source: Author’s chart using company data

Dunkin’ trades for 26.9 times this year’s earnings estimate of $3.05, which is one of the highest valuations it has had in the past several years. It is also above its average from 2012 of ~25, and its 2016 to 2018 average of just ~22. In other words, while Dunkin’s growth certainly isn’t over just yet, it looks to my eye like there is so much already priced in, that it will be difficult for new holders that buy today to fully reap those rewards.

The yield is also down to just 1.8%, and has fallen steadily since 2016 due to the ever-rising valuation. Dunkin’s dividend growth history has been tremendous, but even the yield is telling us to be cautious.

In total, while I still like Dunkin’s strategy and growth potential, too much is priced in today. Dunkin’ needs to trade closer to 23/24 times earnings before investors should buy, putting a fair value estimate at $70 to $75. We’re a decently-sized selloff away from that sort of price, so I think patience is warranted.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.