Still Dunkin' My Money In

|
About: Dunkin' Brands Group, Inc. (DNKN)
by: Eclipse Investments
Summary

Despite reaching its peak share price, benefits from transformative new brand strategy remains underappreciated.

Technology implementation and delivery to reinforce DNKN's on-the-go proposition.

High debt not a critical factor.

Accelerated unit development growth and same-store sales growth to drive EPS growth in coming years.

Editor's note: Seeking Alpha is proud to welcome Eclipse Investments as a new contributor. It's easy to become a Seeking Alpha contributor and earn money for your best investment ideas. Active contributors also get free access to SA Essential. Click here to find out more »

Introduction

Dunkin' Brands Group, Inc. (DNKN) has surged 29% since the beginning of the year, 5% higher than the Consumer Discretionary Index:

Chart Data by YCharts

Its strong performance can be attributed to its well executed new brand marketing strategy, leveraging on technology and other initiatives, which have enhanced its brand equity. Brand equity is paramount for a company like DNKN which is run based on a 100% franchise model.

Even after its recent run, there is still room for further expansion as its brand equity remains underappreciated. Its leverage on technology and delivery will not only enhance its image but also drive long-term growth as its uptake is still in the budding phase. Its enhanced brand equity can further amplify its share value as unit development accelerates in under-penetrated regions of the US.

Transformative new brand strategy

Dunkin' Donut changed its name to simply “Dunkin'” at the beginning of the year. The reasoning behind the new branding was to convey the company's focus on serving great coffee fast while still embracing their heritage. However, the change was barraged with criticism that it is losing its identity, that it was trying to be as good as Starbucks (“SBUX”) but cheaper. In other words, “me too but cheaper”. This is exemplified by its refresh of its espresso platform which requires installation of new espresso machines, creation of the new, bolder taste profile, and extensive employee training.

Critics argue that price is not the only differentiator as SBUX offers a “third place” experience where customers can choose to linger and that it is unlikely DNKN’s “me too but cheaper” approach will be enough to steal customers from SBUX. In other words, SBUX customers are buying its quality coffee but also its “experience”. That is over-generalization at its best.

SBUX has increasingly been focusing on take-away customers, who do not require features like a seating area, bathrooms, Wi-Fi, or clean-up in the way that sit-down customers do, yet they pay the same price for their orders as higher-maintenance customers. These are the target customers that Dunkin' is trying to appeal to: take-away specialty coffee drinkers. Given the strong growth of specialty coffee drinkers in the coffee market, it is a no-brainer to provide what the customer wants. Dunkin' is not trying to be a SBUX, its brand proposition remains the same: a beverage-led, on-the-go brand. The only difference is that it is providing new products with similar quality to SBUX.

Its recent results are testament to its new brand strategy, with same-store sales (SSS) growth of 2.4% in Q1 2019 (its largest quarterly increase in four years) and 1.7% in Q2 2019.

Source: Dunkin' Brands investor relations

Leverage on technology, delivery and other initiatives

DNKN launched its DD Perks Rewards Program in its mobile app in January 2014 as a way to reward guests with points toward free beverages for every visit they make. The use of the rewards program, and the chain’s continued emphasis on digital, appears to be leading to larger ticket sizes.

In 2016, DNKN launched On-the-Go Mobile Ordering which integrates seamlessly with the loyalty programme, also accessed via the mobile app. It is super convenient and allows users of the service to speed past those lines in-store and pick up their coffees and muffins. Mobile ordering is currently in its nascent stage consisting of only 4% of its total transaction in Q2 2019.

Mobile and loyalty program participation is expected to increase exponentially as Americans become more accustomed to digitization and as DNKN provides incentives to increase its uptake such as opening mobile ordering up to customers that are not currently loyalty members as Starbucks has done.

Recently in June 2019, DNKN announced that it is partnering with Grubhub (NYSE:GRUB), the nation’s leading online and mobile food-ordering and delivery marketplace, to begin the roll-out of its new Dunkin’ Delivers service. As the first step in this launch, more than 400 Dunkin’ restaurants throughout New York City’s five boroughs will offer delivery through Seamless, Grubhub’s New York brand. Following the initial launch, DNKN and Grubhub will look to expand the Dunkin’ Delivers service to restaurants throughout other markets in the coming months, including in Boston, Chicago and Philadelphia. Stephanie Meltzer-Paul, Vice President of Digital and Loyalty Marketing for Dunkin’ U.S., said:

Keeping Americans energized with the coffee and food they crave, wherever and whenever they want, is what our guests expect from Dunkin’. By partnering with Grubhub, Dunkin’ will be there for more people even when they’re staying at home or are busy at work

Mobile ordering and delivery further reinforce convenience as a value proposition to DNKN’s customers which helps to increase its brand equity. They are also clear catalysts to drive up SSS growth in the coming quarters. Other catalysts include drive-thru lines dedicated to mobile orders, brighter interior designs, espresso machines, digital order boards, and a tap system serving coffee, iced tea and cold brew.

High debt not a critical factor

Several analysts have pointed out that DNKN’s high debt is an area of concern and its interest expense has been a drag on profitability. The usual metrics to assess debt leverage are debt-to-asset ratio or debt-to-equity ratio. However, this is not relevant for the quick service restaurant industry. Most companies in the QSR industry use an asset-light franchise model which does not account their brand equity in their balance sheets as they are forbidden by U.S. GAAP accounting rules, thereby understating their total assets. An alternative ratio that can be used is the interest coverage ratio. We compare DNKN’s interest coverage ratio (based on FY18 figures) against its peers in the quick service restaurant business:

Source: FY2018 annual reports of respective companies

DNKN does indeed have the worst interest coverage ratio among its peers. It is an asset light company which does not require much capital to grow. So what has DNKN been using the money from its debt for? Share buybacks! Since going public in 2011, the company has used regular debt offerings to raise cash, which is then returned to shareholders via share repurchases. Borrowing for share buybacks is a warranted decision as long as it provides value to its shareholders. One of the reasons given for taking on increased debt to fund a share buyback is that it is more efficient because interest on the debt is tax deductible, unlike dividends.

However, opponents to this dispute that “higher interest expense seems like a needless tax on earnings, which especially punishes new shareholders who are buying the DNKN symbol today and won't receive a tangible benefit from past share repurchases.” Management’s job is to add value to current shareholders, not potential future shareholders. Prospective shareholders of DNKN should base their decision on their valuation of the stock, considering its high interest expense.

Here is my take: If you believe in the growth narrative of this stock, its relatively higher interest expense should not be a concern. The level of debt a company uses to finance its operations and growth is a capital structure decision. Here is how DNKN’s interest coverage ratio looks like over the years:

Management has been keeping it consistent at about 3.6 +/- 0.3, implying that it is a measured decision rather than a haphazard one motivated to hit their KPIs. As DNKN continues to grow, expect it to take on more debt for share buybacks to boost shareholders' returns.

On flip side, as with any company with higher debt leverage, higher debt level increases risk of investing in DNKN. If a slowdown or downturn were to hit the industry, DNKN’s shares will be hit much worse than its peers. Credit rating on its loans might be downgraded resulting in higher interest rates when refinancing is due, causing a further drag on profitability.

While there is still a low probability of such a scenario playing out, it is mitigated by low interest rate trends. Interest rates are likely to go down especially in the current environment where global stock of negative-yielding debt is now in excess of $17 trillion. This is further supported by likely further rate cut by the Fed, reinforced when the U.S. Labor Department reported employers added 130,000 new jobs in August, undershooting economists’ estimates. Even Apple (NASDAQ:AAPL) is borrowing $7 billion while sitting on a $200 billion cash pile to get a piece of the ultra-cheap money that’s up for grabs in the bond market

Valuation and growth opportunities

SBUX's growth in the US is saturated, where there are now 3.6 Starbucks locations within a one-mile radius of the typical Starbucks. Unlike SBUX, DNKN still has much room for store development growth:

Source: Dunkin' Brands investor relations

Several states in the Northwest region which Dunkin' has yet to establish any presence (grey area in the map) represent clear opportunities for unit expansion.

DNKN Next Gen concept store, which encapsulates its new brand identity, is expected to accelerate unit development growth as returns on investment on such stores are higher and more attractive to current or potential franchisees. As Scott Murphy, Chief Operating Officer (COO) of DNKN, mentioned:

And I will tell you, the return that the franchisees are getting, it has a much quicker payback than the previous releases, so that’s why us and the franchisees felt really good about this model.

DNKN is currently trading at about $82 with a trailing twelve-month (TTM) price-to-earnings ratio (PE) of 29.8, which is close to the industry average of 30 as per the chart below:

Source: Yahoo Finance

The current price is based on the following consensus forecast:

Fiscal Year End Consensus EPS Forecast
Dec-20 3.25
Dec-21 3.51

The potential benefits of its transformative brand strategy and growth opportunities are not priced into the stock yet. Compelling growth driven by both unit development and SSS growth will propel its share price further. Our valuation forecast shows significant potential upside to the stock:

Fiscal Year End Our EPS Forecast
Dec-20 3.58
Dec-21 3.86

Key assumptions in our estimates:

1) higher end of 200-250 new units annually in the US for next 3 years.

2) SSS growth of 4% driven by traffic growth of 1%, higher ticket of 3%.

  • Higher ticket driven by favorable mix shift to premium priced espresso and cold brew beverage of about 1.5% and annual price inflation of about 1.5%

Assuming industry PE of 30, our 1-year estimate is about $107 which represents a potential upside of 30%.

Conclusion

DNKN was a growth stock when it was listed in 2011. Its growth seems to have decelerated slightly in recent years, but its new brand strategy seems to have rebooted its growth engine to ensure that its growth narrative remains strong.

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.