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Dunkin' Brands Equity Research Report

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

I have placed a 'Hold' rating on Dunkin' Brands and value the company at $68.59 per share.

Dunkin' Brands has sluggish international growth, carries a significant debt load, and conducts business in a competitive industry. These factors prevent me from placing a 'buy' rating on the stock.

Dunkin' Brands has brand loyal customers and a great business model. Given these strengths, I do not feel comfortable placing a 'sell' rating on the stock.

All financial data is as of 5/24/2018.

Company Overview

Dunkin’ Brands Group, Inc. (DNKN) is a company that develops and franchises quick service restaurants globally. Dunkin’ Brands franchise restaurants operate under either the Dunkin’ Donuts or Baskin-Robbins brand names. Dunkin’ Donuts operates in 42 of the 50 states and 45 foreign countries. Baskin-Robbins operates in 44 of the 50 states and 52 foreign countries. The Dunkin’ Donuts brand name provides baked goods, breakfast sandwiches, bagels, and both ready-to-drink and packaged coffee. Hard and soft served ice cream, frozen yogurt, milkshakes, and ice cream cakes are a few of the products offered under the Baskin-Robbins brand name. The company is divided into four segments: Dunkin’ Donuts U.S., Dunkin’ Donuts International, Baskin-Robbins U.S., and Baskin-Robbins International. Dunkin’ Brands recently decided to franchise their remaining company-owned Dunkin’ Donuts and Baskin-Robbins locations, completing a shift to a franchise-owned and operated business model. In October 2017, the company announced that they are considering shortening the name of all Dunkin’ Donuts locations to “Dunkin’” in a continued effort to prove that they are more than a doughnut company.

Dunkin’ Brands Group, Inc. SWOT Analysis

Quick Service Restaurant Industry Overview

Porter's Five Forces for the Quick Service Restaurant Industry According to their 2017 annual report, Dunkin’ Brands considers themselves a member of the quick service restaurant industry and recognizes Burger King, McDonald’s, Panera Bread, Starbucks, Taco Bell, and Wendy’s as a few of their main competitors. Dunkin’ Brands fits the profile of the quick service restaurant as their food and beverage offerings can be made, ordered, and consumed within minutes, their establishments offer limited table service, and their menu is relatively limited in comparison to standard sit-down restaurants. Companies within the quick service restaurant industry make money by selling quick-service food products to customers, assuming the establishments are company-owned. A company within the quick service restaurant industry might sell the rights to a restaurant to another individual in the form of a franchise agreement. As part of the franchise agreement, the franchisor agrees to let the franchisee own and operate the franchise. The franchisor makes money from a franchise agreement by receiving royalty payments and franchise fees from the franchisee. Royalty payments are typically calculated as a percentage of sales. Franchise agreements are becoming a more popular strategy for companies within the quick service restaurant industry as they are typically a more profitable alternative to a company-owned establishment. Franchise agreements are profitable because the company (franchisor) does not incur the day-to-day expenses of maintaining and operating the restaurant.

According to IBISWorld, the quick service restaurant industry has experienced annual sales growth of 3.1% from 2012 to 2017. Sales growth is expected to slow to 1.6% from 2017 to 2022. Competition in this industry has always been high and is expected to remain the case for the foreseeable future as new players penetrate the market. Franchise-focused business models have made it easier for companies to stay afloat within this industry as a majority of the operational risk is placed on the franchise owner. Heightened competition within the quick service restaurant industry have resulted in lower price points and forced operators to think of more creative ways to attract customers. Furthermore, a more health-conscious consumer is expected to contribute to a decline in sales growth over the next five years. Health-focused eateries and grocery store chains such as Panera Bread, Sprouts Farmers Market, Whole Foods, and Zoe’s Kitchen are expected to steal market share from many of the traditional fast food restaurants in the near future. For this reason, it will be important for traditionally unhealthy quick service restaurants to re-brand and alter consumer opinion through advertising. For example, McDonald’s has done an excellent job of marketing their new Happy Meal that features fewer French fries and healthier side items. Many customers now prefer fast-casual restaurant environments with customizable menu options that can be found at Chipotle and Panera Bread. Operators that are able to advertise effectively, adapt to changing consumer tastes, and offer the highest quality products for the lowest possible price will be most successful going forward.

Consumer confidence, the rate of inflation, cost of ingredients, and the healthy eating index are several demand determinants that drive sales in the quick service restaurant industry. A rise in consumer confidence generally indicates that more people are employed, earning higher wages, and feel optimistic about the direction of the economy. If consumers have higher levels of disposable income, they are more likely to spend it at establishments that provide food and entertainment. The rate of inflation will greatly impact the amount of sales within the quick service restaurant industry. A rise in inflation indicates higher price levels, all else being equal. Higher price levels result in more expensive menu items. As a result, customers will make an effort to find cheaper alternatives. The cost of ingredients such as wheat, chicken, beef, pork, and coffee beans greatly impact the price of menu offerings. If the price of coffee beans were to rise, an operator such as Dunkin’ Donuts would have little choice but to raise the price of a cup of coffee. While it is often difficult to pass the increase in the cost of ingredients on to consumers, in some cases it might be necessary for the business to be successful. Operators could also decide to limit portion sizes, thereby decreasing the overall value of a meal which might encourage customers to do business elsewhere. Finally, the healthy eating index is a measure of the overall diet quality of a population. According to IBISWorld, the healthy eating index is expected to increase over the next five years. An increase in the healthy eating index will typically result in a decline in sales growth for quick service restaurants. However, this variable could have less of an impact on quick service restaurant sales in the future as they continue to provide healthier menu options.

While growth in the quick service restaurant industry is nearing its saturation point, there are still opportunities for innovation and growth. Many countries in Asia and the Middle East have room for growth and existing operators such as Yum Brands! and McDonald’s have achieved great success by investing in these two regions. Yum! Brands recently divided their operations into two separate entities: Yum! Brands and Yum! China. Yum! China controls all business interests in China and Yum! Brands holds the rights to operations in all other countries. While growth domestically is more difficult to achieve, operators should seek to enhance their product offerings and experiment with food delivery service to attract new customers. Yum! Brands operates recognizable brand names such as KFC, Pizza Hut and Taco Bell worldwide. According to IBISWorld, Yum! Brands has announced that they are planning to open approximately 300 Taco Bell Cantina locations in the United States. Taco Bell Cantina will be an upscale version of Taco Bell, providing customers with alcoholic beverages and a wider variety of menu offerings to attract customers. Furthermore, many KFC locations are beginning to experiment with salads and rice bowls in an effort to attract a more health-conscious consumer. According to IBISWorld, McDonald’s is planning to introduce self-serve kiosks at all of their locations within the United States. McDonald’s also plans to introduce a new food delivery service and a new ordering system through their mobile application. Additionally, McDonald’s recently announced that they will expand their beverage offerings to include more smoothies and coffee-based products. More specifically, McDonald’s decision to offer one dollar iced coffee will undoubtedly cut into the market share of Starbucks and Dunkin’ Donuts. McDonald’s and Yum! Brands are examples of two companies who are taking the appropriate steps necessary to position themselves for success in the competitive quick service restaurant industry.

Even though Yum! Brands and McDonald’s are two industry titans, they only account for roughly one-fourth of total industry market share. As a result, industry concentration is low due to low barriers to entry. While barriers to entry are relatively low at the moment, more stringent regulation levied by the Food and Drug Administration regarding food safety and appropriate licensing could heighten barriers to entry in the future. An increase in the federal minimum wage would hurt industry profit margins. According to IBISWorld, wages are the second most expensive cost for operators as the industry is labor-intensive. Food and beverage purchases are the most costly expense for restaurant operators and account for approximately one-third of total expenses. Operators must be able to control costs effectively and operate efficiently in order to manage the fluctuations in the price of food and beverages. Finally, it is imperative that operators develop core competencies that will allow them to gain market share from their competitors otherwise they will be unsuccessful.

Competitive Analysis and Relative Valuation

The table below shows how Dunkin’ Brands ranks in comparison to several of their competitors across many key performance metrics. It is important to note that return on equity, return on assets, gross margin, and profit margin were calculated on a trailing twelve month basis. Dunkin’ has gradually shifted to a franchise-owned business model over the past several years. As of their 2017 fiscal year-end, Dunkin’ did not have any remaining company-owned locations. Since shifting to a franchise-owned business model a few years ago has allowed Dunkin’ to become a more profitable company. As a result, the company has a higher profit and gross margin than any of their competitors listed below. There are two important caveats to remember when analyzing the profitability metrics listed below. First, Dunkin’ Brands carries the lowest operational risk of the group as they have franchised all of their locations. Many companies listed below operate on different business models and have a significant number of company-owned locations. Second, Dunkin’ Brands sells products that are relatively inexpensive to produce and they utilize fewer ingredients than many of their competitors. For example, like Dunkin’, McDonald’s also sells coffee, breakfast sandwiches, and baked goods. However, the majority of McDonalds’ sales are derived from lunch and dinner sandwiches (burgers, chicken sandwiches, etc). These items have higher average ticket prices as they are more expensive to produce. While Dunkin’ Brands directly competes with the companies listed below, they have the highest profit and gross margins as a result of their business model and menu offerings. Starbucks, the other coffee house on the list, has the second-highest profit and gross margins. However, despite having lower average ticket prices, Dunkin’ Brands has a significantly higher gross margin than Starbucks. This could indicate that either Starbucks sources their ingredients at inefficient prices or Dunkin’ Brands is skilled at pricing their products and sourcing their ingredients at low prices.

While Dunkin’ Brands achieved the third-highest sales growth rate and fifth-highest earnings per share growth rate over the last five years, their projected earnings per share growth over the next five years is relatively disappointing according to analysts’ estimates. Twelve percent growth in earnings per share over five years implies a projected annual growth rate of roughly 2.3%. According to the U.S. Bureau of Labor Statistics, United States GDP is projected to grow at a compound average annual rate of 2.0%. Dunkin’ is expected to marginally outpace market growth over the next five years, while competitors such as Chipotle, Domino’s, and Wendy’s are expected to exceed average GDP growth by a wide margin. While Dunkin’ Brands bolsters a healthy current ratio of 2.8, their return on equity value of -298.6% implies that they are an over-levered firm. A firm’s current ratio assesses the company’s ability to pay off their short-term obligations with the use of their current assets. Return on equity measures the profitability of a firm for each dollar of shareholders equity. A negative return on equity value implies that a company is not profitable or that they have a negative shareholders equity value. Dunkin’ Brands had a negative equity value according to their 2017 annual report. This negative equity value was driven by the issuance of an additional 1.4 billion dollars of long-term debt. In general, large debt amounts as a percentage of total equity will need to be monitored closely by the company going forward. Dunkin’ Brands has financed their operations almost exclusively through debt, the vast majority of which is long-term debt, over the past five years. Excessively large debt loads can hinder a company’s ability to grow in the future, especially since the economy has entered a rising interest rate environment. Long-term debt typically carries higher interest rates, which combined with a higher interest rate environment, will drastically increase interest expense on the income statement and reduce net profitability. If Dunkin’ wishes to grow earnings per share significantly over the next five years, management will need to effectively manage the degree of leverage of the firm.

The table below estimates the share price of Dunkin’ Brands across several relative valuation metrics with the use of comparable company analysis. To conduct this analysis, I selected nine competitors of Dunkin’ Brands and calculated the EV/Sales, EV/EBITDA, Price/Earnings, Price Sales, and Price/FCF ratios for each firm. After calculating the five relative valuation metrics for each firm, I took the maximum, minimum, mean, and median values for each metric. I was able to ‘back-into’ the share price of Dunkin’ Brands by using the mean and median values calculated below as well as financial information from Dunkin’ Brands 2017 annual report. The green highlighted numbers in the rows at the bottom of the table represent price per share valuations that exceed Dunkin’ Brands current share price and the red highlighted numbers represent price per share valuations below Dunkin’ Brands current share price. According to the comparable company analysis below, Dunkin’ is undervalued on an EV/EBITDA, Price/Earnings, and Price/FCF basis and overvalued on an EV/Sales and Price/Sales basis. Dunkin’s EV/Sales and Price/Sales price per share valuations were significantly lower than their current share price of approximately sixty-six dollars. These valuations are likely a product of Dunkin’ Brands sluggish and disappointing sales growth in 2017. In 2017, the company grew system-wide sales by just 2.8%, despite growing system-wide sales by 6.6% and 4.1% in the two previous years. Dunkin’ Donuts U.S. accounts for roughly three-fourths of Dunkin’ Brands total revenue. This important business unit achieved same restaurant sales growth of just 0.6%, despite achieving same restaurant sales growth of 1.6% and 1.4% in 2016 and 2015, respectively. Declining growth across existing Dunkin’ Donuts US locations in 2017 was the primary culprit for their low valuation in both EV/Sales and Price/Sales metrics. It is important to note that Dunkin’s Price/FCF price per share figure is based off of their 2016 FCF per share figure, as the company had negative FCF in 2017. I chose to use Dunkin’s 2016 FCF number as a proxy because I did not want to arrive at a negative share price estimate. Dunkin’s share price valuation based on Price/Earnings is inflated for a few reasons. First, the company was able to boost their net income (and therefore their 2017 EPS figure) as a result of United States tax reform. The 2017 tax reform bill allowed Dunkin’ Brands to recognize approximately 145 million dollars in tax benefits as a result of the recalculation of deferred tax assets. In order to arrive at the share price projection for the Price/Earnings metric, I multiplied the median and mean Price/Earnings of Dunkin’s competitors by Dunkin’ Brands 2017 earnings per share figure. Dunkin’s 2017 earnings per share was somewhat inflated (had tax reform not been completed in the 2017 fiscal year Dunkin’ would not have been able to recognize such a large deferred tax asset amount), the stock price estimate was also slightly overestimated. Secondly, Dunkin’s Price/Earnings valuation estimate is inflated because many operators within the quick service restaurant industry are currently trading at rich Price/Earnings multiples. The Price/Earnings ratio of the S&P 500 is 24, which is significantly lower than the 30.7 average Price/Earnings multiple of Dunkin’s competitors. I included the median valuation estimate to minimize the impact of potential outliers. Chipotle and Domino’s are both trading at Price/Earnings multiples north of fifty, resulting in a meaningful difference between the mean and median share price estimate. If Dunkin’ Brands were trading at the S&P 500 Price/Earnings ratio of 24, their valuation would be $92.64. Based on my comparable company relative valuation analysis, I believe that the EV/EBITDA price per share valuation is the most accurate and precise of the five relative valuation metrics because it accounts for expense efficiency while excluding the somewhat artificial boost to net income as a result of tax reform. 

Investment Catalysts:

Increasing Popularity of Specialty Coffee in the United States- The first investment catalyst for Dunkin’ Brands is the increasing popularity of specialty coffee in the United States. Coffee sales accounted for 58 percent of Dunkin’s revenue according to their most recent annual report. The Dunkin’ Donuts U.S. business unit accounts for 75 percent of Dunkin’ Brands total revenue, which means that approximately 44 percent of the company’s total revenue is generated from coffee sales in the United States. Dunkin’ is known for their specialty coffee drinks, such as their Pumpkin-Spiced Latte offered around Thanksgiving, Peppermint Mocha offered around Christmas, and their recently-introduced Girl Scout Cookie-Flavored Coffees. The graph below was generated by the U.S. Specialty Coffee Industry. This graph shows the percentage of American adults who drink specialty coffee occasionally, weekly, and daily over the past two decades. The specialty coffee industry in the United States has achieved exponential growth over the past two decades: the percentage American adults who drink specialty coffee on a daily basis has tripled and the percentage of American adults who drink specialty coffee at least once a week has nearly doubled since 2001. Dunkin’ Donuts U.S. will continue to benefit as specialty coffee grows in popularity. Dunkin’ Donuts modifies their menu to fit with seasonal flavors and holiday themes better than any company in the coffee industry. Constant menu adaptation allows Dunkin’ to keep their menu offerings interesting, consistently market new products, and attract customers who enjoy drinking specialty coffee.

Franchisee Business Model- Dunkin’ Brands second major catalyst is their franchise-focused business model. As of 2017, every Dunkin’ Donuts and Baskin Robbins restaurant is owned by franchisees. The advantage to a franchise-focused business model is obvious: when an operator franchises a restaurant to a franchisee, the operator collects a franchise fee (which is usually a percentage of total sales) while passing all of the operational risk of maintaining the restaurant on to the franchisee. Furthermore, a franchise-focused business model results in higher operating margins for the company, as the franchise owner incurs all restaurant-related expenses. This is important because higher operating margins will generally result in higher net income. A higher net income margin will allow the firm to reinvest profits earned back into the company. The company can then reinvest additional profit back into the business through the acquisition of companies that align with corporate strategy, increase spend on research and development for new menu offerings, or increase their dividend to attract potential shareholders. Dunkin’ collects an additional five percent of total sales from franchisees in the form of advertising funds. These advertising funds are allocated and invested in marketing and advertising initiatives promoting the Dunkin’ Donuts and Baskin Robbins brand names. If all Dunkin’ Donuts and Baskin Robbins locations were company-owned and performing poorly, the company might decide to cut marketing spend. In the franchisee format, franchisees owe the franchisor predetermined fees dedicated to advertising spend, regardless of how well they are performing. As long as the number of franchise restaurants continues to grow, sales growth matches the growth in GDP, and the advertising fee remains constant, Dunkin’ Brands should have an ample amount of marketing spend to acquire new customers and capture market share from Starbucks, McDonald’s and other competitors in the industry.

Brand Identity and Remodeling- Dunkin’ Donuts is one of the most recognizable brand names in the United States. According to their website, Dunkin’ Donuts was ranked first in the Coffee and Baked Goods category according to Entrepreneur Magazine, first in Airport franchising according to the Airport Franchisor, and first in customer loyalty according to Brand Keys Consumer Loyalty Index. Dunkin’ Donuts has close advertising relationships with the Boston Red Sox, New England Patriots, and is currently the home court for the Providence Friars men’s basketball team. Given their Boston lineage, Dunkin’ Donuts has become the go-to provider of coffee and baked goods for customers in the Northeastern United States. Not only is Dunkin’ Brands home to one of the most recognizable franchises in the United States, but the company has done an excellent job of remodeling their brand to fit recent changes in consumer tastes. Dunkin’ Donuts has long been thought of as a restaurant that only sells donuts and coffee. This makes sense, considering the fact that ‘Donuts’ is in the restaurant name. Over the past decade, American consumers have become more health-conscious. As a result, quick service restaurants such as Dunkin’ Donuts have been forced to adapt to changing consumer tastes. Dunkin’ Donuts has done a good job of responding to changes in consumer tastes by expanding the size of their menu to include a broader selection of gourmet and specialty coffees, breakfast sandwiches, and other baked goods (bagels, croissants, etc). In an effort to further eliminate the stigma of being ‘just a coffee and doughnut’ company, Dunkin’ Brands decided to eliminate the word ‘Donuts’ from several of their Dunkin’ Donuts store fronts starting last year. Management is planning to monitor foot traffic at these select locations over the next several years. If this test proves successful, the company could eliminate the word ‘Donuts’ from all of their store fronts in the near future. Many companies within the quick service restaurant industry struggle to remodel their brand without changing their core competencies. While Dunkin’ Donuts still generates the majority of their revenue through coffee and doughnuts, the company has diversified their menu offerings while still finding creative ways to market their coffee and doughnut businesses.

Investment Risks:

Heavily Concentrated in Northeastern United States- Headquartered in Boston, Dunkin’ Donuts has always had a strong presence in the Northeastern United States. The company has done a poor job of expanding their footprint to other areas of the United States, especially states located west of the Mississippi River. The two images below illustrate Dunkin’ Donuts presence in greater detail. The first image shades areas of the United States in one of four colors based on the company’s market penetration in the area. I was surprised to see how small Dunkin’ Donuts ‘core’ region is compared to their ‘established’ and ‘emerging’ regions. According to the image below, approximately half of all Dunkin’ Donuts locations are located in one of eight states: Connecticut, Maine, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island, and Vermont. Maine, New Hampshire, Rhode Island, and Vermont are all low population areas, so the bulk of Dunkin’ Donuts United States revenue is generated from customers in Massachusetts, New York, and New Jersey. Dunkin’ Donuts ‘established’ regions include the majority of the state of Florida as well as the greater Chicago, Cleveland, Philadelphia, and Washington D.C. metro areas. Aside from their core and established regions which include approximately 15 states, Dunkin’ Donuts lacks a significant presence elsewhere in the United States. Less than five percent of all Dunkin’ Donuts restaurants are located west of the Mississippi River. The second image below is a frequency map showing each Dunkin’ Donuts location as well as each location of the company’s direct competitors in the coffee house industry. This image allows us to compare the market penetration of Dunkin’ Donuts in relation to their competitors. As one can see, coffee houses are more frequently located along the coasts rather than the less densely populated mountainous and plains states. This is not surprising as the coastlines contain a larger percentage of the United States population, therefore creating higher demand for coffee houses in those areas. Starbucks and Dunkin’ Donuts are the only coffee houses with national presences, with Starbucks dominating market share in the Western United States (especially along the coast) and Dunkin’ Donuts controlling market share in the Northeastern United States. While both companies have achieved full market penetration near the areas in which they were founded, I would argue that Starbucks can be found more frequently in other regions of the country than Dunkin’ Donuts. For example, the image shows that Starbucks controls market share in the Atlanta, Dallas, Denver, Houston, and Phoenix metro areas while remaining competitive in the Chicago and Washington D.C. markets. Dunkin’ Donuts, on the other hand, is not competitive in as many markets as Starbucks. If the economy of the Northeastern United States were to weaken significantly, Dunkin’ Donuts would suffer as they are overexposed to that area of the country. A study conducted by Wallet Hub utilized 14 different criteria to determine the best coffee cities in the United States. The study found that Portland, San Francisco, and Seattle were the top three coffee-drinking cities. Denver, Los Angeles, and San Diego were other cities located west of the Mississippi River that were included in the top 10. In order to both de-risk their business and better compete with Starbucks, I suggest that the company implement an aggressive growth plan that includes westward expansion into cities where coffee is in high demand.

Loss of Price-Conscious Consumer to McDonald’s- I’ve discussed how Dunkin’ Donuts does a great job of attracting brand loyal customers via various advertising and market strategies. However, there is a risk that the company could lose the price-conscious consumer going forward. McDonald’s began selling iced coffees for one dollar starting last year. Not only did McDonald’s cut the price of their iced coffees, but they trimmed the price of all coffee-related beverages. The pricing adjustment undertaken by McDonald’s will have several ramifications going forward. First, the change will cause the price-conscious consumer to gravitate towards cheaper McDonald’s coffee products and away from more expensive Dunkin’ Donuts coffee products. Second, this change will force coffee house operators to reevaluate their pricing strategies or consider decreasing the cost of their coffee products to compete with McDonald’s. Dunkin’ Donuts can mitigate the risk that McDonald’s price changes will have on their business by implementing one or both of the following suggestions. First, Dunkin’ could ‘bundle’ food products such as breakfast sandwiches and doughnuts with their coffee products. While the company already does this to some extent, they could identify more creative ways to market bundled food and beverage options to customers. Customers are more likely to pay higher prices for coffee products if they perceive that there is some added benefit to doing so, such as receiving a breakfast sandwich, doughnut, or other baked good with their order. Second, Dunkin’ Brands could lower the cost of their coffee products at the expense of profit margin. Unlike other coffee houses, Dunkin’ Brands could probably afford to do this given their high profit margin. However, just because Dunkin’ Brands corporate is profitable doesn’t necessarily mean that the franchise owners are profitable. Dunkin’ would need to conduct research and determine whether the increased volume as a result of lower price points will result in franchise owners being more profitable than if prices remained at their current levels. Nonetheless, I believe that decreasing prices on coffee products could be an effective way to mitigate the risk of losing price-conscious customers to McDonald’s.

Sluggish International Growth- Stagnant international growth is the third major risk to Dunkin’ Brands business. The graph below shows the restaurant unit growth and the same restaurant sales growth for each business unit over the past five years. The bars in the graph below correspond to the annual restaurant unit growth and the lines resemble the same restaurant sales growth. Several important conclusions can be drawn from analyzing the graph below. First, I noticed that Dunkin’ Donuts United States has achieved consistent same restaurant sales growth while also growing the total number of restaurants over the past five years. It is clear to me that Dunkin’ Donuts United States is keeping the company’s growth rates afloat, as the other three business units have either struggled in growing the total number of restaurants or struggled to grow same restaurant sales. Second, international growth (both restaurant units and same restaurant sales) have consistently lagged the growth of Dunkin’ Brands United States. Both Dunkin’ Donuts and Baskin Robbins International have experienced slowing annual unit restaurant growth in addition to declining same restaurant sales growth. The tepid growth in Dunkin’ Brands international business poses a risk to the company going forward. Slow international growth places additional pressure on Dunkin’ Donuts United States (which accounts for 75% of total revenue) to generate higher growth rates to keep investors happy. I question whether the Dunkin’ Donuts and Baskin Robbins concepts will ever gain traction overseas. While there is a significant market for coffee houses and ice cream internationally, particularly in Europe, it will be difficult for Dunkin’ Brands to penetrate the market. Europeans tend to prefer small, neighborhood coffee shops that embody the culture of the communities in which they live. Additionally, the average individual living overseas tends to eat a healthier diet than a person living in the United States. While breakfast sandwiches, donuts, and ice cream cakes are popular items in the United States, they are less likely to be popular items overseas due to healthier eating habits. Given differences in cultural norms and tastes for coffee and ice cream, I am unsure as to whether the Dunkin’ Donuts and Baskin Robbins concepts will ever be successful overseas. Differences in cultural norms and tastes highlighted above are one reason why I believe Dunkin’ Brands international business has been struggling and poses a risk to the company’s underlying business going forward.

Dunkin’ Brands Revenue Projections and Methodology

In this section of my post, I will explain my revenue projection methodology for Dunkin’ Brands over the next five years in greater detail. The first image depicts a detailed model that I have built to project Dunkin’ Donuts U.S. revenue. I chose to build a model for Dunkin’ Donuts U.S. and not the other three business units as Dunkin’ Donuts U.S. accounts for a significant proportion of the total enterprise revenue. Consequently, I felt that it was important to model revenue for Dunkin’ Donuts U.S. using a top-down approach. The second image shows a consolidated roll-up of revenue projections for Dunkin’ Brands by business unit. The top-line revenue figures in the second image will be used in my free cash flow to the firm model that will be discussed in the next section.

Coffee sales account for the majority of Dunkin’ Donuts U.S. total sales and royalty revenue is the largest revenue category for this business unit. With this in mind, I wanted to begin by projecting the dollar value of Dunkin’ Donuts U.S. coffee sales and then use this number to ‘back into’ total royalty revenue for Dunkin’ Donuts U.S. In order to project total Dunkin’ Donuts U.S. coffee sales, I began with the estimated United States population for each year. I multiplied the United States population by the percentage of the population 18 years or older to arrive at the total number of United States citizens 18 years or older. United States population data was retrieved from populationpyramid.net. According to a Gallup poll conducted in 2015 by Lydia Saad, approximately 64 percent of United States adults drink at least one or more cups of coffee on a daily basis. This poll also mentioned that the average coffee drinker consumes 2.7 cups of coffee daily. Using this information, I multiplied the estimated number of United States citizens by 64 percent in order to arrive at the number of daily coffee drinkers in the United States. Next, I multiplied this number by the average number of coffees consumed by coffee drinkers on a daily basis. According to my calculation, more than 158 billion cups of coffee will be consumed by United States coffee drinkers in 2018. Now that I have the total number of cups of coffee consumed by United States adults, I needed to estimate the number of coffee cups that were purchased at Dunkin’ Donuts. This means that I needed to estimate Dunkin’ Donuts 2018 market share. To do this, I took total 2017 Dunkin’ Donuts U.S. franchise sales of $8.5 billion and multiplied this number by 58 percent (the 58 percent represents the percentage of total Dunkin’ Donuts sales that are attributable to coffee). I then grew this number by 2.5 percent, which is equivalent to the projected growth in United States GDP in 2018. This product was divided by the 158 billion cups of coffee, multiplied by $2.95 (which represents the estimated average price of a cup of coffee sold at Dunkin’ Donuts) and grown by 2.5 percent (projected growth in United States GDP in 2018). As you can see below, the quotient ended up equaling 1.06 percent. This means that, on average, 1.06 of every 100 cups of coffee consumed in the United States by regular coffee drinkers is from a Dunkin’ Donuts. In order to estimate the number of cups of coffee sold by Dunkin’ Donuts in the United States in 2018, I multiplied the 158 billion cups of coffee sold by Dunkin’ Donuts 1.06 percent market share. Now that I have estimated Dunkin’ Donuts total coffee volume, I needed to estimate the price of each coffee cup sold. To do this, I utilized data compiled by Khushbu Shah from eater.com. The article states that the average ticket per customer per visit at a Dunkin’ Donuts was $4.86 in 2015. However, I cannot use the $4.86 average revenue per ticket (ARPT) at face value. I need to account for inflation to determine an accurate 2018 estimate. Since 2015, the United States inflation rate has hovered around 1.5 percent. Therefore, I need to grow the $4.86 ARPT by 1.5 percent three times. Doing so increases my APRT to $5.08 in 2018, but I have still not arrived at the estimated average price of a cup of coffee sold at Dunkin’ Donuts. I estimated that the average price of a cup of coffee sold at Dunkin’ Donuts is $2.95. To arrive at this number, I multiplied the $5.08 ARPT by 58 percent (which represents the percentage of total sales attributable to coffee). While this is not a foolproof methodology to estimate pricing, I think it is a sound one as I found it very difficult to find pricing data as it varies by specific product and franchise location. Next, I needed to determine total coffee sales attributable to Dunkin’ Donuts U.S. I multiplied the number of cups of coffee sold by Dunkin’ Donuts by the ARPT attributable to coffee. Once I forecasted total Dunkin’ Donuts coffee sales, I ‘backed into’ Dunkin’ Donuts total franchise sales. To forecast Dunkin’ Donuts total franchise sales, I divided Dunkin’ Donuts coffee sales by the percentage of total revenue attributable to coffee. Now that I have projected total franchise sales for this business unit, I am ready to forecast royalty income. According to their 2017 annual report, Dunkin’ Brands collects 5.9 percent of total franchise sales in the form of royalty revenue. I have estimated Dunkin’ royalty revenue to be roughly 500 million by multiplying total franchise sales by 5.9 percent.

Before I explain how I forecasted other revenue categories, I would like to highlight some assumptions I made in projecting royalty income between 2019 and 2022. As mentioned earlier, I utilized populationpyramid.net for United States population figures as well as the percentage of the United States population that is at least 18 years old. Populationpyramid.net is an excellent resource that projects the United States population and age distribution by year through the year 2100. I decided to keep the average cups of coffee consumed per day by coffee drinkers constant across the projection period because while the United States population is projected to grow older over the next five years, it will also become more ethnically diverse. According to Gallup, elderly Caucasians typically drink the most cups of coffee on a daily basis. I am assuming that any increase in the average age of the United States population will be offset by the increase in ethnic diversity, thereby offsetting any change in the average number of coffee cups consumed per day by coffee drinkers. According to their 2018 first quarter guidance, Dunkin’ Brands indicated that they plan to embark on a Dunkin’ Donuts growth initiative in the United States. More specifically, the company plans to grow the number of Dunkin’ Donuts U.S. locations by 1,000 by 2020. While the company will undoubtedly face competitive pressure from the likes of McDonald’s and Starbucks over the next five years, I believe that they can increase their market share assuming they succeed in accomplishing their growth objectives. As a result, I have made the assumption that Dunkin’ Donuts U.S. will grow their market share by two percent per year. The final two assumptions that I have made in my Dunkin’ Donuts U.S. revenue model are related to ARPT and the percentage of total sales attributable to coffee. I grew the ARPT amount by two percent each year to account for inflation. I chose to increase this number by two percent per year because the Federal Reserve aims to keep the inflation rate near two percent. In Dunkin’ Brands 2017 annual report, the company cited that the growth in breakfast sandwiches and coffee products are increasing while the growth in donuts and other baked goods are declining. The company explained that these trends have existed for several years. To account for these changes in consumer tastes, I have decided to grow the percentage of Dunkin’ Donuts sales attributable to coffee by half of one percent per year.

I used a more simplified approach to project franchise fees, rental income, and other income. To project revenue for these three categories, I decided to calculate franchise fees, rental income, and other income on a ‘per restaurant location’ basis. For example, Dunkin’ Brands earned $5,740 in franchise fees per restaurant, $11,200 in rental income per restaurant, and $1,020 in other revenue per restaurant. In order to project the number of Dunkin’ Donuts U.S. locations in 2018, I took the three-year compound annual growth rate (OTCPK:CAGR) in restaurant units. Next, I applied the three-year CAGR to the total number of restaurants in the previous year to calculate the projected number Dunkin’ Donuts U.S. restaurants in 2018. After I determined the projected number of Dunkin’ Donuts U.S. restaurants in 2018, I needed to calculate the total non-royalty revenue amount earned by Dunkin’ Brands in 2018. The first step in calculating non-royalty revenue involved multiplying the number of restaurants in the current year by the franchise fees, rental income, and other revenue earned per restaurant. The second step involved summing these three products together. The second image below shows a consolidated view of revenue projections by business unit as well as total enterprise revenue in each year of the projection period. In order to calculate total revenue for the remaining three business units, I adhered to the same methodology that I utilized to calculate non-royalty revenue. As one can see, I have projected that Dunkin Donuts International, Baskin Robbins U.S., and Baskin Robbins International will experience stagnant growth over the next five years. If you will recall, sluggish international growth was one of the investment risks that I elaborated on in a previous section. Given Dunkin’ Brands inability to generate consistent growth from their international business, I am skeptical that they will be able to match domestic growth rates over the next five years.

FCFF Valuation and Recommendation

The two tables below make up the free cash flow to the firm (FCFF) model for Dunkin’ Brands. The first table shows the financials for each year in the five year projection period and the second table calculates the terminal value and completes the valuation by arriving at a price per share figure. All revenue figures and growth rates in the table below were taken from my revenue projection model in the previous section. My model assumes that Dunkin’ Brands will improve their operational efficiency by one percent per year as the company completes their transition to a franchised owned business model, optimizes labor efficiency by increasing the number of drive-thru windows at Dunkin’ Donuts locations, and continues to promote high-margin items such as coffee through various advertising campaigns. In their first quarter guidance press release, Dunkin’ Brands management indicated that their effective tax rate in 2018 is expected to be 28 percent. Dunkin’ Brands CEO Nigel Travis mentioned that while the company will stand to benefit from the new tax reform bill, they will have a higher effective tax rate than most companies given the areas of the United States in which they operate. As mentioned in an earlier section, Dunkin’ Brands has a significant presence in the Northeastern United States. States in the Northeast typically have higher state and local tax rates than other regions. As a result, I have assumed that Dunkin’ Brands tax rate will remain unchanged at 28 percent throughout the projection period. I have projected that the net change in working capital will be negative in both 2018 and 2021 as a result of share buybacks. Dunkin’ Brands has already indicated that they plan to repurchase 650 million dollars of stock in 2018. The company also repurchased roughly 625 million dollars of stock in 2015. Consequently, I have assumed that the company will initiate another stock repurchase plan in 2021. I have also projected that the change in net working capital will increase significantly in 2020. This increase is driven by roughly three billion dollars in new common stock issuance. Dunkin’ Brands is planning to grow the number of restaurant locations in the United States by 1,000 by 2020. I do not believe that the company can rely solely on debt financing to accomplish this objective. I think Dunkin’ Brands will make an effort to become a less leveraged firm in the future, as the cost of debt grows more expensive due to rising interest rates. As a result, the company should consider financing growth objectives through the issuance of common stock.

According to the image above, I believe that Dunkin’ Brands is worth $68.59 today, roughly four percent higher than their current share price of $66.02. While Dunkin’ Brands has a recognizable brand name and profitable business model, the company has far too many investment risks. Increasing competition in the quick-service restaurant industry, sluggish international growth, and a lack of restaurant location diversity in the United States could all significantly harm revenue growth in the future. Dunkin’ Brands was undervalued according to EV/EBITDA, Price/Earnings, and Price/FCF and overvalued according to EV/Sales and Price/Sales in my relative valuation analysis. Dunkin’ Donuts U.S. is the only business unit that has been able to achieve positive same restaurant sales growth on a consistent basis. This fact, coupled with a company that carries a significant debt load, makes me hesitant to place a ‘buy’ rating on this stock. However, I believe that the company has customers who are extraordinarily brand loyal and Dunkin’s business model makes them highly profitable. These strengths prevent me from placing a ‘sell’ rating on the stock. Consequently, I am placing a hold recommendation on Dunkin’ Brands as I believe the company is fairly valued at this time.

This article with work cited, as well as other pieces, can be found at http://www.marketanalysisonsteroids.com/blog/.

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