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DUNKIN’ BRANDS (DNKN) BREAKS OUT ON THE UPSIDE – WHAT TO DO?

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DUNKIN’ BRANDS (DNKN) BREAKS OUT ON THE UPSIDE – WHAT TO DO?

Dunkin’ Brands reported their first quarter in early May and the stock has been moving higher ever since, trading near a record high, which in and of itself encourages more buying. Our full writeup, elaborating on our summary provided last week,  is provided below.

CONCLUSION:

Earnings and cash flow generation has been consistent but up only modestly in recent years and likely to remain so. DNKN stock is trading near its high not because fundamental performance has been outstanding, but because (1) institutional investors are embracing an “asset light” model with presumably “free” cash flow (2) The stock market generally has been strong, and investors are reluctant to sell good performers (which DNKN has been) because the proceeds have to be reinvested and cheaper stocks are hard to find (3) the company, led by a new CEO, tells a promising story about operating initiatives (4) a great deal of stock has been repurchased, especially the $680M worth in ’18, which supported the stock and helps to increase EPS.

One could question (and we have) the wisdom of spending a fortune to repurchase shares at over 20x expected earnings and close to 20x trailing twelve months EBITDA, far from a bargain valuation compared to roughly mid-single digit growth in earnings and cash flow. This is  especially questionable when the franchisees (who pay the bills at the end of the day) have “needs”. Perhaps the presumed “free cash flow” is not so free over the long term, especially when $3 billion of debt has to be repaid. Of course, Modern Monetary Theory doesn’t worry about the repayment of debt  🙂

Management admits that the balance sheet has been fully leveraged, with debt at over 5x trailing EBITDA so repurchases of stock will be more modest in the future and earnings per share will not benefit as much as in the past. The timing of the acceleration in US unit growth and same store sales remains to be seen. International progress has been offset by Baskin Robbins weakness so the outlook revolves around the performance of US franchised Dunkin’ locations.  We haven’t noticed that Starbucks or McDonald’s have backed down from the battle for market share. In summary,  we are not inclined to chase the breakout of DNKN common stock.

RECENT RESULTS

The first quarter was better than calendar ’18 as a whole. While international locations are the growth element, it is relatively immaterial  ($14M of segment profit in calendar ’18 vs. $466M  of segment profit from Dunkin’ US and $68M from Baskin Robbins) and partially offset by less profitability from the Baskin Robbins segment. The heart of this company is the US Dunkin’ store franchise system, which showed comp sales of 2.4% in Q1. (calendar ’18 was up 0.6%).  In Q1’19, consolidated revenues were up 5.9%, operating income was up 12.8%, net income was up 4.3%, adjusted net income was up 2.8%, On fewer shares outstanding, diluted earnings per share was up 8.1%.

There are lots of operating initiatives taking place here, which we will detail next week, but for the moment we will focus on the latest guidance for calendar ‘19, which remains almost exactly the same as that provided a few months ago with the yearend ’18 report, remains far from exciting and consistent with recent results. Comps will be at low single digits at US Dunkin’ and BR locations. Dunkin’ US net new units will be at the low end of 200-250 stores, contributing $130M of systemwide sales. (34 net new locations opened in Q1). Consolidated revenues will grow low to mid-single digits. SG&A expenses will be reduced at a mid-single digit pace. Operating and adjusted operating income will be up by mid-to-high-single digits. GAAP diluted EPS will be $2.63-$2.72 (previously $2.74 to $2.83) and diluted adjusted EPS will be $2.94-$2.99. In essence: a flattish performance compred with $2.90 per share in calendar 2018. According to Bloomberg, analyst consensus is $3.24 in 2020, up 8% from the $2.99 consensus for 2019

AN OVERVIEW OF THE LAST SEVERAL YEARS, EXCERPTED FROM THE ’18 10K FILING:

Net Cash Provided by Operating Activities was: $282M in ’16, $283M in ’17, $269M in ’18

Net Income After Taxes was $175M in ’16, $272M in ’17, $229M in’18

Additions to property, equipment and software: $21M was spent in ’16, $21M in ’17, then $52M in ’18.

$1.4 billion of long term debt was added in ’17.

Repayments of long term debt were $25M in ’16, $754M in ’17, $32M in ’18

Stock repurchases were : $55M in ’16, $127 in ’17, $680M in ’18

Dividends paid were: $109M in ’16, 117M in ’17, $114M in ’18

Total Effect on Cash for year was -275M in ’16, +572 in ’17, -538M in ’18

Bottom line, looking at the big numbers: – Cumulatively over 3 years, Total Net Income After Taxes was $676M. Adding back depreciation of a total of $136 provided $812M of after tax cash flow. Total capex (reinvestment in the system) was $94M ($52 of which was spent in ’18) and dividends were $340M, leaving $378M of “free cash flow”. Stock  repurchases amounted to a cool $862M, exceeding free cash flow by $484M and that was financed by incremental long term debt of $589M ($1.4 billion of new debt less repayments of old debt). Cash in hand at year end went from $432M at 12/31/16 to $1.11M at 12/17 to $598M at 12/18.

COMPANY OVERVIEW (2018 10-K):  Dunkin’ Brands Group is one of the world’s leading franchisors of Quick Service Restaurants (QSR) serving hot and cold coffee and baked goods as well as hard ice cream. They franchise restaurants under the Dunkin’ Donuts and Baskin-Robbins brands. They have over 20,900 points of distribution (retail stores) in more than 60 countries worldwide.

Dunkin’ brand is a 100% franchised business model and they believe that this model offers strategic and financial benefits; such as being able to focus on menu innovation, marketing, franchisee coaching and support, and other initiatives to drive overall success of their brand. Financially their franchised model allows them to expand points of distribution (retail stores) and brand recognition with limited capital investment by the Corporation.

Dunkin’ divides its business into four segments: Dunkin’ Donuts U.S., Dunkin’ Donuts International, Baskin-Robbins U.S., and Baskin-Robbins International.

Dunkin’ Brands History:   – Both of Dunkin’ Brands, Dunkin’ Donuts and Baskin-Robbins, history dates back to the 1940’s. Baskin-Robbins and Dunkin’ Donuts were individually acquired by Allied Domecq, PLC in 1973 and 1989, respectively. The Brands were organized under the Allied Domecq Quick Service Restaurant subsidiary being renamed Dunkin’ Brands, Inc. In 2004, Allied Domecq was acquired by Pernod Ricard SA. In March of 2006 Dunkin’ Brands, Inc. was acquired by investment funds affiliated with Bain Capital Partners LLC, the Carlyle Group, and Thomas H. Lee Partnerships LP through a holding company incorporated on November 2005 and was later renamed Dunkin’ Brands Group, Inc. An IPO in July 2011 brought Dunkin’ public once again. completed.

Brands:

Dunkin’ Donuts – U.S. – Dunkin’ Donuts is the QSR leader in donut and bagel categories. Dunkin’ Donuts is also a national QSR leader for breakfast sandwich servings. Since the late 1980s, Dunkin’ Donuts has transformed itself into a coffee and beverage-based concept and is a national QSR leader in servings in the hot regular/decaf/flavored coffee category and the iced regular/decaf/flavored coffee category, with approximately 1.7 billion servings of total hot and iced coffee annually. Over the last ten years, Dunkin’ U.S. systemwide sales have grown 5.4% compounded annually and total Dunkin’ U.S. retail stores grew from 6,412 to 9,419 as of December 29, 2018. Approximately 85% of these locations are traditional restaurants made up of end-cap, in-line and stand-alone restaurants; many with Drive Thru. In addition, Dunkin’ Brands has special distribution opportunities (SDO’s) such as full or self-serve kiosks in offices, hospitals, colleges, airports, grocery stores, wholesale clubs and various small footprint properties.

Baskin-Robbins – U.S. –  Baskin-Robbins is one of the leading QSR chains in the U.S. for servings of hard-serve ice cream and sells a full range of frozen ice cream treats such as cones, cakes, sundaes, and frozen beverages. Baskin-Robbins U.S. segment has experienced comparable store sales growth in six of the last seven fiscal years. Baskin-Robbins enjoys an unprecedented Brand recognition in the U.S. known for its “31 Flavors” and its popular “Birthday Cake” program.

International Operations

 Dunkin’ Brands International operations is primarily based on joint venture and country or territorial license arrangements with “master franchisees” who operate and sub-franchise within their licensed areas. Dunkin’ International is predominantly located in Asia and the Middle East. 2018 International systemwide sales were $2.2 Billion which represented approximately 19% of Dunkin’ global sales. As of December 28, 2018, Dunkin’ had 3,452 International restaurants/points of distributions, up from 2,405 in 2008. As of December 2018, there are 5,491 Baskin-Robbins in their International market base which represents $1.5 Billion in sales.

SOURCES OF REVENUE (2019 QTR-1 10-Q): – For QTR-1 ending March 30, 2019, Dunkin’ Brands had total revenue of $319,091,000. Dunkin’s revenue is generated from primarily five sources: (1) franchise fees and royalty income, (2) advertising fees and related income, (3) rental income, (4) sales of ice cream and other products, (5) other revenues. Systemwide sales for the period ending March 30, 2019 were $2.768 Billion compared to same period last year of $2.660 Billion; a 4.1% increase.

Other noteworthy QTR-1 highlights, further described under Recent Developments:

  • Dunkin’ U.S. comparable store sales grew 2.4%.
  • Baskin-Robbins U.S. comparable store sales grew 2.8%.
  • Dunkin’ added 34 net new locations in the U.S. and a total of 8 new combos of Dunkin’/Baskin-Robbins locations globally.
  • Revenues increased 5.9%.
  • Diluted EPS increased by 10.5% to 63¢.

STRATEGIC INITIATIVES (Updated – Source: QTR1 10-Q March 30, 2019; Earnings Call Slides):

Dunkin’ Brands provided updates on their management’s strategic initiatives during their Earnings Call Presentation on May 2, 2019.  Dunkin Brands’ Slide Presentation offers a detailed look into the Company’s initiatives designed to balance near-term operational initiatives with longer term strategic outlook in an effort to modernize the Dunkin’ Brand while staying true to its core culture.

Dunkin’ USA:

 New Unit Growth Plan: Dunkin’ USA’s new unit growth plan was updated to include the strategic initiative of offering different development strategies for different markets. Regional focus will be based on maturity and store penetration. The U.S. is broken down as follows: The Northeast – a mature market with very heavy penetration. Its development plan is to transform/optimize existing assets. The East market – a mature market with heavy penetration. Its development plan is incremental growth to drive convenience. The West market is younger, with shallow penetration. Its development plan is one of accelerated growth to establish the Brand presence. Lastly, the Frontier market, which consists of the northwestern U.S., has no development as yet.

  • 2019 Target: 200-250 new units with the majority being the Next-Gen design.
  • 3 to 5 Year Target: 200-250 new units annually. 80% of new development outside of core markets.

Restaurant Excellence: This strategic initiative is centered on improving the guest experience through restaurant simplification, new technologies aimed at improving the ordering process/speed of service, and new programs designed to eliminate unnecessary procedures hindering a seamless transaction. A refocus on training at all levels is designed to drive effective customer interaction.

Influence Brand Relevance: Continuing the reimaging of existing locations to the Next-Gen store design. This new design is aimed at improving guest and crew experience. The main features are:

  • Dedicated Mobile Order & Pick-Up area.
  • Front facing bakery cases which promotes impulse purchases.
  • A Tap system to serve iced beverages.
  • Relaunch of the espresso platform.
  • Transition from foam cup to double walled paper cups.

Menu Innovation: Going forward, menu innovation is expected to be led by beverage innovation. From a food perspective, value messaging around sandwiches and wraps is resonating with customers in test markets. Beverage attachment rates are helping to drive higher average tickets.

Unparalleled Convenience: Upgrades to the Drive-Thru experience that seek to improve guest convenience. The Company’s digital efforts also focus on driving members into the Perks Loyalty Program (which stands at 10.6 million incremental members in 2018).

Brand Accessibility: Increased consumer accessibility through the continued development of points of distribution.

Restaurant Excellence: One of the vital components is menu simplification.

The Company has rolled out a simplified menu in many of its core markets and continued this roll out during the first quarter. A 1% improvement in COGS (largely driven by lower waste), a 1% improvement in labor margins, and a 2% increase in order accuracy were seen. The reduced menu simplifies operations, saving approximately 90 minutes/day/store.

New store equipment and technology: Company is focusing on opportunities to help ease the impact from operational bottlenecks and ongoing labor inflation through the introduction of label machines for drinks, machines that help to calibrate coffee equipment, and other speed/accuracy solutions. Other technology solutions include point of sale system improvements that support conversational ordering (improving speed/accuracy of order taking), cloud-based pricing, seamless integration with delivery partners, zero footprint training,  improved labor forecasting, and inventory/cash/labor scheduling management.

Baskin-Robbins:

Raising the Bar: Initiatives include:

  • Improving guest experience.
  • Increase value offerings.
  • Enhance convenience through:
    • Digital in-store ordering.
    • Home delivery with DoorDash.
  • Expanding test of Moments Store Design.
  • Optimize restaurant base through strategic closures and transfers.

International:

Focus on strategic markets and long-term growth opportunities.

  • Enhance in-store experience.
  • Establish strong delivery infrastructure.
  • Grow nontraditional channels.
  • Increase Brand accessibility and convenience.
  • Enhance Brand relevance.

 BASKIN-ROBBINS – STRATEGIC PLANS: – The Company’s goals for Baskin-Robbins is to “Raise the Bar” of total operational activities, maintaining the premium the high quality reputation of Baskin-Robbins heritage. To that end it has overhauled marketing plans and is experimenting with more attractive franchise offers, including multi-unit offers to its top performers. The principal current challenge with BR is to grow its U.S. segment once again.

 INTERNATIONAL:

Dunkin’ Brands continues to stabilize its international businesses and, along with its franchisees, is focused on driving traffic through value offerings, product innovation, and making the brands more easily accessible through digital technologies.

Delivery continues to be an opportunity for both brands, and the Company is working with its partners to further roll out delivery programs, based on the success that its Middle East and Asia franchisees are experiencing.

FINANCIAL TARGETS – 2019 GUIDANCE:

Dunkin’ USA:  Low single digit SSS, Low end of 200-250 net new units,  $130 Million        systemwide sales for new units opened in 2019.

Baskin-Robbins:  Low single digit SSS, 10 net unit closures.

International:  Flat Ice Cream margins, Flat JV net income.

  • Other financial targets:
    • Medium to single digit reduction to G&A
    • 28% effective tax rate
    • $2.63 to $2.72 GAAP diluted EPS
    • 84 Million full year weighted – average shares outstanding
    • $122 Million in net interest expense
    • $40 Million in capital expenditures

SHAREHOLDERS’ RETURN (Source – QTR-1 10-Q May 2019; Press Release May 2, 2019):

 Cash Dividend Declared:  The Board of Directors declared, payable on June 12th,  a quarterly cash dividend of .375¢ per share.

Shareholders’ Deficit – Equity Incentive Plans (Source QTR-1 10-Q May 2019):

 During the three months ended March 30, 2019, the Company granted stock options to purchase 619,306 shares of common stock and 50,287 restricted stock units (“RSUs”) to certain employees. The stock options vest in equal annual amounts over a four-year period subsequent to the grant date and have a maximum contractual term of seven years. The stock options were granted with a weighted average exercise price of $72.28 per share and had a weighted average grant-date fair value of $12.54 per share. The RSUs granted to employees, vest in equal annual amounts over a three-year period subsequent to the grant date and had a weighted average grant-date fair value of $69.13 per unit.

In addition, the Company granted 47,431 performance stock units (“PSUs”) to certain employees during the three months ended March 30, 2019. These PSUs are generally eligible to cliff-vest approximately three years from the grant date. Of the total PSUs granted, 20,681 PSUs are subject to a service condition and a market vesting condition linked to the level of total shareholder return received by the Company’s stockholders during the performance period measured against the companies in the S&P 500 Composite Index (“TSR PSUs”).

Relative to the stock repurchase program: After repurchasing $650M of common stock in the open market in 2018, only $129,000 worth was bought in Q1’19.

Relative to the balance sheet, it is noteworthy that on April 30, 2019, $1.7 billion of new debt prepaid debt from 2015, with new repayment dates of  4.75 years ($600M), 7 years ($400M), and 10 years ($700M). The new annualized net interest expense, on current total debt of $3.1B is approximately $122M  with a blended rate of 3.978%.

 

RECENT DEVELOPMENTS AND CONCLUSION: PROVIDED AT HE BEGINNING OF THIS ARTICLE.

Roger Lipton

 

 

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ASSET LIGHT FRANCHISING – COMPLAINTS FROM FRANCHISEES – LET’S CLEAR THE AIR!!

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ASSET LIGHT FRANCHISING – COMPLAINTS FROM FRANCHISEES – LET’S CLEAR THE AIR!!

The long term investment appeal of well established franchising companies is accepted by the investment community. Most of the prominent franchisors’ equities sell at price to trailing twelve month EBITDA multiples in the mid to high teens (Denny’s (DENN), Dine Brands (DIN), Dunkin’ Brands (DNKN), Pollo Loco (LOCO), McDonald’s (MCD), Restaurant Brands (QSR), Wendy’s (WEN), even higher in a couple of instances Domino’s (DPZ), Shake Shack (SHAK), Wingstop (WING), lower in a number of “challenged” situations like Jack in the Box (JACK), Red Robin (RRGB), Brinker (EAT), Fiesta Rest. (FRGI).

The attraction of asset light franchisors revolves around the presumably free cash flow for franchisors, a steady stream of royalty income unburdened by capital expenditures to build stores. The operating leverage is at the store level.  Franchisees are responsible for building the stores, then controlling food costs, labor, rent and all the other operating line items. Franchisors receive the royalty stream and have the obligation of supporting the system with brand development, site selection advice, marketing support, and operating supervision. These supporting functions, it should be noted, are optional to a degree, and we have written extensively about system support sometimes being short changed by corporate priorities such as major stock buybacks.

THE CURRENT WORD, IN THE FIELD, AS WE HEAR IT

We acknowledge that in every franchise system there will be some operators less satisfied than others. In the same way, customer reviews on Yelp or Facebook are more frequently written by critics. Bad news is more noteworthy and more customers are inclined to criticize than applaud, so we have to listen to the complaints but dig further for the reality. With that in mind, we hear the following from franchisees of various restaurant systems:

“I’ve been in this business for thirty years, and I’ve never seen it this bad. Everyone is making money but me; the landlords, the franchisor, the banks. My margins have been killed, and I’m up against my lending convenants”.

“All the franchisors want to do is build sales to build their royalties. The dollar deals are trading people down. My franchisor doesn’t care about my margins. I can’t maintain my margins, especially with the increasing cost of labor, let alone build it”.

“The franchisor is putting pressure on me to sell, even though I’ve always been considered a good operator, with high performance scores. I’m up to date on my development agreement, but they want somebody else to take me out, and the new buyer will agree to what I consider to be a ridiculously aggressive development contract”.

“The franchisor has replaced experienced long term field support with lower priced (and inexperienced) younger people. They’re cutting corporate overhead, but these kids, who never ran a store, are telling me to how to control costs.””

“I’m doing my best with the development objectives, but it is almost impossible to build stores with today’s economics. Rents are too high, labor costs are killing me, and I can’t raise prices in this promotional environment”.

“As if things aren’t tough enough, I’m being nickeled and dimed with demand for higher advertising contributions and fees on services (including software) that I thought would be provided”.

The valuations provided to the publicly held companies do not reflect the situation as described by the admittedly anonymous franchisees. The commentators quoted above don’t want to aggravate their franchisor, and we don’t want to be unfair or misleading to particular companies by relying on just a few conversations, though they do support one another. For the most part, franchisees are strongly discouraged from talking to the press or investment community. The companies will say that “competitive” issues require some secrecy, but there are few secrets in this industry.

The optimistic view, as represented by the valuations in the marketplace, is that the comments above are not typical or representative of the health of the subject franchise systems. Allow me to provide a short story which leads to a suggestion.

A SHORT STORY

Twenty six years ago, in 1992, IHOP had just come public. I was a sell side analyst, thought the numbers were interesting and the stock was reasonably priced. The company, led by the now deceased CEO Kim Herzer, invited me to attend their franchisee convention, which I did. I obviously had the opportunity to interface with many franchisees and it was clear that, while all was not perfect, the franchisor was providing a great deal of support that was embraced by an enthusiastic franchise community. IHOP stock tripled over several years for me and my clients who owned millions of shares. I attended several more of their annual conventions and maintain some of those relationships to this day. Obviously, the conviction I gained from their open attitude was critical to the success of the investment. I should add, that many of those buyers in 1992 owned the stock for many years, not living and dying on quarterly reports.

THE SUGGESTION

As you are no doubt by now anticipating, my suggestion to publicly held franchising companies: open up your franchisee conventions to the investment community. The companies may quickly respond that lenders are already invited to franchise conventions, but franchisees are unlikely to express their system oriented concerns when they are making a pitch to a potential lender. Companies may also respond that their lawyers think it would be a bad idea, not consistent with full disclosure and analysts would be getting “inside information”. Let’s not allow the lawyers to provide “cover”. A good lawyer will provide a solution to the problem, not just provide the pitfalls. Analysts attending a franchise convention are not being told what sales or profits are going to be. Attending a franchise convention is  a “channel check”, no more than talking to a supplier or customer of a manufacturing company, which any decent analyst will do.

The anecdotal critical comments, as described above, have likely been heard by others, but may be atypical of most restaurant franchising companies. There are no secrets in this business. One of the investment appeals of this industry is its transparency. Notable news is going to leak out anyway. The objective of any publicly held company is to build stock ownership by well informed investors. Investment analysts pride themselves on their ability to “build a mosaic”, enhance the information provided in quarterly reports, SEC filings, and conference calls, with “channel checks”. What channel check would be more pertinent than meeting the franchisees of a company that is dependent on franchisee success? Putting it another way, and taking the highest valuation relative to EBITDA as an example: Wingstop (WING) is a company I have the highest regard for. However, you could call it irresponsible to pay almost fifty times trailing EBITDA for Wingstop stock (and I haven’t) if I couldn’t talk to franchisees of my own choosing?

There’s no particular need to invite this writer if I’m not considered influential enough. I have not spoken to these analysts on this subject, but qualified industry followers such as David Palmer, Nicole Reagan, Matt DiFrisco, David Tarantino, Jeff Bernstein, Andy Barish, Bob Derrington, Mark Kalinowski, Michal Halen, Gary Occhiogrosso, Howard Penney, Jonathan Maze, Nicholas Upton, John Hamburger and John Gordon provide the beginning of an invitation list.  I rest my case.

Roger Lipton

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DUNKIN’BRANDS GROUP

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COMPANY OVERVIEW (2017 10-K):

Dunkin’ Brands Group is one of the world’s leading franchisors of Quick Service Restaurants (QSR) serving hot and cold coffee and baked goods as well as hard ice cream. They franchise restaurants under the Dunkin’ Donuts and Baskin-Robbins brands. They have over 20,500 points of distribution (retail stores) in more than 60 countries worldwide.

Dunkin’ brand is 100% franchised business model and believe that this model offers strategic and financial benefits; such as being able to focus on menu innovation, marketing, franchisee coaching and support, and other initiatives to drive overall success of their brand. Financially their franchised model allows them to expand points of distribution (retail stores) and brand recognition with limited capital investment by the Corporation.

Dunkin’ divides its business into four segments: Dunkin’ Donuts US, Dunkin’ Donuts International, Baskin-Robbins US, and Baskin-Robbins International.

Brands:

Dunkin’ Donuts – U.S.

Dunkin’ Donuts is a leading U.S. QSR concept and is the QSR leader in donut and bagel categories for servings. Dunkin’ Donuts is also a national QSR leader for breakfast sandwich servings. Since the late 1980s, Dunkin’ Donuts has transformed itself into a coffee and beverage-based concept and is a national QSR leader in servings in the hot regular/decaf/flavored coffee category and the iced regular/decaf/flavored coffee category, with sales of approximately 1.7 billion servings of total hot and iced coffee annually.

Baskin-Robbins – U.S.

Baskin-Robbins is one of the leading QSR chains in the U.S. for servings of hard-serve ice cream and develops and sells a full range of frozen ice cream treats such as cones, cakes, sundaes, and frozen beverages. Baskin-Robbins U.S. segment has experienced comparable store sales growth in six of the last seven fiscal years.

SOURCES OF REVENUE (2017 10-K):

For year ending December 2017, Dunkin’ brands had $12,506B global system-wide sales which generated a total of $860,501,000 in revenue (see chart of segment breakdown).

Dunkin’ generates revenue from four primary sources: (1) royalty income and fees associated with franchised restaurant, (2) rental income from restaurant properties that they lease or sublease to franchisees, (3) sale of ice cream and other products to franchisees in certain international markets, and (4) other income including fees for the licensing of the Dunkin’ Donuts brand for products sold in certain retail channels (such as Dunkin’ K-Cups’ pods, retail packaged coffee, and ready to drink bottled iced coffee), the licensing of the rights to manufacture Baskin-Robbins ice cream products to a third party for sale in US, franchisee, refranchising gains and transfer fees from franchisees and online training fees.

This analysis focuses largely on Dunkin’ Donuts US segment since it is by far the largest segment by store count, revenues and it is management’s principle focus.

STRATEGIC INITIATIVES:

DUNKIN’ DONUTS STRATEGIC PLANS (Updated from Dunkin’ Brands 2018 Investor Day Presentation – February 8, 2018)

The Dunkin’ Brands Analyst Day offered a deep dive into operational initiatives embedded in the outlook for the Dunkin’ Donuts U.S. business, and guidance for longer-term financial targets. The Company’s plan balances near-term operational initiatives with a longer-term strategic outlook in an effort to modernize the Dunkin’ brand while protecting what is already a strong brand/organizational culture.

Plans Outlined at Analyst Day – Management presented their Dunkin’ Donuts U.S. blueprint for growth plans aimed at driving operational efficiency at the store-level, menu innovation platforms and digital efforts.

New Unit Growth – Dunkin’s new unit growth plan was updated at the Analyst Day Conference for Dunkin’ Donuts.

  • US New Unit Growth Plans:

o    1,000 new units by 2020

o    90% outside core markets

o    275 for 2018

  • SSS growth of 3% by 2020
  • Strategy Blueprint – beverage led and Grab & Go initiatives
  • NextGen Store – The Company recently opened the first iteration of its NextGen restaurant in Quincy, MA. Designed to cater to the on-the-go customer, the new Dunkin’ Donuts restaurant features innovative in-store technologies and design elements and is 25% more energy efficient than previous design. New technology includes a beverage bar tap system serving premium pours of cold beverages such as Nitro Coffee. The store also features grab-and-go snacks and a double drive-thru with preview boards and order confirmation screens. The crew members in the restaurant wear new uniforms and headwear designed in partnership with lifestyle brand Life is Good®. Dunkin’ Donuts plans to have up to 50 NextGen restaurants by the end of the year.

Menu Innovation – The Company recently hired Ms. Katy Latimer as Vice President of Culinary Innovation in an effort to support innovation of core products and supplement the Company’s already strong pipeline of culinary innovation. Going forward, menu innovation is expected to be led by beverage innovation. From a food perspective, value messaging around sandwiches and wraps is resonating with customers in test markets, and also supporting beverage attachment rates are helping to drive higher average tickets. The recent introduction of “Dunkin’ Duos” is helping to drive awareness and traffic.

Unparalleled Convenience – Dunkin’ recently hired Mr. Tony Weisman into the role of Chief Marketing Officer is working on an upgrade to drive-thru experience that seeks to improve guest convenience. The Company’s digital efforts also focus on driving members into the Perks Loyalty Program (which grew by 2 million incremental members in 2017 and now sits at approximately 8 million total members accounting for 11% of total sales. On-the-Go mobile ordering will also remain a focus going forward. During 3Q17, 3% of total transactions were driven through the mobile ordering channel.

Brand Accessibility – Dunkin’ aims to increase consumer accessibility to its brands through the continued development of points of distribution (including traditional franchise store locations and asset-light partnerships). The growth of branded products sold in the consumer-packaged goods channel is an important point of discussion as it relates to brand accessibility (noting that 6 out of 10 cups of Dunkin’ coffee are actually purchased outside of the retail Dunkin’ store).

Restaurant Excellence – One of the vital components of restaurant excellence is menu simplification. Dunkin’ is testing a simplified menu in approximately 5,000 locations in an effort to improve customer throughput while also driving top and bottom-line growth for franchisees. This initiative also helps to manage labor turnover as it reduces the complexity of in-store preparation for a wide range of sandwich and beverage products while also creating a buffer for menu innovation.

The Company has rolled out a simplified menu in many of its core markets and plans are in place to continue this roll out over the course of the first quarter. A 1% improvement in COGS (largely driven by lower waste), a 1% improvement in labor margins, and a 2% increase in order accuracy were seen. The reduced menu test simplifies operations and saves approximately 90 minutes/day/store.

The Company also discussed a plan for G&A optimization/rationalization to lead to G&A decreasing 5% in 2018 before growing in the 2%-3% range going forward.

New store equipment and technology – At the store level, the Company highlighted opportunities to help ease the impact from operational bottlenecks and ongoing labor inflation through the introduction of label machines for drinks, machines that help to calibrate coffee equipment, and other speed/accuracy solutions. Other technology solutions include point of sale system improvements that support conversational ordering (improving speed/accuracy of order taking), cloud-based pricing, seamless integration with delivery partners, and zero footprint training in addition to improved labor forecasting, inventory/cash/labor scheduling management.

BASKIN-ROBBINS – STRATEGIC PLANS:

The Company’s goals for Baskin Robbins, similar to the plans for Dunkin’ Donuts U.S., aim for product innovation – introducing digital (mobile app) tools and delivery. To that end it has overhauled marketing plans and is experimenting with more attractive franchise offers, including multi-unit offers to its top performers. However, the Company’s principal challenge with BR is to return its U.S. segment to growth, and so far, results have been disappointing. Store growth has been barely positive, revenues are flat to down slightly and segment profits are also basically flat.

Consumer Convenience – Baskin Robbins plan to continue to expand delivery options with almost half of all Baskin-Robbins locations in the U.S. now offering delivery through DoorDash.

Improved BR App and Online Orderings – Early in the second quarter of 2018, Baskin-Robbins plans to launch an improved app and online ordering system. This is expected to improve the guest experience, especially on mobile devices.

New Store Image – Late in the fourth quarter of 2018, Baskin-Robbins U.S. plans to unveil a new store look designed to appeal to guests of all ages.

Product Innovation – The brand is expanding its focus on beverages in 2018, including an increased emphasis on milkshakes, as well as focusing on ice cream cakes.

INTERNATIONAL:

Dunkin’ Brands continues its work to stabilize its international businesses and, along with its franchisees, is focused on driving traffic through value offerings, product innovation, and making the brands more easily accessible through digital technologies.

Dunkin’ Donuts International is encouraged by the early results of its new restaurant design, which positions the brand as a coffee-focused chain. With 40 of the newly-designed international restaurants located in eight different markets, the stores are experiencing an increase in overall average weekly sales and, importantly, an increase in beverage units.

Baskin-Robbins International is focused on ice cream gallon consumption across the business: through stores, delivery, and consumer packaged goods. Sales outside of the restaurants have expanded the brand’s touchpoints, making Baskin’ more accessible and driving incremental ice cream sales throughout the year.

Delivery continues to be an opportunity for both brands, and the Company is working with its partners to roll out delivery programs in as many markets as possible based on the success that its Middle East and Asia franchisees are experiencing.

UNIT LEVEL ECONOMICS:

The Company plan is to double DD US stores to about 19,000. The plan envisions growth in store count to expand westward from its most mature region in the Northeast states (the core region) where its penetration is about 1 store per 8,600 residents through successively less penetrated regions to the Western region where penetration is just 1 store per 282,100 residents. To achieve its ambitions, it expects it can grow its footprint in every region, with the least in its core region (to 1:8, 100) and the most in the Western region (to 1:23,800).

DD domestic PODs range in size from 1,200 square feet to 2,600 square feet (source: 2017 FDD), from which is listed estimate average unit volumes of $930K, or about $547/sq.ft. assuming 1.7K sq.ft. average size.

In the 17Q3 Earnings Conference Call (most recent information) management reported the average capex for the domestic DD stand-alone traditional stores opened in 2015 in the least penetrated (and key to the growth strategy) “West and Emerging” markets (essentially the Midwest) was $500K and first year AUV’s and cash on cash returns were $900K and 20%, respectively; implying a cash contribution margin of about 11.1% of sales. While these returns are a slight improvement over the units opened in prior years, they are not compelling, before regional G&A. Perhaps they will grow to more attractive levels as the stores mature, but they may also explain the slowing pace of franchise investment in the past two years. Perhaps franchisees are awaiting the introduction of a new store prototype – NextGen. It said that a large number of stores are reaching their 10-year mark which will require remodeling under the franchise agreement. It also stated it was examining ways to help franchisees allocate capital between new stores, remodeling and the investments in new digital initiatives. In this regard, the Company appears to be contemplating co-investing with franchisees of both brands to accelerate development; but had not announced any initiatives yet.

Baskin Robbins domestic units range in size from 600-1,200 square feet, from which they estimate AUV’s of $235K or about $260/sq.ft., assuming 900 sq.ft. average size according to the 2015 FDD. BR units opened in the last 18 months generated AUV’s of $385K, the cash outlays for the units ranged from $200-$225K and the cash on cash returns ranged from 20-25%. At the midpoint the implied store level EBITDA margin was about 13% of sales. These margins are only slightly more attractive than DD U.S., but the Company has not provided more current returns as it has with DD U.S. BR does not appear in any FDD after 2015 except as a combo unit with Dunkin’ Donuts.

SHAREHOLDERS’ RETURN (Source – 2017 10K):

During fiscal year 2017, the Company repurchased a total of 513,880 shares of common stock in the open market at a weighted average cost per share of $52.90 from existing stockholders. The current dividend affords shareholders a current yield of 2.31%.

On October 25, 2017, the board of directors authorized a new share repurchase program for up to an aggregate of $650 million of its outstanding common stock. This repurchase authorization is valid for a period of two years and replaces the Company’s existing share repurchase program.

In February 2018, the Company entered into two accelerated share-repurchase agreements (the “February 2018 ASR Agreements”) with two third-party financial institutions. Pursuant to the terms of the February 2018 ASR Agreements, the Company paid the financial institutions $650.0 million from cash on hand and received an initial delivery of 8,478,722 shares of the Company’s common stock on February 16, 2018, representing an estimate of 80% of the total shares expected to be delivered under the February 2018 ASR Agreements. Subsequent to these repurchases, after buying back about 9.5% of the prior shares outstanding, debt will be approximately 5.5x which will be at the top of the range where management is comfortable.

RECENT DEVELOPMENTS (Per Q4’17 Release and 2/6/18 Conference Call)

The comments below should be read in conjunction with the update from the 2/8 Analyst Day as described above.

Q4 highlights included Dunkin’ US comps of 0.8%, BR comps of 5.1%, 141 net new restaurants added worldwide, including 126 net dew DD stores in the U.S. Total revenues were up 5.3%, or 9.8% on a comparable 13 week basis, while diluted adjusted EPS was unchanged at $0.64. It should be noted that adjusted operating income was up 3.6% in Q4, up 7.0% for the full year, with adjusted EPS up 7.5% for ‘17.  The company emphasized that morning comp store sales at DD were up each quarter sequentially, and the fourth quarter was driven by iced coffee and frozen Dunkin’ Coffee. Customer counts improved in the last three quarters of the year, presumably still negative in Q4. More than two million people were added to the loyalty Perks program during 2017, bringing the total to about 8 million. A simplified menu was rolled out late in 2017, to be completed in Q1’18.  Baskin-Robbins had comp sales of 5.1% in Q4, driven by a higher average ticket, offset by a slight decrease in traffic.  The G&A expense target was reduced in two percent in January, which will be a 5% reduction from the ’17 level.

At DD, Q4 saw record breaking sales of breakfast sandwiches, for the fifth straight quarter. However, transaction counts declined in the pm daypart, accounting for over 75% of the full day declines. It is hoped that the simplified menu will reverse this decline. New enhancements of the digital platform and mobile app have been introduced in January. During Q4 the total of CPG products grew by over 30%. CPG products, across both brands, generated $850 million of retail sales, including $150M in ready-to-drink sales for the year. In addition to the 126 net new DD stores in Q4 (vs. 190 LY), 88 remodels were done in the quarter. For the full year, 313 net new DD restaurants were added, versus 397 LY. BR had 22 net new openings for the year, a record since going public in 2011. DD International was “stable”, with comps up 1.6% in Q4. BR International was relatively strong in Q4 with a 3% comp.

Management discussed that franchisees were continuing to respond favorably to the term renewal program offered in 2017, allowing renewal back to 20 years. At 12/31, about 75% of all Dunkin’ restaurants in the US had more than 10 years remaining.

Meaningfully, Management reiterated their previous indication that 2018 will be a year of “foundation setting, simplifying our menu and improving the restaurant experience, rolling out a superior restaurant back office system and building back up our innovation pipeline”.  This means: reduced operating margins this year (our interpretation), which will be at least partially offset by fewer shares outstanding.

 

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