Dunkin' Donuts Eyes Growth West Of Mississippi

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They may not brew the strongest coffee at Dunkin' Donuts. But the venerable Canton, Mass.-based chain has been churning out some pretty strong earnings reports.

And for a well-established coffee and ice cream chain with more than 17,000 stores worldwide,Dunkin' Brands ( DNKN ) has surprisingly strong growth prospects.

In the U.S., Dunkin' plans westward expansion. Meanwhile, its Baskin-Robbins ice cream chain, more of a hit overseas than domestically, is expanding eastward to South Korea, Vietnam and other Asian venues where ice cream is enjoyed outside the home.

Unlike rival Starbucks, which had to cut back on its store count several years ago due to overexpansion, Dunkin' Donuts has been expanding cautiously from its New England core. Now it stands poised to crack Western markets where it currently has minimal presence.

"It's an open template west of the Mississippi," said William Blair analyst Sharon Zackfia.

After five years under private equity ownership, Dunkin' Brands went public in July 2011. Since then, the chain has been able to report solid revenue and earnings growth based on a a mix of expansion and improving same-store sales.

Dunkin' Donuts stores, mostly in the U.S., will contribute more than $530 million in 2013 revenue, JPMorgan analysts estimate.

Ice Cream Shops

Baskin-Robbins will contribute roughly $160 million, most of it from international outlets. In the U.S., Baskin-Robbins just limps along. CEO Nigel Travis said it best when he told analysts in late January that Dunkin' now sees the Baskin-Robbins brand as a "slow growth" rather than "zero growth" business.

Dunkin' gets a cut of revenue from every cup of coffee its franchisees sell. And coffee remains the chain's best seller. But in expanding to such items as breakfast burritos, turkey sausage sandwiches, and single-serve K-cups, Dunkin' has added numerous kickers to store sales. Last year, same-store sales rose by 4.2%.

Meanwhile, Dunkin' has expanded chiefly in Midwestern and Southern markets contiguous to its core store base in New England and New York. Because nearly all Dunkin' units are franchise-owned, the company can expand without onerous capital costs.

Now, the chain hopes to deepen its footprint out west.

Longbow Research analyst Alton Stump believes Dunkin' Donuts has "a huge opportunity" west of the Mississippi. Noting that there is one Dunkin' Donuts shop for roughly 9,600 residents in core Northeast markets, Stump says the chain has just one store per 1 million residents in much of the West. Stump reasons that there is "a good chance" Dunkin' could double its U.S. store base "in less than 20 years."

Dunkin's early success in opening stores out west augurs well for the future. "First year average weekly sales are higher in Western emerging markets than in core and established markets," reported Zackfia.

With just over 7,300 U.S. stores, Dunkin' has plans for 330 to 360 openings this year. Nearly 20% will be in Western markets, says Zackfia. One expansion target is Denver. Dunkin' will enter California by 2015.

Meanwhile, aggressive national TV advertising has enhanced Dunkin's brand awareness. By the time Dunkin' opens in California, says Zackfia, consumers there will have been exposed to five years of TV ads. "Brand recognition is definitely improving," she concluded.

All this should be a kicker to a formula that has been working well in Dunkin's core markets.

Earnings have been growing steadily. Earnings per share grew in 2012 to $1.28, a 51% increase from 85 cents the prior year. Analysts tracked by Thomson Reuters forecast 2013 EPS to grow 20% and 17% in 2014.

Pretax margin grew in 2012 to 35.5% from 26.5%.

In Dunkin's spare and unpretentious shops, the coffee is not quite the same as the rich upscale brews served up at Starbucks. Dunkin's coffee is "middle of the spectrum," according to Zackfia.

But the coffee is priced below premium alternatives. And many prefer a weaker blend. "Consumers like the fact that the coffee isn't as strong as Starbucks," Stump noted.

Over the years, Dunkin' has moved beyond hot coffee and doughnuts to sell bagels and a broad array of sandwiches and sugary coffee-based novelty drinks.

"What they've been able to do is transcend the brand identity as strictly a coffee and doughnut shop," said Wedbush Securities analyst Nick Setyan. He explains how Dunkin' has held its own against rival chains: "Dunkin' Donuts has been able to position itself at a slightly lower price point with a larger mix of products."

That larger mix has been driving same-store sales gains. In the fourth quarter, Dunkin' comps rose by 3.2% in a quarter that had one less week than the prior year's. Same-store sales grew by 7.2%, 4.0% and 2.8% in the first three quarters of 2012.

Sharon Smith manages 19 stores for a multiunit Dunkin' Donut franchisee in Florida and Massachusetts. Sitting at a plain plastic table during rush hour in one of her Boston-area stores, Smith noted that the new sandwiches had extended high traffic to the afternoon and evening hours. Still, coffee sales typically account for about 70% of store revenues, Smith says.

Many analysts like Dunkin's entry into the home-brewing market with its sales of single-serve K-cups. Sales of K-Cups at her shops were very strong last year, notes Smith, but not quite so impressive early this year.

Home Brew

The availability of cheaper home brew alternatives may have also had a bit of a cannibalizing effect. "There are regular customers we're not seeing three times a day, seven days a week. Now we see them once a day four times a week," she said.

That's still pretty good attendance. More worrisome is the threat of a reversal in low interest rates.

Like many firms with a private equity past, Dunkin' is loaded up with debt. "It's one of the more levered balance sheets," noted Stump. To date, the Fed's stubborn insistence on rock-bottom rates has been a boon to heavy borrowers. Should rates reverse, Dunkin's floating rate interest payments will rise. "Yes, there's definitely interest rate risk,' allowed Stump.

But it's probably manageable. For one thing, its business model of franchisee ownership limits capital costs. And if interest rates rise because of improved economic activity, the hit of higher payments should be offset by higher sales

With is loyal customer base in core markets, Dunkin' has a reliable base on which to grow, and because franchisees pay the freight in expansion, its risk in expansion is basically the risk to its growth profile, not its core financials..

But Dunkin' needs successful expansion to sustain that growth profile. "They seem to be cognizant of the fact that there's not a whole lot of room to grow in core markets," said Stump.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Investing Ideas

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