Dunkin’ Brands (DNKN): A 100% Franchised Business Built on a “Morning Ritual”
Guest Write-up by Jayden Preston
Overview
Dunkin’ Brands owns two well-known quick service restaurant (QSR) brands, i.e. Dunkin’ Donuts that sell coffee and baked goods, and Baskin Robbins, selling hard serve ice cream. Dunkin’ Brands is now purely a brand owner, as they currently employ a 100% franchised business model, with over 20,000 points of distribution in more than 60 countries worldwide.
They organize their business into four segments: Dunkin’ Donuts U.S. (DDUS), Dunkin’ Donuts International (DDI), Baskin-Robbins International (BRI) and Baskin-Robbins U.S. (BRUS)
Dunkin’ Donuts is the more important brand to the business. Despite the term “Donuts”, it has moved away from its root to become a major coffee beverage house in the US. It is a national QSR leader in serving coffee, selling more than 1.9 billion cups of hot and iced coffee and espresso-based beverages per year. For 11 straight years, Dunkin’ Donuts has been named the top brand for customer loyalty in the out-of-home coffee category in the US. In FY2016, systemwide sales of DDUS was $8.6 billion, with 58% coming from coffee and other beverages. The brand is even considering shortening its name to Dunkin’. For Dunkin’ Brands, their Dunkin’ Donuts segments generated revenues of $630.9 million, or 79% of total segment revenues in FY2016. Dunkin’ Donut’s brand equity is much stronger in the US, generating $608.0 million in revenue, while the international segment only had $22.9 million in revenue.
The situation reverses for Baskin-Robbins. Its international segment generated revenues of $119.0 million, while the US segment produced $47.5 million. The brand develops and sells a range of frozen ice cream treats such as cones, cakes, sundaes, and frozen beverages. The brand is highly recognizable in the US, where it enjoys 89% aided brand awareness in the US and internationally in South Korea, Japan and the Middle East.
As of December 31, 2016, there were 12,258 Dunkin’ Donuts points of distribution, of which 8,828 were in the U.S. and 3,430 were international, and 7,822 Baskin-Robbins points of distribution, of which 5,284 were international and 2,538 were in the U.S.
Franchising Agreements
Let’s talk first about their franchising agreements.
A franchisor usually has several means to make their franchisees “captive”: 1) Royalties as a percentage of gross sales, 2) Rental payments on properties, 3) Required purchases from a company-owned supply chain and 4) Marketing fund pay-ins.
As with many franchisors, the majority of the Dunkin’ Brand’s revenue comes from royalty income, usually set as a percentage of gross sales made by franchisees, and other franchisee fees, including initial franchisee fee in the US. This is an upfront payment for the right to operate one or more franchised brands from Dunkin’ Brands.
The effective royalty rates for the different segments are 5.5% (DDUS), 4.8% (BRUS), 2.4% (DDI) and 0.5% (BRI). The much lower royalty rates for BRI reflects a difference in business model for that segment. Dunkin’ Brands derives revenue from the sale of ice cream products to BRI, instead of charging a more normal royalty rate. Sale of ice cream products to franchisees were 14% of revenue in FY2016. In fact, many other franchisors derive income by serving as the supplier to their franchisees. Dunkin’ Brands, however, does not follow this same policy for their Dunkin’ Donuts business nor BRUS.
Dunkin’ Brands also generates income from rental payments by subleasing properties to franchisees. Unlike some restaurant operators, Dunkin’ Brands own a very small number of properties themselves. As of December 31, 2016, they owned 96 properties only, and leased 963 locations across the US and Canada. They then sublease those locations to franchisees. In FY2016, rental fees from franchisees were 12% of their total revenue. The remaining balance of restaurants, i.e. the majority of the stores, selling their products are either owned or leased directly by their franchisees.
Franchisees in the US also pay advertising fees to the brand-specific advertising funds administered by Dunkin’ Brands. They generally contribute 5% of gross sales on a weekly basis. The advertising funds cover all expenses related to marketing, research and development, innovation, advertising and promotion, including market research, production, advertising costs, public relations and sales promotion.
All in all, Dunkin’ Brands has four major revenue streams: 1) royalty income and fees associated with franchised restaurants; 2) rental income from restaurant properties they lease or sublease to franchisees; 3) sales 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.
Durability and Moat
Dunkin’ Brand’s business is very durable, with a strong moat.
Both Dunkin’ Donuts and Baskin Robbins sell products, i.e. coffee, donuts and ice cream, with highly predictable demand. Both of them also have a history going back decades. In other words, both of the brands have high visibility to most people in their key markets. With thousands of stores, there is also enough scale for each of the brand to experiment and respond to changes in market trend.
The durability of Dunkin’ Donuts is especially strong. As mentioned, Dunkin’ Donuts is more of a coffee chain than a donut one. More importantly, Dunkin’ Donuts sell relatively cheap cups of coffee that also have mass appeal. And coffee is addictive. More precisely, coffee drinking is basically a morning ritual to a lot of people. Most stores of Dunkin’ Donuts either open 24 hours a day or very early in the morning. And mornings are key to Dunkin’ Donuts’ business. People who built the habit to grab a cup of coffee alongside other bakery from Dunkin’ Donuts before school or work generates very reliable business for the brand. In fact, more than 60% of transactions happen between 4am and 11am for DDUS. The strength in DDUS is reflected when you compare the same store sales performance between them and BRUS. From 2008 to 2010, the comparable store sales of BRUS were -2.2%, -6% and -5.2% respectively. Throughout the same period, DDUS, however, had stronger comparable store sales of -0.8%, -1.3% and 2.3% respectively.
The habitual purchases from core customers suggests ultra-high retention rate for DDUS. Coupled that with the convenience and brand awareness a large existing number of stores provide, it is nearly impossible for a competitor to drive Dunkin’ Brands out of business.
Quality
Being a franchisor suggests the business quality of Dunkin’ Brands is also abnormally high. By way of example, Dunkin’ Brands receives weekly royalty payment on gross sales of franchisees. As such, their earnings are less susceptible to cost changes. And since they receive payments on a weekly basis, there is little cash flow concern for the business.
But Dunkin’ Brands is even more cash flow optimized than many other quick service restaurants. This is due to their history of being owned by private equity firms.
Back in December 2005, Pernod Ricard, then owner of Dunkin’ Brands, sold the business to a consortium of buyers made up of Bain Capital, The Carlyle Group and Thomas H. Lee Partners for a purchase price of $2.425 billion. Dunkin’ Brands was subsequently listed in July 2011, with the investment group selling out their remaining shares in the company the following year. All in all, it was a successful investment, with the investor group earning an estimated $1.8 billion in profits. Like all other private equity case studies, the company was optimized to produce more cash flow to handle the debt load. For instance, during private equity ownership, EBITDA increased 71%, with margins expanding more than 8 percentage points. Moreover, even after the company became public, the debt load is still managed in the way a private equity owner would: 1) The debt level is kept at a high level, between 4x to 6x Net Debt/EBITDA; 2) Once the company has paid down the debt level to around 4x, they would re-leverage the company closer to 6x to initiate a bigger than usual stock buyback. This is exactly what they did around two months ago (in late October 2017). With their net debt to adjusted EBITDA at 4.4x by September 30, 2017, they completed a recapitalization transaction that pushes their total debt from $2.41 billion to close to $3.06 billion. Should they use all the additional debt to buy back shares or return to shareholders as a special dividend, their net debt to adjusted EBITDA would increase to 5.7x.
Under the above context, it should be easier to appreciate the more extreme cash flow optimization in Dunkin’ Brands, as opposed to other quick service restaurants franchisors like Tim Hortons (before they got bought out by 3G Capital), Starbucks and so on.
The key difference is Dunkin’ Brands’ franchisees provide nearly all of the capital for growth of the brand, both in terms of capital expenditure to expand the store base and marketing costs to promote the brand. Unlike peers such as Tim Hortons and Starbucks, Dunkin’ Brands takes very little ownership of the properties their restaurants are located. This means Dunkin’ Brands could pay out a higher percentage of their earnings to shareholders or debt holders each year while still achieving growth in the business.
While it’s straightforward to see the merits of being a franchisor, this in no way suggests that we can neglect the franchisees of Dunkin’ Brands. A franchise agreement is like marriage. In order for it to last, both parties have to be happy over the long run. For franchisees of Dunkin’ Brands, they have mostly been happy due to great unit economics. For instance, the average initial capex was $500,000 for a new Dunkin’ Donut store in the West and Emerging Region of the US. Average unit volume was $900,000. And the cash on cash return was around 20%. Such attractive returns have contributed to stable and increasing net development in the US for Dunkin’ Donuts, increasing from 291 net units in 2012 to 415 in 2016.
In fact, profitability for franchisees is such a crucial element that it was a major focus for the private equity firms. The following is what Carlyle highlights in their case study of their investment in Dunkin’ Brands (emphasis is mine):
“Executing on a Disciplined Growth Strategy
Before addressing opportunities in the fastest-growing international markets, Dunkin’ focused first on expanding into existing and contiguous U.S. markets. The company opened 2,125 new domestic Dunkin’ Donuts stores, many of which were in new markets, validating the opportunity for Dunkin’ outside its core geographies. With strategic assistance from Carlyle, Bain Capital, Thomas H. Lee and through Carlyle’s global network, Dunkin’ expanded both of its brands in key, fast-growing regions, resulting in 2,800 net new openings in markets such as China, India and Latin America. Key to this growth was strengthening the store-level unit economics for franchisees. The team executed several initiatives to optimize franchisee returns on new store development, including lowering food costs by streamlining the menu and migrating to standardized builds. From 2008 through mid-2012, store build-out costs were lowered by ~24% and supply chain costs were reduced by ~$245 million from strategic sourcing and operational efficiencies. In addition, the team focused on driving increased coffee and beverage sales and improving repeat customer traffic. Stronger franchisee demand allowed for robust new store growth, which continued past Carlyle’s ownership.”
Unit economics for BRUS was last given in their 2015 Investor Day. While unit productivity of BRUS is much lower than DDUS (around $365k vs $900k), the build-out costs is also significantly lower ($220k vs $460k). Cash-on-cash return for BRUS was at 20% to 25%.
Growth
DDUS is the strongest segment for Dunkin’ Brands. Not only is this segment currently generating the most revenue and profits, it’s likely to remain so in the future.
The brand awareness and the market share the brand already commands together render the growth potential in the US easiest to achieve. With around 9,000 stores in the US, management has guided for eventually doubling that number of stores. (Starbucks already have close to 14,000 stores in the US) At the moment, close to 80% of their stores cluster in the North-Eastern part of the States. Meanwhile, they have less than 500 stores in the West. In terms of penetration, there is one store for every 8,600 people in their core market, i.e. New England. In contrary, the penetration is only 1:270,400 in all of the West. The potential to fill up the West with more Dunkin’ Donuts is thus immense. At the current rate of 400+ net development per annum, this would take them roughly 20 years to saturate the US market. Doubling in 20 years equals a store count increase of 3.5% p.a.
The future is much less visible for Dunkin’ Donuts overseas. Internationally, there are more than 3,400 Dunkin’ Donuts in 34 countries, with most restaurants in Asia and Middle East. While it’s easy to project international success of American brands, such as McDonald’s, to a popular brand like Dunkin’ Donuts, the truth is it’s difficult to channel the popularity of a food brand from one country to another. This could be a cultural issue, where the food in consideration is simply not appreciated in an oversea market. You can never directly copy your American success recipe to another country without close historical linkage. Modification needs to be made. However, if the needed change runs afoul of what your core products naturally represent, localization would be difficult to make. For instance, Dunkin’ Donuts had multiple failed attempts at cracking the world’s most populous market, China. One major problem they kept encountering is that Chinese are averse to breakfast sweets. It certainly wasn’t a lack of time or trying, since Dunkin’ first attempted a break into China in 1994.
Difficulty in finding the right local partner is the other major reason. Most franchisor employs a master franchisee model for their international market to rely on their partner(s) with local expertise for all of that particular market. As your brand is being built up, execution is key. And execution will always be the responsibility of your local partner, especially when your whole business model relies on franchising even at your home country. And it could be difficult to find the right partner. Again, looking at China, Dunkin’s second attempt in 2008 was supposed to be a more calculated one. Yet, it is arguable that it was worse. And Dunkin’ had to switch the franchisee a few years later.
In their current third attempt, now partnering with Philippine food service group Jollibee Foods and Hong Kong-based investment firm RRJ Capital, they are trying to shape Dunkin’ Donuts more of a coffee-shop feel and less of a doughnut chain. In the signed Master Franchise Agreement with those partners, they are hoping to open at least 1,459 Dunkin’ Donuts in various China territories over a 20-year period. How realistic is this goal? Starbucks already has more than 3,000 stores in China. They also plan to add another 2,000 by 2021. As such, the number of store itself is not outrageous at all. The big unknown is whether they can finally make Dunkin’ Donut a desirable brand in China that resonates with local customers.
Selling ice cream is in no way a bad business (average profit margin is actually pretty high for the product category), but Baskin-Robbins is clearly the inferior business among the two. It is probably more difficult to create sticky customers by building up habitual purchases for ice cream when compared to coffee. Despite being the number one hard-serve ice cream player in the US, the brand hasn’t exactly fared too well in the last decade. In fact, from 2006 to 2013, there had been net store closure in the US. Two main reasons include a general decline in American ice cream consumption and the growing popularity of substitutes in frozen yogurt and gelato, or more premium offerings. Starbucks has famously grown to its current gigantic size in spite of declining coffee consumption in the US. However, they have been able to do so by consolidating the market. Baskin-Robbins clearly has had difficulty in achieving that in the US. Furthermore, another contributing factor might be historically management has focused more resources on Dunkin’ Donuts.
Baskin-Robbins is a stronger brand internationally, especially in South Korea, Japan and the Middle East, where more than 3,300 stores exist. But even in a stronger market like Japan, they are experiencing some challenges. In FY2015, they wrote off $54.3 million in the value of their investment their Japan JV as a result of “continued declines in operating performance of the joint venture and reduced future expectations of Baskin-Robbins business in Japan. As such, despite stronger brand presence for BR internationally, an estimation for its future can only be a less confident one than that for DDUS.
Let’s take a look at the company’s own mid-term 5-year plan back in 2015. The net unit development target was 4% to 6% per year. And the longer target was to increase overall points of distribution to above 30,000 globally. Over the past 5 years, net new outlets per year across both brands overseas averaged around 300. With 8,600 stores internationally (ex US), that is 3.5% annually. On a per brand basis, it is 3.6% for DDI and 4.8% for BRI.
All in all, our conservative estimations for unit growth for each segment might look like this: 3.5% for DDUS, 2% for DDI, 0% for BRUS and 2.5% for BRI.
Valuation
We will value each revenue stream separately and then deduct the present value of headquarter expense. I am assuming general inflation rate of 2% for all segments below.
From FY2014 to FY2016, the segment profit margin for DDUS averaged 74.4%. The latest figure is 76.8%. It is believable that it will stay at this higher level now that they have sold all their own restaurants. Using the latest segment profit as a proxy for the earning power of DDUS, the figure is $467 million. As discussed, this is Dunkin’ Brands’ strongest segment. With an expected unit growth of 3.5% and simple inflation growth for each unit, this segment is clearly worth a multiple of 30x net earnings or free cash flow. Now, the massive tax reform has passed into law, we will use the new 21% as the tax rate going forward. At 21% tax rate, this should equate an EV/EBIT multiple of 23.7x. At 35%, it’s closer to 19.5x. Our estimated valuation for DDUS is $11 billion.
For DDI, segment profit margin averaged 45%, with average segment profits of $9.8 million. There is clearly potential for faster unit growth in the future for DDI, should their JV partners finally be able to crack the China market for instance. Yet the opportunity also lies in ramping up productivity of stores. But we will ignore both possibilities and just look at the 2% unit growth with inflation growth per unit. In this case, a multiple of 20x to 25x free cash flow would be reasonable. With a blended tax rate of around 25%, this equates an EV/EBIT multiple of 15x to 18.75x. The range of valuation for DDI is therefore $147 million to $184 million.
BRUS has been doing better, with comparable store sales stabilizing and net new stores have been slowly added in the past few years. But to be conservative, we will assume no new stores can be added. We will further assume each existing store can keep up with inflation. An income stream that can grow with inflation with no reinvestment needs is probably worth 10x to 15x free cash flow. At 21% tax rate, that is 7.9x EV/EBIT to 11.85x EV/EBIT. With 3-year average segment profit at $30.6 million, the range of valuation for BRUS is $240 million to $360 million.
Finally, for BRI, the 3-year average segment profit is $38 million. Unlike the other segments, it derives most of its revenue from sales of ice cream. There is some fluctuations from commodity cost changes, but all cost changes should, on average, be passed on to franchisees over the long run. The Baskin-Robbins manufacturing network is comprised of 14 facilities. But none of them are owned or operated by Dunkin’ Brands. Basically, they simply utilize facilities owned by Dean Foods to produce ice cream products which they then purchase and distribute to many of their international markets. Others are all supported by other third-party producers or producers owned by the franchisees themselves. In other words, this business model doesn’t seem meaningfully inferior than a pure royalty income approach. With 2.5% expected store count growth, alongside inflation growth for each unit, this income stream should be worth around 25x free cash flow. At 25% tax rate, this equates an EV/EBIT multiple of 18.75x. As an upshot, our valuation estimate for this segment is $712.5 million.
Headquarter expenses or what they refer to as corporate charges averaged $136.7 million during the same period. As a percentage of total segment profits, it has been declining in the past 3 to 4 fiscal years. If we use the average percentage and apply that to the latest total segment profits, we get a figure of $147 million. To be conservative, we will use this figure alongside the multiple for DDUS. As such, corporate charges has a present value of $3.5 billion.
All in all, our enterprise value estimates for Dunkin’ Brands as a whole is $8.6 billion to $8.76 billion. As Dunkin’ Brands has yet to employ the additional cash raised from the refinancing for share buybacks, the company currently still has net debt of $2.15 billion. (They only announced they would repay $733 million of their existing debt. But the remaining $677 million has not been paid to shareholders yet.) This gives us a market capitalization estimates of $6.45 billion to $6.61 billion.
As of November 3, 2017, 90.32 million shares were outstanding. The range of share price for Dunkin’ Brands is therefore $71.4 to $73.2.
Misjudgment
Given their weaker positioning, the biggest misjudgment clearly lies in the two weaker segments of Dunkin’ Brands, i.e. DDI and BRUS. While we are not looking at meaningful unit growth for either of them, we are assuming they can at least keep up with inflation. This means we are not taking the possibility that they could decline into consideration. Nevertheless, this potential error is likely more than offset by the possibility that they, especially DDI, could fare better in the future. More important, their current contribution to our valuation estimation for Dunkin’ Brands as a whole is not very meaningful. Even both of them go to zero will not affect the intrinsic value of Dunkin’ Brand in a significant way.
Dunkin’ Brand’s debt might be a concern on face value. Yet, its debt is very attractive borrowings. It is mostly long term with fixed rates at 3% to 4%. Even with gross debt level at $3.1 billion, the interest expense will “only” be $93 million to $124 million. With DDUS alone generating $467 million in segment profits, and corporate charges at $147 million, there is a stable pretax cash flow of $320 million that can service the debt. An interest expense coverage of more than 2.5x should offer adequate safety.
Conclusion
Dunkin’ Donuts US is a super high-quality business. Being the franchisor of this business basically endows you a very durable income stream derived from habitual purchases. There is also still reasonable room to double store counts of DDUS. With DDUS generating most of its revenue and segment profits, Dunkin’ Brands is clearly a high quality, predictable business worth monitoring. Should the share price drop to below $46, the stock would be a no-brainer investment.
The stock closed today at $64.39 a share. So, a price decline of 36% from here would make DNKN a no-brainer investment.
Other Materials
https://www.bizjournals.com/boston/stories/2007/12/03/daily9.html
https://www.fool.com/investing/small-cap/2011/07/13/is-dunkin-brands-ipo-a-slam-dunk.aspx
https://ddifo.org/as-private-equity-cashes-out-whats-next-for-dnkn/