3 Cornerstones of Dunkin' Brands' 2014 Game Plan

A look at three themes emerging in 2014 from Dunkin' Brands' business model.

Apr 8, 2014 at 8:15PM

As its peers engage in pitched battles over breakfast and coffee, Dunkin' Brands Group (NASDAQ:DNKN) has been keeping its head down while quietly implementing its game plan. One quarter into 2014, three major themes stand out as being pertinent to the company's success during this fiscal year and beyond.

Let's review these cornerstones to get a sense of Dunkin's near-term prospects.

Let's face it: U.S. expansion is still dominated by the East 
Dunkin' Brands' western U.S. strategy was received warmly by investors last year, as management penciled in a long-term goal of opening 1,000 units in California, and slating expansion for states such as Texas, Nevada, and Utah. But while the thousand California locations sounds like huge growth, it's actually only equivalent to 13% of the current Dunkin' Donuts U.S. base. Dunkin' Brands CFO Paul Carbone put the numbers in perspective during the company's most recent earnings call:

I think it is important to note that we believe we still have a 3,000 store opportunity east of the Mississippi River. There's a tendency for all of us to jump to California when we discuss our long term store expansion plans. It will be many years before California and the west in total makes up a significant portion of our annual development. 

Carbone went on to note that there are still significant opportunities in major eastern cities like New York. As a system that originated and grew up in New England, Dunkin' Brand's most experienced franchisees, and a good part of its supply chain, are naturally located "east of the Mississippi." The supply chain is characterized by the presence of "centralized manufacturing locations," or CMLs: franchisee-owned and operated baking facilities that supply baked goods to the majority of Dunkin' Donuts locations.

Often, franchisees will pool resources to invest in high-capacity CMLs. In turn, the larger CMLs can support further store expansion in a metropolitan area. Crain's Chicago Business recently profiled Unified CML, LLC, a Chicago-area facility that is the largest doughnut factory for Dunkin' Brands, turning out an incredible 90 million doughnuts per year.

While CMLs will develop in tandem with restaurants in the West, the company's robust supply structure in the eastern half of the U.S. points to continued franchisee development closer to its home base, and in the near future revenue expansion will remain heavily dependent on this part of the map.

Setting an effective criterion for global expansion


Dunkin' Donuts at Berlin Hauptbahnhof, courtesy xvla under Creative Commons License.

Many consumer goods multinationals appear to view emerging markets as their single best opportunity for future revenue growth. Yum! Brands is probably the poster child for this thinking, as it has invested enormous resources in China in the last few years, to the point where China now accounts for 53% of Yum!'s revenue. Dunkin' Brands has a more nuanced view of global expansion. The company is homing in on countries that exhibit a high Gross Domestic Product, or GDP, a criterion which may or may not include emerging-market economies. Management reasons that high GDP countries provide more opportunities for greater weekly revenue for Dunkin's locations.

While this may seem at first blush like common sense, these calculations aren't so simple. Positioning company resources in emerging markets due to predicted growth usually means taking risks now and making investments that will flourish over a multiyear time horizon. Dunkin' doesn't really have the luxury of waiting for markets to mature, as franchisees own most of the brand's existing locations (as we'll discuss below).

Thus, restaurants have to show returns almost immediately to justify franchisee investment. Within major cities of high-GDP countries, you can usually find the necessary density of traffic and a population with enough disposable income to sustain individual franchisee locations soon after opening. This has made the company as open to growing in Europe as in China, which is both an emerging market and a high-GDP country. Dunkin' Brands management has in fact recently cited the extremely developed, stable, and lower-growth economy of Germany as a preferred expansion market.

Maintaining franchisees' high return on investment
At the end of the 2013 fiscal year, Dunkin' Brands claimed 18,122 "points of distribution," i.e., locations that offered Dunkin' Donuts or Baskin-Robbins ice cream products for sale. Out of these locations, the company itself owned and operated only 36, meaning that 99.98% of Dunkin' Brands' retail revenue is in the hands of franchisees.

In this structure, franchisors like Dunkin' Brands trade the revenue of operating their own stores for the profits associated with low overhead and a steady stream of franchise fees. This structure works as long as franchisees continue to show high returns on investment on individual stores. Dunkin' Brands likes to point out that its franchisees enjoy a 25% "cash-on-cash" return on operating the typical Dunkin' Donuts location. A cash-on-cash return is the return before tax an owner can expect on operations, after debt service has been subtracted from cash flow. 

One area of visible support for franchisee returns has been the introduction of new cafe restaurant formats, which encourage longer visits from customers outside of  Dunkin' Donuts' traditional breakfast-hours stronghold. In conjunction with menu innovation in the form of non-breakfast sandwiches, the corporation seeks to add incremental revenue for franchisees, and it plans to continually innovate within its sandwich menu to add to this effect.

Yet the nearly 100% franchisee model presents some risk as well. Should the economics of running Dunkin' franchises change, the company may find itself with limited levers to control its profitability. For example, Dunkin's U.S. locations are primarily coffee shops, with 57% of total revenues deriving from coffee and other beverages. What if Dunkin' Donuts loses some of its coffee cachet to an ever-competitive Starbucks or a newly coffee-focused McDonald's? It follows that franchisee revenues and margins would suffer, and in turn, Dunkin's main source of revenue -- royalty income -- would decline.

This risk is somewhat mitigated by the collective strength of Dunkin's franchisees, which benefit from economies of scale through the CMLs discussed above, but also through a franchisee-owned purchasing cooperative, National DCP, LLC, or NDCP. This member cooperative is an integral part of Dunkin' Brands' supply chain. By pooling purchasing power, franchisees can gain some control over costs. As far as the all-important revenue stream of coffee is concerned, NDCP purchases 90 million pounds of coffee each year. That's one pound of coffee for each doughnut that the Chicago area CML mentioned above bakes each year!

In the end, an effective game plan
In constructing its profit and loss formula, Dunkin' Brands employs tactics that diverge slightly from those of its peers but that seem to work given its own unique characteristics. Eastern expansion supported by a franchisee-owned supply chain, logical global growth, and a push to expand dayparts to juice franchisee returns should all contribute toward sustaining the company's recent high-single-digit annual revenue growth and 20%-plus quarterly profit margins.

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Asit Sharma has no position in any stocks mentioned. The Motley Fool recommends and owns shares of McDonald's and Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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