2 Reasons Why Dunkin’ Brands Group Is Misunderstood

This company looks like just a doughnut shop, but it's really much more.

Jul 2, 2014 at 1:09PM

If you say the words Dunkin' Donuts to most people east of the Mississippi, they immediately know the company. However, the parent Dunkin' Brands Group (NASDAQ:DNKN) and its doughnut chain are far less known out west. The company plans on addressing this issue by expanding the Dunkin' Donuts chain nationwide. While some investors look at Dunkin' and see potential problems, the stock represents a real opportunity for two reasons.

Are these real problems?
In an industry where companies like Starbucks (NASDAQ:SBUX) and Keurig Green Mountain (NASDAQ:GMCR) are two of its biggest competitors, Dunkin' Brands has to stay on its toes. A few years ago, investors were wondering aloud if Starbucks had seen its best days, and just last year, Keurig Green Mountain was floundering at around $20 a share.

However, each of these competitors has found its footing and then some. In the most recent quarter, Starbucks reported sales growth of 9 %. Keurig Green Mountain reported 10% sales growth and almost double-digit increases in both its brewer and portion-pack sales.

Though Dunkin' Donuts is called a doughnut chain, the company actually is known for its coffee as much as for its sweet treats. In recent years, Dunkin' has begun to offer breakfast sandwiches and wraps, as well as other snack and food items, throughout the day.

However, even these new introductions haven't been enough for the company to keep up with some of its peers. Dunkin's revenue growth in the current quarter came in at just 6 %, below that of either Starbucks or Keurig Green Mountain. On a same-store sales basis, Dunkin' Donuts' comps increased by just 1.2% in the domestic market and actually dropped more than 2% internationally.

Since Starbucks managed to post 6% same-store sales growth both domestically and abroad, investors in Dunkin' have a right to worry about problems. However, the business model of Dunkin' Brands is very different than those of its peers and that is a key to understanding how to value the stock.

Moving west
One of the key reasons to invest in any business is to make money. When it comes to making its franchisees money, Dunkin' Brands has a serious competitive advantage in its Dunkin' Donuts stores.

Since nearly 100% of Dunkin' Brands stores are franchised, the company needs strong returns to attract future franchisees. With the company concentrating on moving westward, the chart below shows a rising tide of profitability at franchisees west of the Mississippi in the last three years.

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This is the first reason why Dunkin' Brands is misunderstood. The company generates sales and earnings from its franchisees not only from the initial franchise payments, but from ongoing royalties as well. As you can see, in the last three years as the company has ramped up store openings in the west, the sales and EBITDA picture has steadily improved at the store level.

While Keurig Green Mountain and Starbucks are already selling to the majority of the U.S. population, millions west of the Mississippi don't have a Dunkin' Donuts close to them. The improvement in sales and earnings suggests that franchisees will line up to expand west.

Returns of 25%!
If most investors were offered the option to invest today and gain a 25% return in the first year, they would jump at the chance. Dunkin' Brands can make this claim to its franchisees as the company generated at least 25% cash-on-cash returns per franchised store in each of the last three years.

This is the second reason why Dunkin' Brands is misunderstood. Unlike some other companies, Dunkin' Brands attractive cash-on-cash returns allows the company to expand using almost 100% franchised stores. This heavy reliance on franchisees is the primary reason for the company's higher margins. The company doesn't have the expense of building and maintaining company owned stores like its peers.

 The company's margins are huge relative to those of its peers. Though Keurig Green Mountain sports a gross margin of 42% and that of Starbucks is even more impressive at 58 %, Dunkin' Brands takes the cake with a gross margin of more than 77%. The company generates significant free cash flow from what looks like fewer sales.

The bottom line is that although Dunkin' Brands appears to be underperforming its peers in a few areas, the company's huge returns for franchisees and significantly better margins are two solid reasons to consider buying the stock. Long-term investors who want to benefit from this sweet deal should consider adding DNKN to their personalized Watchlists today.

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Chad Henage owns shares of Dunkin' Brands Group. The Motley Fool recommends Keurig Green Mountain and Starbucks. The Motley Fool owns shares of 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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