Dunkin' Brands Group Inc (DNKN)
Q3 2020 Earnings Call
Oct 29, 2020, 7:00 a.m. ET
- Prepared Remarks
- Questions and Answers
- Call Participants
Ladies and gentlemen, thank you for standing by, and welcome to the Dunkin' Brands Third Quarter 2020 Earnings Conference Call. [Operator Instructions]
I would now like to hand the conference over to your speaker today to Stacey Caravella, Senior Director of Investor Relations. Thank you. Please go ahead.
Stacey Caravella -- Senior Director, Investor Relations
Thank you, operator, and good morning, everyone. Speaking on today's call will be Dunkin' Brands Chief Executive Officer, Dave Hoffmann; President of Dunkin' Americas, Scott Murphy; and Dunkin' Brands Chief Financial Officer, Kate Jaspon. Today's call is being webcast live and recorded for replay. Before I turn the call over to Dave, I'd like to remind everyone that the language on forward-looking statements included in our earnings release also applies to our comments made during the call. Our release can be found on our website, investor.dunkinbrands.com, along with any reconciliation of non-GAAP financial measures mentioned on the call with their corresponding GAAP measures.
Before I turn the call over to Dave, I'd like to note that we will not be conducting a Q&A session today. Now to Dave.
David Hoffmann -- Chief Executive Officer
Thanks, Stacey, and thanks, everyone, for joining today. Before we get to Q3 results, as we stated in our press release on October 25, we have held preliminary discussions to be acquired by Inspire Brands. There is no certainty that any agreement will be reached. However, given the ongoing discussions, the Board of Directors has taken no action with respect to a cash dividend. We will not comment further on the discussions unless and until a transaction is agreed to or discussions are terminated. All right. Now on to our third quarter results. The world has faced challenges in 2020, that collectively we could never have imagined. And our thoughts and prayers are with all of those who have been impacted by this global pandemic and global unrest. The pandemic has also challenged the U.S. economy, in particular, small businesses, including restaurants. However, through tight alignment with our franchisees and licensees, we quickly adapted our brands to anticipate the changing consumer landscape and achieved low single-digit growth across key financial metrics of revenue and operating income.
Importantly, we had positive same-store sales in the U.S. for both Dunkin' and Baskin-Robbins. For Dunkin' U.S., the segment responsible for more than 80% of our operating income, our third quarter performance is a result of the initiatives we have put in place over the past two years under our strategic plan, the Blueprint for Growth. Speed and convenience have long been the hallmarks of our brand and 'great coffee fast' is our guest promise. But under our blueprint, we have been working to make Dunkin' faster and even more convenient for our guests. Dunkin' U.S. is a high frequency, low-touch affordable ticket business and that plays well in any environment, including today's. Over the past few years, we've made smart strategic investments, both direct and indirect into the Dunkin' U.S. business. The first was menu simplification. While this resulted in some near-term reduction to same-store sales at the outset, we knew it was the right thing to do to enable strategic product innovation and future sales growth.
Next, we co-invested along with our franchisees and new espresso equipment and drive-thru tools focused on speed and capacity. And finally, we made the investment to bring our digital app in-house as well. Let me describe how each of these strategic moves delivered returns during COVID. First, in regard to menu innovation. America's morning ritual has been upended with customers working and children attending school from home. As a result, they began visiting Dunkin' later in the day and we needed to respond with food and beverages that were suited for morning and afternoon day parts. Because we simplified our menu, we created room for growth for all day product innovation. We were able to quickly expand our menu with easy to execute handheld snacking items such as Bagel Minis that complement premium beverages like our Signature Lattes. For more than a year now, our franchisees and crew have been delivering a premium espresso experience to our guests, enabled by our new espresso equipment. And these products -- these are products that you can't -- be easily made and replicated at home as well. And without this, I can tell you, we wouldn't have had the permission to stretch in Macchiatos to Matcha to Oatmilk Lattes as well.
Next, we focused on improving the guest expectation through a better digital experience. As I said earlier, speed and convenience are core to Dunkin', and digital is a key enabler of both. During the first quarter, we completed the lift and shift to bring in-house the intellectual property running our Dunkin' app. This gave us the ability to make 2.5 times the number of updates than we previously would have been able to. These enhancements have clearly resonated with guests as we surpassed 21% of sales through our digital assets in the third quarter. Value has also taken on greater importance for our guests during COVID. This has driven enrollment and active participation in our loyalty program. We're learning more about our guest purchasing behaviors than ever before, clearly paving the way for a loyalty transformation next year. Among our achievements this quarter, I am the proudest -- the proudest of the grit and determination displayed by our DBI family and our great, great franchisees who kept their restaurants open and safe, their crews employed and their communities running on Dunkin. They also held the line on pricing through COVID, all with the goal of doing the right thing by our guests.
And now I'll turn it over to Scott to cover the rest of Dunkin' U.S. Scott?
Scott Murphy -- President
Thanks, Dave. As Dave mentioned earlier, Dunkin' U.S. delivered positive same-store sales in the third quarter at 0.9%. Sales continued to improve sequentially each month, with July down low single digits, August turning positive and then an acceleration in September. Through the week ended October 24, same-store sales were low single digits. We came into COVID with a strong foundation, having worked our Blueprint for Growth for multiple years with our franchisees. As a reminder, our Blueprint is centered around menu evolution, digital transformation and convenience and accessibility. Let me go through each pillar of the Blueprint as it relates to our Q3 results, and I'll start with menu evolution. We transformed our innovation to market process and are taking calculated risks on products to move faster than ever before. Pink Velvet Macchiato, Matcha Lattes, Dunkin' Refreshers, Oatmilk and Chai Lattes, we are building equity with premium-priced beverages and expanding our menu sweet spot beyond hot drip coffee. And importantly, we're talking to a new consumer who visits us later in the day.
We're drawing attention to both new and existing products through nontraditional marketing. The Charli is a great example. It's simply cold brew with Caramel milk promoted by Charli D'Amelio, a 16-year-old tiktok sensation who genuinely loves Dunkin'. We took an existing product, renamed it after her and positioned it to appeal to a younger consumer. And we did this through a highly relevant social media channel, keeping Dunkin' in the forefront of the American dialogue. We also launched our fall menu products, such as our Pumpkin Spice Signature Latte and Pumpkin and Apple Cider Donuts in August, earlier than ever because we knew the guests were craving the comfort of autumn. This drove record average weekly sales for espresso and a significant increase in donut sales. Looking ahead, we'll continue to emphasize quality, customization and flavor. We're tapping into a younger consumer by leveraging our leadership in iced beverages and bringing color and texture to our lineup. We're engaging them and driving awareness and adoption across all touch points: advertising, in-store and social. We will balance our product innovation with operational simplicity, which is always a top priority.
We'll continue to roll out easy to execute snacking products like our Bagel Minis, Croissant Stuffers, and Roll-ups that pair well with our beverages. We'll also bring news to existing products like highlighting hash browns in our snacking menu. Our beverage innovation and snacking options are a powerful combination. We're building an all day sales opportunity and bigger and more profitable transactions. Value is also a critical part of our plan going forward. For example, the $2 Dunkin' Refresher introductory offer. While the rollout of Dunkin' Refreshers was already in our product plans prior to COVID, the value offer was not. But by working with our franchisees, we quickly implemented it across the country, resulting in the most successful beverage LTO launch in our brand history. While our menu is evolving with a focus on specialty beverages, we're not walking away from our heritage as a hot drip coffee business. We're continuing our high-volume smart brewer installations and expect to have those completely rolled out in the first quarter of 2021. The smart brewers will enable us to expand our variety of drip coffee blends, reduce waste and most importantly, enhance our quality and consistency across the system.
Lastly on menu, we are truly an omnichannel brand. Consumers continue to look for trusted brands in the retail space, and we are seeing strong sales across all our CPG products, up 19% in the third quarter according to IRI. Sales of our K-Cups in retail channels were up approximately 28% or nearly three times the category trend. Between our CPG and in-restaurant business, we are selling more drip coffee than ever before. COVID accelerated many of our Blueprint initiatives, most notably our digital transformation. We want guests visits to Dunkin' to be the easiest, most convenient part of their day. In Q3, we eclipsed 5.4 million 90 day active perks users, a more than 30% increase over Q2 and more than 55% increase versus last year. Growth was driven by offers like Free Coffee Monday, requiring a food purchase and Free Donut Friday, requiring a beverage purchase. Both drove incremental sales, net margin and an increase in transactions. We have the strongest active DD perks enrollment on record during the three weeks these offers were available. And on the launch day of the Charli tiktok partnership, we hit a new record for daily active app users.
More than one in five Dunkin' transactions is now through a digital channel. Mobile ordering, delivery and curbside growth have increased exponentially as customers demand contactless purchasing and easier accessibility to the brands they love. On-the-go mobile ordering now represents 8% of our transactions, and we continue to push this consumer convenience by pulsing in bonus point offers as well as launching new features in the app like quick ordering. We have also made on-the-go pickup area larger and a more prominent fixture in our NextGen restaurant design. In existing restaurants, we're adding more permanent visuals and expanded shelving to the pickup area. In Q3, delivery average weekly sales grew nearly 2.5 times versus Q2. They were fueled by our -- expanding our U.S. footprint to 6,500 restaurants in partnership with Grubhub, DoorDash and Uber Eats.
As well as offering compelling national promotions such as DoorDash's free 25-count Munchkins and free delivery on orders greater than $10. As for curbside, it's now available in approximately 1,500 restaurants. Non drive-thru locations with curbside are significantly outperforming the rest of the non drive-thru sites. We're continuing to work with our franchisees to activate more restaurants, particularly in our core markets where drive-thru may not be an option. Finally, let me touch on store development. As we announced in Q2, we are working with our franchisees to scrub our asset base by eliminating low volume, low profit restaurants. Year-to-date, our field teams, along with our franchisees, have made great progress, closing 687 Dunkin' U.S. locations, including 447 speedway self-service kiosks. For many franchisees, closing these restaurants will enable them to redeploy capital into the brand, whether through NextGen remodels, building new restaurants or relocating restaurants to higher traffic areas where they can add a drive-thru. Specifically, in the third quarter,
Dunkin' U.S. franchisees opened 80 gross new units, for a total of net negative 41 units, excluding the Speedway closures. In keeping with our development focus on quality over quantity, year-to-date, our 2020 gross openings are exceeding our initial targets for new first year sales. So while our franchisees are opening fewer units this year due to COVID, the ones they are opening are generating higher sales per restaurant. Franchisees also completed 60 remodels during the third quarter, bringing our total number of NextGen restaurants, both new and remodeled, to more than 800. Leveraging our learnings from COVID, we now have a NextGen remodel that is "low contact" and includes options such as removable seating, no-touch faucets, a walk up window and a reconfigured front line to further encourage social distancing for customers in the queue. Of all the lessons we learned during COVID, the power of the drive-thru was overwhelmingly evident.
Our drive-thru locations, approximately 70% of our traditional portfolio and more than 90% of our restaurants in newer markets had double-digit same-store sales growth in Q3. We have accelerated various drive through technology tests, including adding more outdoor digital menu boards, line busting handheld tablets and a new high-definition speaker system. We're also working with our franchisees to test exterior first remodels and to incorporate select safety features, such as the low contact options in existing restaurants. Our performance in newer markets where we have the most significant growth potential continues to be a highlight during the pandemic. With other concepts closed, new guests discovered our innovative everyday value-priced specialty beverages and our low contact service options, and they're making us part of their everyday ritual. In the West and Southwest markets, Q3 saw double-digit comps positive traffic, strong beverage sales and rapid digital adoption, supporting not only franchisee enthusiasm, but strong cash-on-cash returns.
Our field teams are working closely with franchisees to turn the enthusiasm into additional new restaurants. We've never been more excited about the performance in our newer markets. And we're seeing increased interest in our brand from sophisticated and well-capitalized operators and were recently named The Top Franchise Brand by Entrepreneur Magazine. We believe that the long-term potential for Dunkin' restaurant expansion is unchanged. We are still a growth brand. With our focus on great coffee fast, Dunkin' is thriving in a COVID world, and we are excited about the future. Our partnership with the franchisees is strong. That relationship remains our biggest asset, and I know, it will serve us well as we emerge from this pandemic.
And with that, I'll turn it back to Dave to cover Baskin U.S. and international. Dave?
David Hoffmann -- Chief Executive Officer
Okay. Thanks, Scott. Baskin-Robbins U.S. had another impressive, impressive quarter, delivering positive same-store sales growth of 6.5%. This is a sequential improvement from Q2 and was achieved despite rolling over the traffic-driving Stranger Things promotion last year. Comp performance was driven by the launch of our new Creature Creations program which captured consumers' imaginations and provided families with a fun escape during these trying times. Baskin is a brand known for bringing people, particularly families together, which has been especially true during COVID. Online sales of cakes, quarts and take-home items were up more than 100% versus last year as consumers were looking for more options for at-home consumption. And delivery sales through DoorDash were up more than 200%. During the quarter, we added Uber Eats as a delivery partner in approximately 1,100 Dunkin' and Baskin restaurants.
In total, delivery is now available in more than 90% of our U.S. system. Consumers are going to brands they trust. And with our 75 years of brand heritage, Baskin continues to resonate with customers in this environment. Okay. Now on to International. In Q3, both brands saw a sequential improvement in same-store sales. Baskin-Robbins is proving resilient during pandemic in our international markets as well. High-value strategic partnerships such as the collaboration Korea with K-pop sensation BTS as well as menu innovation with Nutella in the Middle East are driving global awareness, engagement and, of course, sales. Digital plays a critical role in our international plans and COVID has accelerated our use of digital assets to improve easy access to our brands offerings. In Q3, ice cream cake sales were up 30% versus the prior year as Baskin-Robbins offered cakes through delivery and curbside pickup as well.
Digital transformation continues to spread across our international markets as we recently partnered with our Malaysian licensee, Golden Scoop, to stand up a local app in 10 weeks. And as we discussed last quarter, many of our international franchisees and licensees are performing a real estate investment, similar to what Scott referenced earlier for Dunkin' U.S. Our international franchisees and licensees closed 212 of the anticipated 350 restaurant closures in the third quarter. Again, these are low volume sales locations which had been unprofitable for our franchisees and licensees and not representative of our true brand expression. Globally, both brands have stood tall through COVID, all of our strategic run work over the past few years in conjunction with our franchisees and licensees is really paying off.
And so with that, I'll turn it over to Kate to cover our financials. Kate?
Kate Jaspon -- Chief Financial Officer
Thanks, Dave. We are very pleased with the faster than expected recovery of the Dunkin' U.S. business. Getting to positive same-store sales for Dunkin' U.S. in Q3 was a major milestone. Its impact was reflected in our solid revenue and operating income growth, given our 100% franchised asset-light business model and our continued ability to leverage our G&A. As a result of the positive comps, we now expect 2020 Dunkin' U.S. franchisee cash flow when factoring in the Paycheck Protection Program to be positive and will likely exceed our initial expectation of 80% of where we thought it would be coming into the year. Keep in mind, this is an average, and we expect year-over-year cash flow will be negative and harder hit urban areas such as New York City.
We still have a small population of restaurants that we're closely monitoring the performance of, including many in New York City as well as other urban markets like Boston, where many corporate offices have yet to return to fully open. We have seen slight sales and traffic improvements on a week-to-week basis in many of them, but they are still not close to early first quarter levels. Therefore, we are extending financial support, primarily with royalty relief through the end of the calendar year to help stabilize franchisee cash flow during their recovery period. Our goal remains to reinforce the financial stability of our franchisee networks in these hard hit areas to ensure that they remain well positioned for when traffic returns. Now to our third quarter financial results. Revenues for the third quarter increased $5.7 million or 1.6% compared to the prior year period. This was primarily due to an increase in franchise fees as a result of the deferred revenue recognized due to the strategic closure of restaurants, including Speedway and an increase in advertising fees and related income.
This was offset by a decrease in variable rental income as a result of a decline in sales at our leased locations. Operating income and adjusted operating income for the third quarter increased $7.6 million or 6.2% and $7.5 million or 6%, respectively, compared to the prior year period. This was as a result of the increase in franchise fees as well as an increase in ice cream margin and a decrease in G&A expenses resulting from reduced spending due to COVID. Net income and adjusted net income for the third quarter increased by $1.6 million or 2.2% and $1.6 million or 2.1% compared to the same period last year. This was primarily a result of the increases in operating income and adjusted operating income, offset by an increase in income tax expense and a decrease in interest income earned on our cash balances. Income tax expense was up, driven primarily by the increase in income in the current year period as well as excess tax benefits from share-based compensation of $1.8 million in the prior year period, compared to $0.5 million in the current year period.
Third quarter tax expense also reflects a benefit of approximately $1.3 million related to foreign income and foreign tax credits upon filing our fiscal 2019 tax return. Diluted earnings per share and diluted adjusted earnings per share for Q3 increased by 3.5% to $0.89 and 3.3% to $0.93, respectively, compared to the prior year period as a result of the increases in net income and adjusted net income, respectively, and a decrease in shares outstanding. Excluding the impact of recognized excess tax benefits, both diluted earnings per share and diluted adjusted earnings per share would have been lower by approximately $0.01 and $0.02 for the third quarter of fiscal years 2020 and 2019, respectively. Excluding cash reserved for gift cards and advertising funds of $239 million, we ended the third quarter with $341 million in unrestricted cash held domestically and $33 million held in accounts outside of the United States. We also have $117 million in available capacity under our variable funding notes.
As required under our debt agreements, our restricted cash reserve of $90 million includes approximately three months of debt service amounts, including principal and interest. Moving to our leverage. We ended the third quarter with a debt to adjusted EBITDA ratio of 5.1:1. Although, we don't have any debt maturities until fiscal 2024, our prepayment penalty on those maturities goes away in November of 2021 on two of our tranches, and so we continue to monitor the debt markets accordingly. In closing, I'd like to reiterate the quarter-to-date domestic sales information in this morning's release as well as to highlight some other Q4 financial considerations. As of the week ended October 24, quarter-to-date same-store sales were low single-digit positive for open stores for Dunkin' U.S. and high single-digit positive for Baskin-Robbins U.S.
As a result of continued depressed sales in certain urban markets, we anticipate we will provide our most impacted networks relief of up to $4 million which will reduce Q4 royalty income. While we remain down on a year-over-year basis in G&A, given significantly reduced travel and other corporate expenses, we expect Q4 G&A to be in line with this third quarter. As business continues to recover, we have resumed certain projects, made contributions to expedite digital technologies and we have reinstituted employee benefits that were put on hold at the onset of COVID. We expect net interest expense for Q4 to be in line with Q3. And for tax, we expect our Q4 tax rate to be approximately 26.5% as a result of anticipated favorability relative to our foreign income.
Now I will turn the call back over to Dave.
David Hoffmann -- Chief Executive Officer
Okay. Thanks, Kate. Over the past several years, we have accomplished much to be proud of, including the creation, collaboration and execution of strategic plans for our three business segments that led to the transformation of our two well-known brands, not to mention the iconic rebranding of Dunkin'. We stood tall during COVID and supported our franchisees who, in turn, had the backs of their crews, their guests and their communities. Our guiding principle was people over profits. And resulted in strong top line and bottom line results, proving that the two are not mutually exclusive. None of this would have been possible without our strong, unique relationship with our world-class group of franchisees, licensees, suppliers and employees.
So on behalf of our DBI family, thank you. Thanks, everyone.
[Operator Closing Remarks]
Questions and Answers:
Duration: 30 minutes
Stacey Caravella -- Senior Director, Investor Relations
David Hoffmann -- Chief Executive Officer
Scott Murphy -- President
Kate Jaspon -- Chief Financial Officer