Why These 4 New Dunkin' Donuts Could be a Game Changer

Looks quite inviting, right?  Source:  Wikimedia Commons

For a company with nearly 11,000 restaurants in 33 countries, the announcement of just four new Dunkin' Donuts in California would seem barely worthy of a footnote. However, that announcement may actually be one of the most important yet.

The Golden State news
On June 10, Dunkin' Donuts made it official. The company has been teasing for several quarters now with plans to expand into California and throughout the West where it scarcely has a presence. Now, the locations of the first four were revealed with plans in place for another 54 more and agreements in place for a total of 200.

Currently, California is the largest market of Starbucks with over 2,000 locations who has enjoyed having barely any direct competition. It's obvious that Dunkin' Donuts, which actually sells more coffee than food, would love to get a piece of Starbucks' coffee pie out there, but the donuts themselves may do well too.

Californians loves doughnuts. Krispy Kreme Doughnuts says that its California stores are showing some of the best growth across its chain. There are also smaller chains seemingly on every corner such as Yum-Yum Donuts and Winchell's Donut House.

Not so inviting. Source: Wikimedia Commons

Next time you're in California, give them a try. They may remind you of your grammar school cafeteria quality. If Californians like the doughnuts currently available in the state, they are literally in for a real treat when Dunkin' Donuts lands. Despite the  low quality of the smaller chains, people love them.

In the announcement, Dunkin' Donuts stated that it expects to start construction in late June, months ahead of schedule. The reason for the time pressure, according to Dunkin' Donuts President Paul Twohig, is due to the "strong interest of prospective franchises and consumer across the state." Sounds promising.

What's perhaps more important is twofold
First, it's not about the revenue or profits from these four restaurants or even the next 54 restaurants. It's about a model, a test, a pilot in the eyes of the investing community about the potential profitability of Dunkin' Donuts expansion on the Left Coast.

The preliminary results could very well telegraph the next large wave of openings. If it's successful, it may lead to acceleration of the rollout just like these first four. Currently according to the release the company believes the state can eventually have as many 1,000 locations. If the tests go as well as the company hopes, however, you have to think that the number could be greatly lifted above 1,000 locations.

The company may be sandbagging this somewhat low target of 1,000 locations.  In many areas where Starbucks is located throughout the country, there are around two Dunkin' Donuts for every one Starbucks within the same market. 

During a presentation in October of last year, Paul Carbone, CFO of Starbucks, mentioned a survey that found 21% of consumers in Los Angeles said they get their morning coffee from Dunkin' Donuts.  The brand is so immensely popular already there that consumers are buying it by the truckload at grocery stores.  Carbone added, "We sell the most coffee poundage in California."  

2,000 Starbucks in California means potentially let's say room for 4,000 Dunkin Donuts in that single state alone, in a best-case scenario if the company is truly sandbagging.   While it will likely take many years to build out, that also means many years of expanding top and bottom lines. Again, this assumes the initial stores are as successful as many hope.

Remember that Dunkin' Donuts is almost entirely a franchise model and only uses franchisees for its expansion going forward.  This means each $1 increase to the top line, all things being equal, is roughly a $0.77 increase in gross profit. There will be then be some overhead expansion as the company grows in order to cover things such as quality control monitoring of its franchisees.  At the risk of oversimplifying the unknown, let's assume what I think is conservative is that increased same store sales growth (and its franchisee royalties) and its associated gross profit covers increased overhead.

Over time, earnings and cash flow become one in the same since the business model of a franchisee-based company is rather simple.  It owns few to no liquid tangible assets and income streams other than cash owed to it and cash coming in both from franchisees which makes the accounting earnings and cash flows rather similar.

Dunkin' Donuts currently has 11,000 worldwide locations with a target of another 7,500 domestically.  In 2013 Dunkin' Brands Group earned $362 million in royalties alone just for its Dunkin' Donuts segment.

In again an effort to remain conservative, let's ignore other forms of income including for example initial franchise fees for each new store and just assume those are at break-even levels.  $362 million is $33,000 per location. 

Dunkin' Donuts plans to double its domestic store count including those 1,000 California locations.  If we use 6,000 California locations instead as explained above, that means another 12,500 total locations domestically.  $33,000 times 12,500 is  $412.5 million.

Using say 100 million diluted shares outstanding (after stock buybacks) and a 33% tax rates based on history, this adds $2.76 earnings per share.  Considering Dunkin' Brands Group the company only earned an adjusted $1.53 last year, that's a significant jump to $4.29 per share using conservative numbers and assumptions but an optimistically executed roll out.

Based on the current share price, that puts the P/E at less than 10 which seems like a fantastic opportunity for any solidly earning and growing company is a healthy industry such that Dunkin' Brands is in.  True, it's many years into the future and you'd need to include a rate of discount to account for the time value of money, but it's hard to pinpoint how far into the future this will be.  Dare I say the growth in international and Baskin-Robbins makes up for that?  While I hate to make assumptions, as with any company, there will be all sorts of unknowns and opportunities that neither you nor I can account for at this time.  

The second thing...
Aside from the company's stock itself possibly starting to price in (AKA move higher) on investor confidence of Western expansion,  the expansion itself would help Dunkin' Donuts diversify its operations geographically. The currently very high Northeast concentration puts its results at higher risk.

Not very appetizing looking either. Source: Wikimedia Commons

Dunkin' Donuts, or at least its investors, learned this the hard way this past winter. Same-store sales for the overall company were barely in the black. The company's executives blamed the weather for interrupting the ritualistic nature of its core customers who stop by Dunkin' Donuts on the way to work or school.

Those who got snowed in at home stayed home, and didn't buy double the donuts and coffee the next day. Those lost sales for the snowed-in days were lost forever. The more regions Dunkin' Donuts can spread out to the better, so that when geographic-specific disruptions due to natural or other disasters happen it won't have as devastating an effect. Case in point, Starbucks was able to brush off the snow and report its 17th quarter in a row of same-store sales greater than 5%.

Foolish takeaway
Look for comments and details on how these first four California locations are doing, as these may give you a tiny but good enough sample on what to look forward to in the years ahead. Just be careful to take with a small grain of salt the initial honeymoon period that most restaurants experience in the first three months of opening. Regardless, it will be interesting to see how these four do and what kind of disruptions it causes to the local doughnut chains and even the local Starbucks locations.

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The article Why These 4 New Dunkin' Donuts Could be a Game Changer originally appeared on Fool.com.

Nickey Friedman has no position in any stocks mentioned. The Motley Fool recommends 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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