What to Expect From This Restaurant Stock

Anjali is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Americans spent a lot of money eating out each year and thus, investors who buy restaurant stocks have the potential to make a great deal of money. However, it is imperative for investors to understand the major growth drivers before investing in any business. I was looking at PE ratios of various fast food restaurant chains and found that the PE of Dunkin Brands (NASDAQ: DNKN) is higher than McDonald’s Corp (NYSE: MCD) and Yum! Brands (NYSE: YUM) despite comparable Same Restaurant Sales (SRS) growth rates. In order to make an investment decision on Dunkin, I did some research and came up with the following conclusion.

In early lifecycle stages, the typical restaurant valuation multiple is highly correlated with unit growth. As a restaurant company matures and unit growth slows, valuation is driven by the cash flow generated by the existing asset base which is best measured by SSS growth and margin expansion. For a restaurant chain as big as McDonald’s, which already has a global store base of ~33,500, we can’t expect unit growth to accelerate or even sustain its current rate. Thus, we need to look forward to same store sales growth and margin expansion opportunities before investing. However for a restaurant chain like Dunkin Brands, with a relatively smaller unit base and lesser international presence, unit growth potential plays a prominent role. It is for the same reason that Dunkin Brands enjoys a premium valuation as compared to restaurant chains with vast international presence, including McDonald’s and Yum! Brands. Let’s analyze the valuation multiple and growth prospects of Dunkin Brands, McDonald’s and Yum!.

<table> <tbody> <tr> <td> <p>Company</p> </td> <td> <p>McDonald’s</p> </td> <td> <p>Yum Brands</p> </td> <td> <p>Dunkin Brands</p> </td> </tr> <tr> <td> <p>Forward PE</p> </td> <td> <p>15.5</p> </td> <td> <p>18.65</p> </td> <td> <p>20.64</p> </td> </tr> <tr> <td> <p>Next Year Growth</p> </td> <td> <p>10.20%</p> </td> <td> <p>14.70%</p> </td> <td> <p>19.80%</p> </td> </tr> <tr> <td> <p>Next 5 Year Growth</p> </td> <td> <p>9.20%</p> </td> <td> <p>13.70%</p> </td> <td> <p>16.80%</p> </td> </tr> </tbody> </table>

Source: Yahoo! Finance

We can see that Dunkin Brands’ expected growth is far better than McDonald’s and Yum! Brands and as a result has a higher multiple. Moreover, Dunkin’ Brands’ adjusted operating margin also lead the publicly traded restaurant industry; reflecting a nearly 100% franchised model with a high percentage of royalty revenues. The following table summarizes the operating margins of Dunkin Brands, McDonald’s and Yum! Brands.

<table> <tbody> <tr> <td> <p>Company</p> </td> <td> <p>McDonald’s</p> </td> <td> <p>Yum Brands</p> </td> <td> <p>Dunkin Brands</p> </td> </tr> <tr> <td> <p>Operating Margins (ttm)</p> </td> <td> <p>30.61%</p> </td> <td> <p>16.61%</p> </td> <td> <p>34.32%</p> </td> </tr> </tbody> </table>

Furthermore, with relatively low capital requirements and fixed costs, Dunkin’s margins will continue to rise, while generating healthy free cash flow. Let’s now dig a little more into Dunkin Brands and analyze the unit growth opportunities and see whether the expected growth rate is achievable. 

Domestic Markets

In the domestic circuit, there's roughly one Dunkin' Donuts store in the northeast for every 9,700 residents but one for every 1.2 million people in the West. Dunkin’ Donuts operates more than 7,000 points of distribution in “core” and “established” markets that in total represent less than 30% of the U.S. population. That means, Dunkin’ Donuts brand is materially underpenetrated in markets that are home to almost 70% of the U.S. population, which means the concept currently has development white space comparable to what McDonald’s and Yum! were seeing a decade ago.

International Markets

Even in the international markets, Dunkin Brands has a healthy unit growth opportunity, especially in emerging markets like India and China. Baskin Robbins is going strong in international markets and posted the “best-in-class” international revenue growth (20.7% growth in international sales) among the quick service restaurant chains. Dunkin Donuts also has a huge growth potential as coffee consumption in emerging markets is expected to grow at a fast pace. International markets represent just 12% of the Dunkin Brands’ profits whereas China alone represents over 40% of the profits for Yum and about 25% of the profits for McDonald’s. Thus, I see ample room for unit growth in the international circuit as well.

The company believes it can more than double the number of domestic Dunkin’ units over the next 20 years to 15,000 and given a huge white space opportunity west of the Mississippi river, the target looks achievable. In addition, I see a huge runway for growth in international markets as well. To conclude, I expect Dunkin Brands’ premium valuation to sustain as the company has good share gain prospects with long-term unit growth opportunity, SSS gains and larger franchisee transactions to accelerate growth. Thus, I recommend it as a good long term buy. 

AnjaliPaliwal has no positions in the stocks mentioned above. The Motley Fool owns shares of McDonald's. Motley Fool newsletter services recommend McDonald's. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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