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Dunkin' Brands Offering No Flavor of the Month

As the environment for quick-service restaurant operators slowly rebounds, Dunkin' Brands, which includes Dunkin' Donuts and Baskin-Robbins, is brewing an appropriately priced IPO.

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In what will be one of the most anticipated offerings of 2011, Dunkin' Brands (DNKN) is set to bring its IPO to market Tuesday, in a deal expected to reach nearly $380 million. Morningstar senior analyst Joscelyn MacKay believes the deal is appropriately priced, with a fair value estimate of $17 per share. However, she thinks the appetite for restaurant growth stories could push the offering above the current range. Her full take on Dunkin is below:

Dunkin' Brands (DNKN) - Capital Sought: $378 million; Offer Range: $16-$18; Fiscal 2010 Revenue: $577.1 million; Fiscal 2010 Operating Margin 33.6%; Morningstar Fair Value Estimate: $17 per share

"As the environment for quick-service restaurant operators slowly rebounds, Dunkin' Brands DNKN-which includes Dunkin' Donuts and Baskin-Robbins-is brewing an IPO. Dunkin' Donuts represents the bulk of the combined brands, or 76% of revenue and 82% of operating profit. Dunkin' Brands was purchased from Pernod Ricard by private equity firms Bain, Carlyle and Thomas H. Lee in 2006. We assign a high interest level to Dunkin' Brands' IPO due to its expansion potential and market positioning close to players in our coverage universe such as  Starbucks (SBUX) and  Tim Hortons (THI). According to the NPD Group, Dunkin' Donuts maintains the number one or two market share position in a number of quick-service restaurant categories in the U.S., primarily in the sought-after breakfast daypart. Breakfast represents roughly 25% of all quick service restaurant transactions, and is a more stable segment for restaurants due to the habitual, regular customers. Baskin-Robbins is the number one server of hard ice cream in the U.S. and has a developing presence internationally. The firm is looking to raise as much as $400 million, and the transaction should price on July 26.

Dunkin' Brands generates revenue- -$577 million in 2010--primarily through franchise fees from over 16,000 locations in 57 countries. Dunkin' Brands' franchise model provides the firm with an annuity-like stream of rent and royalty payments, which are subject to a lesser degree of fluctuation during difficult economic times and periods of rising commodity costs. The firm's franchised business model also has lower capital requirements as franchisees pay for the restaurant development costs. This nearly 100% franchising model has allowed Dunkin' Brands to achieve stellar 35% operating margins-stronger than any restaurant in our coverage universe and more than double that of Starbucks.

In our analysis of the firm, we're more focused on the Dunkin' Donuts brand, as opposed to Baskin-Robbins, as it generates the bulk of revenue and we believe it has the greater potential for growth. Despite stiff competition from Starbucks, Tim Hortons and Caribou Coffee, Dunkin' Donuts' comparable store sales held up during the downturn with only modest declines and recovered in 2010 with 2.3% growth. We attribute this not only to the firm's franchise model, but also to its solid brand positioning and marketing. We believe many consumers traded down from pricier Starbucks, which experienced mid-single digit comparable store declines during the downturn. As we emerge from the downturn, Dunkin' Donuts continues to tempt its customers with new and exciting products.

From our perspective, despite its seventy-year history, Dunkin' Donuts has ample opportunity to expand in the U.S.--particularly outside the brand's core Northeast region. With 22 stores per one million people, Dunkin' Donuts has lower penetration relative to its primary competitor, Starbucks, which has 30 stores per one million people according to In the Western part of the country, there is just one Dunkin' Donuts per one million people, providing the brand a significant opportunity for growth, in our opinion. If Dunkin' Donuts were to expand in the West such that its penetration is just 10 stores per million people, the store count would grow to 1,300 from just over 100, and we estimate this would add $20 million in revenue.

Still, as with many companies, the largest potential for growth remains outside the U.S. Over the past ten years, Dunkin' Brands has nearly doubled its store locations internationally. But, at just under 7,000 restaurants (roughly 3,000 Dunkin' Donuts and 4,000 Baskin-Robbins), we believe there is opportunity for growth. Starbuck's international presence is nearly double that of Dunkin' Donuts. While we don't expect Dunkin' Donuts to grow to Starbuck's scale due to Starbuck's dominance (it represents about a third of coffee cups sold at retail), we assert Dunkin' Donuts is one of the few North American mid-tier chains that has realistic aspirations for international expansion, particularly in emerging markets. To be sure, Dunkin' Donuts recently signed a partnership with a local franchisee in India-where the quick-service restaurant market growing at an estimated 30% annually--agreeing to open at least 500 stores.

Our main concern for Dunkin' Brands is its Baskin-Robbins concept-roughly a quarter of sales. Basin Robbins has had declining comparable restaurant sales for the past three years and we expect the decline to continue for the next year or two. We view the ice cream market as highly fragmented with rapidly changing consumer tastes and preferences, with a higher degree of competition and marked with frequent bankruptcies. From our perspective, these competitive headwinds will limit management's effectiveness in reinvigorating the brand through new marketing campaigns. We wouldn't be surprised to see Baskin-Robbins divested at some point in the future in order to allow management to focus on the core Dunkin' Donuts brand.

While Dunkin' Brands has compelling brands and returns on invested ca pital (excluding goodwill and intangible assets such as trade names) in excess of 20%--more than double our 9.8% cost of capital assumption--the firm operates in the highly competitive quick-service restaurant industry, with low barriers to entry and no switching costs. However, these factors alone are not enough to prevent an economic moat, as we award some quick-service restaurant chains moats such as Starbucks and McDonald's. We do not believe Dunkin' has an economic moat due to its smaller size, which prevents it from having meaningful economies of scale and power over suppliers. From our perspective, Dunkin' Donuts does not have the national brand cache of wide moat competitor Starbucks, which enjoys price leadership advantages and has greater access to prominent locations.

Dunkin' Brands has applied to list its shares on the NASDAQ under the symbol "DNKN." The proposed IPO of 22.25 million shares represents just under 18% of the firm's value. The rem ainder will be owned in equal proportion by the three private equity sponsors: Bain, Carlyle and Thomas H. Lee. Underwriters also have the option to purchase another 3.3 million shares from Dunkin' Brands. Dunkin' Brands hopes to sell the shares between $16 and $18 per share, yielding net proceeds to the company around $348 after underwriting fees and transaction expenses. The proceeds, along with $100 million borrowed under a term loan, will go towards prepaying the firm's $475 million Senior Notes due 2018.

Taking into account both the favorable growth trajectory and intense competition in its industry, we view Dunkin' Brands' IPO as fairly valued. Our fair value estimate of $17 per share implies forward fiscal price/earnings of 21 times and an enterprise value/EBITDA of 11 times (on par with Morningstar's restaurant coverage universe). However, given the market's willingness to pay up for restaurant stocks with strong unit growth potential --  Chipotle Mexican Grill (CMG),  Panera Bread (PNRA), and Starbucks are currently trading at 48, 29, and 27 times our forward earnings estimates, respectively--we would not be surprised to see this stock trade above the high end of its expected offering range.

Our fair value estimate assumes roughly 10% top-line growth in 2011, followed by a few years of high single digit growth, and then tapering off to the mid single digits. Our estimates are primarily driven by Dunkin' Donuts' store growth. We forecast the Dunkin' Donuts brand will grow its locations by roughly 50%, to a total around 14,500, over the next ten years. We also believe the firm will be able to expand its already-impressive operating margins to roughly 48% at the end of our forecast period from 35% currently, as it leverages its growing scale. We expect strong investor demand for the offering given the popularity of the Dunkin' Donuts brand (particularly in the Northeast), coupled with the firm's growth potential, both domestically with nearly 100% brand awareness and internationally where it has a growing presence."

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Bill Buhr does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.