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Dunkin' Donuts: House of Nuts

Ray put together an insightful piece titled: s47: Exclusive Dealing and Third Line Forcing.  Although it was published nearly a month ago, the article was most likely past over given his use of nippy titles.  Or, it was simply not within my full screen view, on BMM, without having to scroll down to the bottom one third.  Fortunately, s47 resurfaced after Boudica laid down some views on Franchise Supply Chain Secrecy.  Of course, in typical BMM style, Boudica’s views were expanded upon with Ray’s bold statements on Franchisor Financial Gouging Models

What captured my attention was Mr. X’s story on the “group buying power” of a franchise being the underlying mantra pitched by most retail franchise systems.  It’s simple common sense: As the franchise system grows, raw material demand increases, leading to efficiencies in the supply chain through “group buying power” leverage over the market suppliers. 

The business lifecycle curve of the most sustainable fast food franchise brands have had a history of stable management teams that were focused on eliminating layers in each component sourcing the “entire” system’s supply chain – which includes, 1) equipment, furniture, & fixtures to deliver a “turnkey” business, and 2) day-to-day operating food/paper COGS. 

These franchise systems are today’s Iconic Fast Food Brands.  Royalties paid to the franchisors returned tremendous value to their franchisee community owners.  Increasing collective buying power was the driver that “aligned” the goals between – 1) the franchisor’s sales growth, and 2) the franchisee’s profitability.                          

Collective buyer power theory is valid during the ramp up stages in the franchise’s business lifecycle curve.  Especially, during the evolution from “Start-Up”, to “Growth”, and ultimately the “Maturity” plateau.  What happens along the curve is that the franchisor evolves the supply chain closer and closer to the raw material commodity source.  The “pedigree” brands, for most part, found themselves attached or under the umbrella of another, much larger, multinational food conglomerate.  One of the only exceptions was McDonalds.

In the Maturity Phase, franchisee profitability is maximized and the goals between the franchisor and the franchisees are “aligned”.  Meaning, the franchisees are “happy” with their franchisor and the strength of the relationship has peaked.  Many fast food franchise systems that evolved during the 1960’s and 1970’s hit their respective maturity phases during the early 1990’s

Some of the “pedigree” brands came under the radar of corporate raiders in the late-1980’s.  One such brand was Dunkin’ Donuts.  To fend off a hostile takeover attempt, management sought out Allied Lyons, PLC as their White Knight to keep management intact and to maintain a sense of Brand autonomy.        

The Dunkin’ Donuts Story

Dunkin’ Donuts began franchising in 1955.  The founder, William (Bill) Rosenberg, in 1963, transferred day-to-day control of Dunkin’ Donuts to his son Robert (Bob) Rosenberg.  In 1968, Dunkin’ Donuts went public by listing its stock on the NYSE.  After going public, Bob Rosenberg pursued an aggressive expansion plan.  Between 1969 and 1972, the number of shops nearly doubled by increasing the amount of corporate leverage.  By 1973, the company operations were not in sync due to decentralized regional management teams and inconsistent field communications.  In the mist of Dunkin’s financial problems, the individual litigation matters against its multiple franchisees formed into a class action lawsuit.

Between 1973 and 1978, management underwent an organizational restructuring and became more focused on their franchisee’s profitability.  In 1976, the U.S. Court of Appeals decided in Dunkin’s favor by decertifying the franchisee’s class action.  Thereafter, Dunkin’ cut a deal with its National Franchisee Advisory Council to give the franchisee greater control of the system’s supply chain.  In 1982, the 1st franchisee owned Distribution Commitment Partnership (DCP) facility opened to serve the Northeast and growing Mid-Atlantic markets.  Today, there are 4 national distribution centers serving the supply chain needs of the Northeast, Mid-Atlantic, Southeast, and Mid-West regions.

The sale of Dunkin’ Donuts to Allied Lyons PLC, in 1989, did not affect the franchisee’s ownership of the DCP supply chain infrastructure.  During the mid-1990’s, Dunkin’ Donuts experience another period of growth led by successful product launches, such as, Bagels and Coolattas.  Profitability in the Northeast and Mid-Atlantic markets improved due to shifting consumer preference towards Dunkin’ Donuts coffee based beverages – helped by the growth of Starbucks.

In 2003, management underwent a major organizational restructuring but remained under the ownership of Allied Lyons PLC - which changed its name in 1995 to Allied Domecq PLC.  The management team became known as Dunkin’ Brands Inc.  The restructuring was a necessary strategic move in order to prepare for Dunkin’s ultimate separation and spin-off from their UK based parent company.  A consortium of private equity funds led by Bain Capital acquired Dunkin’ Brands Inc in the largest fast-food restaurant LBO of 2006.  The reported purchase price was $2.46 Billion.                          

Dunkin’ Donuts Westward Ho!

To support the new debt, Dunkin’ needed to expand nationally.  However, there is no franchisee owned regional DCP supply chain infrastructure West of the Mississippi.  In order to foster the westward expansion, in 2007, management aligned it’s goals with a national consumer brand distribution company – Procter & Gamble.  After beefing up coffee sales, with the addition of Dunkin’ Donuts, P&G sold the Folgers Coffee Company business to food conglomerate JM Smuckers (SJM) in 2008.

The supply chain infrastructure that was once owned by the Dunkin’ Donuts franchisees became a hybrid multilevel ownership model that is sourced by JM Smuckers’ green coffee bean procurement and roasting facilities.

Over the past three years, existing Dunkin’ Donut shops have seen flat to negative same store comparable sales.  Yet, Dunkin’ Donuts, as a brand, continues to report year-over-year growth.  New store openings do not stand out as they once did in both new and existing development markets.  In fact, many of the large franchisee developers went bankrupt in 2009.  This phenomenon is known as intra-brand competition.  Franchisees are competing in a David and Goliath battle against the likes of a publically traded powerhouse – JM Smucker (SJM) and the powerful scope of their deep channel distribution arrangements.  Dunkin’ Donut franchisees have clearly entered the Decline Phase of their business lifecycle curve. 

The Race Is On: How will the Dunkin’ Donuts Franchisees reverse their diminishing investment returns?

A quick review of SJM’s 2010 annual report states their Principle Products to be:

Principal Products. The principal products of the Company, which are sold across the Company’s U.S. retail market segments and Special Markets segment, are coffee, peanut butter, shortening and oils, fruit spreads, canned milk, baking mixes and ready−to−spread frostings, flour and baking ingredients, juices and beverages, frozen sandwiches, dessert toppings, syrups, and pickles and condiments.

Walking through a typical Dunkin’ Donuts full producing [with a kitchen] shop you will certainly find, in the store's current inventory, at least 1 brand related to each category within SJM’s principle product portfolio.

Last week, M.J. from Erie, PA, asked Malcolm BerkoShould I buy stock in Smuckers? - since M.J. happens to be a fan of Jif Peanut Butter.  To offset DD franchisee diminishing returns, one may consider investing in SJM to balance out their franchise investment returns – logically, it would make sense since Coffee is SJM’s growth driver. Mr. Berko concludes (be sure to read the comments that follow in Mr. Berko's blog):

I’m not absolutely certain, but I don’t see the stock rising above the $80-$82 level - even though Smucker also owns those Dunkin’ Donuts stores that dot the streets, avenues and boulevards of a thousand American cities. (Have you ever tried a peanut butter cappuccino?)

And while I really like the company, admire its management and lust after its tasty comestibles, I don’t consider Smucker a compelling buy at $60. But I would, with alacrity, own this stock in the high $40s. So consider placing an open order with your broker in the $47 range. And if the market tumbles again, you might catch 200 shares above the stock’s $37 lows of 2009, 2008 and 2006, and above its $46 low of 2007.          

Today, TheStreet.com rated SJM a “Buy” with a $81.35 price target that is in-line with Mr. Berko’s conclusion.  Seems like Wall Street sees some more growth in SJM’s Folgers Coffee Business to move the stock higher from today’s closing level of $61.90.

Buying stock in SJM would not resolve the franchisee’s diminishing return dilemma since they would not gain the voting rights to control the Company’s distribution related to the Folgers Coffee Business.  Given the growth in Folgers is driven by double digit gains in Dunkin’ Donuts coffee sales, the franchisees could make a bid for the entire Folgers business - which could very well be valued at – say, $4.5-$5 Billion today.  Thus, the thought of franchisees going after Folgers isn’t very realistic.

What can the Dunkin’ Donuts franchisees do to save their investments in the Brand?

Franchisees need to start understanding how Globalization affects their local ownership.  In recent news, Allied Brands (AB), the Australian Master Franchisee for Baskin-Robbins Australia, is under a termination threat by Dunkin’ Brands Inc for reasons related to AB’s poor BR asset management.  By enforcing a termination of AB, DBI stands to gain as the 35% joint venture partner of Baskin-Robbins Australia.  The remaining 65% interest is owned by the securitization Master Issuer DB Master Finance LLC.  Eliminating the Master Franchisee middleman, DBI becomes the direct BR ice-cream distributor in Australia – and, benefits from increased product sourcing margins (Silver Pail Agreement - a savvy term for volume based "rebates" and "kickbacks"). 

DBI is not the franchisor today.  They are a 3rd Party Master Servicer as a result of the 2006 DB Master Finance LLC 144a Private Placement securitization.  Ultimately, DBI must exit the current securitization environment through a recapitalization by 2011.  Depending on market conditions, in 2011, DBI can extend their recapitalization exit horizon for up to 2 additional years – making 2013 the drop dead window to exit.  If successful, DBI will control as the successor Franchisor. 

How will the Recapitalization occur?       

There are 2 ways to recapitalize the current securitization – 1) IPO or 2) Merger/Acquisition.  Regardless of how the securitization is ultimately recapitalized, neither an IPO nor an acquisition will benefit the franchisee community.  Both strategies will bring in “new” DBI management teams, since the current management team is focused on cashing out their make whole bonuses – the securitization “carrot” covenant trigger. 

Merger/Acquisition = more debt.  IPO = greater channel distribution.

The acquisition front is quite interesting to review.  Many of the long term franchisees know that William Rosenberg’s parents started out in the grocery store business.  The Brand’s evolution to date has already exploited the grocery channel distribution opportunities.  What remains is actual unit growth West of the Mississippi – primarily, California.  Although Baskin-Robbins is no longer a California corporation, BR has always had a presence under California Franchise Investment Law – not Dunkin’ Donuts.  In order to grow nationally the franchise must be able to sell Dunkin’ Donuts franchises in California.  Therefore, ownership in California is paramount, and a “must”, for any potential acquirer of Dunkin’ Donuts. 

West to East was the theory behind the 1997 Togo's acquisition.  The Togo’s strategy failed miserably and was ultimately sold off in 2007.  The way I see it, and in my sole opinion, I believe DBI will look for a publicly traded California based acquirer to recapitalize the securitization.

Tom Schwarz, former President of Dunkin’ Donuts, had once asked “What business are we in?”:

When all was said and done, however, we agreed we were basically in the high end of the "bakery and snack" businesses [and] for three reasons:

First, we had a competitive advantage in this business. Independent "mom-and-pop" neighborhood bakeries were fast disappearing from the market, being replaced by bakery departments in supermarkets. But most people buying from supermarkets were buying because of convenience, not quality. Not many supermarkets were baking their products from scratch, so customers weren't getting the "top of the line." Fast-food chains, at the same time, were avoiding bakery items because they couldn't very well automate the labor-intensive baking production process.

Second, customers perceived Dunkin' Donuts shops as places to acquire "handmade," "fresh" products at all hours. A lot of people came in on impulse. It wasn't the same as planning a trip to McDonald's for a meal. In the minds of most customers, we were a nationally known neighborhood bakery shop serving refreshments 24 hours a day.

Third, the "bakery and snack" business was compatible with our company's strength. We established a smooth production operation run by trained bakers and equipped with the right kind of machinery. We also operated a relatively small store in which quick product turnover was the key to success. Finally, we displayed all our finished products to encourage customers to try a variety of items.    

Although the product mix has shifted towards the beverage category, especially, in the core Northeast and Mid-Atlantic markets, our primary business across the nation is still “bakery and snack”.

In Tom Schwarz’s view:

It’s our job to enhance shareholder value.  That depends on how well we use our capital, both human and financial, and grow the company.  We’re in great shape, but we have to continue to satisfy our customers, and to do so we have to make sure our franchisees are successful.  Recently, the franchisees haven’t been as profitable as we’d like, and if they aren’t profitable, they won’t invest in their shops to maintain standards or introduce new products.  We know we’re not going to get people to eat a lot more doughnuts, but by increasing our distribution we can get a lot more people to eat our doughnuts.  We’ve got some work to do.

In an IPO situation, JM Smucker can facilitate increasing channel distribution into the “Center Of The Grocery Store” aisles by offering “frozen” Dunkin’ Donuts products – such as, frozen bagels, frozen muffins, frozen donuts, etc.  However, this strategy would further drive sales away from our existing franchisee owned retail stores.  To offset the cannibalization of a full blown channel distribution offering the Franchisor must have another retail level platform to offer its franchisees.  The Open Kettle comes to mind – and, Ye’ Ole Kettle Cooker™ isn’t really that far-fetched of an idea when viewed from Mr. Redenbacher’s popcorn patch in Orrville, Ohio.

In the context of the views shared here, I’d venture to guess that a California based “nut” company could be the ideal acquirer of Dunkin’ Donuts.  The Street never understood the UK ownership of both Dunkin’ Donuts and Burger King.  At least with Diamond Foods, one could rationalize the potential fit between the two distinct retailers under a House of Nuts.

Think about having another brand under your single roof top once our supply chain investments are wiped away.  A National DCP must control the supply chain; otherwise, Franchisees will not have an equitable deal after the securitization is recapitalized.  Smuckers' certainly seems to have good wholesome intentions.  However, these crossroads are about money – and, nothing else matters, except the $$$.

Will the Franchisees be left in the cold rain and snow?

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