Top Stock for March 2014: “The McEmpire is Dying!”

What's Ian Wyatt's company that has better margins than McDonald's and Starbucks?

By Travis Johnson, Stock Gumshoe, March 12, 2014

That “top stock” headline is the promise of Ian Wyatt, not myself, just to be clear.

Wyatt and Taylor Laundon put out a letter called Top Stock Insights, the text of the ad for that letter says it’s from Taylor and the letter is “signed” by Ian Wyatt, so I guess we’ll assume it’s a group effort … and this is the basic spiel of the letter:

“A rapidly expanding rival is chipping away at the McDonald’s empire…

“it’s opening 8,000 new restaurants and quickly stealing away market share, and profits!

“Get all the details of this “immediate buy” below – and find out why it’s our Top Stock for March 2014….

“… the fast-growing restaurant chain that’s CRUSHING McDonald’s and spreading to every city in the country!”

So who is it? We had several guesses come flowing in the door here at Stock Gumshoe — no, it’s not Chipotle (CMG), that’s too big and not profitable enough for the clues … and it’s not Buffalo Wild Wings (BWLD), also not profitable enough, or Noodles & Company (NDLS) or any of the other “hot” restaurant stocks folks suggested.

I’ll leave you in suspense for just a moment as we wander through the clues …

“You see, unlike McDonald’s, this restaurant chain is growing same store sales – at a 3.75% annual clip – while at the same time it’s adding thousands of new locations (adding new revenue streams each quarter).

“It’s exactly where McDonald’s was decades ago… before it spread into every city across the country.

“Right now, this restaurant chain is really only concentrated in one part of the country – the East.

“People there know it well… but it only has 244 restaurants in the rest of the country – the entire West Coast and MidWest has yet to be introduced to this restaurant chain….

“… management is rapidly expanding… and increasing its restaurant count 20-FOLD in these underserved regions.

“(That’s 5,000 of the 8,000 new restaurants it’s building dedicated to this market.)

“This includes two of the most populous states in the union – Texas and California.

“And the best part is, this company’s business model delivers gross margins of over 80% – that’s the best in the industry…

“And its operating margin of 42% is also best in the group….”

The little graph they showed with comparable operating margins, by the way, puts the number about 39%, not 42%, but these things fluctuate (Starbucks is around 15%, McdDonald’s around 30%, Yum around 15% … the biggest differentiator among restaurant chains tends to be the percentage of franchisees, franchised stores enable the parent to have much higher operating margins since the franchisee handles the operating costs of the physical space).

And a few more specific clues to help out the ol’ Thinkolator:

“When you invest in this company today, you can see a nice return in a matter of months.

“In fact, revenue is expected to grow by 7% in 2014…

“Operating income expected to grow by 11%…

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“And EPS (earnings per share) is expected to grow by 17% to 20%…

“Plus, on top of all this growth, this company is extremely shareholder friendly…

“Dividends are expected to grow by 20% this year alone!

“Currently, shares of this company carry a yield of 1.79%. But considering the fact that management continues to raise dividends…

“And that its payout ratio of profits to dividends is the same as McDonald’s (56%) it’s not unrealistic to say its yield could easily double in the years ahead.”

So now that we’ve got a passel of clues under our belt, what’s the answer? Have no fear, I fed it all into the great big hopper on the Thinkolator, set it on “pulverize,” and it wasn’t long before the answer come pouring out … this is New England’s own Dunkin’ Brands (DNKN), owner of the Dunkin’ Donuts and Baskin Robbins brands.

Which those of us in Massachusetts wouldn’t really think of as a “growth” company — here it’s more of a fixed physical presence in every single town and mall, like a traffic light or a post office. I think it might not actually be legal for New Englanders to live more than ten miles from a Dunkin’ Donuts.

But yes, they are paying a small but growing dividend, and their payout ratio happens to match that of McDonald’s at 56% (that means they pay out 56% of earnings as a dividend). And their operating margins are huge, just under 40%, because their stores are overwhelmingly franchisee-owned … that also keeps gross margin up near 80%, though it’s a couple ticks below that at the moment, since it’s the franchisees who pay rent and buy dough and run bakeries and hire counter help, etc.. Gross margin for an individual franchise owner must be very low, but it’s awfully high for the parent company that just collects the franchise fee/royalty and marketing share payments from the restaurant owners.

And yes, same store sales have been growing for Dunkin’, too, which is pretty impressive — whether that’s just price hikes or it also is made possible by their menu expansions, I don’t know (they’re trying to get some lunch business with sandwiches, and have rolled out higher priced breakfast stuff and fancier beverages too). I do know that the donuts are far less tasty than the Dunkin Donuts of my youth, but I guess that’s what mass standardization and factory restaurants do to food. Their same store sales growth in the US is far higher than McDonald’s, as teased, but is actually pretty close to Starbucks recently, in the 3-5% range, so perhaps it’s just that the coffee folks are doing better than the burger sellers.

Dunkin Donuts is an old and well-known brand in the Northeast, and they are pushing expansion both globally and to the rest of the United States — the company has been on a store opening tear for almost a decade now, ever since they were bought by a consortium of private equity companies back in 2006 (they had been sort of a “hidden” asset of a large liquor company before that), which turned them into a franchising machine, and that growth stepped up even more after they were taken public in 2011.

Analysts do think that this $5 billion company will continue to grow faster than the market, they’re predicting roughly 7% sales growth and 16% earnings growth for next year, a slight deceleration from the 19% earnings growth they expect for 2014 … they grew earnings per share by almost 50% last year, so to some degree it might just be the law of large numbers catching up a little bit, it’s hard to post ridiculous earnings growth every year if growth depends, to a large degree, on the physical build-out of new stores and on marketing to new regions. But even 15-20% earnings growth is tremendous, so that keeps investors paying a nice premium for the shares — right now they trade for about 38X last year’s earnings and about 25X 2015 estimated earnings.

The real competitor, I think, is Starbucks (SBUX) — and the valuations are fairly comparable on a forward earnings basis even though SBUX is about 10X larger than DNKN … so if you were looking for a big coffee chain you could go with either the heavily franchised DNKN that is growing slightly slower, or the much larger operator of company-owned stores in SBUX that posts substantially lower margins. Both are valued at about 1.5X their growth rate, which is decent for a growth company — I am personally inclined to like Starbucks as a company much better, largely because it’s so entrenched as a brand, but haven’t been tempted to buy the stock at premium prices (and was too much of a chicken to buy in the low teens last time the stock stumbled)… but I think DNKN probably has more potential for upside growth surprises because of their ability to much more rapidly expand their footprint and because of their much higher margins.

But it’s your money, so what do you think? Interested in investing along with Dunkin’ as they try to colonize the rest of the country? Think it’s too pricey? Let us know with a comment below.