Why Did Lone Pine Capital Trade Green Mountain Coffee for Dunkin Donuts?

Dunkin Brands Group, Inc. (NASDAQ:DNKN), more commonly known as Dunkin Donuts, has attracted even more hedge fund interest. Stephen Mandel’s Lone Pine Capital has taken a 6.7% stake (7,021,945 shares) in the company. Stephen Mandel is a Tiger cub, being one of the many elite manages who once worked at Tiger Management, but left Julian Robertson to build their own stellar record. Dunkin’s stock rose almost 5% following the news. Dunkin is commonly considered a coffee company, but also operates the turnaround ice cream company, Baskin-Robbins.

LONE PINE CAPITAL

Mandel and Lone Pine Capital recently closed out a large position in Green Mountain Coffee Roasters Inc. (NASDAQ:GMCR), an indirect competitor to Dunkin Donuts. Mandel had amassed a stake in the coffee maker that represented ownership just under 4%, and totaled 5.99 million shares.

At of the close of the second quarter of 2012, there appeared to be mixed feelings among hedge funds with respect to Dunkin; various funds added Dunkin to their portfolios, while others downsized. However, the general consensus was positive, with Philippe Laffont of Coatue Management increasing his position by 36%. See all of the hedge fund interest in Dunkin here.

Dunkin’s main competition includes McDonald’s Corporation (NYSE:MCD), Starbucks Corporation (NASDAQ:SBUX) and Krispy Kreme Doughnuts (NYSE:KKD). Dunkin trades high on a multiples basis when compared to its peers. The trailing P/E ratios of Starbucks and McDonalds are 28 and 17, respectively, while Dunkin trades at 56.  However, a noteworthy comment is that based on consensus EPS estimates, Dunkin is trading at a forward P/E of 23. Earnings are expected to remain strong for the company, but investors are still skeptical and have held back on adding the stock to their portfolios.

The high P/E multiple of Dunkin should be considered in the context of its current market opportunities.  Whereas Starbucks and McDonalds have saturated the U.S. and many international markets, Dunkin still has many growth prospects. Dunkin has more than 50% of its stores in the Northeastern part of U.S., with plans to aggressively expand to the Western part of the country. Dunkin also still generates about 78% of its revenue from the U.S. market, leaving much room for international growth. The company has recently increased its expectations for market expansion, with estimates to add 600-700 stores in 2012, versus the previous target of 550-650.

The battle to be considered the top coffee stock has come down to Starbucks, McDonalds and Dunkin. Starbucks is the leader in the battle for U.S. coffee retail market share, with McDonalds expected to provide more competition for both Starbucks and Dunkin going forward. There have been no insider purchases since the company started trading in July 2011. The vast amount of insider selling has been initial shareholders closing out their positions to lock in gains and access capital they had tied up prior to the IPO.

Dunkin announced a quarterly dividend of $0.15 in March 2012, which represents a current dividend yield of 2.0%.  Although the payout ratio of 48% is above its peers, we do not believe there is need for concern. The franchising business model provides a steady stream of income and the company should be able to capitalize on its strong brand recognition without having a large outlay of capital, given franchisees bear the majority of expenditures.

The company’s second quarter results beat on the revenue and income numbers, with income of $18.5 million, versus $17.2 million for the second quarter last year.  However, a steep drop in operating income, which came in at $46.1 million, compared to $61.8 million last year, placed downward pressure on the stock. Dunkin has also seen its stock beaten down due to concerns over weakening same-store sales.  However, in the latest quarterly numbers, Baskin-Robbins saw an increase in same-store sales of 4.6%, compared to a 2.8% decline in the prior year’s quarter.  As well, Dunkin Donuts same-store sales rose 4.0% in the U.S., up from the 3.8% in the prior year. Management has also increased its EPS estimates, but even with revised guidance and strong growth prospects, Dunkin’s share price has fallen over 12% since its second quarter announcement.

With Dunkin’s opportunities for further market penetration and additional market expansion, the concerns that have placed pressure on the stock may very well represent a buying opportunity.

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