Why Dunkin' Donuts Stock Will Stay Warm (DNKN)

It's difficult to classify Dunkin' Brands Group (ticker: DNKN). It's more than just a coffee chain, as breakfast has become one of the biggest drivers of sales for the Dunkin' Donuts brand.

But it's more than just breakfast, because it also owns ice creamery Baskin Robbins. And, Dunkin is more than just a northeastern enterprise, despite the reputation, as its global footprint continues to expand.

But defining Dunkin' Donuts is the best way to understand how large this company can grow; especially considering it competes against some of the biggest names in fast food, including McDonald's Corp. (MCD) and Starbucks Corp. (SBUX).

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Now, as Dunkin tries to implement a new technology strategy focused on quicker service and improving the customer experience, it has to weigh upcoming increases in labor costs. Could one issue derail the efforts of the other?

It's a question worth pondering as the chain known for its quick cup has countered a yearlong slide in its stock with an 11 percent jump over the past three months.

Franchisees are feeling the effects of minimum wage hikes. There's a nationwide push by unions and workers to increase the minimum wage to $15. We've seen many companies take a proactive approach by implementing plans that will increase the wage scale well above $10. New York City will see the minimum wage rise to $15 within four years.

For Dunkin, this is bad news. Last year, for example, CEO Nigel Travis called any plans to raise the minimum rate to $15 as "outrageous."

"In particular, we expect price hikes taken to offset higher labor costs to hurt store traffic and prevent (comparable) sales from improving in the near term," Argus Research analyst John Staszak says.

But shareholders of DNKN stock have some protection against these wage hikes. The company's shops are 100 percent franchised -- that means the parent company doesn't take on the risk of owning the real estate, operating the spots or even paying the store employees. It simply collects the fees stated within the franchise agreement. In short, any payroll increases are absorbed by the franchisee.

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Of course, to combat higher labor costs franchisees will likely increase prices, resulting in a possible drop in customers. We're already seeing that happen, as Wedbush Securities analyst Nick Setyan says menu prices jumped 3 percent in the most recent quarter.

Technology could be the way Dunkin prevents further price hikes. With franchises increasing prices, Dunkin' Brands wants to prevent further efforts to pass along the cost to the customer. They're working "on ways to help franchisees bolster sales without relying as heavily on price increases to defend margins," William Blair analyst Sharon Zackfia says.

This month, Dunkin' is set to test a new feature within New York coffee shops called "On-the-Go." The service, which is linked to a customer's membership loyalty account and accessed through a smartphone, will allow customers to order drinks before they get to the store and pick up orders without waiting in line.

The goal is to bring this service to all Dunkin' coffee shops that don't have a drive-thru, which is about 50 percent of the stores, and incorporate it with "third-party delivery providers," Barclays analyst Jeffrey Bernstein says.

These tech improvements look to address comparable sales numbers, which have begun to show a disturbing trend -- per-store sales growth at U.S. stores have declined from 5.1 percent in 2011 to 1.4 percent in 2015.

There's ways to grow, if it can beat out the giants. Headquartered in Massachusetts, Dunkin' locations are ubiquitous on the East Coast, but there's plenty of room for expansion in other parts of the country. The company plans to add 430 to 460 new franchised Dunkin' Donut shops in the U.S. this year, with 24 percent opening in western markets.

However, it's competing against companies that have a far bigger footprint (and money). Looking at Dunkin' strictly as a coffee and snack business, its largest competitor is Seattle-based Starbucks, which has a market capitalization of $82 billion. And McDonald's is also a big player the coffee-and-breakfast space, sporting a market cap of $114 billion.

But despite Dunkin's $4 billion market cap, it's not like it's a small player in the field, says Morningstar analyst RJ Hottovy. It's the second-largest coffee chain, and a top-10 brand in quick-service restaurants.

Still, Dunkin' is searching for other ways to increase the bottom line. Last year, it began licensing its single-serve K-cups to companies, like Keurig Green Mountain and J.M. Smucker Co. (SJM). These companies distribute the pods through grocery stores and other venues, generating more than $500 million in sales from retail stores.

It's expensive, unless you look long-term. The problem with Dunkin is that it's already priced very high. DNKN stock's price-earnings ratio is already a sky-high 37, above the industry average of 27 and the Standard & Poor's 500 index (18).

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Instead, it's a "strong long-term growth story," Bernstein says. Investing on a long time horizon will provide the opportunity for the technological efforts and the increased stores to take hold.

Ryan Derousseau is a journalist with nine years of experience writing about investing and leadership issues. His work has been read in Fortune, Money, CNNMoney and Fast Company, among other publications. You can find more from him on Twitter @ryanderous.