CLSA's Jeremy Scott: I'm Upgrading Dunkin' On Valuation

• Dunkin Brands Group Inc DNKN shares are down 9 percent in the last three months, trading below the $50 mark through September.
• CLSA's Jeremy Scott upgraded the rating on the company from Underperform to Outperform, while reducing the price target from $56 to $50.
• Following the recent decline in the company’s shares, the risk-reward appears more attractive, Scott mentioned.

Analyst Jeremy Scott said that the recent sell-off in Dunkin Brands’ shares appears overdone and the stock now offers “a much more attractive risk-reward.”

Scott added, however, that the company’s EPS growth had shifted downwards, from high-teens in 2011-2014 to mid-to-low-teens. “It’s important to note that while Dunkin faces a slower climb in earnings over the coming years, the company remains an asset-light, cash-rich perpetuity model with significant store growth opportunities, and that it deserves a premium multiple relative to the group.”

The EPS estimate for 2015 has been reduced from $1.93 to $1.90 to reflect short-term headwinds. The EPS estimate for 2016 has been reduced from $2.28 to $2.25 to reflect the impact of the lower base and the announced closures.

The analyst commented that minimum wage laws had resulted in a meaningful increase in costs, and this could continue. Consequently, fast food restaurants would need to hike prices by 1.3-1.4 percent in both 2015 and 2016 to fully offset the impact.

“The Dunkin franchisees have accelerated that hike by taking roughly 300bps of pricing in 2015, which is above food-at-home and food-away-from-home inflation rates. Pricing action of this magnitude is noticeable, particularly for a concept that cherishes routine consumption,” Scott wrote.

Traffic was light through 1H15 and turned negative in 3Q. Management does not have direct control over the pricing action of its franchisees, and can only persuade them. It is unclear whether such persuasion works, but “franchisees are undoubtedly feeling the impact,” the CLSA report stated.