Dunkin's Coffee Buzz
The once dowdy New England doughnut chain is riding high on the popularity of its brew. Can it go coast to coast?
By Matthew Boyle, Fortune writer

(Fortune Magazine) -- By the time the doors opened at 5 A.M., nearly two dozen people were waiting in the sultry late August heat. Their mission: coffee and doughnuts. That's what happens these days at the grand opening of a Dunkin' Donuts, in this case at a shopping center in the Nashville suburb of Franklin, Tenn.

Electricians, office workers - even the town mayor and athletes from the local NFL and NHL teams - piled in throughout the morning. By the time the stampede subsided, customers had purchased 600 dozen doughnuts in a little more than five hours. That's about 1.4 million calories, give or take a cruller. The crowd would have bought more, but the store ran out well before noon.

Who'd have thought a frumpy regional chain from outside Boston - best known for a somnambulistic TV spokesman mumbling "time to make the doughnuts" - could be sparking a frenzy in suburban Tennessee? Even more striking has been Dunkin's transformation from a musty doughnut house that sells coffee into a blue-collar-chic coffee retailer that happens to sell doughnuts. CEO Jon Luther admits that Dunkin' has considered removing "Donuts" from its name (he's mum on potential alternatives) now that sugary confections represent a mere 15 percent or so of its sales.

Caffeine is delivering a jolt to the company. Sales have surged more than 40 percent during Luther's nearly four years as CEO, and Dunkin' claims its coffee-drink market share is up from 15 percent to 18 percent. Meanwhile, the company has been expanding at top speed, opening 550 outlets in the past year.

That's only the beginning for Dunkin', which was bought for $2.43 billion in December by private equity firms Bain Capital, the Carlyle Group and Thomas H. Lee Partners. They're supporting Luther's plan to stretch Dunkin' beyond its Yankee roots to the Southeast, Midwest and eventually the West Coast, with the goal of tripling Dunkin's U.S. locations to 15,000 by 2020. To grab more sales in the slack afternoon hours, the company is also remodeling drab stores and expanding the menu beyond baked goods to include items like Dunkin' Dawgs (tiny pigs in a blanket).

Dunkin's plan faces myriad obstacles. The company has failed in the past when it tried to expand beyond its home market. And the menu alterations risk alienating, say, Boston Kreme loyalists who are turned off by the espresso crowd.

Then there's the competition. Luther's strategy pits Dunkin' against fast-food titans like McDonald's (Charts) and Burger King (Charts), which have spruced up their joe. Meanwhile, Canadian coffee-and-doughnut purveyor Tim Hortons (Charts) plans to expand in the Lower 48. And there's also that coffeehouse chain out of Seattle to worry about.

How Luther and Dunkin' handle these challenges will go a long way toward determining whether the company ends up resembling a national juggernaut like Starbucks (Charts) or follows the trajectory of another regional doughnut house with a fanatical following and a populist cachet - Krispy Kreme - that ended up biting off more than it could chew.

Here's a piece of coffee trivia: It was Dunkin' founder Bill Rosenberg - not Starbucks' Howard Schultz - who pioneered the practice of overcharging Americans for their brew. When Rosenberg founded his chain in 1950, its 10-cent cup was double the going rate.

But Rosenberg's operation was resolutely about the glazed, the jelly, the sprinkled - the doughnut. And it took off. By 1963, Rosenberg had 100 stores. Still, he never cared much for pushing beyond the East Coast. More distant expansion was almost accidental. If a Boston franchisee happened to be moving west, he might open an outlet.

After Rosenberg sold the chain in 1990 to what became Allied Domecq, the approach remained slapdash. Dunkin' was lax in franchisee selection, allowing munchkin operators who could barely finance a single store to launch. To compound matters, headquarters provided scant assistance with site selection, construction, operations, employee training and marketing. It didn't help that Allied, which also owned ice cream shop Baskin-Robbins and sandwich chain Togo's, attempted to co-brand all three under one roof. Franchisees rebelled, and growth stagnated.

Still, the companies were profitable, with combined operating earnings of $160 million in 2004, their last full year in a public company. That's in part because a decade ago, Dunkin' saw the black gold in Starbucks' approach and began emulating it with successful products like the Coolatta.

In 2003, Allied brought in Luther, now 62, who had turned around fried-chicken chain Popeyes, to replace Dunkin's retiring CEO, Jack Shafer. During a recent interview at his Canton, Mass., office, strewn with memorabilia, including a copy of Babe Ruth's Yankees contract, the genial Luther mixed candor with monastic silence when it comes to broaching the private company's financials. He's trying to inject a broader, more ambitious worldview. "The [Dunkin'] leadership at the time believed this was a great regional brand, but for them the world ended at the Hudson River," Luther recalls. "They were not prepared to build a national brand."

To do so, Luther believes, requires support from headquarters. Today, franchisees are assisted by Dunkin's local development teams, who lend a hand with all facets of the business. Luther has also pushed for stronger franchisees, recruiting well-heeled operators who can afford to open multiple stores.

Bernard Brophy is a perfect example. The 46-year-old former gold trader at Goldman Sachs likes to say he now deals in different commodities - coffee, sugar, and wheat - as the owner of two Dunkin' franchises on New York's Long Island. He has a third on the way and hopes to open as many as ten. Says Brophy: "I got a lot of ribbing from my Wall Street friends about 'time to make the doughnuts,' but to be honest, some of them are actually jealous."

Dunkin' plans to expand methodically. Today, only about 60 stores sit west of the Mississippi River. The company will start in Cincinnati, Cleveland, Tampa, Charlotte, Atlanta and Nashville and then head westward. It is planning distribution points in Dallas, Phoenix and Las Vegas.

While he expands Dunkin's footprint, Luther is doing the same to its menu. The first step was to amp up the emphasis on coffee, which is far more profitable than doughnuts. And its market is percolating: The percentage of workday coffee bought outside the office increased from 36 percent in 2003 to 48 percent this year, according to the National Coffee Association. In Luther's first year, Dunkin' launched a line of espresso-based drinks, which now accounts for 5 percent of sales. A variety of flavored brews followed, and this year fruit smoothies were added to the mix.

Dunkin' has introduced new items like cookies and a ham-and-cheese melt. They can stall service - Dunkin' wants your order in your hands in 150 seconds or less - so the company's creating express lanes in some stores for customers who want only coffee.

Not everything has clicked: A steak-and-cheese sandwich got dumped because "people didn't know if it was an A.M. or P.M. thing," Luther says. Franchisees admit that building the afternoon business will be hard.

But the enhanced menu has lifted average franchise sales from $800,000 to $900,000-plus, and Luther thinks that figure will hit $1 million by 2008. A good franchisee can earn margins of 20 percent to 25 percent. And Dunkin' projects same-store sales growth - a key indicator - between 4 percent and 5 percent for the year ended Aug. 31. That compares with the industry average of 2.8 percent.

Dunkin's ambitions come as Starbucks is showing a rare glimmer of vulnerability. The $6.4 billion, 11,950-unit chain saw its shares sink 9 percent in one day on word that July sales grew at their slowest pace in nearly five years. One problem: labor-intensive Frappuccinos, which can bog down operations.

The Dunkin' folks delight in poking fun at Starbucks' prices - they call it "Sixbucks" - and note that you don't need a dictionary to order from Dunkin's menu. But as Dunkin' remodels its 5,000 U.S. stores, elements of Starbucks are evident, from the self-serve milk bar to the colors on the walls. (Say goodbye to garish pink and orange.) Dunkin' even made its chairs more comfortable, but "not so comfortable that you could sit on them for an hour," says chief creative and innovation officer Joe Scafido. If you want to linger, in other words, go to Starbucks.

Dunkin' isn't the only coffee-and-cruller chain with national aspirations. Toronto-based Tim Hortons, whose menu resembles Dunkin's, plans to double its U.S. store base from 250 to 500 by the end of 2008. Hortons, which was spun off by Wendy's earlier this year, is flush with cash. And Hortons is tiny compared with McDonald's and Burger King, which may not be known for coffee but whose ubiquity and resources make them dangerous competitors.

Dunkin's owners praise Luther: "He has done an incredible job of providing franchisees with the support they need," says Thomas H. Lee Partners co-president Tony DiNovi - and acknowledge that their endgame will be an IPO. But they shy away from specifics. Still, while it's easy to predict that the investors will find a way to cash in, it's harder to tell whether Dunkin' will really make a go of it against so many larger opponents. But as long as they can get people to wait in line at five in the morning for a cup of coffee, they've got a shot.

Reporter Associate Patricia Neering contributed to this article. Top of page