A Java Jolt For Dunkin' Donuts

CEO Luther has launched an ambitious growth plan. Can he take on Starbucks?

Allied Domecq PLC CEO Philip Bowman recruited Jon L. Luther to revive Dunkin' Donuts two years ago after complaining that the venerable chain had become a sleeping giant. Krispy Kreme Doughnuts Inc (KKD )., with a cult-like following for its sugary doughnuts, was running circles around it. In coffee, Dunkin' hadn't even bothered to offer the lattes that gave Starbucks Corp. (SBUX ) its buzz. And while it was a powerhouse in the Northeast and mid-Atlantic, much of the U.S. was ignored. "What about the rest of America?" Bowman remembers wondering. "Is there some reason that these folks in this white space [on the map] don't drink coffee or eat doughnuts?"

Luther was brought in from Popeyes Chicken & Biscuits (AFCE ), and these days, the 54-year-old chain is acting like it has swallowed a triple shot of its new fresh-brewed espresso. It has left the imploding Krispy Kreme in the dust, thanks in part to better execution and a strategy that stresses beverages rather than carb-laden doughnuts. It has begun an aggressive expansion that aims to triple Dunkin' outlets, to 15,000, within a decade or so. Now Luther's team is even daring to talk about taking on the coffeehouse crème de la crème. "We're every bit as good as Starbucks," insists John Gilbert, vice-president of marketing, who has brazenly launched ads claiming Dunkin' offers "A taste that Starbucks can't beat."

Advertising taunts aside, not even Luther believes Dunkin' Donuts can beat Starbucks at its own hipster game. Rather, Dunkin' is building on its red-state coffee image, even though it's based in blue state Massachusetts. Starbucks popularized Italian espresso drinks. "But we offer more of an Americanized espresso, with a more mellow blend," says Luther. Similarly, while Starbucks baffles newcomers with its "tall, grande, or venti" cups, Dunkin' sticks to small, medium, and large, at prices some 25% lower. Luther is betting there are lots more coffee drinkers who want espresso drinks at lower prices without the jiggy atmosphere.

Filling a void left by the stalled Krispy Kreme and riding Starbucks' espresso coattails is making Dunkin' one of the hottest acts in fast food. Thanks to a 6.9% jump in same-store sales, and 423 new stores, U.S. sales surged 14% in the fiscal year ended Aug. 31. That's nearly three times the industry average for sales growth, according to Technomic Inc. And while Dunkin' has little in common with its British parent's core wine and spirits business, it is a cash machine. Dunkin' Brands -- which includes the Baskin-Robbins ice cream chain and Togo's sandwich shops -- accounts for about 9% of Allied's sales, but 14% of its total profit.

No question Dunkin's basic business model looks all the more attractive against its faltering nemesis Krispy Kreme. A year ago, Krispy Kreme's stock was soaring. But now the chain's fortunes have collapsed under the weight of mismanagement, overexpansion, and accounting probes. Meanwhile, Dunkin' is finding smarter ways to move the doughnuts. Increasingly, it's transferring production out of stores into nearby central kitchens that can serve a whole district of Dunkin' shops. And it's pushing the new espresso products to price-sensitive latte sippers while still offering its old reliable cups of joe. Smart move -- java orders are growing four times faster than those for lower-margin doughnuts, estimates Harry Balzer, vice-president at market researcher NPD Group Inc.

But Luther still has a long way to go to catch Starbucks, which boosted sales 30% in the fiscal year ended on Oct. 30 -- twice as fast as Dunkin'. His first move, in Fall 2003, was the launch of the espresso-based drinks. Rather than pay baristas to craft lattes, Dunkin' hired Swiss manufacturer M. Schaerer Ltd. to produce an idiot-proof $8,000 machine. It churns out consistent cappuccinos in less than a minute. This combination of speed, consistency, and a lower price is winning converts. "Both are good, but Starbucks takes too long," says Leslie Bello in Framingham, Mass., a Starbucks-to-Dunkin' convert. The new beverages already account for up to 10% of store sales. And they're the prime focus of a new ad campaign, which aims to get consumers to stop by for an afternoon pick-me-up. Next summer, Dunkin' will roll out Turbo Ice -- iced coffee with a shot of espresso -- as a freshly made alternative to Red Bull and other energy drinks.

Luther's broader mission is to improve the image of Dunkin's coffee, and he's getting help. The December Consumer Reports rated Dunkin's ground coffee a "Best Buy," and far higher than Starbucks', which it found "burnt and bitter." Starbucks CEO Designate James L. Donald's retort: "Thirty million customers vote with their feet every week."

NO LUNCH BUNCH

Kicking Dunkin' up a few notches in coffee drinkers' minds is not as easy as getting the milk frothed right. Dunkin' has some star franchisees who build fiercely loyal customers with spotless stores and personalized service. But many franchisees fall short, and some stores are downright dingy. Also, Dunkin's shops are largely deserted before and after morning rush. Despite numerous attempts with sandwiches and soups, it has never made the transition to the lunch crowd. A store redesign is under way, but it will take years.

Dunkin's biggest opportunity is geographic expansion rather than a bigger menu. Currently, 80% of its sales come from just 34% of the U.S., and it's all but invisible in much of the Midwest, Southeast, and West. Dunkin' is invading four new markets -- Cleveland, Charlotte, Tampa, and Cincinnati -- and will enter four more over the coming year. U.S. COO Will Kussell, who's directing the expansion, predicts it will soon be opening over 500 stores a year, up from under 200 in 2001.

Ultimately, Luther's aim is to vault Dunkin' closer to the stratospheric performance of Starbucks, which has 40% more U.S. stores than Dunkin'. Rapid expansion has its perils, as Krispy Kreme discovered. To succeed, Dunkin' doesn't need to match its rivals sales pace. But it does have to find a flock of new well-financed franchisees willing to keep standards high. Then it has to persuade some of the millions still drinking the swill sold at most convenience stores and gas stations to trade up. That strategy may not be as glitzy as Starbucks's Wi-fi connections, comfy couches and hip music, but it's as straight forward as an honest cup of coffee.

By William C. Symonds in Boston, with David Kiley in New York and Stanley Holmes in Seattle

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