Dunkin’ Brands (DNKN) had a wildly successful IPO on July 28th in which it surged nearly 50% leaving many investors scratching their heads. This is the type of result that investors have come to expect from hot technology startups but not from sleepy coffee retailers. Let me preface this article by stating that I love Dunkin’ coffee and donuts. I really wanted to find a reason to buy the stock (already a behavioral finance warning sign!) but when I analyzed the S-1 I saw nothing but red flags. Below I have highlighted five reasons why you should stick to buying Dunkin’ Donuts and not the stock.
LBO Horry Story
Dunkin’ Brands Group was acquired in December 2005 for $2.43B by private equity firms (“PEFs”) Bain Capital Partners LLC, the Carlyle Group, and Thomas H. Lee Partners, L.P.. Most private equity firms have the objective of generating a large profit in a short period of time; however, this has not been the case with Dunkin’. After years of lackluster performance, these private equity firms sold approximately 25% of their investment in an IPO last week. Specifically, 22.25 million shares were sold in the oversubscribed offering at $19 per share versus a range of $16-$18). This means that the PEFs will take a loss of approximately $300M on the deal. If these insiders are willing to take such a significant loss on the deal why should you as a personal investor even take the risk?
The most shocking part of the entire deal is that the PEFs paid themselves a $500M special dividend that is now debt for the newly minted Dunkin’ shareholders. As an investor I would not be pleased to see my capital being used in this way as it sends the message that the PEFs come first and the common investors are secondary. Who is to say that there will not be any more special dividends in the future?
$1.5 Billion Reasons to Say No
After the IPO proceeds “repay” much of the special dividend granted to the private equity firms, Dunkin’ will still have approximately $1.5B in debt on the books. The interest payments and lack of financial flexibility will continue to be a significant drag on profitability. In particular Dunkin’s obligation to maintain certain financial ratios as part of the debt restrictions will be especially onerous. As a result, even if Dunkin’ is able to execute on its lofty growth plan, it will be hard pressed to expand as quickly as investors may expect. I tend to avoid companies with such significant debt burdens and instead prefer financial stable firms that are able to generate copious cash flows from operations. There is no immediate liquidity concerns as the current and quick ratios are both approximately 1.0, but the long term solvency gives me concerns.
Is This The PE of a Retailer?
Dunkin’ is a self described quick service restaurants (“QSR”) but it is trading like a new technology 2.0 firm. Even after adjusting for the future interest payment savings Dunkin’ still trades at a PE well into the 40s. In contrast rivals Starbucks (SBUX) and McDonalds (MCD) trade at 28.0 and 17.4, respectively. Furthermore, even Apple (AAPL) trades at less than half (15.6) of Dunkin’s multiple, despite a vastly lower earnings growth rate. In this economic environment I am hard pressed to pay over 20x for a company unless I find their growth prospects extremely compelling. If I could buy Dunkin’ at a PE closer to that of McDonalds in the mid-teens then we might have something interesting but for now stay away.
Northeast Bias Will Be Expensive To Break
Dunkin’ was founded in 1950 in Massachusetts and still is predominately in its “hometown” of New England and New York. 54.9% of Dunkin’s restaurants are in the Northeast while only a fraction of the restaurants are in the Western U.S. On one hand, this presents a tremendous growth opportunity for Dunkin’ to grow rapidly; however, there is a momentous risk. The lofty valuation pegged on Dunkin’ is contingent on the company expanding West and penetrating these untapped markets.
Besting Starbucks and McDonalds in such an entrenched, mature market will not be easy: this strategy will require significant investments in marketing and advertising. This is another substantial expense that will erode Dunkin’s fragile profitability. In essence Dunkin’ needs to convince customers in these markets to “trade down” to a lesser perceived brand. Starbucks has built its empire on the concept of an affordable luxury that has become a status symbol while Dunkin’ is a more “blue collar” coffee. Quite simply, this western expansion will not be a repeat of the 1940s gold rush and is hardly a sure thing.
America Does NOT Run on Baskin-Robbins
The Dunkin’ Group also includes the “#1 QSR chain in the U.S. for servings of hard serve ice cream in Baskin-Robbins; however, that appears to be a drawback to the investment. The only conclusion that I could draw after review Baskins’ key financial metrics is that its prospects are bleak. Domestic same store sales are lagging significantly and there appears to be a general lack of momentum. The picture for Baskin-Robbins International is definitely brighter but I think Dunkin’ could benefit from focusing more on the higher profit beverage business rather than ice cream. In closing, this was the final nail in the coffin for my decision not to invest in Dunkin’.
Taking the abovementioned five reasons together it is quite clear that Dunkin’ is a risky investment. It will face significant interest, marketing, and advertising expenses for the foreseeable future while it launches its ambitious western growth plan. If I could buy Dunkin for around $15 per share I would be less apprehensive about my investment but I cannot justify assuming so much risk in the face of such potent, larger competitors.
Disclosure: Author is long AAPL.