Dunkin' Brands (DNKN) had its successful IPO almost one year ago and it is time to reevaluate my 5 Reasons to Buy Dunkin' Donuts, Not Dunkin' Stock. Dunkin is up nearly 25% in that timeframe as it significantly outperformed the S&P 500 starting in April 2012. Many "fast casual" restaurants have performed well over this period as consumers seek affordable luxuries as the economy still poses a challenge. Since Dunkin' is a well positioned to continue to capitalize on a stagnating economy, is Dunkin' a stock that you should have in your portfolio? Below I will readdress the five reasons I mentioned in August 2011 and see if they are still valid - who knows, maybe it might make sense to finally buy Dunkin' stock?
Reason 1: Insider Selling
Dunkin' Brands Group was acquired in December 2005 for $2.43B by the private equity firms ("PEFs") Bain Capital Partners LLC, the Carlyle Group, and Thomas H. Lee Partners, L.P. and most of the PEFs exited their positions at the initial public offering last year. These PEFs and other insiders are looking to further reduce their positions by selling 22 million shares. Other analysts on Seeking Alpha continue to be bearish with insider selling a strong reason why and I share the same sentiments. There are many reasons why insiders will liquidate their positions but Dunkin's history with the private equity firms leaves a sour taste in investors' mouths. It is likely that the PEFs are of the opinion that the easy money has been shaken out of Dunkin' and it is time to exit the position.
Reason 2: Crippling Debt Burden
Dunkin' had approximately $1.5B in debt on its books after the IPO and management not made it a priority to improve the firm's financial flexibility. The long term-debt-to-equity ratio sits at 2.0 which I consider troublingly high given Dunkin's growth aspirations. As long as the current ratio sits above 1.0 there are no immediate liquidity concerns but Dunkin' will need to improve financial flexibility in the near future if it hopes to successfully execute on its growth plan (see reason number four below). One factor working in Dunkin's favor is that its stores are less costly to open because the vast majority are franchised. Note that the private equity secondary offering will not help the financial condition of Dunkin' as the proceeds of the offering will go directly to the PEFs.
Reason 3: P/E Ratio Out of Line
Dunkin went public with a PE in the mid forties which I considered too high compared to the likes of Starbucks (SBUX) and McDonald's (MCD). The TTM P/E is currently a downright scary 68 but that does not tell the entire story. The forward P/E which normalizes some extraordinary charges is a much more reasonable 27; however, I still cannot support an ordinary retailer with such a high multiple forward multiple. As I said in August, "In this economic environment I am hard pressed to pay over 20x for a company unless I find their growth prospects extremely compelling."
(Source: Adapted from Seekingalpha.com)
After McDonald's recent decline from 100 to 92 the P/E sits at 17.3. It is difficult for me to envision a scenario in which I prefer Dunkin' over McDonald's. Furthermore, Starbucks' forward P/E is also 29 and the company has been performing very well recently with management's recent initiatives firing on all cylinders.
Reason 4: Difficult To Expand Geographically
Dunkin' did not break out the number of stores it opened in its recent quarterly filing but there have been news stories indicating that Dunkin' will be expanding into the central and west United States. For example, there have been reports of planned new store openings in Denver, New Mexico, and Texas. It is still too early to grade Dunkin' in this growth department but I am not optimistic given the company's high debt and the difficulty of influencing consumer preferences in such an entrenched market. People are very passionate about their coffee and it will not be cheap to sway their morning rituals.
Reason 5: Baskin Robbins Is A Drag on Performance
I was very critical of Baskin Robbins at the IPO because it continued to post declining same store sales to which I stated "I think Dunkin' could benefit from focusing more on the higher profit beverage business rather than ice cream." Much to my surprise the performance of Baskin has been actually improving as management has been closing underperforming stores and sales growth is now strongly positive for the first time in years. Additionally, from the most recent 10Q:
- Baskin-Robbins International systemwide sales growth of 11.6% primarily as a result of increased sales in South Korea and Japan.
- Baskin-Robbins U.S. systemwide sales growth of 10.8% resulted primarily from comparable store sales growth of 9.4% driven by capitalizing on favorably warm weather, product news and innovation, the launch of a new advertising campaign, and improved operational execution.
Clearly, Baskin's management is at least taking steps in the correct direction. This is still just a small piece of the Dunkin' story but it is at least good to see a source of underperformance being rectified.
Dunkin' Starts To Payback Investors
All is not bleak for Dunkin'; over the last year as Dunkin' initiated a $.15 quarterly dividend in March that translates into a current yield of approximately 1.75%. To quote CFO Neil Moses:
The health of our overall business and the strong cash flow we generate position Dunkin' Brands to return cash to our shareholders through a regular dividend. We believe the initiation of a dividend, only a few months after our initial public offering, demonstrates our commitment to enhancing shareholder value and underscores our positive outlook for our future performance.
For reference, McDonald's and Starbucks yield 3% and 1.3%, respectively.
In closing, I still maintain my hold rating on Dunkin' Brands as its improvements in some areas are more than offset by the rise in the stock price during 2012. The reasons above are largely interrelated: Dunkin's high P/E indicates that the market expects strong future growth but that cannot come to fruition unless management reduces long-term debt. McDonald's has stronger financial flexibility, a global brand, and more attractive valuation which makes it my preferred pick over Dunkin'. Investors would be wise to take advantage of McDonald's rare recent stumbles to initiate a position.