Investors in Dunkin Brands (NASDAQ:DNKN) were disappointed last week after the coffee and baked good chain released a disappointing guidance for the upcoming 2015.
Fierce competition and a disappointing performance overseas hurts the anticipated achievements in 2015, which resulted in a big sell-off on the market as the market has been attaching premium valuation multiples to Dunkin's shares in the hope for high and consistent growth.
Given the still premium multiples and leverage employed by the business, I continue to be cautious even after shares have lost a fifth of their value over the past year and despite the long term rosy growth prospects.
The 2015 Guidance
CEO Nigel Travis reflected upon 2014, calling it a ¨challenging¨ year as he was pleased that comparable store sales and transactions remained positive.
The challenging conditions result from pressure on the consumer as well as lower sales of packaged coffee in the restaurants, trends which are expected to continue in 2015. On the back of these developments and disappointing developments in the overseas joint ventures in Korea and Japan, Travis had to introduce disappointing targets for 2015.
US comparable store sales for the coming year are seen up between 1 and 3% for both its Dunkin Donuts stores as well as the Baskin Robbins stores. This growth is anticipated to be accompanied by 410 to 440 net new store openings of Dunkin Donuts in the US, another 5-10 Baskin Robbins store openings, and 200 to 300 net new openings abroad.
This growth of a total 615 to 750 net new units are anticipated to drive growth in combination with the comparable sales growth. As a result revenues are seen up between 5 and 7% which in its turn should drive 6 to 8% growth in adjusted operating earnings.
This translates into adjusted earnings of $1.88 to $1.91 per share for the upcoming year, based on some 106 million shares outstanding.
Despite the disappointing guidance for 2015, Nigel Travis remains committed to the long term targets of the business which includes the commitment to return to double-digit growth. The official long term targets call for 6-8% growth in sales and 10-12% growth in adjusted operating earnings, with earnings per share seen up more than 15% on an adjusted basis. In my eyes these targets are quite aggressive, and an investor has to wonder of how great usage these targets are after two softer years in a row.
Dunkin Brands is essentially a pure franchise business operating under the namesake brand as well as Baskin Robbins. The near 100% focus on franchising allows for a very asset light business model with the entire ecosystem covering more than 18,000 restaurants across the globe.
While the company presents itself as a global business, it is still very much a North American business, with 74% of sales made up by Dunkin Brands in North America as Baskin Robbins makes up 6% of total sales in North America. The remainder of the sales are achieved internationally, spread out over its two brands.
The growth strategy is simple, which is essentially comprised out of growth by increased comparable sales, more store openings and growth abroad. Despite the fact that Dunkin's ecosystem covers roughly 8,000 stores in the US, it is very much focused on the North-Eastern parts of the US, lacking any substantial coverage in the Middle and Western parts of the country.
This creates a huge opportunity to grow sales in the future, with Dunkin seeing potential for some 17,000 stores within the US alone in the long run. At the current pace of roughly 400 store openings per year, it will take the business some two decades to achieve these ambitions.
The average investment for franchisees to open a store comes in just below half a million, with stores achieving sales of close to a million, generating attractive cash returns.
The international activities are largely represented by Baskin Robbins and focus on Asia where the company has nearly 6,000 stores through joint-ventures. Penetration in other areas is very much more limited with the company having about a 1,000 stores in the Middle East, some 700 stores in Europe and a similar number of stores in Latin America.
The Business Model
For the third quarter, Dunkin reported that its franchisees reported sales of $2.58 billion, a 5.7% increase compared to the year before. Growth was driven by an increase in the network, with some 18,600 restaurants being part of the company's franchise network. This means that average revenues per store come in around $140,000 for the quarter.
On these franchise sales, Dunkin generated sales of $192.6 million, which was up just 3.4% compared to the year before. This implies that the business takes an average cut of roughly 7.5% of the reported franchise revenues. Note that these percentages are not exact, as the company has still a few company-owned restaurants which means that this percentage is not exactly comprised just out of franchise and related fees.
Running such a business model is very profitable as well as asset light in its nature. Dunkin reported adjusted net income of $52.2 million, for incredible after-tax profit margins of 27%.
The company ended the quarter with $155 million in cash and equivalents while operating with a very sizable $1.8 billion debt position, resulting in a net debt position of $1.65 billion. Given that the business has few real tangible assets, this is a substantial borrowing amount. In relation to reported trailing EBITDA of $360 million, this results in a leverage ratio of around 4.5 times
With shares having fallen towards $42 per share, and given that there are some 108 million shares outstanding, Dunkin's equity is valued at $4.5 billion. This is equivalent to roughly 6 times sales and 23-24 times adjusted earnings foreseen for 2014.
Final Thoughts, A Complicated Playing Field
The food and quick drinks sector operates under multiple kinds of business models including a pure company-owned store strategy, a pure franchise-based strategy and a mixture of the two. McDonald's (NYSE:MCD) is a prima example of the mix, while company's like Starbucks (NASDAQ:SBUX) focus on company-owned stores, as Dunkin and Burger King (BKW) focus on the franchise-based strategy.
This makes the discussions of revenue multiples and profit multiples not very fair nor informative, given that these are completely different strategies with a different risk-return profile and different requirement for capital. As a result, one needs to value Dunkin on its stand-alone potential.
Dunkin has only been public since the summer of 2011 when the company made its debut by selling shares to the general public at $19 per share, after it has been held private since 2006 following a buyout from private equity firms Bain, Carlyle and Thomas H. Lee Partners. Ever since shares have seen significant appreciation, having risen to highs of $53 in March of 2014, after which shares have lost some 20%, partially the result of the disappointing 2015 outlook.
I like the business and the potential, with the store base growth across the globe being secured for decades, if Dunkin can attract franchise organizations. That said, the leverage employed is still on the high side, as the valuation is demanding as well, trading at 22 times forward earnings, which is even based on an adjusted earnings metric. These two factors make me a bit cautious, despite the disappointing returns seen so far this year, and the dividend yield which currently returns 2.2% to investors per year.
Given the growth story a premium might be warranted, yet I am cautious to attach this premium valuation to the shares as a result of the significant leverage employed. An 18 times adjusted 2015 earnings metric already seems generous, which translates into a targeted entry point of roughly $34 per share, still a long way from current levels. As a result, I continue to watch the action from the sidelines for now.
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