Dunkin’ Donuts Stock: Due To Get Dunked?

Expansion at Dunkin’ Brands Group (DNKN) has gone well since its 2011 IPO, and excitement about that has kept its share price among the most expensive in the restaurant sector. But a couple of things have changed since 2011 that might make today’s investors question the wisdom of paying top dollar for Dunkin’ shares.

In particular, changes in borrowing rates and the way franchisees pay Dunkin’ for new Baskin-Robbins stores will simultaneously increase costs and decrease potential cash flow. While neither development marks a devastating development for Dunkin’, they do highlight those nagging doubts about whether its shares can continue to trade at valuations (based on forward PE ratio) well-above those of peers like Starbucks (SBUX), McDonald’s (MCD), Panera Bread Co. (PNRA) and Canadian equivalent Tim Hortons (THI).

DNKN Forward PE Ratio Chart

DNKN Forward PE Ratio data by YCharts

DNKN EV / EBIT TTM Chart

DNKN EV / EBIT TTM data by YCharts

Dunkin’ shares get a preponderance of hold ratings from analysts, many of whom mistrust the high valuations the shares carry. Investors continue to be enthusiastic about them anyway, sold on the special story of Dunkin’s fast, cheap expansion plan. Dunkin’ is just beginning to cover about two-thirds of the U.S. and the world overseas with its Dunkin’ Donuts and Baskin-Robbins stores, and it can open new ones at very little cost. Unlike at Starbucks or in part at McDonald’s, Dunkin’ Brands’ franchisees, not the corporation, foot the bills for new stores. Dunkin’ collects a portion of the revenues once they’re up and running. Investors like this arrangement so much that they’ve run up Dunkin’s share price nearly 60% in its two years of trading. It’s up 33% since Jan. 1, as seen in a stock chart.

DNKN Chart

DNKN data by YCharts

Dunkin’s heavy debt loan makes many investment professionals cautious about joining those buyers. As a former ward of private equity owners, Dunkin’ came loaded with debt used largely for paying off the original investors. Its debt-to-equity ratio remains more than four times that of its popular competitors. As a result, Dunkin’ is forced to use a far higher portion of its earnings to feed debt than its competitors do, as seen on this chart of EBIT to interest expense seen below. (We left off Starbucks and Panera, whose interest obligations are negligible.)

DNKN EBIT to Interest Expense TTM Chart

DNKN EBIT to Interest Expense TTM data by YCharts

This chart shows how debt funding eats into Dunkin’s free cash flow.

DNKN Free Cash Flow Chart

DNKN Free Cash Flow data by YCharts

About half of Dunkin’s debt is in variable rate agreements whose rates will surely rise in today’s market. Management is taking some steps to keep down the long-term costs of borrowing even as interest rates rise. They include raising debt levels even higher now in order to avoid taking out more expensive loans later. Nonetheless, Dunkin’s financing costs can be expected to grow.

The change in franchisee payments stems from Dunkin’s desire to encourage the opening of Baskin-Robbins ice cream stores, which has been a hard sell. There have been more Baskin-Robbins closures than openings in recent years. As an incentive, corporate in June said it would allow existing franchisees to waive the normal $25,000 new store payment, as well as royalties for the first two years. New franchisees can amortize the initial payment over 10 years and pay greatly reduced royalty rates for the first five years. Dunkin’ expects about 80 will open by 2016, but they won’t make as much money on those new stores as investors expected.

Investors so far have been happy enough to ignore Dunkin’s high share valuations. But as more money gets sequestered for debt, and the cash flow from some new stores looks measly, investors may find that Dunkin’ isn’t quite so special after all.

Dee Gill, a senior contributing editor at YCharts, is a former foreign correspondent for AP-Dow Jones News in London, where she covered the U.K. equities market and economic indicators. She has written for The New York Times, The Wall Street Journal, The Economist and Time magazine. She can be reached at editor@ycharts.com. You can also request a demonstration of YCharts Platinum.

Read more articles about: Company Analysis  stocks that look pricey   fast food stocks   

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