Dunkin’ Brands (DNKN) Memo
Name: Haroon Masood College/School: McIntire School Year: 2014 Avg Vol: 1,126,790 P/E (ttm): 108.32x EPS (ttm): $0.29 Dividend Yield: 1.95% Debt/Equity: 3.32 Net Profit Margin (ttm): 5.48% Important Company Financial Data Price: $30.99 Market Cap: $3.64B 50W Range: $23.24 – $32.44 Thesis / Key Points 
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Fragile Capital Structure: Dunkin’ Brands has approximately $1.5B in long-­‐term debt on its balance sheet, which is set to mature between 2015 and 2017. This is about two times the amount of equity that the company holds. Each year, this debt produces over $100,000 in interest expenses, which is more than half of its 3-­‐year trailing operating income. Furthermore, according to the company’s S1, it must maintain tight ratio requirements on its debt as prescribed by its creditors in order to prevent default. What does this mean? It means that the company has little margin for error. With large interest payments, tight creditor repayment expectations and maturing debt, the company will have to grow at a tremendous pace in order to remain healthy. However, with high levels of debt, the company will face difficulty in achieving this rapid growth because it will have to reduce cash for investment in order to pay off its obligations. In all, Dunkin’ has a highly fragile capital structure that will require them to perform to perfection. As I will show below, this will be extremely difficult. Tech Stock Valuation: Dunkin’ Brands valuations are simply ludicrous. The company is trading at a P/E ratio of 105.95x, which is significantly higher than the quick serve restaurant industry average of 20.72x (including DNKN) and its closest competitor, Starbucks’ valuation of 35.19x. This is despite the fact that Starbucks has grown at a quicker pace than Dunkin’ over the past few years and achieved 2% greater revenue growth, 12% same-­‐store revenue growth, and 10% greater net income growth than Dunkin in 2011. Some analysts advise investors to assess the company on an adjusted income basis even though the company will probably incur debt-­‐restructuring costs, so-­‐called one-­‐time losses, in the coming years. Even if we do this, the company is still valued at a P/E of 50.49x, which is more than twice that of the industry average. On a relative basis, therefore, the company looks overvalued and will again be pressed to grow at a rapid pace despite interest payments and maturing obligations. No Shortage of Competition: Perhaps Dunkin’ would deserve such a high valuation and be capable of meeting high growth expectations if it was a monopoly or if it offered a product that would render its competitors obsolete. However, when we look at Dunkin’ we see a company that receives 60% of its revenue from coffee drinks and beverages and the remainder from baked goods and ice cream. In other words, it naturally has many competitors. To make matters worse, numerous companies like McDonalds (McCafe line) and Krispy Kreme who have similarly priced products are making concerted efforts to increase their coffee beverage offerings. This means that Dunkin’ will face increased competitive pressures for its most important products. Presumptuous Expansion Plans: To meet the lofty growth expectations implied in its price, Dunkin’ must expand beyond Northeast America, its backyard. The company’s major focus is to expand east of the Mississippi River. I am skeptical of Dunkin’s ability to quickly penetrate these markets. Dunkin’ failed in its efforts to penetrate this region in the past and today, Caribou Coffee, which gave Starbucks a difficult time, dominates the region. Moving further west, the company will be challenged by Starbucks itself, which has a strong foothold along the Pacific. To make matters worse, Dunkin’ will also face headwinds due to growing competition in the coffee shop space. According to Mintel, a global leader in food and beverages market research, there was 70% growth in coffee shops in the US between 2000 and 2005. Mintel further anticipated that the ratio of coffee shops to US citizens would increase from 1:14000 to 1:10000 by 2010. 100% Franchising with Unhappy Franchisees: Dunkin’ is almost 100% franchised. Thus, naturally it is in Dunkin’s best interest to develop healthy relationships with its franchisees because they are responsible for growing the business. It seems that Dunkin’ doesn’t understand this concept. In the period between 2006 and 2009, Dunkin filed over 154 lawsuits against its franchisees, which is about 12 to 15 times the number of lawsuits filed by other franchisers like McDonalds and Subway. This is certainly not a good indication of healthy relationships between Dunkin’ and its franchisees. To make matters worse, numerous charges have been brought up by franchisees, who have accused Dunkin’ of extortion. These accusations have been documented in numerous articles including Paul Steinberg’s article in the Penn State Law Review. Ultimately, I believe that these problems will slow down Dunkin’s anticipated growth because individuals will not want to enter franchising agreements with the company and because existing franchisees will raise charges against Dunkin’ as they push for aggressive expansion. Massive Insider Selling: It is no surprise that with the massive amount of debt on the balance sheet, the inflated stock price and the numerous challenges that Dunkin’ has ahead, insiders are looking to get out of the company. During the IPO in July 2011, the private equity trio that owned 80% of Dunkin’s shares sold 22 million shares. In November 2011, the group sold another 22 million and recently, in March, these companies announced that they will sell off 22 million shares again. The three firms have hurt future shareholders by packing the company with loads of debt and financing fat dividends for themselves with more debt. Now they are trying to get out of Dunkin’ before prices collapse. Confidence in the company is further hurt by the fact that the chairman of the company announced that he would be selling 32% of his stake in the company during the next offering. Dunkin’ Brands (DNKN) Memo
Misperception 
Expansions Plans Justify Price: The key misperception with Dunkin’ is that people believe that the company’s price is justified by its expansions plans for regions beyond the Northeast. Analysts argue that while the company’s trailing P/E is relatively high, its 2013 forward P/E is approximately 21x, which they argue is reasonable. Quite frankly, I don’t know how analysts forecasted a forward P/E of 21x. EPS would have to grow by approximately 400% for the company to have a forward P/E of 21x. Last year, EPS grew 31% YoY and the year before it actually declined. Some analysts make their estimates based on adjusted net income, which removes so-­‐called one-­‐time losses associated with debt restructuring. Even if we use adjusted net income for P/E calculations, the company would have to grow its earnings by 240% in order to achieve a 21x P/E. The company’s 3-­‐year adjusted EPS CAGR is approximately 45%. These growth expectations implied in the price just don’t make sense. To make matters worse, as mentioned above, the company will face difficulty expanding beyond the Northeast, especially with poor relations with its franchisees, who are effectively responsible for growing the business, and a high debt burden. To cap everything off, Dunkin’s performance is highly correlated with macroeconomic trends. There is still great uncertainty regarding the short-­‐term future of the US economy. VAR 
Survey: I conducted two surveys at Bice Residence Hall, the Pavillion and Clemons Library to get an idea for the coffee and donut preferences of students at the University of Virginia. The survey was conducted to gauge Dunkin’s penetration into markets outside the Northeast. It is important to note that Dunkin’ hopes to rapidly expand in states such as Virginia in the immediate future. The first survey asked 121 students, “If you want coffee, where do you prefer to get it from: Starbucks, Dunkin’ Donuts or somewhere else?” 65.3% of the respondents said that they would prefer to get coffee from Starbucks, 9.9% said that they would prefer to get coffee from Dunkin’ and 27.8% said that they would prefer get coffee from a different place. The second survey asked 112 students, “If you want donuts, where do you prefer to get them from: Dunkin’ Donuts, Krispy Kreme or somewhere else?” 40.2% said that they would prefer to get donuts from Dunkin’ Donuts, 50.9% said that they would prefer to get donuts from Krispy Kreme and 8.9% said that they would prefer to get donuts from somewhere else. These surveys are not conclusive in and of themselves, but they help reinforce the skepticism that exists regarding Dunkin’s lofty expansion plans. Dunkin’s primary source of income is its coffee line. As the survey indicates, it can be difficult to get people to alter their tastes for coffee once a previous brand has entrenched itself within markets. Also, the donuts survey reinforces the idea that Dunkin’ is not seen as the best source for donuts, which means that the company’s store traffic will ultimately suffer. How It Plays Out 
MII should immediately short Dunkin’ as the company’s price is highly inflated. By purchasing the stock right now, we can benefit from downward price pressure that will occur in the short-­‐term as insiders continue to sell their shares. In November 2011, following the last 22 million share sale by insiders, DNKN plunged close to 20%. In the medium term, I think there will be further correction in the price because Dunkin’s high debt burden and inflated price require strong growth and offer little room for error. These price corrections, which may be caused by high coffee prices, expansion difficulties, macroeconomic trends or missed earnings, will further increase MII’s return. Overall, in contrast to many short pitches I have heard in the past, this pitch does not attempt to identify a dying business whose faults may never get priced in or whose faults have already been priced in. Instead, it attempts to identify a structurally fragile company that must perform to perfection in order to sustain its stock price. Perfection is difficult to reach. Risks / What Signs Would Indicate We Are Wrong? 
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Successful Expansion Beyond the Northeast: If Dunkin’ successfully expands beyond the Northeast, it could give investors confidence in the company’s ability to expand beyond its core market. This would help to further develop growth expectations and increase the company’s price. In particular, it will be important to examine store-­‐level metrics. Generally speaking, Dunkin’s stores outside of the Northeast generate 40% less revenue than those in the Northeast. Free Cash Flows Increase Significantly: Currently, Dunkin generates about $100 million in free cash. This limits the company’s ability to pay down debt significantly because it has to split this free cash between its investment requirements and debt repayment efforts. If the company can continue to increase free cash at a rapid pace, this might help the company repay more of its debt before maturity and forego some refinancing costs. Signposts / Follow-­‐Up 
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Examine movements in long-­‐term debt. A rapid reduction creates greater margin for error for the company. Examine the company’s net margin. If it starts to expand, the company’s interest payments are having a smaller net impact on profitability. Examine same-­‐store and de novo sales growth Company Description [DNKN] franchises quick service restaurants that sell coffee beverages, baked goods and ice cream. The company owns two primary brands, Dunkin Donuts’ and Baskin-­‐Robbins, earning 76% and 24% of revenues respectively. It operates these brands in 57 countries with over 16,000 points of distribution. Dunkin’ Brands (DNKN) Memo
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Insider Sell-­‐Off Price Pressure Source: Google Finance DNKN Stock Chart
Dunkin’ Brands (DNKN) Memo
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Dunkin’ Brands (DNKN) Memo
Ideas for the Club Process Standardization: This semester, I think our team did a good job of highlighting inconsistencies that we had within our decision-­‐making procedures. Moving forward, I would like for us to continue to make a concerted effort to standardize a lot of processes (i.e. associate selection) so that they are not only thorough, but also fair for everyone in the club. Template Standardization: I think it would be nice to have similar templates for all public and private material produced by MII. This way, all of our work will look coordinated and professional. This will be great for our organization’s marketing initiatives. Manager/Officer Stock Competition: I would like to suggest a stock pitch competition between managers/officers. There will be one officer, one manager and two associates per team. Each team will work with members according to a pre-­‐set timeline to develop a stock idea. We can have a few teams compete in the fall and a few compete in the spring. The benefit of such a competition is that there will be greater interaction between the executive team and members. There will also be greater learning opportunities for members. Ultimately, I think the investment ideas that will come from this competition will be strong because they will involve less individual work on the part of the members and they will be more structured.