Dunkin' Brands Group Inc. (NASDAQ:DNKN)
, owner of the Dunkin' Donuts and Baskin-Robbins chains, is in the danger zone. DNKN's illusory growth in accounting earnings has driven the stock up nearly 40%, while the S&P 500
(INDEXSP:.INX) is up only about 20% over the past year. Diligence reveals that while reported earnings are up, DNKN's economic earnings are in decline. Future growth expectations are overblown as well, because the company's plans to expand outside of the Northeast pit it against formidable, entrenched competitors such as Starbucks (NASDAQ:SBUX)
and McDonald's (NYSE:MCD)
, as well as other aggressive, fast-growing chains such as Krispy Kreme (NYSE:KKD)
and Tim Hortons (NYSE:THI)
Earnings Growth Is Misleading
On a GAAP basis, DNKN grew its earnings by 36% in 2013 and 214% in 2012. However, these numbers are misleading, as they include a number of unusual nonoperating expenses that drove down reported earnings in both 2011 and 2012.
In 2011, major nonrecurring expenses included a $15 million sponsor termination fee
, a $34 million loss on debt termination
, and a $20 million impairment charge
on a South Korean joint venture.
In 2012, major nonrecurring expenses included a $21 million charge
due to a lawsuit brought about by former franchise owners and $5 million in secondary offering costs
. In addition, the Baskin-Robbins International segment had a one-time delay in revenue recognition that impacted revenue by $6 million
When we remove these unusual items, we see that DNKN's true net operating profit after tax (NOPAT) in 2011 and 2012 were higher than reported. Therefore, the growth in 2013 is much smaller than it appears on the surface. In 2012, DNKN grew NOPAT by 30%, and in 2013 DNKN grew NOPAT by just 7%. That's not a bad growth rate, but it pales in comparison to the double-digit growth that bulls are touting and the stock valuation reflects.
Digging further into DNKN's balance sheet, we see that economic earnings declined by over 380% in 2013. This decline comes from the fact that the company's balance sheet is growing faster than its cash flows. In other words, the company is seeing incremental returns on capital that are much lower than current returns, and its return on invested capital (ROIC) has fallen below its weighted average cost of capital (WACC). This decline is a bad sign when the company's profitability is already worse than many of its competitors.
With ROICs of 15% and 22%, respectively, McDonald's and Starbucks have ROICs that are double and triple DNKN's ROIC. Smaller competitors such as Panera (NASDAQ:PNRA)
at 12% and Einstein Noah Restaurant Group (NASDAQ:BAGL)
at 9% also have higher ROICs.
Such a low ROIC means that DNKN is in no position to expand. Its current franchises aren't profitable enough to justify growth. If the company is not able to generate higher returns from its small base of business, then why should we expect it to generate anything but lower returns when it expands into markets with competitors that have higher ROICs?
Expansion Means More Competition and Even Lower Profits
"America Runs on Dunkin'" has been the company's slogan for years. But it's really just the East Coast that's running on Dunkin. Given that 81% of DNKN's profits came from its domestic Dunkin' Donuts segment in 2013, it's clear that, for all its international presence, DNKN still depends largely on one region in the US.
DNKN is trying to expand aggressively into the western part of the country. However, profit growth in this region seems unlikely as the company faces competition from incumbents such as Starbucks and McDonald's, which have already worked to saturate these markets and have higher ROICs and much better brand recognition than DNKN. The idea that DNKN can compete with or take market share from higher ROIC companies such as SBUX and MCD seems absurd to me.
One of my firm's analysts visited a new Dunkin' Donuts location here in Nashville a few times and found it to be almost or entirely empty each time. That location was competing against a Krispy Kreme two blocks away in one direction, and a Starbucks and McDonald's in the other direction.
Smaller competitors have the same expansion plans as DNKN. Canadian favorite Tim Hortons plans to build over 300 new US franchises in the next few years. Krispy Kreme, which has shown impressive growth since bottoming out in 2006, has plans to open nearly 100 new stores worldwide this year, almost double its total from 2013. Einstein Bros is even stepping up its expansion, with 80 new stores planned this year.
Don't forget about competition from home coffee brewers, led by Keurig Green Mountain Inc. (NASDAQ:GMCR)
or gas stations, which also often serve coffee and doughnuts.
DNKN's expansion plans face serious challenges and could lead to major write-offs in the future as they build out stores that never turn a profit.
Best-Case Scenario Already Priced In
This stock has two major problems.
First, while 2013's 7% NOPAT growth isn't terrible, it is far below the growth expectations embedded in the stock. The current valuation of ~$51/share implies that the company will grow NOPAT by 15% compounded annually for 12 years
If the company continues on the 7% NOPAT growth rate for 15 years, it has a fair value of just $19/share
. Moderate 7% profit growth means major downside for investors.
The second problem for the stock is that the misallocation of capital for expansion will further undermine the profitability (i.e., ROIC) of the company. Taking the profits from already struggling stores and plowing them into less-successful stores means the company's ROIC will decline further. This decline may be masked by top line revenue and earnings growth in the near term, but ultimately it leads to a lower ROIC and a less-profitable company, which means a lower stock price.
My research on DNKN's ROIC highlights the need for investors to perform due diligence for prior years as well as the present one. My adjustments
for 2013 aren't all that significant, but adjustments to previous years put DNKN's 2013 results in an entirely different perspective.
For a company that's supposedly in a growth stage, DNKN's executives are cashing out at a surprising rate. Over the past six months, insiders have sold 540,000 shares, or 8% of their holdings. That amount of selling suggests that the stock may have run out of steam after an 80% increase since its IPO in 2011.
DNKN is not a bad company, but at ~$51/share, it is a bad stock, and insiders seem to agree. Double-digit profit growth for over a decade is not a realistic expectation for a quick-service restaurant in a crowded field. DNKN's reported earnings growth may look tempting, but investors should resist the urge to take a bite.
David Trainer is a Wall Street veteran and corporate finance expert. He specializes in reversing accounting distortions on the underlying economics of business performance and stock valuation. He is the author of Modern Tools for Valuation (Wiley Finance 2010).