The nearly 5% drop in shares of Dunkin Brands Group (DNKN) this week suggests that investors may finally be smelling what’s brewing at the owner of the Dunkin Donuts and Baskin-Robbins chains. Illusory growth in accounting earnings drove the stock higher, but a closer look could warrant lower prices.
Our 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 like Starbucks (SBUX) and McDonald’s (MCD) as well as other aggressive growers such as Krispy Kreme (KKD) and Tim Hortons (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 non-operating expenses that drove down reported earnings in both 2011 and 2012.
In 2012, major non-recurring 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 after-tax operating profit (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 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%, McDonald’s (MCD) and Starbucks (SBUX) have ROICs that are double and triple DNKN’s ROIC. Smaller competitors like Panera (PNRA) at 12% and Einstein Bros (BAGL) at 9% also have higher ROICs.
Such a low ROIC means that DNKN is in no position to expand. Its current franchises are not 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
While Dunkin Donuts slogan for years has been “America Runs on Dunkin”, it is really just the east coast that is running on Dunkin. Figure 1 shows just how concentrated Dunkin Donuts is in New England and the Atlantic coast.
Figure 1: Map of Coffee Chains in the U.S. – Dunkin Donuts In Pink
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