The rationale for investing in Dunkin Brands Group (DNKN) at their current valuation – price/earnings is 33 and 2016 P/E is 25 – is for their long-term growth. However, the company’s fiscal strategy may be putting that future in danger in exchange for rewarding current investors. If I owned the stock, I wouldn’t sell based on the balance sheet situation, but that and the current valuation make me hesitant to enter a position.
The Balance Sheet
Let’s take a look at the few crumbs of good fiscal news before we move on to the bad news, data courtesy of Stock Rover. The good news is that Dunkin has the cash on hand to cover short term obligations, which gives them some padding to deal with their long term debt problem. They have also been decreasing intangibles as a percentage of their assets, while increasing cash, both positives.
The bad news is, the company has negative equity, and if you look at tangible equity (below) the situation is even worse. On a per share basis, Dunkin’s shares are backed by $3.35 in cash, but each laden with $25.03 in debt. On the plus side, the company did refinance their debt in January, shifting their long-term obligations from variable rate to fixed rate bonds, which will help keep the debt manageable.
Further, the company’s fiscal situation is actively getting worse. Just two years ago, Dunkin’s equity was $407 million in the black, and their debt was significantly less than it is now. Clearly, management is comfortable with Dunkin’s leverage – and investors who are uncomfortable with it should be aware of management’s strategy.
Of course, much of this is a result of Dunkin’s asset-light business model: since the company franchises almost all of its stores, it doesn’t accumulate equity the way other restaurant chains do. This also means that the company can open more stores without needing to invest a lot of assets. Below, I’ve compiled some figures so we can examine Dunkin’s debt relative to the size of the income, rather than their equity.
Dunkin’s interest coverage based on earnings before interest and taxes (EBIT) is 4.7, which is tolerable but not great. If we recalculate that using free cash flow instead, we get an even worse 2.2. Since Dunkin also deploys capital for dividends and share buybacks, as we’ll see in a minute, this doesn’t leave a lot of room for the business to maneuver.
Dunkin’s debt is also large relative to their income. Dunkin’s Debt/EBITDA is 6.6, and their Debt/Free Cash Flow is a whopping 15.8. That means that if Dunkin earned the same free cash flow in perpetuity and committed all of it paying down their debt, it would take the company almost 16 years. Now of course, this scenario probably won’t happen: Dunkin’ has strong growth prospects, and I think management is banking on the company growing into its debt.
Coupled with that debt is an emphasis on rewarding shareholders now, as we can see below. Dunkin has expanded their dividend pretty aggressively over the past three years, and has consistently kept their annual payout rate above 50%, meaning they’ve paid out more than half of their earnings as dividend each year. The company has also engaged in share buybacks, repurchasing 7.3 million shares through the open market and an Accelerated Share Repurchase (ASR). Taken by itself, this commitment to rewarding shareholders is encouraging. But when we look at the broader balance sheet picture, it does look like management is to some extent mortgaging the future to reward the shareholders of the present.
Of course, the investment thesis for Dunkin at its current price/earnings of 33 and 2016 p/e of 25 is predicated on growth, as is management’s strategy, I think. As anyone familiar with Dunkin knows, the bulk of their stores are clustered in the northeastern U.S. And as anyone in the northeastern U.S. knows, there’s a Dunkin almost every few blocks. The company has proven it can perform well with a lot of store density, which bodes well for eventual growth. So far, management has reported expansion initiatives in California and Colorado have done well, while international expansion is mixed. Management seems pleased with continental Europe, but has recently closed two dozen outlets in the Philippines.
The company currently has about 8,000 DD and Baskin-Robbin stores in the U.S, and 3,000 more internationally, and management’s long-term goal is 17,000 U.S. stores. This clearly leaves plenty of room for growth, and management is confident they can continue to add menu items to increase same-store sales. The company is expected to grow revenues 7% this year and 6.5% next year, with most of that growth coming from new stores. It wouldn’t surprise me if Dunkin maintained a 5-7% annual expansion rate for years and years to come.
Some investors will be comfortable paying 33x current earnings for that kind of growth story, and others won’t. While I would shell out that much for the right company, Dunkin’s balance sheet management makes me hesitant to enter a position at the current valuation. As a long-term investor, I’d prefer management give me delayed gratification rather than leverage the business for immediate return. If the stock were much cheaper, I might tolerate that, but right now the price just isn’t right.