Last week, Dunkin' Brands Group (DNKN) received the kind of swift and brutal lesson investors usually reserve for high-growth technology stocks that have temporarily flown past their potential.
Dunkin' stock, which had been up more than 32% for the year as recently as July (though it's steadily eroded since), plunged 12.2% during the company's "Investor & Analyst Day" on the first of October. The DNKN ticker is now down virtually flat in 2015.
Dunkin' Brands' third-quarter comparable-store-sales outlook, revised down to just 1.1% on the morning of the investor meeting, was quickly blamed as the catalyst for the stock's sell-off.
Yet the source of lingering investor discomfort can perhaps be traced to other parts of the quick-service giant's presentation. Let's review a few key slides the company put forward for some insight on why Dunkin's stock hasn't quite rebounded yet.
Recent history is compelling, but cautionary
Dunkin' Brands' investor-day materials included many graphics detailing company performance since its initial public offering just over four years ago. The following slide highlights the doughnut and coffee chain's revenue growth, expressed as a compound annual growth rate, or CAGR:
Source: Dunkin' Brands 10/1/2015 "Analyst & Investor Day" presentation.
Dunkin' improves its revenue using two major levers: adding new stores -- the vast majority of which are U.S.-based Dunkin' Donuts-branded locations -- and increasing comparable store sales, or comps.
Since going public, the company has added U.S. Dunkin' Donuts restaurants at a CAGR of roughly 4.75%. The rate of addition has climbed above 5% the last two years, and the company eventually wants to add U.S. restaurants at a CAGR in excess of 6%.
The other major component of revenue expansion, comparable-store sales growth, is unfortunately heading in the other direction. Comps were recorded at a solid 5.1% in the year of Dunkin' Brands' IPO, and have been decelerating ever since:
| Year/Quarter | 2011 | 2012 | 2013 | 2014 | 2015 Through 6/27 | Q3 2015 (Estimated) |
|---|---|---|---|---|---|---|
| U.S. comparable-store sales growth rate | 5.1% | 4.2% | 3.4% | 1.6% | 2.8% | 1.1% |
Source: Dunkin' Brands 10-K and 10-Q filings; 10/1/2015 "Analyst & Investor Day" presentation.
Note that after what appeared to be some stabilization of comps in the first half of this year, they're headed back to a minimal gain in Q3. Company executives forecast that comps will finish the year between 1% and 3%. This kind of growth looks precarious, doesn't it? It hardly inspires confidence.
Dunkin' Brands does have a viable means to spark comps growth, and that's through the digital platform it's invested in over the past few years. This platform includes a loyalty program integrated with the company's apps, as well as mobile ordering, which will be tested beginning in November. Management has argued that it will be able to incentive further purchasing from loyal customers by analyzing purchase data, and personalizing offers. Yet shareholders are waiting for clear evidence that the technology will have the intended effect on comps.
Charting out the next five years
A major objective of a corporation's annual investor day is to discuss future revenue, and to this point, Dunkin' revealed that it's shooting for "mid-to-high-single-digit revenue growth over the next five years." This corporate shorthand signals that the organization will try to grow its top line at a rate anywhere between 5% and 9%. As for the two levers of growth we discussed, the following is a breakdown provided in support of the projection:
Source: Dunkin' Brands 10/1/2015 "Analyst & Investor Day" presentation.
The problem that shareholders probably noticed in this visual, and perhaps a more forceful reason that the stock tanked (versus simply the weak third=quarter comps number), is that the comps and unit development growth rates pictured above aren't ambitious enough.
Remember, Dunkin' has grown revenue at a 7% CAGR over the past four years by achieving an annual U.S. unit growth of just below 5%, and a comps average that benefited from a comparatively strong 2011 and 2012.
Thus, comps of 2%-4% and unit development of 4%-6% aren't aspirational targets. In fact, they leave no room for error. If comps continue to remain flat or turn negative, the "mid-to-high" single-digit revenue growth target won't be attainable.
But what about the bottom line?
Often, when faced with revenue-growth headwinds, dynamic companies can turn to operational improvements as a way to keep shareholders engaged. This will be difficult for Dunkin' Brands to do, as it's chosen a nearly 100% franchise model. Unlike McDonald's, which owns roughly 20% of its restaurants, Dunkin's revenue derives almost entirely from the franchise fees and royalties it receives from operators that license its trademarks. It has little operational leverage of its own to improve profits.
The great benefit of the total franchise model is extremely predictable cash flow. But Dunkin' has used this advantage to increase leverage, steadily adding on long-term debt, as illustrated in the following slide:
Source: Dunkin' Brands 10/1/2015 "Analyst & Investor Day" presentation.
The company tends to highlight its leverage as a virtue, because it often uses borrowings to pay dividends and buy back shares. But I'm not so convinced. As management pointed out without irony, in a slide I won't include here, its ratio of 5.5 times net debt to adjusted EBITDA is well in excess of McDonald's leverage by the same measure (2.0), and competitors Yum! Brands (1.3) and Starbucks (0.7).
The latest debt issuance, in January of this year, allowed Dunkin' to refinance long-term debt at an attractive fixed rate of 3.76%. Yet the company actually expanded debt by nearly $700 million in the refinancing, to bring total outstanding borrowings to $2.5 billion. It used about $500 million of this excess for share repurchases. Dunkin' now has a projected interest expense for this year of $96.5 million; seven times what it was last year. This annual expense may be in excess of one-quarter of total operating income for the next few years.
Drawing these various strands together, Dunkin's outlined plan of slim growth, combined with a rigid business model and perhaps too much leverage, is surely causing unease among shareholders. Perhaps the best thing the company can do to raise its stock from its current slump is to get those comps energized again, and that too beyond a mere range of 2%-4%.
