Why This Doughnut Maker Could Put a Hole in Your Portfolio

If I asked you to describe what you can purchase from Dunkin' Brands (NASDAQ: DNKN), what would come to mind? If you thought "doughnuts" or "coffee," close -- but no cigar. Dunkin's real business is selling its name. With a heavy dependence on franchising, Dunkin' is starting to rapidly expand, which could ultimately set up the doughnut maker for a serious sugar crash.

Franchise heaven
Dunkin' distinguishes itself from other quick-service restaurant companies by focusing its efforts on setting up franchises. The doughnut purveyor operates a measly 0.2% of its stores, making those locations' impact minute in the grand scheme of the company's overall operations.

It's easy to see some of the pros in avoiding store operations:

• Low costs: Dunkin' has astronomical gross margins because its costs are relatively limited to legal fees associated with franchise and licensing contracts.
• Resources flexibility: Instead of spending capital on property and labor costs, Dunkin' can focus on expansion plans and R&D.

But there are some serious setbacks to relying on franchise operations.

I need a brand-aid
By placing 99% of store operations in franchisees' hands, Dunkin' loses some control over how its stores are run, not to mention its customer satisfaction consistency and ultimately, its, brand representation.

Ever go to a restaurant, order a favorite meal, and then leave disappointed because it wasn't made the way you're used to? That is exactly what a chain wants to avoid. McDonald's (NYSE: MCD) is the king of consistency -- I ate nothing but McDonald's cheeseburgers on my high-school trip to London, because I was wary of the local food and knew that those burgers would be exactly what I expected.

Starbucks (NASDAQ: SBUX) ran into a consistency issue a few years back, when the smell of its breakfast sandwiches overwhelmed the aroma of coffee. CEO Howard Schultz had to dispatch a task force to keep the coffee, and not burning cheese, on its customers' minds. The sandwich smell wasn't necessarily offensive, but it took away from the chain's atmosphere. Without its company-owned stores, completing Starbucks' mission would have been harder, since it tested proposed solutions in-store before rolling them out to the rest of its stores nationwide.

Franchisees have a lot of power, and exerting pressure on them can backfire on two levels:

• Their refusal to comply leads to lost sales and costly lawsuits.
• Damage to a company's reputation among franchisees can make further franchise expansion difficult.

Dunkin' doesn't have the best reputation within the franchisee community already. It has a history of suing franchisees (filing more than 350 suits in 2009), and it's currently a defendant in a lawsuit regarding the company's alleged racial discrimination when awarding franchises.

Growing like a weed
At first blush, Dunkin's franchise strategy appears advantageous to a company looking to expand, but history tells another story. To demonstrate the shortcomings of this model, let's review the cautionary tale of Boston Chicken.

After Boston's IPO in 1993, the company set out to expand its franchised stores across the U.S. with a plan totaling 2,700 locations in five to seven years. The more rapidly expansion progressed, the more Boston needed to continue expanding to generate new franchise fees on the books, undermining existing franchisees and stunting same-store growth.

There's a delicate revenue balance for expanding chains. If Dunkin' focuses on the revenue from expansion instead of developing growth in its existing stores (and the slice of revenue it gets from store sales), momentum will build to a point that's no longer sustainable. It's like running downhill -- at some point you can't run fast enough to keep up with your momentum, and you tumble.

The bread and butter of restaurant chains
It's not necessary for Dunkin' to own the majority of its stores; of its competitors, only Starbucks does. But by focusing on mass franchising, the company misses out on the key benefits of owning and operating a larger share of its stores. Traditionally, company stores generate better same-store revenue growth, thanks to greater oversight, product and marketing initiative testing, and more efficient operations.

Sources: Company 10-Qs and 10-Ks.

Dunkin's company stores' sales growth proves the point, but be warned -- company acquisitions of franchised stores  will throw off these results. By acquiring some franchised stores during the year, its same-store growth is skewed larger than it would have been without the addition of the newly corporate-owned stores. None of Dunkin's competitors had the same situation during the time period represented in the table.

Rival Panera Bread (NASDAQ: PNRA) also demonstrates the benefit to revenue growth nicely, with company-operated stores' sales growth of 18.7% year over year nearly doubling franchised stores' 9.7%. With its stores almost equally distributed between company- and franchisee-operated, this trend benefits Panera's growth, while other chains with lower concentrations of company-run stores don't get as large a boost to their overall revenue.

McDonald's seems to buck the revenue growth trend, with company stores growing at a lower rate than franchised locations. But within its 2011 10-K, the burgermeister says that to be a legitimate franchisor, a company has to run its own stores, too. That's why McDonald's constantly monitors its mix of franchised and company-owned stores. Hear that, Dunkin'?

A Fool's perspective
If you follow the Foolish investing philosophy, you'll spot several red flags when reviewing Dunkin's operations. Its franchise-heavy model has no sustainable competitive advantage, its management is frequently at odds with its operators, and though its brand is recognizable, it's no Starbucks or McDonald's. You can expect the company to continue its expansion, but be wary of its sugar-coated earnings.