Dunkin Brands Group Inc (NASDAQ:DNKN) – together with its subsidiaries franchises quick service restaurants worldwide. For many years, Its restaurants have been serving us coffee, donuts and other goodies.
As tempting as the fast food sector may appear, I believe that currently there are a few warning signs that any investor should clearly pay attention to. Many investors though, prefer to turn a blind eye to the company’s operations and focus on Dunkin Brands Group Inc (NASDAQ:DNKN)’s share price instead. That’s a big mistake.
Who Competes with whom?
In the coffee segment, the company competes with other coffee servers like Starbucks Corporation (NASDAQ:SBUX) and McDonald’s Corporation (NYSE:MCD). In the doughnuts segment, Dunkin Brands Group Inc (NASDAQ:DNKN)’ competes with its much smaller, yet fierce competitor, Krispy Kreme doughnuts (NYSE:KKD).
The business model of Dunkin’ Doughnuts is to franchise all of its goodies. It doesn’t own a single store of its approximately 10,000 donuts stores and 6,700 ice-cream stores. It’s paid in royalties and rental income from its franchisees.
Warning sign #1: Insiders are selling
A year ago, on March 16th, 2012, the company disclosed to the SEC its intentions to pursue the sale of 22,000,000 common shares of the company. The star sellers are the three private equity firms that participated in the initial buyout of Dunkin Brands Group Inc (NASDAQ:DNKN) – Bain Capital, the Carlyle Group and Thomas H. Lee Group.
You see, the business model of equity funds is to always buy a company using excessive leverage, load the new company with excessive amounts of debt while pulling out fat dividends at the same time so the fund can finance the debt obligations it incurred in the process of the purchase. Then, once the company shows a good performance record, the Private Equity guys immediately sell their shares.
In almost all cases, that is a great point to exit, not to enter.
Warning sign #2: Valuation makes no sense
Dunkin Brands Group Inc (NASDAQ:DNKN)’ isn’t about to come out with a new medicine that cures cancer. But it certainly trades as if it were. At a hefty P/E of 40x and price/sales of 6x, expectations of the company are sky high.
In the fast growing coffee segment where it competes with Starbucks and McDonald’s, the company’s valuation also seems exceptional. .Starbucks, for instance, trades at a P/E of 30x and price/sales of 3x. That’s by far cheaper than Dunkin’. Even McDonald’s which obviously enjoys a much better economies of scale, trades at a P/E and price/sales of 18x and 3.5x, respectively.
This ridiculous valuation seems even harder to explain when you think about the nature of these businesses. McDonald’s and Starbucks sell a vast range of food products. You can’t say that about Dunkin’. Not only that Dunkin’ is basically relying on a single product, but that product also happens to be in the sugary dessert category. This specific sector is currently being heavily targeted by regulators and various health organizations alike.
In the baked goods segment, Krispy Kreme doughnuts (NYSE:KKD) is a tough competitor of Dunkin Brands Group Inc (NASDAQ:DNKN)’. The maker of glazed doughnuts used to trade on the cheap for years. But following a 100% run in the share price over this past year, Krispy Kreme doughnuts (NYSE:KKD) is no bargain anymore. It currently trades at a P/E and price/sales of 49x and 2.2x, respectively. Not that Krispy’s valuations are justified, but the fact that it’s a much smaller rival with plenty of room for growth, makes it a bit more logical. Dunkin’, on the other hand, .is a mature and stable company. It simply doesn’t have the luxury to grow at a double digit pace. After all, how many donuts can a sane person consume?
Warning sign #3: Capitalization structure
The company’s balance sheet is far from being conservative. In the jolly days of 2005 – 2006, the company has loaded itself with massive debts, with the warm support of private equity funds. Later on, the funds sold their position in the company and left the company with an enormous $1.6 billion debt. Once growth slows down a bit (and I assure you, it always does eventually…), shareholders will quickly realize that paying $100 million each year, on interest alone, isn’t such a great deal.
The Foolish bottom line
I believe that Dunkin Brands Group Inc (NASDAQ:DNKN)’ Doughnuts isn’t only bad for your health but also for your stock portfolio. A dangerous combination of high debt, extravagant valuation and heavy selling by insiders – make this company a very risky investment.
Shmulik Karpf owns shares of McDonald’s. The Motley Fool recommends McDonald’s and Starbucks. The Motley Fool owns shares of McDonald’s and Starbucks.
