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As I was leaving the Dunkin’ Brands road show appearance this Wednesday at the Manhattan St. Regis — a splendid affair with filet mignon, served chilled, and then topped off with a cup of delicious Baskin-Robbins ice cream for the 500 or so attendees — I listened to two youngish analyst-types discuss what they had just witnessed. One analyst asked, “Now, why is Dunkin’ Brands doing this?” And the other immediately retorted, “Come on, it’s for the limited partner fees and the dividend.”
Boy, did they get that one right.
This IPO, which is offering about 20% of the company for $400 million, is designed to accomplish one thing and one thing only: enriching the private consortium owners, Bain Capital, Thomas H. Lee, and The Carlyle Group, who acquired the company for $2.4 billion in 2006. The funds are not going towards new product development – and God knows, the franchisees could use another breakthrough product like the Coolatta.
The money will not be used to construct new market central baking facilities for the ambitious expansion plans touted during the presentation. It’s going to be up to the franchisees to pay for these multi-million dollar donut factories.
No, the money will be used exclusively to retire debt, and according to Neil Moses, CFO of Dunkin’ Brands, this is expected to free up enough cash flow (about $100 million) for the Board to consider issuing a dividend in 2012. Of course, 80% of any dividend will be paid to the private equity sponsors but that’s how the PE business model works when it acquires a franchising company. And let’s not forget about the fees – Dunkin’ Brands will be paying itself $14 million to cancel its own management contract when the IPO is completed.
As any Dunkin’ Brands franchisee can tell you, the PE owners have not put a dime into the company since they acquired it but have instead, obsessively focused on creating new retail and supermarket channel deals that have diverted revenue from the franchisees directly into their own pockets, started suing franchisees in record numbers for refranchising dollars, and juiced up the new store pipeline – something CEO Nigel Travis admitted to the crowd was a prior administration’s mistake they didn’t plan to make again. Then again, when you have leveraged up a company like Bain and its partners did in 2006, one has no choice but to aggressively pursue new revenue in the face of the daunting mountain of debt payments which has resulted in a money-losing year (2008) and money-losing quarters as recently as Q-1 2011.
Franchisees – whether it’s Dunkin’ Brands, Burger King, and now as we read in the Wall Street Journal, Quiznos – know the drill when private equity comes to town. But do investors? Considering what I heard from the mouths of the company’s CEO, Nigel Travis, and its CFO, Neil Moses, at the St. Regis, I’d be very concerned.
I have no doubt that there’s enough institutional money out there to buy up the offering but for those smaller investors who are looking for more pop over the expected pricing of $16 – $18 per share, please keep reading. This is one stock that I’d bet is going to be trading below its offering price a year from now. Once you get past the superficial analysis provided by the likes of Jim Cramer – analysts who seem to think this is a restaurant stock rather than the franchising play that it is – there is much to be concerned about.
Any IPO pop it gets will hit a headwind in six months when 100,000,000 shares of PE shares unlock.
Following a perfunctory media presentation,Travis and Moses spelled out how they plan to make good for their new investors. According to Travis, a Brit who left Papa Johns to become the CEO in 2009, Dunkin’ Brands plans to increase royalty revenue through “comp store growth and by expansion into contiguous markets,” – a catch phrase he trumpeted several times. This means he plans to increase the comp sales of existing franchises (Dunkin’ Donuts and Baskin-Robbins) and increase the store count. In the face of a continuing sluggish economy and debt crisis, this seems doubtful but after I heard the game plan, it sounded downright impossible.
Investors may not know that comp store sales for both Dunkin’ Donuts and Baskin-Robbins have been lagging the QSR industry the last few years and not just because of the recession. Dunkin’ Donuts U.S. – the primary revenue generator for the company providing over 60% of its revenues – is being pressured in its critical morning daypart by McDonalds and others who are now offering a premium coffee product.
I’ve tasted the Green Mountain coffee that McDonald’s is selling and I have to say, it’s every bit as good as Dunkin’ Donuts and priced more competitively. This puts Dunkin’ Donuts in a real bind. The company has successfully played this game with Starbucks but now they find themselves on the receiving end in a bad economy. The only way they can keep market share is by lowering prices on their primary product and that’s not good for the franchisees operating the stores – the same franchisees that the company is dependent upon for new store development. And although the prospectus talks about increasing the afternoon daypart, ask any Dunkin’ Donuts franchisee about this and they will cite any number of failed initiatives over the last thirty years. You can read my book, Dunk’d: A True Story of how Big Money is Corrupting the Franchising Industry to find out what happened when the company tried to incorporate the Togo’s sandwich brand a few years ago into their ill-fated combo-marketing initiative. This debacle ended up costing me and hundreds of other franchisees millions of dollars.
So if comp store increases don’t seem like a good bet, then what about the expansion plans for Dunkin’ Donuts, which call for over 200 new net stores on an annual basis for the next two fiscal years. Again, I would remind Investors that Dunkin’ Brands is not a restaurant company. It’s a pure franchising company (an asset-light model, as Neil Moses described it) and is completely dependent on their franchisees for nearly all the revenue it collects. The franchisees fund every penny for the development of new stores, so expansion will only occur if they elect to expend the capital required to offer new products and invest in and build new stores because they believe this will be a profitable venture.
It remains an open question as to whether the U.S. franchisees will continue to invest their capital while experiencing less than stellar returns on their capital investment in new stores. Moses admitted at the St. Regis that the new Dunkin’ Donuts stores outside the core Northeast market are less profitable. The Northeast stores average over $1 million in annual sales while the other regions lag way behind. And since the Northeast is virtually tapped out for new stores, this is where the future increases in royalties are coming from. Travis and Moses made it clear that no new funding for development capital will be made available for expansion. In fact, Moses confirmed that the franchisor is not budgeting any money for the construction of central bakery facilities in new markets. This is the key piece of the development puzzle, providing the economy of scales that make the Dunkin’ Donuts business the profitable venture that it is in the Northeast. So, if the franchisees do not step to the plate, then the expansion program is likely doomed before it even begins. No worries, though, said Nigel Travis, who spoke about the use of frozen baked goods in these new markets. Wow, I thought, as I heard these words coming out of his mouth – if he really thinks you can fool customers into buying frozen, not fresh, donuts then Nigel has not been getting out of his office at the Canton headquarters.
As the Q & A began, an astute attendee asked for a breakdown of store revenues by region. A sensible question, given that the Northeast stores are significantly more profitable than the non-core markets. This is easy to understand when you consider the brand’s heritage status and its unprecedented market share in New England. But, curiously, neither the CEO nor the CFO possessed the information to answer the question – a question I am confident that they will not answer for as long as this road show continues.
Another attendee asked Travis about the status of new products. The CEOs response was limited to LTOs (limited time offers) and K-cups. In other words, the product development pipeline, so crucial to QSR success, is barren. Travis insisted that the new K-cup deal will not cannibalize store sales but ask any franchisee how K-cups, which are brewed either at home in the office, are helping his bottom-line and you will get the answer you expect. Travis spent a lot more time than I expected making the case for the future prospects of Baskin-Robbins’ international expansion. He really thinks he has a diamond in the rough but all I know is that while this brand has succeeded on the US West Coast, it was an utter disaster the last time it was rolled out in the Northeast – just think Togos. Baskin is a distraction and not signficantly additive to DNKN.
This didn’t appear to be a crowd that understood the franchising business. The buzz seemed to focus on the iconic nature of the Dunkin’ Donuts brand, and why not, NYC is part of its core market. So no questions were asked about the company’s infamous refranchising budget and all the lawsuits (over 500) they have filed against their own franchisees over the last few years – the same people they are dependent on for implementing new programs and opening new stores.
For anybody that does not understand refranchising, this happens usually when a franchisor forces a franchisee out of their store by either termination or a coerced settlement agreement, so they can then resell it to another franchisee for a windfall profit. This has been a key budget item at Dunkin’ Brands and their then Chief Legal Counsel, Stephen Horn, implemented any number of creative methods for separating franchisees from their stores and the investments they made in them – often their life savings. Again, read my book if you want to learn more about these pernicious practices.
It was only happy talk any time the subject of franchisee relations came up in the presentation. Travis has been quoted in the business press, saying “the key…to our whole business is the relationship we have with the franchisees.” Well, if Travis asked his franchisees how good that relationship is he wouldn’t like the answer. It would be easy to do if only the company would recognize the franchisee association, which has been in existence since 1989, and treat it as the conduit to its franchisees. Unlike other major franchisors, Travis refuses to provide an official role for its franchisee association despite insisting that the brands success, “comes down to how good a relationship you have,” with your franchisees.
If investors want to quantify the value of the Dunkin’ Brands offering, they need to understand how bullish the franchisees are on the future prospects of the business. As a former franchisee, I can confirm the deterioration of the gross margin at the store-level, which has continuously declined over the past twenty years, mostly due to changes in the franchise agreement and operations manual. The gross margin, which was once almost forty percent, has decreased to below twenty percent. When you add rising commodity costs and the increased difficulty in raising development financing to the equation, Dunkin’ Brand franchise owners are facing a perilous scenario when contemplating the development of new stores, especially outside the brand’s core market of New England and New York.
So let’s review what we all learned from Nigel Travis and Neil Moses at the St. Regis this week. Dunkin’ Brands is planning on meeting its future projections by increasing its comp sales, which depends on driving its afternoon daypart business – something it has never accomplished – and then successfully expanding into “contiguous” but nevertheless untested new markets. They will not be supporting this development by capitalizing central baking facilities and instead plan on fooling their new customers with frozen donuts. They are completely dependent on their franchisees for making this happen but said they will not support them financially but, instead, are planning to take any free cash flow they generate and pay that to the sponsors as a dividend, and that’s after they have taken a fee of $14 million. Although the company insists they are cleaning up its act regarding its litigation practices, dozens of cases are still being tried in the courts. I don’t know about you but this sounds to me like a recipe for a losing long term investment.