Dunkin' Donuts Problems Rise

Stock in Dunkin’ Brands (NASDAQ: DNKN) has soared 34% since an initial public offering in July at $19 a share, driven by investor optimism on the coffee and doughnut chain’s growth potential in markets beyond the East Coast. However, could a balance sheet weighted down with significant indebtedness prove an obstacle to an expansionary strategy dependent on new restaurant openings by franchisees?

On August 1, the company sold 22.5 million shares of common stock in an IPO, resulting in net proceeds to the company of approximately $390.0 million, after deducting underwriter discounts and commissions. Unfortunately, little of these monies are available for working capital purposes, as $375.0 million went to retiring outstanding debt.

Prior to the IPO, the private equity partners — Bain Capital, Carlyle Group and Thomas H. Lee Partners — rewarded themselves last November with $500 million disguised as dividend payments. Walking away with these jelly doughnuts added to an already onerous debt load. At second-quarter ending June 25, Dunkin’ owed almost $1.5 billion (due in November 2018); quarterly interest payments on this debt totaled $28.8 million — almost 47% of operating income.

The asset side of Dunkin’s balance sheet is bloated too: 55% of total assets, or $1.7 billion, is nothing more than intangibles (like franchise “rights” and trade names). Additionally, strip out restricted cash of $73.6 million (escrowed for franchisee advertising and gift-card programs), and working capital slips into jelly red by some $60 million.

“Running on Dunkin’” — Franchisees

Although the Canton, Mass.-based Dunkin’ has some 16,400 sites worldwide, it is the 6,800 U.S. stores that sell the most coffee and breakfast quick-serve eats (bagels and doughnuts). In first-half of 2011, the company generated $203.6 million, or 68.7%, of total revenues from domestic operations.

With nearly all of its stores franchised, the company receives most of it revenues in the form of royalties (5.9% of gross sales) and initial franchise fees (of $40,000 to $80,000 per site). For the quarter-ended June 25, the company also generated 15.6%, or $46.2 million, of total sales of $296.2 million from rental income (about 977 locations across the U.S. and Canada are leased or subleased to franchisees.

The advantage to this franchisee-driven business model is that it allows Dunkin’ to grow profits and brand recognition without investing too much of its own working capital. Notwithstanding a liability for “uncertain” tax positions of $29.6 million (a dispute with the IRS over recognition of income from sale of gift cards) and long-term debt servicing, the company is not burdened with contractual, cash-draining events like purchase obligations to food suppliers or capital leases involving restaurant equipment.

In addition to funding the major costs of restaurant openings, franchisees fund substantially all the advertising that supports the Dunkin’ Donuts’ brands!

A careful review of regulatory filings by the 10Q Detective shows that though Dunkin’ will work with its franchisees to obtain business financing, it usually steers clear of guaranteeing franchisee payments and commitments to financial institutions. Total amounts the company is contingently liable for were an immaterial $7.4 million at quarter-ending June.

Dunkin’s financial results depend more on the organic success of franchisees — and, to a large extent, new store openings — than on its own liquidity. Like any restaurant chain, however, Dunkin’ remains (indirectly) a slave to the vagaries of an uncertain economy — as consumer discretionary spending goes, so follows the breakfast sales of its franchisees.

Management forecasts opening as many as 250 new U.S. locations per year in 2011 and 2012. In the next 20 years, the company looks to more than double its number of U.S. stores to 15,000.

“It’s the Economy, Stupid.”

As George H. W. Bush found out in his unsuccessful bid to be reelected president back in 1992, the company cannot lose sight of pocketbook sensitivities. With only $88.8 million of unused commitments still available under its secured credit facility, a slowdown in customer traffic due to rising unemployment could come back to bite Dunkin’ on the bagel and intensify an already strained ledger.

Specifically, the company’s credit facility contains restrictive covenants (which tighten each successive year): maximum total leverage (debt outstanding to adjusted EBITDA) cannot climb above 8.6 times (narrowing to 6.75 times EBITDA in second-quarter 2016); interest coverage (profit before income and taxes) cannot fall below 1.45 times interest charges (and 1.85 times by second-quarter 2016), according to Dunkin’s credit agreement with its lenders.

On August 1, Dunkin’ was in compliance with its senior credit facility covenants, including a leverage ratio of 6.2 to one and an interest coverage ratio of 2.4 times. If America stops “Running on Dunkin’,” however, weakening credit metrics could distract management from doing what it does best, introducing innovative breakfast (and daytime) snacks, such as the new “Bagel Twists,” and store expansion beyond the Mississippi.

David Phillips