Skip to main content
restaurants

Canadian investors have heard the pitch: Restaurant Brands International, the new parent of Tim Hortons, will use its international growth expertise gleaned from its ownership of Burger King to make Tims a global doughnut machine.

There may be a hole in that story, if you will: That investing thesis isn't unique. Dunkin' Brands, the owner of Dunkin' Donuts and Baskin-Robbins ice cream, is employing the same asset-light, franchisee-heavy business model to take its doughnuts and coffee across the United States and the world. With a western U.S. expansion under way, investors like the early returns, sending Dunkin' shares to a record high on April 24. And yet, the shares are still at a discount compared with other franchise concepts, including those of Restaurant Brands International.

It suggests that investors who are betting solely on Tims' parent might consider making it a double-double and pick up Dunkin' Brands, as well.

Double, in fact, is what Dunkin' Brands shares have done since its mid-2011 IPO, about which I was unenthusiastic at the time. When Dunkin' debuted, it was debt-heavy, pricey and had said it was going to take a cautious approach to growth.

Some of those things haven't changed: Dunkin' Brands has a fairly high level of borrowing, with net debt (total debt minus cash) at 5.7 times its EBITDA, or earnings before interest, taxes, depreciation and amortization. (That's the second-highest ratio of 70 restaurant companies on the major U.S. and Toronto Stock Exchanges, according to S&P Capital IQ, with Restaurant Brands International the clear "leader" at 13.4 times.)

Analysts say it's less of a problem for companies such as Dunkin' and Restaurant Brands International, whose restaurants are nearly 100 per cent franchised, minimizing the need for capital expenditures. Instead, both companies pay dividends and service the debt, which came in part from a leveraged buyout in the case of Dunkin' Brands, and the cash component of the Tim Hortons deal in the case of Restaurant Brands International.

Dunkin' also remains relatively expensive by broad-market standards, although its forward price-to-earnings ratio of 27 is just about average for the popular restaurant group. What has changed, however, is Dunkin' Brands pace of expansion, and the success it's having in new markets.

The company is a Northeastern U.S. phenomenon, with half of its 8,160 U.S. stores in its "core" markets of New England, eastern New York State and northern New Jersey. But while Dunkin' said in 2011 it would move out gradually from its western frontier – now Michigan, Illinois and Arkansas – it is now executing ambitious plans in California, Colorado and other states on the other side of the United States.

Dunkin's expansion map should look familiar to any long-time Tim Hortons investor, where the story in this country was that the company's Western Canadian markets were a far cry from the dense store network of Ontario. In the case of Dunkin', it currently has just one store for every 450,000 people in the west, versus one per 8,900 in its core markets.

"The primary earnings driver over the next five years will be the expansion of Dunkin' Donuts into major metropolitan areas in the western U.S., where it is largely underrepresented," says analyst Jeremy Scott of CLSA Americas, who initiated coverage of the stock in October with a $51 (U.S.) target price (which the company has now blown through, closing Friday at $52.43).

"Dunkin' also plans to expand into a number of international markets through master franchise agreements, including India, China, the Middle East and Western Europe," says Mr. Scott. "As the international business evolves, it will grow into a royalty-driven model akin to the U.S. operations and provide an earnings ramp well past the next five years."

Analyst Gregory Badishkanian of Citigroup Global Markets Inc., who has a "buy" and a $54 target price, noted that Dunkin' Brands management said on its April 23 earnings call that California and Colorado were "way above" the company's expectations to date. Mr. Badishkanian and his Citi associates conducted a survey of California coffee drinkers "that showed Dunkin' already enjoys significant brand awareness and perception among California consumers and is likely to enjoy strong initial trial at new locations with decent repeat traffic."

Dunkin' Brands' first-quarter results, in which sales were robust, assuaged some concerns about 2014's softer results. The shares are now up 23 per cent this year, making it one of 2015's best-performing restaurant stocks. But David Palmer of RBC Dominion Securities Inc.'s U.S. research arm says Dunkin's stock still trades at a discount to "fully franchised" peers such as Restaurant Brands International, Domino's Pizza Inc. and Popeyes Louisiana Kitchen Inc.

If Dunkin' can maintain its price-to-earnings ratio of 27 into 2016, which Mr. Palmer believes it can, it would be a $60 stock, he says.

To be sure, a number of the analysts who are bullish on Dunkin' also have "buy" ratings on Restaurant Brands International. Mr. Badishkanian's target price of $49 implies a greater upside for the Tim Hortons parent, as he says the current share price "doesn't fully reflect the international growth potential of the [Tim Hortons] brand or possible cost savings of the combined company."

However, Restaurant Brands' "show-me" story, coupled with a valuation higher than Dunkin' Brands (a P/E of 41, and a higher multiple of EBITDA, as well) have cooled most analysts on the stock. While 16 of the 31 analysts covering Dunkin' Brands have "buy" ratings, just four of 13 following Restaurant Brands International are positive on the shares.

Analyst David Hartley of Credit Suisse, who has an "outperform" on Dunkin' Brands and a $58 target price, is neutral on Restaurant Brands International. "Valuation keeps us on the sidelines," he says, with strong profit growth "already priced into the stock."

Any future announcement of what the company plans to do to expand Tim Hortons, he says, will be a catalyst for the stock, but the company's management is "ask[ing] investors to be patient." Meanwhile, he's already modelled "fairly robust expansion" for both of the company's chains, and can't derive a target price of more than $42, just a bit above Friday's closing price of $41.37.

Restaurant Brands may still announce, and then execute, a growth plan for Tim Hortons that makes today's stock price a buy. But Dunkin' Brands, increasingly, is the doughnut-and-coffee company that's rising.

Globe app users click here for chart

Follow related authors and topics

Authors and topics you follow will be added to your personal news feed in Following.

Interact with The Globe