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Dunkin' for dollars in a red-hot java market

Whenever we consider Tim Hortons' ability to expand southward and crack the U.S. market, one name is inevitably raised: Dunkin' Donuts, which has a commanding share of the coffee-and-doughnut market in the American Northeast.

So, with Dunkin' Brands Group Inc., the chain's parent, ready for an initial public offering this week, should Canadian investors consider buying into a south-of-the-border doughnut success story? It seems the company is robustly valued at its IPO price. Any significant first-day pop in the share price will create an unhealthily high ratio of dollars to doughnuts.

The company, which owns both the Dunkin' Donuts and Baskin-Robbins brands, says it has 16,000 "points of distribution" in 57 countries, ranging from actual restaurants to small self-service kiosks in grocery stores, airports and hospitals.

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Yet Dunkin' Brands owns almost none of them - it is predominantly a franchise operation, meaning the company gets the majority of its revenue from royalty payments that are a small percentage of system-wide sales. All told, Dunkin' Brands pulled in $577.1-million (U.S.) in revenue in 2010 - and just $26.9-million in net income.

The profit figure, combined with the top end of the $16 to $18 range in Dunkin' Brands' proposed offering price, implies a trailing price-to-earnings ratio of more than 80. Yet that's a bit misleading, as the Dunkin' Brands IPO is the exit strategy for the group of leveraged-buyout firms (Bain Capital Partners, Carlyle Group and Thomas H. Lee Partners) that bought it in 2006.

The company paid almost $113-million in interest on its debt load last year; since the IPO proceeds will be used to retire a batch of notes paying nearly 10 per cent, Dunkin' Brands figures it can slice about $40-million from interest expense going forward. That will flow directly to the bottom line (and bring the P/E back down to the low 30s).

Still, Dunkin' Brands will have almost $1.5-billion in debt even after the IPO, nearly eight times its EBITDA, or earnings before interest, taxes, depreciation and amortization, in the twelve months ended March 26 of this year. The company's book value - assets minus liabilities - will be negative even after the offering.

(The debt burden might have been smaller had the private-equity owners of Dunkin' Brands not paid themselves a $500-million dividend last November. The dividend also helps explain why the firms aren't selling any shares in the offering.)

What, then, are Dunkin Brands' newest investors getting for their purchase of this heavily leveraged company? A solid, but not spectacular, growth story so far.

The Dunkin' Donuts U.S. segment had experienced 45 consecutive quarters of positive comparable store sales growth until the first quarter of 2008. Same-store sales growth returned to positive territory in 2010, but as recently as the first quarter the figure was 2.8 per cent.

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From 2007 to 2010, Dunkin' Brands grew its top line by just over 10 per cent; over the same time period, sales by Tim Hortons grew more than one-third.

Dunkin' Brands says it will build on sales-store growth momentum by selling more coffee, in part by packaging it in the trendy Keurig K-Cups. The company apparently took the K-Cup packaging on its IPO road show recently, hoping some of the investor fervour over Green Mountain Coffee Roasters rubs off on it. (Cable TV stock talker Jim Cramer said, "the coffee market is red hot right now and it looks like Dunkin' Donuts will be the cheapest way to play it.")

The company also pitches the possibility of geographic expansion: Despite its brand recognition, Dunkin' Donuts is in fact just a regional chain.

While it has a location for every 9,700 people in New York State and New England, it has just one store per 48,400 in other areas east of the Mississippi River. The Western U.S., as Dunkin' Brands defines it, has 130 million people and just 109 stores, a ratio of one per 1.2 million people.

The chain is not yelling "Westward, ho!" however. The company says in the near-term it will stick to developing in markets adjacent to its existing store base. It will then move outward in progression, in order to achieve supply-chain efficiencies. That seems to be smart growth, but it's also slow growth.

However, given the buzz, so to speak, over the Dunkin' Brands offering, and the rip-roaring performance of other U.S. coffee concerns, the stock seems primed to zoom on its first day, leaving individual investors with little or no chance to buy in at the offering price. If presented with Dunkin' Brands shares approaching $30 or more, Canadian investors should stick with the growing coffee-and-doughnut company here at home.

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Dunkin' Brands Inc.

Global headquarters: Canton, Mass. Proposed Nasdaq ticker: DNKN

Dunkin' Donuts

Founded: Quincy, Mass., 1950 Points of distribution (shops, kiosks, etc.): 9,805, of which 6,799 are in the U.S. and 3,006 are international. Key international markets include the Asia-Pacific and Latin America.


Founded: Glendale, Calif., 1946 Points of distribution: 6,482 in 35 countries, of which 2,523 arein the U.S. and 3,959 are international.

Figures are as of March 26, 2011; Source: Dunkin' Brands Group prospectus, corporate website

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