“Today we’re going to take a look at Dunkin’ Brands Group, Inc. (DNKN). The parent company of Dunkin’ Donuts has been in business for a very long time. But based on its newly redesigned business strategy, the company is poised to follow in the footprints of McDonald’s and become a serious contender in the premium coffee market. Six weeks ago, we could not own this company. That’s because Dunkin’ was tightly held by a trio of private equity funds. Bain Capital, Carlyle Partners and Thomas H. Lee Equity Funds each held roughly one-third of the company and spent the past several years revamping the company’s growth strategy.
“On July 27, the group sold 22.2 million shares to the public at a price of $19 per share. Investment managers scrambled to pick up shares and by the close of the first day of trading, Dunkin’ was up 47% to close at $27.85.
“When the stock began trading, there was a lot of discussion as to whether the company was really worth the price tag. A number of analysts looked at the favorable terms that the private equity guys were getting for selling their shares and said it was unfair to the new stockholders. Other analysts looked at the long-term prospects for the company and noted that this stock could be a tremendous growth opportunity. ... On the bullish side of the ledger, we have Dunkin’ Brands’ profitability and growth prospects.
“In 2008, the company lost $2.14 per share as consumers faced increasing economic uncertainty and as Dunkin’ struggled with aging stores and an unappealing company perception. But over the past three years, the private equity trio has worked hard to develop a growth strategy, create a better consumer perception of the company, and beef up the quality of products offered. ... In 2009, the company generated a modest profit of 28 cents per share, and then in 2010, profit grew by a respectable 21%. This year, however, growth is accelerating. As the company rolls out new locations and attracts new customers, earnings are expected to grow 109% to 71 cents per share. ...
“Whenever a company expands aggressively, there is a level of risk involved. Just ask Starbucks (SBUX)— the king of coffee-shop expansion. ...The strategy of opening new stores anywhere and everywhere has created a lot of risk for the company. Since 2008, the company has announced almost 900 store closings as many of the new locations have turned out to be disappointments. See what I mean about the growth days being over for Starbucks? Dunkin’ Brands may be just as aggressive as Starbucks when it comes to new stores, but the company has adopted a franchise strategy that is significantly less risky. As a franchised concept, Dunkin’ relies on private storeowners to foot the expense of opening new stores, hiring employees and developing a local customer base. Dunkin’ provides direction for how the stores are laid out; the company provides displays and of course the doughnuts, coffee and other products being sold. But as investors in the stock, we don’t have the same risk that Starbucks investors have. If a number of stores turn out to be unsuccessful, the majority of the risk falls on the franchisee that originally purchased the right to open a Dunkin’ store. This type of growth also gives Dunkin’ flexibility when it comes to expansion. Dunkin’ doesn’t have to build a war chest of expansion capital. It won’t cost the company hundreds of millions in build-out costs to open new restaurants. In fact, the company immediately begins receiving royalties and license fees from every store that is opened. ...
“Dunkin’ fits the profile of a strong growth IPO with strong profit potential. As I mentioned, the stock came to market at $19 per share and immediately traded 47% higher. This is typical of a stock transaction where dozens of high-profile hedge fund and mutual fund managers are competing for a limited number of shares. There are a couple of key issues I want to point out here: 1) The private equity owners still hold a majority position. ... The fact that this group of investors continues to hold the majority of stock in Dunkin’ is a great indication of their expectations. With so much demand for the stock, the underwriters could have stepped in and increased their offering. But it’s clear the people who know the most about this company’s growth plans are maintaining a significant investment in the company. ... 2) The underwriters have a strong incentive to support the stock price. OK, this concept may ruffle a few feathers (I know I was a bit disturbed when I realized the way IPOs were manipulated), but IPO stocks don’t typically trade in a ‘fair’ market environment. Underwriters are the brokerages that help private equity companies sell stock to the public. In the case of Dunkin’, there were five primary underwriters (JPMorgan, Barclays, Morgan Stanley, Bank of America and Goldman) who split $27.5 million in fees to get the IPO done. Since the private equity group still owns the majority of Dunkin’s shares, they are going to call on these underwriters again to help sell more stock in the future. The underwriters have a strong incentive to write positive research reports on Dunkin’ so they stay in favor with the underwriters and get the chance to make more fees when new stock is offered. ...
“My recommendation is to buy the stock ONLY once it crosses $28.60. If you buy at that point, it will ensure that you are buying as Dunkin’ begins to move higher, and keep you from getting involved too soon, before the rally gets underway. When placing this order, you want to use a buy-stop order, which means that the trade will not be executed until Dunkin’ is at or above $28.60.”
Zachary Scheidt, Taipan’s New Growth Investor, September 2011
