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Homer Simpson is not a financial genius. That’s putting it mildly since the guy once bargained away his employer paid dental insurance for a keg of beer. He also deposited his daughter Lisa’s college tuition fund into a poker website. But Homer does know doughnuts. So instead of making these boneheaded money decisions, had Homer followed Peter Lynch’s maxim about investing in what you know (and also not been a cartoon character), he would understand Dunkin’ Brands Group (NASDAQ: DNKN), Krispy Kreme Doughnuts (NYSE: KKD), and Tim Horton’s (NYSE: THI) like the back of his yellow, four fingered hand.
With low barriers to entry for potential competitors and essentially no customer switching costs, the quick-service restaurant industry is one of the most competitive businesses. These three doughnut purveyors have similar product menus focused on baked goods and drinks, especially coffee, so Starbucks (NASDAQ: SBUX) is a significant competitor for all three. Tim Horton’s and Dunkin’ are both expanding their menus into lunch items like sandwiches and wraps so McDonald’s (NYSE: MCD) is also becoming a more direct competitor. Dunkin’ does have more product diversification than both Tim Horton’s and Krispy Kreme because it currently generates about a quarter of its revenue from its Baskin-Robbins ice cream stores.
Krispy Kreme is moving to a franchise model similar to the one employed by both Dunkin’ and Tim Horton’s and one trend that is currently moving within the industry is single serve coffee products. For example, Tim Horton’s has its own brand of Tim’s T DISC single-serve products for use with Kraft Food's Tassimo system while Dunkin’ offers K-Cup Packs made for the Keurig® K-Cup® brewing system. Starbucks, estimated to sell about a third of all retail coffee and more than 20% of single serve premium coffee, has an established line of single serve coffees including K-Cup, VIA, and Verismo systems. For its part, McDonald’s recently rolled out bagged coffee in Canada and single serve products may be next.
Krispy Kreme and Dunkin’ shares have been on a tear with gains of just less than 38% and 25%, respectively, year to date. Over that same time, Tim Horton’s shares have dropped a little less than 4%. Based on recent prices, Dunkin’ and Krispy Kreme trade at forward PE ratios of 20.5x and 16.4x, respectively, compared to 15.3x for Tim Horton’s. However, this disparity is diminished when considering price to earnings to growth (PEG) multiples of 1.1x for both Krispy Kreme and Dunkin’ and 1.2x for Tim Horton’s. Investors are willing to pay similar multiples for expected earnings growth but since cash is king, a comparison of dividend yields and cash flow multiples may help to sort out the investment attractiveness of these rivals.
First, Dunkin’ and Tim Horton’s have similar dividend yields at 1.9% and 1.8%, respectively while Krispy Kreme does not pay a dividend. However, Tim Horton’s dividend is much more secure with a payout ratio of only about 30% compared to almost 75% for Dunkin’ which initiated its dividend this past year. It’s important to note also that Tim’ Horton’s financial position is much better with equity at more than 53% of capital whereas Dunkin’s equity is only about 10% of capital. When it comes to turning revenue into cash flow, Dunkin’ leads the pack with a 26% free cash flow to revenue ratio compared to 10.7% for Tim Horton’s and 3.3% for Krispy Kreme. The problem is that this comparison may be skewed because Dunkin’ went public (for the second time) in 2011 so we have only 3 years of results. Further confusing the analysis is the fact that free cash flow yield (trailing twelve month FCF/market capitalization) is 5.3% for Krispy Kreme, 4.9% for Tim Horton’s, and 4.0% Dunkin’, again only based on 3 years.
Of course, investors are concerned about where these companies’ operations and share price are headed rather than where they’ve been, so these concerns about past results should be placed in proper context with projections about the future. Consensus analyst earnings growth is estimated at 19% for Dunkin’, 15% for Krispy Kreme, and 13% for Tim Horton’s. Dunkin’s growth prospects are admittedly bright given its low store penetration (22 per 1 million people vs. 30 for Starbucks- and only 1 store per million people in the western U.S.) and low unit volumes of below $700,000 per store compared to $1 million for Tim Horton’s. But as a conservative investor I am reluctant to invest in such a highly leveraged company as the margin for operating error or harmful external event is too thin.
Despite producing the fastest revenue and earnings growth historically, estimates of growth for Tim Horton’s are the lowest of the group. This is reasonable because as it grows in the U.S. the company will not have the same scale advantages it has in Canada where it still dominates with about 30% of the industry and 3,300 stores compared to 1,400 for McDonald’s and 1,200 for Starbucks. Krispy Kreme’s growth will be driven in part by its transition to a greater concentration of franchised stores and the eventual rollover of franchisee royalty rates that are currently below market. With only about 730 stores (less than 250 of which are franchised) and recent quarterly results showing that higher traffic (rather than price increases which are less robust) is driving improved same store sales, Krispy Kreme appears well positioned to achieve 15% EPS growth. That could lead to mouthwatering returns that would make investors and Homer Simpson both say “mmmmmm, doughnuts.”
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