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Throwing iced coffee on the Dunkin' IPO

July 26, 2011: 12:11 PM ET

The Dunkin' Donuts IPO is expected to be hot. But like a sugar high, Dunkin's price could crash hard after the euphoria of the first bite wears off.

By Cyrus Sanati, contributor

Dunkin Donuts

Update 6:15pm: Dunkin' Donuts shares priced at $19, above their price range of $16 to $18.

FORTUNE -- America may run on Dunkin', but investors may want to run away from Dunkin' Brands when the private equity-backed company goes public on Wednesday.

Valuations for the franchise behemoth look richer than the confectioneries being served up by its flagship brands, Dunkin' Donuts and Baskin & Robbins. The private equity firms that took the company private during the buyout boom hope that this offering will make Dunkin' look more attractive to prospective buyers down the road. But that could be a tall order given today's bleak economic climate.

It's hard to miss a Dunkin' Donuts when pounding the pavement in New York City or Boston. They are everywhere in the northeastern United States -- in fact, there is one Dunkin' Donuts store for every 9,700 people in the region. In New England, where Dunkin' got its start back in the 1940s, the company has a 52% market share of all breakfast visits and a 57% market share of all the coffee served up by quick service restaurants.

Coffee, it turns out, is the big money maker for Dunkin', not donuts or ice cream. Approximately 60% of the firm's sales for 2010 were generated from coffee and other beverages. The company plans on increasing that number as it focuses the bulk of its advertising on its beverages through campaigns such as "America Runs on Dunkin" and "What are you Drinkin'?"

So the firm is in essence a coffee shop that sells some donuts and ice cream on the side. It plans on doubling the number of stores it has through expansion in international markets and at home in the western U.S. But the money it's raising in the IPO isn't going toward that expansion -- it's going toward lowering its crushing debt load.

Swimming in debt

Dunkin has debt -- lots of it. It was taken private in 2006 in a leveraged buyout by a consortium of private equity firms -- Bain Capital Partners, The Carlyle Group and Thomas H. Lee Partners paid $2.4 billion to buy the company, mostly through borrowed cash, which was then parked on Dunkin's balance sheet. As with most private equity deals, the hope was to grow the company just enough in order to flip it for a tidy profit in around five years.

And grow it did. From 2008 to 2010, the consortium lowered upfront capital expenditure costs for franchisees to open a new restaurant by 23%, helping to drive store openings at home and abroad. The number of stores across their network grew by 1,615 in 2010, bringing the total number to over 16,000. And since Dunkin' is nearly 100% franchise-owned, the expansion required limited financial investment from Dunkin' Brands as the new store development were funded by franchisees.

But while the consortium has been able to grow the business in terms of the number of locations, it hasn't been able to grow its revenues fast enough to yield the 20% annual returns that their investors are looking for. Since 2007, the first full year the consortium controlled Dunkin' Brands, same store U.S. sales have been less than stellar, growing at 1.3% in 2007, -0.8% in 2008, -1.3% in 2009 and 2.3% in 2010. From 2008 to 2010, the company generated total revenues of $1.66 billion and an operating profit of around $237 million for a net operating profit margin of around 14%.

But add in the debt payments, and the company' profit is wiped out, for a total net loss of $208 million.

That doesn't sound like a recipe for a tasty investment, which is probably why the consortium hasn't been able to offload Dunkin' at a price that satisfies their investors. Normally, private equity would completely exit its position in an IPO, but in this case, the consortium is holding on to around 75% of the company. At $17 a share, the middle of the offering range of $16 to $18 a share, the company will raise around $378 million, which implies a total valuation for the company at around $2.1 billion, around $300 million less than what the PE firms paid five years ago.

The members of the consortium recently paid themselves $500 million in a special dividend, which ended up as debt on the company's books, so the IPO proceeds will essentially go to pay for that little kicker. After the offering, the company's debt burden would fall to $1.5 billion, saving it around $40 million a year in interest payments.

Donut bubble?

But even with the reduced debt load, is Dunkin' worth the $16 to $18 a share that the consortium is asking? Based on that valuation, the company would have a price to earnings ratio of around 80 times its trailing 2010 earnings – higher than most tech companies during the first dot-com bubble and far higher than most today. But factor in debt savings from the money raised and the price to earnings ratio should fall to the mid to lower 30s.

That still seems expensive compared to its competitors like Starbucks (SBUX) and McDonald's (MCD), which currently trade at 17 and 28 times earnings. Dunkin's price points are more like McDonald's and it doesn't sell the higher-end coffee products that allow Starbucks to charge a premium to their customers. While the company's growth strategy is ambitious, it is unclear it can capture enough high-margin customers in new markets to justify trading at a premium to Starbucks.

After all, Dunkin' controls the New England market primarily because it was born there ages ago, not because it's such a superior product. Getting people in Houston, Seattle or Beijing to put down their Shipley's donuts, Starbucks lattes or their oolong tea for some Dunkin' products would be tough. Such an expansion would require a lot of investment in advertising by the parent company, eating away at whatever little profit it is able to generate each quarter.

Despite the heady valuation, the consortium is betting that the equity markets will come to their aid. Brokers tell Fortune that the deal is oversubscribed at this point, which could mean it will price at the higher end of the range. But like a sugar high, Dunkin's price could crash hard after the euphoria of the first bite wears off.

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