Doughnuts And Delusions
Dow Jones Daily Bankruptcy Review. Thursday, August 06, 2009
Tim Hortons, the doughnut king of Canada, is storming New York. Not only is the raider from the North daring to confront local favorite Dunkin’ Donuts in its own backyard, in a slap to the American giant’s face it’s planting its flag at 12 former Dunkin’ Donut sites. I’m thinking this is not exactly what the U.S. franchisor needs, not at all.
The parent of Dunkin’ Donuts, DB Brands Inc., the product of a buyout by TH Lee, Bain Capital and the Carlyle Group, insists all is well despite the fact that the world’s financial picture has changed in ways not anticipated just a few years ago.
While there is no evidence the company is in trouble, neither is it apparent that the company has a whole lot of room to maneuver, and that’s a theme being played over and over in the restructuring world today. As tough as the economy is right now, there are many companies that could survive if appropriately restructured but whose creditors and investors favor buying time over dealing with reality. Too many of them will find that delay doesn’t just kick the can down the road, it sends it right off a cliff. Now I’m not saying that Dunkin’ Donuts faces that kind of future, but there are warning signs.
Dunkin’ Donuts was a 60-year-old company when it was folded, along with its much smaller cousin Baskin Robbins, into a $2.5 billion buyout at the end of 2005. Six months later, in what was heralded as one of the year’s most creative deals, the $1.5 billion of debt used to fund the transaction was completely taken out by a securitization of the company’s franchise royalties; essentially all of the company’s future cash flow, franchise agreements and real estate were pledged to the creditors of DB Master Finance. The terms of the debt included interest only debt service for five years, at the end of which time DBI planned to refinance. Fast-forward a few years and that refinancing takeout is looking a bit problematic given the state of the credit markets. But in a recent letter to franchisees, the company said it’s determined to meet unit growth and coverage targets, targets that would allow it to extend its interest-only terms another two years.
Now, at its initiation, the success of the DBI deal rested on a new supercharged growth strategy that moved the company away from its reliance on mom-and-pop owners, who built their operations slowly, to “large-area developers,” franchisees it believed were capable of opening many outlets in a short period of time. For a couple years, it seemed to work. Money was cheap and plentiful, particularly from the CIT Group, Dunkin’ Donuts’ “preferred lender.” Obviously, the folks at DBI can’t be pleased that CIT is in a credit crunch of its own and working to avoid bankruptcy. But, of even more concern, perhaps, is the condition of many of the stores that have opened since the buyout’s consummation.
A number of the very franchisees Dunkin’ Donuts was pinning its expansion hopes on have recently folded or filed for bankruptcy, including Kainos Partners, the Dunkin’ Brands 2007 “Developer of the Year,” which just last summer signed an agreement to open 75 Dunkin’ Donuts in Houston in addition to the 150 it was already on tap for in its existing territories. The reasons cited for the recent failures vary - soft sales (Kainos noted that its revenue had declined to nearly 40% below the level necessary to service its debt), an inability to find financing for the units required to make a rapid build program profitable, an unreceptive audience in a new territory – but they may not be isolated problems given the state of the retail industry and the credit markets. If more of these newer franchisees fail, Dunkin will be under even greater pressure to open units, a difficult task given the problems facing CIT, a major provider of financing to franchises.
One of a series of opinion columns by bankruptcy professionals
Of course, it’s not enough for DBI just to open restaurants; those outlets actually have to perform. If a meaningful number of its operations experience the recession-driven revenue declines already reported by some franchisees, the cash flow required to service the securitization debt will be unfavorably impacted, creating another stress point for the company.
DBI says it doesn’t “expect any issues in the future.” But what if troubles crop up? All of its debt is tied up in a securitization that wasn’t exactly designed to accommodate a consensual negotiation should it become necessary to get some relief on debt service and allow the company to adopt a less aggressive expansion strategy or free resources to shore up struggling franchisees.
Pity the poor private-equity firms that sit at the bottom of the securitization structure; should DBI not meet the DB Master Finance targets, all of those equity returns will get sucked up by the layers above them. But perhaps those higher level investors shouldn’t be too sanguine either. Most of them bought in subject to an Ambac wrap that gave them and the rating agencies AAA confidence that the promised returns would be delivered. With Ambac itself now a junk credit and DBI facing its own challenges, some of the investors may rue the day they agreed to straitjacket themselves into such a brain-dead structure.
It could well be that DBI is on a forced march to meet unrealistic financial and business plans. If so, it is not alone as witnessed by the rapidity with which “extend and pretend” has become the latest mantra of the workout industry. From where I sit, a more accurate characterization of what’s going on is “delay, deny then die” (my words). Whether because of the free pass the Financial Accounting Standards Board gave banks on marking down their loans (and that may be changing if FASB’s July 15 fair-value decision is any portent), the desire of PE firms to keep collecting fees on deals where their equity is probably gone, gone, gone or really poor options in a post-BAPCPA bankruptcy regime, there are plenty of companies that are indebted beyond levels they will ever be able to grow out of, yet the only response is to push off the day of reckoning. As some will find out, failing to face facts is not simply an exercise in procrastination, it is suicide. Choices made to manage a company for growth it cannot achieve crowd out better strategies, better ways of allocating capital and better uses of human resources. In all too many cases, those foregone choices would have made the difference between survival and liquidation.
If it turns out that the plans the DBI buyout was financed on are now just pipe dreams, there are options, even given the franchisor’s discombobulated capital structure. But resetting the course for the future will require DBI, or indeed any other company that finds itself with a financial structure and a business strategy developed in frothier times, to make tough, clear-eyed changes now that will likely be painful for all constituencies. But then again, isn’t it better to deal with the facts than be buried by them?