Starbucks Vs. Dunkin' Brands: Which Is the Best Buy?

Investing great Peter Lynch once said "If you stay half-alert, you can pick the spectacular performers right from your place of business or out of the neighborhood shopping mall, and long before Wall Street discovers them."  

With that said you may notice a Dunkin' Brands' (NASDAQ: DNKN  ) Dunkin Donuts, a Baskin Robbins franchise or a Starbucks (NASDAQ: SBUX  ) on your nearest street corner, road intersection, or shopping mall. Both Starbucks and Dunkin' Donuts fulfill the morning time coffee and hunger cravings of the masses. Moreover, Baskin Robbins serves the sweet tooth of the multitudes. Which of these two companies represents the best investment?

Let's take a look under the proverbial hood to see if these companies grow their revenue and free cash flow and retain some of that cash for reinvestment and/or return cash to shareholders in the form of dividends.

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A diverse company
Dunkin' Brands and its franchisees sell coffee, donuts, and sandwiches under the Dunkin' Donuts brand and ice cream and cake under the Baskin Robbins brand.  As of the most recent quarter, on a global scale, Dunkin' Brands and its franchisees operated 18,200 "points of distribution" or areas where Dunkin' Brands' products get sold such as restaurants, gas stations, etc. Specifically, Dunkin Donuts and Baskin Robbins had 10,901 and 7,353 global points of distributions respectively. Franchisees operate more than 99% of the restaurants meaning the company puts forth minimal cash outlays for new store development. 

In the most recent quarter, Dunkin' Brands grew its overall revenue 6% . Robust ice cream sales  and same store sales growth in every segment with the exception of it Dunkin' Donuts international segment contributed to the growth in revenue . The segment experienced an overwhelming decline in South Korea. On that note, Dunkin' Brands decided to close 26 stores in its Dunkin' Donuts international segment.

 Dunkin' Brands net income declined 4% during the quarter due to a loss on extinguishment of debt and refinancing.  While normally a decline in net income shouldn't be applauded any effort on a company's part to pay down debt represents a good thing over the long term. High debt breeds a huge amount of interest expense that could choke out long-term profitability and cash flow.

Dunkin' Brands' free cash flow resided at a negative $2.8 million in the most recent quarter compared to a negative $34.8 million the same time last year. Improvements were due to higher net income and favorable changes in operating assets and liabilities.

 Dunkin' Brands sits on a highly leveraged balance sheet. While its cash balance clocked in at 52% of stockholder's equity its long-term debt to equity ratio came in at a whopping 461%. Operating income only exceeded interest expense by four times. The general rule of thumb for safety resides at five times. Currently Dunkin' Brands pays its shareholders $0.92 per share per year and yields 2% annually.

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Caffeinated growth
Starbucks and its franchisees operated roughly 20,200 locations selling coffee, tea, pastries and sandwiches; and approximately 350 Teavana restaurants where it sells tea and accessories as of the most recent quarter.  Starbucks also sells coffee, juices, and tea through the grocery store and food service channels. In contrast to Dunkin' Brands Starbucks owns a little more than half of its stores.

 The company experienced robust year to date revenue and net income expansion growing 11% and 18% respectively. Comparable, new store growth, and its CPG and foodservice segment  aided overall top line expansion. Sales growth, higher margins, lower commodity costs, and a litigation credit aided in the expansion of net income.

 Starbucks free cash flow resided in the negative range due to a one time litigation charge.  Without the litigation charge free cash flow would have grown 44%.  Starbucks sits on an excellent balance sheet with cash and stockholder's equity clocking in at 30% and 41% respectively.  Operating income exceeded interest expense by a comfortable 47 times.  Currently the company pays its shareholders $1.04 per share per year and yields 1.5%.

Who's the best?
Starbucks stands on the most solid financial footing with lower amounts of debt and higher coverage of interest expense by operating income. Starbucks represents an innovating machine as it introduces new products such as the Oprah Tea Latte and experimentation with hand crafted sodas. Moreover, roughly 6,600 restaurants operate outside the western hemisphere meaning it has plenty of room to run in the emerging markets.

 However, while Starbucks represents the superior investment, keep in mind that Dunkin' Brands can still take customers away from Starbucks with innovations of its own and it may improve its balance sheet over time. For now, the better bet lies with the company with the better balance sheet: Starbucks. 

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