Financial media pundits like to compare Dunkin' Brands (NASDAQ:DNKN) and Starbucks (NASDAQ:SBUX) as if the two companies represent mirror images of one another. It's true that many similarities do exist; both companies serve beverages, pastries, and sandwiches for instance. However, many differences must be taken into consideration when deciding on whether to invest in one of these companies, both of these companies, or neither. Here's why.

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Dunkin' Brands sells ice cream
Like Starbucks, Dunkin' Brands under its Dunkin' Donuts label sells sandwiches, beverages such as ice tea, and various coffee products in addition to pastries such as donuts, donut holes, muffins, cookies, and cakes.  Unlike Starbucks, Dunkin' Brands also sells ice cream under the Baskin Robbins label. Here's an interesting fact you may or may not know— Baskin Robbins' operating margins climbed over the past three years whereas the operating margins of Dunkin' Donuts declined (see table below). This means that the contribution of ice cream to company profitability increased over the past three years.

Dunkin' Brands Operating Margins

 

Q1 2014 

Q1 2013

2013 

2012

2011 

Dunkin' Donuts U.S.

72%

70%

73%

73%

74%

Dunkin' Donuts International

67%

55%

41%

62%

76%

Dunkin' Donuts Operating Margin Total

72%

69%

72%

73%

74%

Baskin Robbins U.S.

53%

58%

64%

62%

50%

Baskin Robbins International

32%

37%

45%

41%

40%

Baskin Robbins Operating Margin Total

37%

42%

50%

47%

43%

Source: Sec Filings and Author's Calculations

The culprit here lies in the Dunkin' Donuts' international division which saw sharp drops in operating margins over the past three years. Dunkin' Donuts struggled internationally due to the write down of the Spain joint venture, advertisement expenses, and investments in personnel over the past three years. Increased ice cream sales and strict cost control contributed to operating margin growth in the Baskin Robbins segment.

It appears that the trend isn't playing out so far this year. Baskin Robbins saw higher decreases in high margin year to date revenue streams such as royalty income, franchise fees, and rental income.

Dunkin' Brands sports a higher margin
Dunkin' Brands represents a more profitable company with operating margins hovering between 33% and 43% over the past five years versus 5% and 15% for Starbucks . Why is this? Dunkin' Brands represents a 99% franchised company versus 48% for Starbucks. This means the Dunkin' Brands franchisee foots most of the overhead for the company  However, it also means lower revenue for the company as a whole but with a higher percentage of the profit. With Starbucks owning 52% of the company locations it still needs to foot part of the overhead leaving a lower percentage of revenue leftover for itself and its shareholders.

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Starbucks sports less debt
Investors should always look for companies with low long-term debt as a percentage of equity. Long-term debt creates interest which chokes out profitability and cash flow. As a rule of thumb you should look for companies with operating income exceeding interest expense by at least five times. Investors should look for companies with long-term debt to equity ratios of 50% or less.

In the most recent quarter, Dunkin' Brands sported a long-term debt to equity ratio of 461% ! As a result, Dunkin' Brands incurs a great deal of interest. In 2013, operating income only exceeded interest expense by four times. 

Starbucks, by contrast, sported a long-term debt to equity ratio of 41%  in the most recent quarter. Starbucks operating income, with its one time litigation charge backed out, would have exceeded interest expense by 87 in 2013.

Final takeaway
Regardless of the superior operating margins of Dunkin' Brands, the safer bet lies with Starbucks due to lower debt and better interest coverage. What's the point of possessing better operating profit margins when most of it goes toward paying interest? However, investors should watch Dunkin' Brands as it made recent efforts to pay down debt. Moreover, if Baskin Robbins continues to boost its profitability it may become just as relevant if not more so than its Dunkin' Donuts making Dunkin' Brands more of an orange versus the Starbucks' apple. 

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William Bias owns shares of Starbucks. The Motley Fool recommends Starbucks. The Motley Fool owns shares of Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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