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Summary

  • Starbucks is thriving, while Dunkin' Brands' growth is slowing.
  • Starbucks is posting record results despite increasing its coffee prices.
  • A company that can demonstrate pricing power to this degree is the hallmark of a great business.

The coffee wars keep heating up, and as a result, Dunkin' Brands (NASDAQ:DNKN) and Starbucks Corporation (NASDAQ:SBUX) are both opening hundreds of new locations around the world. While they're both enjoying the fruits of international expansion, it's a different story back home. In the United States, there is a notable difference between their performances. Starbucks is still firing on all cylinders here, while Dunkin' Brands is hitting a wall.

Nowhere was this more evident than in their most recent earnings reports. Starbucks' comparable-store sales growth, which measures sales growth at locations open at least one year, stands significantly better than Dunkin' Brands'.

If you're looking for a reason why, look no further than the strategic pricing decisions made earlier this year by both companies that are now having a meaningful effect.

For Starbucks, raising prices was the key

Last quarter, Dunkin' Brands generated just 1% growth in same-restaurant sales in the United States. Total revenue increased by just 4%, and was due mostly to new store openings. Management attributed the sluggish sales growth to its hesitant consumers.

By contrast, Starbucks had almost nothing but great things to say about its own customer base. U.S. comparable-store and total net sales increased 7% and 11%, respectively. The U.S. did extremely well for Starbucks last quarter, and in fact matched the performance of its international markets. In all, Starbucks produced $4.2 billion in revenue, which set a record for the third quarter.

What accounts for such a difference?

A few months ago, Starbucks announced a crucial change of course that is keeping sales growth intact. The company announced it would raise prices on several of its in-store beverages, by $0.05-$0.20, in addition to a $1 increase to the prices of its packaged coffee sold in grocery stores.

This came on top of a similar increase the year prior. Starbucks upped its prices by about 1% in June 2013.

When the company initially made the announcement, it took a lot of heat in the financial media, which believed it would suffer a consumer backlash. After all, as critics contended, you can't raise prices in this uncertain economic climate without seeing customers opt for cheaper alternatives.

And there is an element of truth to that idea. The U.S. consumer is still pinching pennies amid sluggish growth in the labor market.

But those fears were misplaced. While that sentiment is directly applicable to Dunkin' Brands, those who felt Starbucks was vulnerable to cost-conscious consumers, simply don't know Starbucks.

The key difference between Starbucks and Dunkin' Brands

The reason why Starbucks did so well in the United States, while Dunkin' Brands struggles to grow, is their respective customer base. Starbucks is a premium brand with premium products, and its customer base generally consists of higher-income consumers. It made all the sense in the world to increase prices, since underlying commodity prices have gone up considerably.

Back when it made the announcement that it would increase prices, arabica beans were up more than 50%. In order to protect its image and keep the fat margins it enjoys, Starbucks had to raise prices.

And rest assured, pricing drove its results last quarter. Starbucks' operating margin increased 200 basis points, and set a new record for the third quarter. Management attributed this to "sales leverage", and you can guess what that means.

Dunkin' Brands couldn't match Starbucks' price increases because it simply can't. When Starbucks announced it would raise prices, Dunkin' resisted, and there was a reason for this hesitancy. Its customer base is far less affluent than the Starbucks consumer, and management knows this.

The major takeaway

I favored Starbucks' decision to raise prices back in June, and I think there may actually be room for even greater increases if underlying commodity prices keep going up. Starbucks is a company with high prices, a fact that shouldn't come as a surprise to anyone. It raised prices last year, did so again this year, and all along, keeps racking up higher same-store sales and fatter margins.

Starbucks caters to a relatively affluent consumer that can easily afford modest price increases. On the other hand, Dunkin' Brands enjoys no such luxury.

That's why it made all the sense in the world for Starbucks to raise prices. Its consumers can easily absorb higher prices. Dunkin', meanwhile, doesn't have that option.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: The Real Reason Starbucks Is Growing Much Faster Than Dunkin' Brands