Drive-thru coffee chain Dutch Bros (BROS -2.86%) continues to expand its footprint while delivering piping-hot growth. The third-largest coffee chain (behind Starbucks and Dunkin Brands) is looking to have 800 stores open by the end of next year, when Wall Street expects it to produce nearly $1 billion in annual sales.
Yet the market has knocked the stock down a peg or two this year with the shares trading 31% below where they started in 2022.
The S&P 500 itself is down 15% year to date, and there’s a good likelihood the U.S. may enter a recession sometime early next year. With high inflation, persistently high energy costs, and rising interest rates hurting consumer pocketbooks and confidence, can Dutch Bros rebound?
Let’s take a closer look at whether this emerging national coffee chain can make it past the headwinds that are starting to pick up speed.
Building a fortress for growth
Dutch Bros is opening a steady stream of new locations, most of which are company-opened, through a process known as “fortressing,” or putting new stores in relative close proximity to existing ones.
The strategy was popularized by Domino’s (DPZ -0.73%) over a decade ago as it sought to minimize marketing costs while ensuring it remained top of mind with consumers and helped cut delivery time and costs. If everywhere you turned there was a Domino’s pizzeria, you just might decide to ring up a nearby Domino’s the next time you wanted a pizza.
But fortressing often causes sales to be cannibalized at individual restaurants, even as the company’s overall sales tend to rise. It’s an expensive option as well, as you’re spending more money in an area where you already have a presence. That could mean it’s a strategy that doesn’t pay off for Dutch Bros the way it did for Domino’s.
Eating its own
Last quarter, the drive-thru coffee shop reported that revenue grew 53% to $199 million. It opened 38 new locations on its way to opening 130 new stores in total this year. It ended the quarter with 641 restaurants in 14 states and plans to open as many as 150 more stores next year. It ultimately envisions as many as 4,000 Dutch Bros stores across the U.S.
Although revenue soared, comparable store sales were up just 1.7% for the period, and that was almost wholly because it has hiked prices three times this year to offset the effect of inflation. The cannibalizing effect of fortressing also caused a 150-basis-point hit to systemwide comps. Company-owned stores took an even bigger hit with a 240-basis-point decline.
The tough environment Dutch Bros is operating in is also apparent in its cost of sales, which jumped 63% to $148 million at the same time its interest expense more than doubled to $5 million.
Dutch Bros has some $98 million in long-term debt and $34 million in cash and equivalents available to it. It has $2.7 million in debt maturities coming due next year, with $4.5 million coming due in 2024, and $7 million in 2025. While the coffee chain shouldn’t have difficulty in meeting those payments, it did also change the way it will finance its growth going forward — and in a high-interest-rate environment, it could be costly.
A costlier way to build
Earlier this year, Dutch Bros switched from a build-to-suit lease arrangement to a ground lease agreement. In the first type, the property owner incurs the cost of developing the property to the tenant’s specs and charges the tenant rent for the space. In the other, the tenant leases the property, but develops and owns the building.
That means Dutch Bros is going to face higher costs for each new store it opens. Although it should pay off over the long term — ground leases tend to be very long, as in decades — the coffee shop is going to bear all the costs up front.
Another factor Dutch Bros investors will need to consider is the effect of a recession and whether energy costs will remain elevated. As we saw during the early stages of the pandemic, driving habits were vastly disrupted by business closures, causing drive-thru chains to experience significant drop-offs in visits. If gas prices remain high (or go higher, as is possible), it may result in people driving fewer miles, which would be damaging to a drive-thru-oriented business like Dutch Bros.
Drive past for now
The coffee chain’s stock is not exactly deeply discounted either, going for more than 8 times sales and 99 times next year’s earnings estimates.
While I like the long-term outlook for Dutch Bros as a business, the cannibalizing of sales and the higher costs associated with opening more stores amid a dicey macroeconomic backdrop mean buying the coffee shop’s stock at this time leaves me cold like day-old joe.
Rich Duprey has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Domino’s Pizza and Starbucks. The Motley Fool recommends the following options: short January 2023 $92.50 puts on Starbucks. The Motley Fool has a disclosure policy.
