Fast-growing Dutch Bros (BROS 4.75%) is touted as the third-largest coffee chain in the U.S. behind Starbucks (SBUX -0.17%) and Dunkin Brands but is really a very distant third to its rivals. Where Starbucks has over 15,700 locations and Dunkin more than 8,500, Dutch Bros has just 641.

To help achieve its goal of reaching 800 locations by next year and expand across the country afterward, Dutch Bros is employing a strategy known as "fortressing," a term popularized by pizza chain Domino's (DPZ 1.32%) that essentially means flooding a given market with more stores.

Domino's first introduced the practice as far back as 2010 but really picked up the pace in 2018 as sales began to slow. Since then, revenue has grown from $3.4 billion to $4.3 billion, an 8% compound annual growth rate, while net income is up 12% annually over that same period.

Obviously a success for the pizzeria, but can it work for Dutch Bros? I'm not so sure.

Person handing out a drink at the drive-thru window.

Image source: Dutch Bros.

Devouring its own

A key impact of fortressing is the cannibalization of same-store sales, or what the coffee chain calls "sales transfer." That's where sales that would have gone to one location are now partially shifted to the new shops.

Although comps at Dutch Bros were up 1.7% in its most recent quarter, that was almost wholly the result of price increases the chain imposed. Dutch Bros recently raised prices for the third time this year to offset the effects of inflation. The sales transfer actually caused a 150-basis-point drag on comps systemwide, while the effect on company-owned stores was more severe, with a drop of 240 basis points.

That's an acceptable outcome of the strategy, and Domino's experienced it, too, but the theory goes that while individual stores are dinged, the company as a whole will benefit as total sales rise. It would seem the proof is in the pizza sauce when it comes to Domino's, but I don't know that Dutch Bros will get the same result. 

Limiting its full potential

One of the primary reasons the pizza chain adopted the fortressing strategy was so it didn't have to spend as much on marketing its stores, as a network effect was created by the expanded store base that promoted customer awareness. It also meant delivery times were faster, ensuring product freshness.

Other than the potential for some marketing savings, as Dutch Bros spent over $30 million on advertising last year, the coffee chain derives no meaningful operating efficiencies or product quality improvements from putting more stores in an area.

While Starbucks and Dunkin may benefit from a certain multiplier effect of generating more visits from the greater density of stores it opens, Dutch Bros has yet to achieve a similar critical mass and might do better opening more stores in areas where it doesn't have a presence yet, even if it's in states where it already operates. 

Wait and see

Stealing sales from existing locations seems to be a limiting factor, retarding even greater revenue growth potential by cutting into store-level sales.

Dutch Bros' growth so far has shown there is still potential for innovation in a mature business like coffee. However, with a stock that's still pricey and a strategy that's purposefully cannibalizing sales, investors may want to let this coffee stock age a bit and see if the fortressing tactic can pay off before jumping in.