Fast-growing coffee chain Dutch Bros (BROS -1.04%) continues to expand quickly, adding a record 38 new locations in the third quarter to bring its total of drive-thru shops to 641 in 14 states.
With revenue soaring and gross margins widening sequentially, the stock of the third-largest coffee chain (behind Starbucks and Dunkin Brands) catapulted 22% last Thursday after its third quarter earnings report was released. It was also a riotous day on the market itself as the Dow Jones Industrial Average surged 1,200 points.
Yet as good as this performance is, there remain some off notes to the results that stand out like the taste of day-old coffee.
Image source: Dutch Bros.
Driving through to higher growth
Dutch Bros remains on pace to open 130 stores in 2022. Over the first three quarters, it added 103, and the number opened this time around was almost as many as it opened in all of 2019. While that means it's opened 30 or more stores for five straight quarters, it suggests fourth-quarter openings will slow slightly to around 27 stores.
All the new stores are helping revenue to accelerate, growing 53% from last year to hit $198.6 million, or double what it was 18 months ago, with same-shop sales rising 1.7%, a nice reversal from the 3.3% decline experienced in the second quarter.
Adjusted earnings of $0.09 per share handily beat the $0.06 per share forecast by Wall Street, while also beating on the top line, and analysts are expecting the momentum to continue.
While Dutch Bros itself didn't offer fourth quarter guidance, analysts currently estimate the coffee shop will earn $0.04 per share, or double is adjusted earnings last year, with revenue rising a robust 37% to $193 million. For the full year, Wall Street is looking for $0.22 per share in earnings on $728 million in revenues, which is slightly ahead of management's guidance of $725 million.
Traffic stalls as inflation rises
Yet it should be noted that while comps improved each month as the quarter progressed, the gain was not due to more customers coming in to buy drinks, but rather price hikes Dutch Bros initiated during the period. In fact, it was the third time this year it raised prices.
That's not a fault of the coffee chain, as it needs to pass its own higher costs along, but it's not the clean turnaround in comps it appears. Customer traffic remains negative, even if the numbers are improving, but they are expected to be negative in the fourth quarter, too.
However, it is also true that most of the traffic issues are in California, which is experiencing higher costs than much of the rest of the country, so consumer income is more constrained. For example, where the national average for gasoline is $3.79 per gallon, California has the highest price at $5.46 per gallon. The state also saw one of the highest increases in monthly inflation costs.
California will continue being a high-cost state for the foreseeable future, as it began issuing stimulus checks at the start of the fourth quarter, which should further fuel inflation, and it recently created a Fast Food Council that could hike the state's minimum wage to as high as $22 per hour.
Paying a premium for growth
With its expansion strategy, there is also the risk of cannibalization, or what Dutch Bros calls "sales transfer." Basically, as each new store opens, existing stores lose revenue as customers visit the new locations instead. Overall company revenues rise, but store-level sales are lower.
The company noted that, as difficult as it's been this year with comparables going up against strong year-ago numbers, it is also seeing a drag from sales transfers, which caused a 150-point drag on comps in the third quarter companywide, but on company-owned stores the impact was even greater, or 240 points. (Comps are typically stores that have been open at least a year and look at the repeat business a company generates while adjusting for prices and other factors).
Management says this is well within expectations, but as Dutch Bros grows to its target 800-store size, sales transfer could hold back its performance, which would be in addition to any additional price hikes it felt were needed. So far in 2022, Dutch Bros has raised prices about 4% each time it's increased them.
With the coffee stock richly priced at 89 times next year's earnings estimates and customer traffic continuing to decline, it may be that this will be a difficult situation for investors to swallow.
