Dutch Bros (BROS -1.04%) is one of the fastest-growing businesses in the restaurant industry and may be on the radar of many growth stock investors. But it's trying to make a name in a market dominated by just a couple of companies, and it'll be tough to overcome some significant competitive advantages of those bigger businesses.
Dutch Bros stock could pay off in the long run, but I put my money to work in one of its biggest competitors. And that competitor is getting bigger. It plans to add a whopping 18,000 additional stores by the end of the decade.
That scale, along with the strength of its brand and technology, ultimately convinced me to buy shares of this stalwart coffee company instead of the industry up-and-comer.
The biggest coffee chain in the world
If you haven't figured it out already, I bought shares of Starbucks (SBUX 0.47%).
Starbucks' scale is a significant competitive advantage, and that shows up in its operating margin. While Starbucks and Dutch Bros have similar gross profit margins, Starbucks manages to consistently produce an operating margin in the mid-teens. Meanwhile, Dutch Bros is just starting to show operating leverage, producing a 7.8% margin in the second quarter.
The benefits of scale for any business are many. Starbucks can spend less on marketing relative to its overall sales because it has so many locations to amortize the cost of national and international ad campaigns. It also has leverage over suppliers for beans and paper supplies, which can allow it to offer a better product at a lower cost. Both support strong profit margins.
Importantly, Starbucks isn't done scaling the business. As mentioned, management sees its store count expanding from 37,222 at the end of the last quarter to 55,000 by 2030. That's a rapid pace of expansion of over 2,700 stores per year. For reference, Dutch Bros doesn't even have 1,000 locations at this point.
To its credit, Dutch Bros is taking a fortressing approach to its store openings. It opens new stores near successful existing locations. In that way, it's attempting to replicate some of the advantages of scale -- namely, lower marketing expenses -- on a local level. Still, it's hard to compete with a company 20 times the size in the U.S.
The coffee brand
People don't say, "I'm gonna grab a coffee." They say, "I'm gonna grab some Starbucks."
Starbucks brand has appeal across demographics. Teens, notably, love Starbucks. It's consistently the second-highest-rated restaurant among teens in Piper Sandler's semi-annual Taking Stock with Teens survey, bested only by Chick-fil-A. Brand Finance estimates Starbucks is the most valuable brand in the restaurant industry, and the gap between it and second place is widening.
Starbucks' brand strength is instrumental in its ability to scale. It has no trouble attracting franchisers or international customers, and it can launch retail products in grocery stores with high confidence of success.
On top of that, the brand gives it tremendous pricing power, which is essential for helping it grow same-store sales. Management expects to generate 7% to 9% comparable sales growth every year through 2025. Combine that with thousands of new store openings every year, and Starbucks should produce strong top-line growth over the next couple of years.
Pushing all the right buttons
The last big advantage of Starbucks is its technology, which consists of two pieces: in-store technology and consumer-facing technology.
At last year's investor day, Starbucks management outlined its "reinvention" plan. Part of the plan is to invest heavily in new equipment that can speed up processes for baristas. One improvement is called the Siren System, specifically aimed at improving the speed of making cold drinks with faster blenders and automatic ingredient dispensers. Cold drinks now account for 75% of Starbucks' orders.
Increasing throughput is another way to push same-store sales higher.
Dutch Bros is working to improve its efficiency as well. It's installing tap systems for cold drinks in its stores, which should speed up drive-thru lines.
But where Starbucks really stands out is in its mobile app. And it continues to invest in improving the mobile app experience, driving customers to sign up for Starbucks Rewards, and connecting the mobile app and in-store experience. It's pushing more licensed stores to use the rewards program, which has been shown to drive traffic and sales. In the future, it could provide a seamless drive-thru experience for mobile orderers by implementing automatic customer recognition based on their license plate. The strong rewards system and the personalized incentives in the app help drive targeted traffic to stores.
Expensive coffee, but the stock is priced right
Starbucks certainly charges a premium for its coffee, but its stock isn't too expensive.
Shares currently trade at a forward price-to-earnings (P/E) ratio of about 23 times. That's in line with many other large restaurant stocks. Over the last five years, the stock has traded at a median P/E ratio of 31.8 times. It's trading at a meaningful discount to that number today.
It's worth pointing out that Starbucks trades at a premium to Dutch Bros. Its price-to-sales ratio of 3.1 times is well above Dutch Bros' 1.6 times multiple. But Starbucks' scale, brand, and technology advantages mean its revenue should be worth more than Dutch Bros, even if it's not expected to grow the top line as quickly. Simply put, Starbucks is better positioned to turn its revenue into profits for its shareholders.
Dutch Bros could turn out to be a big winner for investors. It's certainly growing fast, and its operations hold a lot of promise. But Starbucks' significant competitive advantages are more attractive to me, and the stock trades for a fair price, which makes it a better buy for my portfolio.
