As a business that had its initial public offering just over two years ago, and one that's fully focused on growth above anything else, Dutch Bros (BROS -1.04%) is certainly catching the attention of investors. Their hope is that as it rapidly expands the number of coffee shops it operates, its sales will climb, and shareholders will achieve massive gains.
But if you're looking to add Dutch Bros to your portfolio, it might be best to forget about it. Starbucks (SBUX 0.47%) is a magnificent coffee stock to consider instead.
Reasons to avoid Dutch Bros
Dutch Bros currently has 831 stores nationwide. Management plans to have 4,000 locations open in 10 to 15 years. This targeted fivefold expansion is what draws investors to the stock. However, it means the company isn't necessarily sound from a financial perspective.
Dutch Bros needed to raise $300 million of external equity capital in September to fund its growth efforts. And it might need to raise more again in the future. Therefore, its success and survival are likely to be dependent on capital market conditions, which are completely outside of its control. This adds risk to the equation.
It's not a surprise that Dutch Bros' net income of $13.4 million in the third quarter translated to a weak margin of 5%. And while it's opening new locations at a fast clip, same-shop sales only increased by 4% last quarter. That was about half the rate of growth that Starbucks achieved.
At its current scale, with third-quarter revenue of $264 million, I'd argue that Dutch Bros doesn't have a competitive moat. It lacks the brand recognition to be considered a household name. Making matters worse, the coffee industry is incredibly competitive, making things more difficult for its leadership team.
Because Dutch Bros is a younger, more nimble, company with a potentially larger growth runway than an established giant like Starbucks, investors might feel compelled to scoop up its shares. But that would be a mistake.
Focus on Starbucks' positive traits
Starbucks, with its long and successful operating history, is the obvious better coffee stock to buy and hold. There are numerous reasons why this is the case.
For starters, Starbucks does possess a moat. Its brand is a powerful intangible asset that is recognized across the globe. Not only does this help protect the business from competitive threats, but it lets Starbucks charge premium prices for its food and beverage items, which are essentially just commoditized products.
It is also consistently profitable, and has already proved that its business model can work in a sustainable way. In its fiscal 2023 (which ended Oct. 1), Starbucks posted an operating margin of 16.3%, better than Dutch Bros.
Even better, Starbucks generates copious amounts of free cash flow. This allowed management to pay out $2.4 billion in dividends and buy back $1 billion worth of outstanding shares in its most recent fiscal year. It could be decades until Dutch Bros can implement a favorable capital return strategy like this.
Given that Starbucks already has 38,038 stores across the globe, critical investors might assume that Starbucks has little room left for growth. Its leadership team disagrees. The company has set a goal to have 55,000 locations open by 2030 -- a much bigger footprint that would produce considerably more sales and earnings. While most of that expansion is planned for international markets, particularly China, it will also keep adding new coffee shops in the U.S., which will surely make things difficult for Dutch Bros.
As of this writing, Starbucks shares are trading 26% below the all-time high they touched in July 2021. Furthermore, they trade at an attractive valuation: The current forward price-to-earnings ratio of 22.6 is about as cheap as the stock has sold for in the last three years, presenting investors with a good opportunity to add a winning business to their portfolios.
