Dutch Bros is expanding rapidly via new store openings, but there's a potential second leg of growth that long-term investors need to consider.
Dutch Bros (BROS -3.51%) is a fast-growing coffee chain with around 830 locations in the United States. Management expects to add another 150 to 165 new stores this year.
Even with those additions, Dutch Bros is tiny compared to other major chains in the restaurant industry, but there's more here to consider than just location count.
Getting bigger is step one at Dutch Bros
There's no question Dutch Bros is focused on expanding its store footprint. The company ended 2023 with 831 total locations, up 24% for the year. This is going to be the primary driver of the company's growth for years to come.
Image source: Getty Images.
Given that pace of new openings, revenue soared 32% year over year through the first nine months of 2023, and adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) more than doubled.
However, this rapid expansion also carries the risk that new stores cannibalize older locations, which is why investors need to monitor same-store sales along with the overall top line. While same-store sales should rise in the low-single-digit range for 2023, management previously said it is willing to suffer a bit of cannibalization in these early stages.
A profitable restaurant that's also expanding rapidly should be a very attractive proposition for growth-oriented investors, but there's more to this opportunity when you dig a little deeper.
Dutch Bros' second leg of growth
Last year, Dutch Bros added just 14 new franchised locations. The company is concentrating on company-owned stores, which now make up 65% of the total versus just 32% in 2019. That makes good business sense because it allows Dutch Bros to have tighter control over operations and service during this leg of growth.
However, this is in stark contrast to a company like McDonald's, which only owns and operates around 5% of its restaurants with the remainder in the hands of franchisees. Without the cost of operating its tens of thousands of locations, higher profit margins offset the lower revenue from this franchise-heavy model.
And at Dutch Bros, the story is no different. In Q3 2023, company-owned stores brought in roughly $236.5 million in revenue while franchisee revenue totaled just $28.0 million. But the cost of operating the company-owned locations came in at $179.5 million, leading to a gross margin of 24%. That's not bad, but the cost of sales for franchised locations was only $9.8 million, leading to a gross margin of 65%.
To understand the potential opportunity here, look to Burger King, the popular fast food brand owned by Restaurant Brands International. The company recently agreed to buy out a major Burger King franchise operator, Carrols Restaurant Group, with the goal of accelerating the modernization of Carrols' more than 1,000 locations. Over the next five to seven years, Restaurant Brands intends to refranchise most of those locations. The sales of those operating assets will bring in cash for Restaurant Brands while improving the profitability of the overall business.
And this is the long-term opportunity for Dutch Bros -- open and establish a base network of successful locations before selling them to franchisees. Only in this case, the cash being raised will probably go toward further geographic expansion.
In other words, when you look at the rapid pace of store openings at Dutch Bros, don't think of it as a fleeting trend. The second layer of growth provided by a shift to franchising could take the company's earnings even higher than you expect.
What should investors do with Dutch Bros?
Dutch Bros went public to much fanfare in Sept. 2021 with shares climbing swiftly to an all-time high of more than $75. Enthusiasm for the stock has cooled off dramatically since then, but if you are a long-term investor, there is still a huge growth opportunity here.
That is most obvious in the pace of new store openings and strong operating results, but don't overlook the potential benefits of shifting from a company-owned model to a franchise one. Even if the transition is still years away, you should be thinking about it now.
Reuben Brewer has no position in any of the stocks mentioned. The Motley Fool recommends Restaurant Brands International. The Motley Fool has a disclosure policy.
