Earnings Call Transcript - BROS Q3 2022

Operator, Operator

Greetings, and welcome to the Dutch Bros Inc. Third Quarter 2022 Conference Call. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Paddy Warren. Thank you, and you may begin.

Paddy Warren, Investor Relations

Good afternoon, and welcome. I'm joined by Joth Ricci, President and CEO; and Charley Jemley, CFO. We issued our earnings press release for the quarter ended September 30, 2022, after the market closed today, and we'll file our 10-Q in the upcoming days. The earnings press release, along with the supplemental information deck, have also now been posted to our investor relations website at investors.dutchbros.com, and we will post our 10-Q there as well when it is available. Please be aware that all statements in our prepared remarks and in response to your questions, other than those of historical facts, including statements regarding our future results or financial condition, strategies, plans, and objectives, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are inherently subject to risks, uncertainties, and assumptions. They are not guarantees of performance and are expressly qualified in their entirety by cautionary statements. These forward-looking statements are made as of today's date. Except as otherwise required by law, we are under no obligation to update these forward-looking statements to reflect subsequent events, circumstances, new information, actual results, revised expectations, or the occurrence of unanticipated events. We may not actually achieve any plans, intentions, or expectations disclosed in our forward-looking statements, and therefore, no one should place undue reliance upon them. For more details, please refer to our earnings press release and to the risk factors in our annual report on Form 10-K for the year ending December 31, 2021, filed with the SEC on March 11, 2022, and our upcoming quarterly report on Form 10-Q for the period ending September 30, 2022, which will be similarly filed with the SEC. We will also reference non-GAAP financial measures on today's call to enhance investors' overall understanding of our financial performance. These non-GAAP financial measures may be different from the non-GAAP financial measures used by other companies. As a reminder, non-GAAP financial measures are neither substitutes for nor superior to measures that are prepared under GAAP. When evaluating our business, please do not rely on any single measure. You can also review the reconciliation of non-GAAP financial measures to comparable GAAP results in our earnings press release. And with that, I'd like to turn the call over to Joth.

Joth Ricci, President and CEO

Thank you, Paddy, and also thank you for starting this on time. Good afternoon, everyone. We appreciate your continued interest in Dutch Bros. We continue to execute our growth strategy, leveraging our strong team to open new shops and our proven operational playbook and loyalty programs to engage and connect with new and existing customers. In the third quarter, we opened a record number of shops, 38, grew our revenue by more than 50%, and expanded our shop level contribution margins both year over year and quarter over quarter. Our real estate pipeline and our team's ability to execute new shop openings remain strong. For perspective, we opened almost as many shops in Q3 2022 as we did in the entire year of 2019. We have now opened at least 30 shops in five consecutive quarters, and we fully expect to cap off our first full year as a public company by reaching our 2022 development target of at least 130 new shops. While I am proud of these headline numbers, I'm equally proud of the quality of our new shops. Our brand continues to demonstrate strength as we travel east into new geographies and as we further penetrate our existing markets. Revenue in Q3 grew 53% to $198.6 million compared to Q3 last year and has actually doubled in just 18 months. Same shop sales grew 1.7% in Q3, sequentially improving each month of the quarter. As we mentioned in last quarter's remarks, traffic trends began to stabilize in July and continued into August. Our same store sales performance was driven by our cold beverage business, which accounted for over 90% of sales in the last 90 days, and was headlined by the strength in our Rebel and Dutch Freeze categories. Additionally, we saw greater consistency across dayparts with positive sales from morning through afternoon and into the evening. Same store sales in Q3 benefited modestly from 4.4% additional menu pricing taken at the beginning of September, bringing our year-over-year pricing to 10.3%. Effective pricing during the quarter itself was closer to 9.1% based on the timing of our Q3 pricing action. Separately, we increased prices for Rebel and coffee sold through our franchisees effective September 1. We try to keep a long-term perspective when we choose to take price. Our pricing philosophy centers on: One, to maintain a consistently strong value proposition; two, to keep the opportunity to customize top of mind for customers; and three, present a clear path towards upsizing. In Q3, company-operated shop contribution grew 62% year-over-year to $44.3 million, outpacing our top-line growth and generating margin expansion. Importantly, in Q3, we saw sequential 100 basis points of company-operated shop margin improvement from Q2 2022 and 730 basis points of improvement from Q1 2022, as the impact of pricing and operational improvements, such as better labor scheduling, flowed through our profit and loss statement. In Q3, we incurred $4.5 million in pre-opening expenses, which were elevated due to our record 34 company-operated shop openings in the quarter. Third quarter adjusted EBITDA reached $27.8 million, meeting our expectations and remaining in sync with our full year guidance of at least $90 million. Recall that at the beginning of our public company journey, we shared five key objectives: to continue to attract and develop people on growth capital, open new shops wherever people want great beverages with an eye toward 4,000 plus shops in the next 10 to 15 years, increase brand awareness and encourage deeper customer engagement, invest in and use technology to improve the customer experience, and expand consolidated margins through operating leverage. It's now been just over a year since our IPO, and we have remained focused on these priorities. In Q3, our shop level and management turnover remained below industry averages, and our shops remained fully staffed. Trailing 12-month shop turnover remained below industry average at 78%, but was up from just 66% in Q2. This was not entirely unexpected, as turnover is often higher when we enter new markets and have to staff from scratch and build our internal employee brand. Importantly, shop manager turnover remains in the low double digits, far below the industry average. And for operators, whom we view as the linchpins of our field organization, turnover was once again virtually nonexistent. The combination of fully staffed shops, a deep bench of qualified operator candidates, and a 20:1 ratio of frontline applications to new hires positions us as an employer of choice and gives us confidence that we have the right pieces in place to fuel our growth. We are committed to growing our field organization organically, partnering with our franchisees to identify and promote outstanding crew members, and providing a realistic growth ladder from being a barista to an operator with multi-unit responsibilities. In Q3, we promoted nine new operators, and over the past 12 months, we have promoted 45 new operators. In combination with our people-first culture, we believe our outstanding career opportunities drive our comparatively low turnover. People capability and availability are fundamental to realizing our growth potential. We've recently made several key hires and appointments. In September, we welcomed Victoria Tullett as our first-ever Chief Legal Officer. Victoria joins us from Papa Murphy's, where she served for more than 20 years. In August, we welcomed Ann Miller, who joined the Dutch Bros Board as our third Independent Director and brings deep governance experience and currently serves as Executive Vice President and Chief Legal Officer of Nike. Across geographies, our new shops continue to perform. For example, our Oceanside, California shop, our first in San Diego County, generated $123,000 in sales over four days. Even more encouraging, the shop demonstrated staying power and strength of operations by generating $629,000 in its first month. We're obviously thrilled by such a warm reception in San Diego County, but we must also quickly open additional shops to satisfy consumer demand and maintain this goodwill. Since 2017, we have developed a strategy successfully in several markets, including Tucson and Las Vegas, resulting in significant brand awareness and market share gains, improved customer experiences, and increased operational efficiencies. Our new shop pipeline is fully populated for 2023. New additions to the pipeline are slated for opening in 2024 and in 2025. Through proactive bulk purchasing of key materials, we've been able to sidestep many supply chain disruptions and keep our construction timelines stable. While we have seen cost escalations in several inputs, including site work and skilled labor, we remain focused on the long game and are encouraged by the resilience of our strong cash on cash returns, which remain in the range of 30% to 40% for ground leases. In 2018, we publicly announced our five-year goal of operating 800 total shops by the end of 2023, and we expect to meet this goal right on schedule. Given the strength of our people development and new unit pipelines, we can now commit to 150 new shop openings next year. Since 2020, we've entered seven new states, reaching Tennessee earlier this year. As we have moved across the country, we've seen a strong reception, including 1.8 million annualized average unit volumes in the greater Nashville market, 2 million in the greater Kansas City market, and 1.8 million in the greater Oklahoma City market. Our 2020 and 2021 classes produced trailing 12-month average unit volumes of 2.1 million, approximately 10% higher than our system average. Our success across these diverse markets has given us confidence in our decision to accelerate openings in 2022 and increase the pace into 2023. And as we grow, we are committed to being good stewards of our planet's resources. Since 2020, Dutch Bros has purchased renewable energy credits to outsource our energy use. The first year, those credits covered nearly all of the electricity at our headquarters buildings. In 2021, the program expanded to include all of our shops. In 2019, we installed solar panels on our roasting facility, and this summer we began taking water-saving measures that are now integrated into every new shop build. Moving forward, all new shops will have an improved instrument cleaning process that will reduce the number of water-consuming dipper wells. Together, these moves help us conserve energy and water, but we know these steps alone aren't enough. We're in the process of identifying and executing other sustainability measures to ensure we're doing our part for the environment. Dutch Rewards has continued to grow along with shop count, increasing brand awareness and creating a stickiness to customer engagement that we believe comes with the feeling of inclusion and membership. As of September 30, the Dutch Bros app had 2.9 million 90-day active users. This is up from 2.6 million as of the end of June. On average, we now have approximately 4,600 active members for each shop. In Q3, approximately 63% of our transactions came from Dutch Rewards members. We believe there's a runway to expand this program, especially in our newer markets. When our members preload funds and pay with Dutch Pass, their average spending is 23% higher than non-members, achieving additional operational benefits from faster payment times. Yes, that's the power of membership. We believe there is an opportunity to enhance our members' experience and earn loyalty through personalization within the Dutch Rewards program, specifically employing one-to-one targeting to encourage users to explore, customize, and create their own perfect drink at the ideal moment of the day. For example, we have the opportunity to target offers to encourage coffee users to try cold brew and encourage Rebel drinkers to try Soft Top. We are well-positioned to provide customers with high levels of customization. Cold beverages, which are inherently more customizable, accounted for over 90% of our menu mix in the last 90 days and over 80% in the last 12 months. Our POS and operational systems are designed to accommodate high levels of flexibility in the order-taking and drink-building process. In Q3, Soft Top was added to 16% of our drinks, up from 10% last year. We also saw success with the launch of the Real Fruit modifier, which customers loved adding to Rebel drinks, teas, lemonades, and Dutch sodas, creating customized and fun beverages unique to them and only from Dutch Bros. We are investing in technology to improve both the broista and customer experiences. In Q3, we innovated by giving Dutch Rewards members the capability to share the good vibes by sending their redeemed rewards to other members in the form of free drinks. In Q3, tens of thousands of free drinks were shared among our customers, a powerful extension of the word-of-mouth engagement the brand excels at creating. In the near future, we plan to further expand this capability by allowing users to buy, send, and utilize digital gift cards through the app. Finally, we are committed to expanding margins over time through operating leverage. We remained agile in responding to input cost headwinds, utilizing both pricing and productivity measures to navigate macroeconomic uncertainty. In September, we completed a 4.4% price increase. Since November 2021, we have taken approximately 10.3% in total pricing. We believe our measured strategic approach to pricing remains a competitive advantage for us, as we believe we offer our customers a strong value, especially with modified beverages. Our efforts to align repair and maintenance and refine our labor metrics and staffing standards began to show results in Q2 and continued throughout Q3. Additionally, in Q3, we began adding resources to our procurement function to achieve greater purchasing efficiency that will come with our growing scale as we move eastward. These efforts have yielded 730 basis points of company-operated shop contribution margin expansion in the last two quarters. We have continued to see leverage in our newest shops, which are demonstrating predictable margin progression, typically maturing in three to four quarters, and reliably generating profits thereafter, with the class of 2020 approaching our target of 30% near contribution margin on a trailing 12-month basis in Q3. Reflecting over our first 12 months as a public company, we have witnessed many changes in the macroeconomic environment and within our industry. But we are resolute in our core strategy to grow the Dutch Bros brand and remain focused on delivering great experiences to our customers. Earlier this year, inflation for some of our key inputs, including dairy, reached record levels and hampered our profitability. When it became evident that price increases were necessary, we chose to make measured moves. Keeping the long-term interests of our customers remains a guiding light for us, allowing us to better manage periods of uncertainty. Last quarter, we began to see margins rebound. This trend continued into Q3. Cost escalation and commodity inflation stabilized, and our measured approach to menu pricing began to pay benefits. Meanwhile, we sharpened our pencils on key controllables. We've made moves to invest wisely in labor by limiting overtime and building schedules more efficiently. Balance is important too because at times our lines are long, and we must be careful not to reduce labor in a manner that would constrain revenue growth. In short, we doubled down on being resourceful. As a 30-year-old company, we have had the good fortune of our operating teams executing through many economic cycles. Throughout all the uncertainty of the past year, the fundamental strength of the Dutch Bros' four-wall operating model has held firm. I couldn't be more proud of this team and what we've accomplished together. I couldn't be more excited for the next phase of growth on our path to 4,000 shops in the next 10 to 15 years. And as we like to say, we at Dutch Bros are here to make a massive difference. We are here for the long run, and we are just getting started. Now I'd like to turn the call over to Charley to review our financials.

Charley Jemley, CFO

Thanks, Joth. Joth’s comments provide perspective on the massive change this business has experienced over the past 12 months and indeed over a period of several years. I will take a moment and build upon that perspective with some facts. The brand surpassed $1 billion in annual system-wide sales in Q2. We've achieved four successive quarters of strong revenue growth, three of which were 50% or greater. We're approaching 400 company-operated shops. Our 370 company-operated shops at the end of Q3 are 54% more than just a year ago. Fast growth does not come at the expense of our high operating standards because we're always focused on the experiences of our people and our customers. We're executing our sales transfer fortressing strategy, delivering on our commitments to infill under-penetrated existing markets, rapidly expand new markets, and evenly space demand for the convenience our customers deserve, and new shop average unit volume performance remained strong. Openings from the first half of this year are on track to deliver $1.9 million, and Q3 openings are trending similarly. As a reminder, we are targeting new shops to perform at or above our company-operated shop average unit volume. At present, that's approximately $1.85 million. New shops are ramping toward cash flow efficiency in line with our expectations. Typically, it takes new shop margins three to four quarters to reach average efficiency, and this trend continued in Q3. We target 30% plus year two contribution margins for our new shops. This metric removes depreciation and strips out the impact of pre-opening expenses, which are typically borne in the first year of operations. Our classes of 2020 and 2021 are delivering gross margins of 24% including 5% depreciation expense. Remember, this also includes depressed margins from the first half of this year as commodity costs escalated ahead of our menu pricing actions. Comparable shop sales increased 1.7% in Q3 after declining 3.3% in Q2. As Joth mentioned, we saw recovery in the afternoon and strength in our cold differentiated beverage categories, such as Rebel and Freeze. For context, our 1.7% Q3 same-store sales result is lapping a 7.3% same-store sales increase in Q3 of 2021. Q3 same-store sales are 11.4% higher than 2019's pre-pandemic levels. Our planned sales transfer fortressing infill strategy created a 150 basis points drag for the system and a 240 basis points drag for company-operated shops in Q3. This remains in line with our expectations. Overall, company-operated shop profitability is recovering. Since Q1, we have seen 730 basis points of margin recovery now at 25.6% in Q3. This is 100 basis points higher than last quarter, despite moving to a period of lower average unit volume seasonality. Despite cost pressures, company-operated shop contribution in Q3 is now essentially level with last year, 40 basis points ahead of Q3 2021. Key takeaways are; ingredient and packaging costs increased year-over-year 400 basis points; dairy, which is the most significant single item in our ingredient and packaging cost basket, has increased over 25% this year; shop operating expenses increased by 120 basis points; labor expenses increased by 70 basis points. In total, that is 590 basis points of cost pressure. Pricing actions have now relieved 570 basis points of this total cost pressure. We have been very careful not to be excessive or to profit from inflation. Our objective has been to recover costs and preserve what we see as a top-tier four-wall model. That four-wall model is the economic engine behind the thousands of shops we intend to open over the next decade plus. We are taking a long view as we serve many existing customers and are quickly introducing Dutch Bros to many new ones through rapid shop growth. It is important we maintain a strong value proposition with all our customers relative to the competitive set, service quality, and speed at a good value. In our franchising and other segment, we instituted a price increase on September 1 on the coffee and Blue Rebel products we provide to our franchisees. Similar to our approach on menu pricing, we chose to wait until we had a clearer view of the operating environment before passing along cost increases to our franchisees. Gross profit for the franchise and other segments held flat at $15.8 million compared to $15.9 million in the same period last year, this was after declining in the first half of 2022. The full impact of the price increase will be realized in Q4 and onward. Shifting now to SG&A. For the quarter, SG&A was $45.4 million and includes $10.6 million in stock-based compensation. Adjusted SG&A was $34.7 million, falling to 17.5% of total revenue in Q3 2022 as compared to 18.6% in Q3 of last year. Annually, we expect adjusted SG&A leverage as anticipated revenue growth outpaces the growth in costs associated with people and infrastructure investments. Moving to overall profitability, Q3’s adjusted EBITDA results strengthened to $27.8 million, 33% higher than the prior year. Importantly, this is 16% higher than Q2. A few comments on liquidity. Our balance sheet is strong and well-capitalized. As of September 30, we had $35 million in cash and equivalents and $312 million of undrawn liquidity on our $500 million credit facility. Our net debt was $152 million and this remained consistent with Q2. I'll shift now to guidance. For the full year 2022, we are raising our revenue guidance and affirming our shop openings, same shop sales, adjusted EBITDA, and CapEx guidance. Total system shop openings in 2022 are expected to be at least 130, of which at least 110 shops will be company-operated. In 2023, total system shop openings are expected to be at least 150. Total revenues are now projected to be at least $725 million. Same shop sales growth is estimated to be approximately flat. Adjusted EBITDA is estimated to be at least $90 million. Capital expenditures are estimated to be in the range of $175 million to $200 million, which includes approximately $15 million to $20 million for our new roasting facility that we project will open in late 2023 or early 2024. With that, I'll turn it back over to Joth for closing remarks.

Joth Ricci, President and CEO

Thank you, Charley. For 30 years, Dutch Bros has been in the business of building and nurturing relationships, and we have all the building blocks to remain a successful and enduring company, including a powerful authentic brand, strong people, systems that drive company culture and fuel our shop growth, a highly engaged customer following, customizable and uniquely curated beverages, highly consistent and highly attractive unit-level economics, a portable model that is successful across geographies, a strong and well-capitalized balance sheet that provides ample liquidity, and an engaged co-founder and an experienced leadership team. We have been there and we will continue to be there for our people and our customers as we execute through a difficult operating environment. Keeping our eyes keenly focused on our long-term opportunity to expand our footprint and create real value for our shareholders. Thank you again for your interest in Dutch Bros, and we now would be happy to take your questions. Operator, please open the lines.

Operator, Operator

The first question comes from Andrew Charles from Cowen.

Andrew Charles, Analyst

Charley, I wanted to talk about the pricing dynamic, and I know that you guys look at three-year trends on an added basis. But if we look at it more on a geometric three-year basis, it’s the way I think investors look at it a little more from Q2 to Q3, we can see that same store sales sequentially go down by about 260 basis points, but there's about 380 basis points of increased pricing from Q2. So perhaps you can just talk about the traffic in September and what you observed in October, and the ability for consumers to digest this? I know you're trying to be measured with it. But just from the outside, these numbers do seem a bit high while recognizing that sales transfer has been pretty similar between Q2 and Q3.

Charley Jemley, CFO

So sales transfer was negative 240 basis points. We definitely had negative traffic, both sequentially and year over year as you're pointing out.

Andrew Charles, Analyst

Can you discuss the strategies in place to ensure that, particularly with the afternoon SKUs, the pricing is being implemented in a way that minimizes any negative impact on traffic?

Charley Jemley, CFO

Well, if you isolate that negative traffic, there is a geographic element, and we referred to this last time. So definitely in the California market, where disposable income is more constrained, that’s the driver of the traffic drag that we're seeing. In the non-California markets, we aren't seeing that sort of decline. So I think if it were a broad decline, we'd have a different response than we have with an acute specific decline.

Andrew Charles, Analyst

And just my last question, on Page 10 of the supplemental, it looks like gross profits from the most recently opened stores improved to 15.8% from 8.4% a quarter ago. What's driving that improvement as the new store volumes remain kind of similar around $2 million?

Charley Jemley, CFO

As we continue to move east, the economics are accretive. We've opened a lot of shops in Texas. So if you look at that on a portfolio basis, that's the driver of the margins moving upward.

Operator, Operator

The next question comes from Sara Senatore from Bank of America.

Sara Senatore, Analyst

I have a quick follow-up and then a separate question. Just to clarify the traffic versus ticket question. I think you had probably 400 basis points more price on the menu in Q3 than in Q2, so I just wanted to make sure I was getting the sort of sequential change in pricing right. And also to ask if there's anything besides negative traffic, if there's any mix or anything like that going on in the composition of the comps. And then I'll have a separate question, please.

Charley Jemley, CFO

So, Sara, we took just over 4% menu price in September, on September 1. So the effect on the quarter is actually quite small, right? So it's much less than that, just over 1%. So I want to make sure you make note of that. It's really going to be the fourth quarter that builds the uptick from that.

Sara Senatore, Analyst

So you've had roughly similar pricing between Q2 and Q3?

Charley Jemley, CFO

Let me consider that. Well, we took just under 4% in May and June, late in the quarter. And then we took 4% late in the quarter in Q3, so roughly the same effect in each quarter.

Sara Senatore, Analyst

I wanted to ask about California, which continues to experience a drag, but there has been more normalization across different times of the day. Can you explain what this indicates? Are there initiatives with the loyalty program influencing this, or are people simply becoming accustomed to high gas prices, leading to more discretionary spending? Additionally, regarding the new units, can you clarify the differences in performance between regions with 1.9 versus 1.85? You've previously had very high new volumes, so I'm curious if you're noticing any changes as you expand into new markets compared to your early stores as you moved further east. I'm trying to understand the factors driving the top-line growth.

Joth Ricci, President and CEO

The components of the menu, I think, a couple real positive things. We saw growth across all dayparts except what we call late night in Q3. So we did see a recovery across the board in dayparts. We saw strong growth in our Freeze and Rebel business. Those are our two fast-growing businesses. Those are big categories for us. And the movement by the team to continue to attract people into those categories was strong and we like those categories. Another element of growth that we didn't touch on is that 38 of the 39 markets that we track grew in Q3. The one market that didn't grow was the Sacramento area. We've cut the decline in that market about in half from where it was in Q2. But real strong growth across the board, just still isolated down on that one market that we're still working through. As it relates to comps and things of that nature, I think that we're opening up a lot of trade zones and we're opening up a lot of new shops that may also contribute to some sales transfer that we're seeing in the market. So it's in the way that we're modeling things out that not every store we are going to open is going to be at 2.1, because in many cases, we might drop store one into a market but other shops are coming into a trade zone to knock those things down, and it won't open up as strong as that 2.1 number. So that's why we kind of look at that total market growth and make sure that we've got our handle on how that's doing.

Operator, Operator

The next question comes from David Tarantino from Baird.

David Tarantino, Analyst

Charley, I wanted to ask you to clarify a comment. I think you mentioned that traffic was down year-over-year and sequentially, so I just wanted to understand how to interpret that. So I guess, what did you mean by sequentially when you talked about traffic?

Charley Jemley, CFO

So sequentially, from quarter two to quarter three, now we have seasonality in there as well, but we've seen some decline in traffic counts from quarter two to quarter three. And then certainly year-over-year, we have seen a decline excluding sales transfer. These are small declines, though; they're not significant.

David Tarantino, Analyst

So is that adjusted for seasonality, or if you think about the year-over-year change, was it a little softer in Q3 than in Q2? Is that what you're trying to say?

Charley Jemley, CFO

So seasonality wouldn't be a year-over-year effect, to your point. It can be an effect as you move from quarter to quarter; quarter two is typically our highest seasonality. I think the best way to characterize quarter two to quarter three outside the price advance is pretty much, I'll call it, running in place; not a lot of change in traffic.

David Tarantino, Analyst

I wanted to understand your perspective on the fourth quarter because the full-year guidance suggests a diverse range of potential outcomes. However, if taken literally, it could indicate a decline to negative comparisons in the fourth quarter. Could you clarify if that's how you're approaching it? Additionally, if that is the case, why would the comparisons be turning negative despite an increase in pricing?

Charley Jemley, CFO

So we are positive through three quarters. We're projecting flat. So yes, you are correct that we are expecting a small decline in the fourth quarter and reported comps. There is sales transfer to consider through that. And then in terms of the lap, the lap in Q4 is pretty aggressive versus Q3. So make note of that when you look at comp stacking data that we provide in the supplemental. Moving parts are that we are going to add stores; we are going to go into a lower period of seasonality, we have a full quarter of pricing; we are expecting a little softer, a little tougher lap in traffic year over year, and that's how we kind of end up guiding where we guided.

David Tarantino, Analyst

And then Joth, I was interested in hearing more about the one-to-one marketing that you mentioned. You have that capability now, it sounds like, and I was hoping you could elaborate on what your plans are in the near term and whether you are planning to use that vehicle more aggressively to try to protect the traffic?

Joth Ricci, President and CEO

We have done several different programs. I think the team has created a nice playbook of how to look at the varying degrees of what the customer is going through. So literally, you can create a customer engagement and see, is it a daypart issue, is it a trade down issue, is it a promotional opportunity to convert them into another beverage category, what's the behavior that we are seeing through the Dutch Rewards program that would maybe give us the opportunity to communicate with that particular customer in a certain way? So we are driving frequency. It's introducing them to other parts of the menus so that they come back on different dayparts. We are still mining through the data to figure out what that looks like. So you could almost pick any scenario, David, and say that’s one that we are using because of the way that we can promote utilizing the app. But I think the ability to drive, to utilize the sharing of points program that we put in place, we also, in Q4, have a big digital card that we are going to be launching through the app, and that’s a big gift item for the holidays, which we like that. The other thing I want to speak on just quickly related to Charley's comments is that Q4 last year was really that last run of COVID challenges, I think that we saw in the marketplace. And we had a very strong fourth quarter of last year because we were open, we were running, and we were doing very well at that time. And so I think there’s still some settling down happening in year-over-year numbers related to who was open, who wasn't, what was going on in the market, and what's happening now. So I think that's some of our hesitancy to be more positive about the fourth quarter, is we know what we're up against versus last year.

Charley Jemley, CFO

It's the highest two-year stack we face.

Operator, Operator

Thank you. The next question comes from John Ivankoe from JP Morgan.

John Ivankoe, Analyst

The question was on what you're seeing with taps and film. Certainly, I think about this as speed of consistency, certainly it fits with some of the environmental goals that you have. Could you give us an update on what you're seeing in new stores and any opportunities that you have to retrofit some of the existing stores? And I have a follow-up.

Joth Ricci, President and CEO

Our colder tap system is currently in old taps, and we have a plan to roll that out. We just launched a new tap design at a stand in Grants Pass, focusing on a Rebel on tap, and we are testing that program. We anticipate scaling up in the latter half of 2023. We’ve selected a new shop and are working on new design and programming to roll out in July and continue through the rest of the year.

John Ivankoe, Analyst

And anything that you can share operationally? I mean, is it in terms of its significance, why you're doing it? I mean, certainly, again, we see the waste aspect, but anything from a customer and employee perspective?

Joth Ricci, President and CEO

The feedback has been fantastic. It's straightforward and user-friendly; we are eliminating the traditional can and simply pressing a button to pour the perfect drink. This process is often much quicker, allowing us to deliver to customers promptly and enhance efficiency. Additionally, there's the advantage of not having to ship full product cases, such as cases of cold brew, Rebel, and even our sparkling water. We will continue to streamline our finished goods and focus more on a concentrate business as we move into the latter half of the year. While we've tested and modeled it, I can't commit to any numbers until we see it in action.

John Ivankoe, Analyst

Second question on turnover. I think I wrote down hourly turnover went from 66 to 78. Not unexpected, but that's not a small increase, especially for you. So kind of go through why I guess employees are leaving at an accelerated rate relative to the second quarter versus last year? I know new markets might be a part of it. But are we seeing a similar phenomenon in existing markets? And I'm curious, I don't know this to be the reason. A lot of hourly workers have opportunities to earn tips where they didn't before. And I think quite frankly, you've led the industry and shown some others the way of how good that can be from both, I guess, profitability but also, more importantly, an employee perspective. So just wanted to get some more color in terms of that increase in turnover, and if you see it as an issue that you guys need to, I guess, make sure it doesn't get any worse?

Joth Ricci, President and CEO

And just the case study that is the labor market right now is fascinating. So a couple of comments. One is that our turnover in the third quarter is always going to be higher. Just the nature of summer ending and back to school, the type of employee base that we have, we always see higher turnover in the third quarter. The reason why the trailing 12-month number is higher is actually more driven by the phenomenon of the first quarter and the second quarter, which were higher than the first quarter and second quarter of 2021. In the first and second quarter of 2021, we had the lowest turnover we've probably ever seen just because we were open; people had a job, and they were staying. But we did see increased turnover in the third quarter of last year. And what will happen is we'll see that drop off in the fourth quarter, it'll kind of bounce around for the first and second quarter, and then it'll increase again in the third quarter. The tipping question is a great one. I think that we've all seen an increase in the opportunity to tip across all segments of business in the last six months, and we've seen a reduction in that number. At the same time, I think that, I think it's an interesting phenomenon as well that I'll stay away from my opinion on that. But I do think that we need to make sure that we're tipping great service and we're acknowledging people that are doing amazing work. And I hope that everybody in every job does amazing work so they get a great tip.

Operator, Operator

The next question comes from Nicole Miller on Piper Sandler.

Nicole Miller, Analyst

On comp last quarter, if I have this down properly, you talked a lot about California. And I think it was something like if you could exclude, I think, it was both California and sales transfer, comps would've been down very, very modestly. So can you give some context for the third quarter comp around the impact of California, and if California was a driving force to the positive? You know, there was an earlier question about that consumer absorbing inflation, which is a great one. Or is it the fact that they had a stimulus that I guess was technically really in October, not in Q3. But if you just had any line of sight into like maybe they knew that was coming, so they started to feel better, and if that is a lasting event or phenomenon or sentiment kind of.

Joth Ricci, President and CEO

And you're right, the stimulus was in October, so we didn't see any value of that so far. But back to the California question and I want to isolate the California situation actually into the Sacramento area, and what we would just call a Sacramento DMA. If you remove that DMA from our entire system, our total system same-store sales would be up 4.1%; that's how much of an impact that market has on our same-store sales related to the system. So 4.1% would be the growth number if you take that out. In the second quarter, that market was down 9.7%. In the third quarter, that market was down 4.8%. So we've seen an improvement there. But we still have work to do and it's kind of back to that 38 of the 39 markets that we talked about being up. Again, we're isolating that, we're looking at that, figuring out ways that we can kind of work in that market but also being focused on everywhere else that is going what we would consider to be very well.

Nicole Miller, Analyst

The recovery was seen in cold drinks and during the afternoon. I think the mix shift held us back in the first half of the year. Has the mix shift improved?

Charley Jemley, CFO

Not necessarily.

Nicole Miller, Analyst

So really, it’s traffic then, traffic and price. Is it negative still, or is it still a drag?

Charley Jemley, CFO

Mix is a drag, slight drag, probably some trade down going on there, which is logical.

Nicole Miller, Analyst

And then for Q4, like was asked earlier, so for the whole year being flat, and you kind of said, if I have this down, negative comp. So with price, again, just the same kind of level, a little bit more price, so a little bit more negative traffic. Is that the way to think about that, given those reasons that you kind of cited? And I don't know if it was one question or three questions ago, but is that right?

Charley Jemley, CFO

Yes, on a year-over-year basis. But again, I'd encourage you to look at that Slide 8 because you can see the two-year stack for Q4 is really big. It's 15.8%. And so you all know that comp is a two-part equation, what you deliver in the current frame and what you're comparing it to. So that's why we're not concerned about reporting a negative traffic number with that big of a lap.

Operator, Operator

I have a question about the roasting facility. Does it help reduce any pressures? Does it allow things to move faster or become more cost-effective? What advantages does the roasting facility provide in the end?

Joth Ricci, President and CEO

When you think about our supply chain, we are shipping almost everything that we make out of the most expensive markets in the country on the West Coast. And so we are currently using a third party in the Dallas market to offload some of the pressure that we have from our roasting facility in Grants Pass. And right now we produced probably 97% of our roasted bean volume coming out of the Grants Pass market. As we move those things to Texas, we'll start a supply chain that comes up through Houston and directly goes into the Dallas market that allows us to ship throughout that Midwest market and then to the East Coast. So one is we'll get out of a third-party situation, which is absolutely more expensive to make. And we'll get into our own situation, and then we'll be able to offload and also take some risk out of the equation with having one roasting facility on the grid in one location. And with what's happening in the summers with fires and the other things that we're facing on the West Coast, we want to make sure that we're able to supply regardless of any situation.

Charley Jemley, CFO

Ultimately, from our original roasting node, we will lose capacity and we don't want to add capacity in a single risk environment like that.

Operator, Operator

The next question comes from Jeffrey Bernstein from Barclays.

Jeffrey Bernstein, Analyst

Just following up on the menu pricing, the 9% I guess that we're talking about in the third quarter, which seemingly would go up a little bit in the fourth quarter. Just wondering how do you go about arriving at the price increases? I know you said you prefer more smaller increases. But is that just the price increase determined based on your needs to hold margins at a certain level? Or, I mean, how do you test it to make sure that there is not going to be outsized pushback from a lower-income consumer in this environment?

Joth Ricci, President and CEO

Yes. So every price move that we've made in the last year, the three that we've made have really been measured to that degree. One is that we're going to go slow. We want to continue to create a value position for our menu across just about most of the categories that we're in. We want to be careful about how we do it. So we basically, what we say is we want to earn price as we put that on our menu, there's a taking price. So we've been careful about the impact on the consumer during this time, and we've also been careful about where we put price. So we've done things on a lot of our products that you premiumize an item with. We've done that so that the customer is choosing an item that you would take price on. We also look at other places in our menu that we feel like that there's a price opportunity there. We've also protected other parts of our menu against the customer base that may not be able to take price. So so far, we're very pleased with the way that that's worked. We've seen just about all of it flow through in the last year and will continue to be measured as we get out of the end of this year and then look again kind of at the first half of next year.

Jeffrey Bernstein, Analyst

And obviously, the pricing is in place to mitigate inflationary pressures. I'm just wondering if you can quantify the basket of commodity and labor inflation for the third quarter and maybe what your outlook is for the fourth quarter, or more importantly, directionally into ‘23. Hopefully, we're expecting these things to ease in ‘23, but any kind of color on the current quarter and the near-term outlook would be helpful.

Charley Jemley, CFO

Our overall year-over-year cost of goods basket inflation in the third quarter was just shy of 11%. Our wage inflation is just below 1% currently. We don't anticipate significant changes at this time and do not think it's wise to rely on that. However, dairy is a major factor in this, with over a 25% increase in prices. Coffee prices rose by high single digits in the third quarter.

Joth Ricci, President and CEO

Yes, we are not hearing anything that gives us a strong sense of optimism that things will change in the near future. Dairy prices are expected to remain stable until spring next year. The coffee price, which we are closely monitoring, is beginning to decrease, which is usually a positive sign. However, if you're involved in futures trading, that can be a more complicated situation. We're keeping an eye on that. Additionally, labor costs are something we are paying close attention to. We've had success in hiring, with one out of every 21 applicants being selected, which is encouraging. Nonetheless, we need to be mindful of wage inflation as we progress into the beginning of the year.

Operator, Operator

The next question comes from Sharon Zackfia from William Blair.

Sharon Zackfia, Analyst

I was pretty impressed by the labor leverage that you saw in the quarter. And I know you mentioned labor scheduling and I think less overtime. Is there anything else that went into that metric because there's really good leverage, particularly for the comps you put up in the quarter? And then secondarily, I was curious if you could talk about what new markets you might be looking at opening in 2023.

Charley Jemley, CFO

On the labor side, the team has done a really good job of ensuring that we forecast sales as accurately as we can. We write a schedule; we're close to that sales level and get the dayparts right and then work with the schedule that we write. And given that we have still had relatively low turnover and we have a reliable staffing model, we're able to just fine-tune that and set our schedules more effectively, removing overtime and limiting the training expenses that we had. So we just got better at our craft in the third quarter because the environment was less disruptive.

Joth Ricci, President and CEO

And Sharon, looking at the markets for next year, about 60% of our planned shops will open in California and Texas as we continue our expansion there. Currently, we have 92 locations planned for these two states, and we'll be focusing on existing markets. The main new markets will be in Alabama, Tennessee, and Kentucky. Key areas like Huntsville, Knoxville, and Lexington will be central to our growth. We'll apply a similar strategy to what we did in Texas, opening in secondary markets like Lubbock, College Station, and Fort Hood to establish a strong presence. We're excited about next year, and the team is eager to get started with the $150 million investment.

Operator, Operator

The next question comes from Patrick Johnson on for Chris.

Patrick Johnson, Analyst

I wanted to follow up on your mention of California being a key factor in the traffic declines. Could you clarify if the stimulus payments that were distributed in California at the beginning of the fourth quarter have had any impact? I also have a follow-up question.

Joth Ricci, President and CEO

At this moment, we don't have any specific details regarding the Q4 numbers. We haven't really looked into it or analyzed the impact it may have had so far. I wish we could provide more information, but I don’t have much to share on that matter.

Patrick Johnson, Analyst

And then also, Joth, does the company have a higher level of promotional activity during the third quarter than maybe it did last year? And then as we think about the fourth, and I appreciate the comments on the lab, but I'm curious if you could provide some color on just what the level of promotional activity might be around the holiday season compared to last year as well.

Joth Ricci, President and CEO

We're not a big promotional company, and part of that is related to the lines we manage and the traffic we handle. We don't aim to drive large volumes into our stores because we're focused on maintaining operational efficiency. When our lines become too long, we risk losing customers who don't want to wait. This is why our one-to-one promotion strategy is crucial. Our discount rate in promotions has remained consistent throughout the year, and we've managed our promotions within that discount percentage without engaging in large promotions that could disrupt our operations. Overall, I would say there hasn't been anything unusual compared to last year, and our team has been disciplined in managing this.

Patrick Johnson, Analyst

And then lastly, I mean I know you mentioned, or you highlighted, modifiers and customization like Soft Top as a driver of incremental revenue opportunities in your prepared remarks. And I was just curious if you have any product innovations in the pipeline or additional beverage enhancements that you think you could roll out that would provide additional options for customers to sort of self-select and add on those high-margin beverage modifiers?

Joth Ricci, President and CEO

We have done a variety of work to get Soft Top to that 16% mark over the summer. When we launched Soft Top, we had no idea that two-plus years later, it would represent 16% of our beverages and continue to grow as our consumers and baristas effectively offer it. You can add it to cold brew, Rebel, lemonade, hot drinks, and many other options. Real fruit has also become popular for enhancing drinks without using syrup, allowing us to use actual fruit in beverages. Its usage has expanded beyond just teas and lemonades, now including Rebels, soda, and other drinks we offer. We are cautious about too much innovation due to the operational efficiency required in our shops to manage volume. We did launch a Mangonada and tested a product with Tajín in the third quarter, which received positive feedback from both consumers and our baristas. We are considering a few similar products for the coming year. Additionally, our menu currently features a wealth of innovations, including a secret and insider menu with hundreds of unique drink options not provided by others. We will continue to highlight these beverages to our customers, particularly in new markets where they are still becoming familiar with the Dutch Bros experience.

Operator, Operator

There are no further questions at this time. I'd now like to turn the call back to Joth Ricci for closing remarks. Thank you, sir.

Joth Ricci, President and CEO

So once again, I want to thank everyone on the call. I also want to thank our thousands of baristas and our teams in the shops and our hundreds of people here that support our HQ that makes such a great experience for our customers and our employees in the marketplaces. This has been an amazing year. 2022 has again thrown challenges at us that we've taken on and developed and worked on, but we've created record numbers along the way. So I want to thank everybody for joining on the call. I wish everyone a very happy, safe and great holiday season, and we look forward to speaking to you again at our Q4 call in the first quarter of next year. Thank you.

Operator, Operator

Thank you. This completes today's teleconference. You may disconnect your lines at this time, and thank you very much for your participation.