Difficulties Still Brewing in Wake of Diedrich Coffee Expansion

Diedrich Coffee Inc.’s ambitious plans to expand nationwide propelled the Irvine specialty coffee chain to the nation’s No. 2 slot, behind behemoth Starbucks Corp.

But the company is paying a steep price.

Diedrich’s losses are mounting, it has shed assets to satisfy its lender, and this week the company said it expects its stock will be delisted by Nasdaq after falling below $1 a share. Meanwhile, some franchising agreements that the company had banked on to fuel its expansion have crumbled, while others may be unraveling.

Facing an increasingly bleak future in the cutthroat specialty coffee arena, the company’s main hope may be to scale back its operations, focusing on its Southern California roots, according to some industry observers.

Though Diedrich’s brand is strong locally, the chain’s efforts to make inroads elsewhere have not taken hold, experts say.

“The concept just hasn’t traveled,” said Randall Hiatt, president of Fessel International, a restaurant consulting firm in Irvine. “Most of the major markets have Starbucks and may have their own local independent or mini-chain kind of competition. Diedrich doesn’t come in and create a ‘wow’ brand that delivers anything new to the customer.”

Company executives would not discuss Diedrich’s woes.

Diedrich also took a huge misstep last year in acquiring a much bigger competitor--Coffee People Inc.--taking on some poorly performing mall-based shops that are sharply different from the Diedrich coffeehouse concept, industry observers say.

In September, Diedrich hired turnaround expert J. Michael Jenkins to engineer a comeback. Meanwhile, one of the architects of its ambitious expansion, John Martin, has quietly vacated Diedrich’s executive suite, moving from “executive chairman” to “nonexecutive” status in October, according to a report with the Securities and Exchange Commission. Martin also gave up his $100,000 salary. He could not be reached for comment.

Despite Diedrich’s considerable troubles, most insiders aren’t writing off the company.

“I still think there’s a strong core business within Diedrich,” said Ted R. Lingle, executive director of the Specialty Coffee Assn. of America, an industry trade group in Long Beach. “My expectation is they will regroup around that strong core, or someone will buy it out from under them.”

With 20 million Americans drinking gourmet coffee beverages every day, experts say the industry itself remains strong, albeit dominated by Starbucks. But with Starbucks so far ahead of the pack, investors are less likely to pour funds into smaller chains, analysts say.

Diedrich traces its ambitious expansion to the arrival of Martin, former Taco Bell chairman, in 1997. He brought along Timothy Ryan, also formerly with Taco Bell, as chief executive.

The company soon signed deals with franchisers to open dozens of stores from San Diego to North Carolina.

But many of the plans stalled. In an interview with trade publication ChainLeader, Martin franchisees simply didn’t select proper locations.

Diedrich wants coffee shops at the end of strip centers on the “going-to-work side” of the street, Martin said. “We underestimated the learning curve.”

Last year Diedrich took a major leap, buying Coffee People, a Castroville, Calif.-based chain that included 278 Gloria Jean’s mall coffee stores, as well as the Coffee People and Coffee Plantation brands.

But some of the Gloria Jean’s stores were poor performers, positioned in malls and catering to an older crowd while devoting more space to products such as kitchen and gift items. Diedrich closed down 39 Gloria Jean’s, logging about $15 million in special charges.

Though Diedrich has built its business to 381 retail locations in 38 states and 10 foreign countries, it lost $22.4 million on sales of $74.5 million for its fiscal year ended June 28. Its losses in the first quarter widened to $1.1 million from $390,000 a year earlier as sales at stores open at least a year declined.

Moreover, after technically violating its lending arrangement, Diedrich has agreed to sell off some of its operations, giving half the proceeds to lender Fleet National Bank.

Diedrich’s stock has lost more than 90% of its value this year, slumping as low as 25 cents Wednesday after the company warned of the possible delisting. The stock closed Friday at 38 cents, down 25 cents a share.

Since Jenkins took over as chief executive two months ago, the company has scaled back, scrapping plans to build four company-owned stores in Southern California and deciding against building three other stores elsewhere.

Industry experts say it is difficult to expand a specialty company with franchises.

“Coffee is one of the most difficult products to franchise, because a lot of the success of the business is driven by the quality of the product,” Lingle said. “It’s hard to bring someone in from the outside and really convince them that quality drives sales.”

Diedrich is also burdened by trying to operate two very different concepts, the mall-based Gloria Jean’s and Diedrich. Starbucks, by contrast, operates under one strong business model.

The chain has said it plans to bring Coffee People and Coffee Plantation stores under the Diedrich brand over the next year or so.