2023-05-11 17:24:59 ET
Summary
- As financing costs soar, companies can no longer pursue growth at the expense of profitability.
- Dutch Bros has suffered immense losses since inception as its working capital level collapses due to its nearly chronic unprofitability.
- Although Dutch Bros is an increasingly popular brand with strong historical growth, it is likely to need to pursue more significant debt financing or equity dilutions to maintain its growth.
- Based on optimistic EPS projections and reasonable valuation discounts, I believe BROS is worth $20.40 and possibly less if it fails to achieve profitability soon.
- Dutch Bros may be best avoided until the company refocuses on organic growth, away from its current aggressive strategy that could force excessive equity dilutions.
The sharp increase in interest rates and growth in strain around the banking system has dramatically increased lending standards . Most companies have had access to extremely cheap and abundant capital for over a decade due to QE-backed money supply growth and near-zero interest rates. Problematically, this has left many companies with significant financial debt that they may be unable to refinance at operable interest rates. Further, the "easy money" era led to the excessive growth of many fundamentally unprofitable companies that have become entirely reliant on nearly free capital. The rise in borrowing costs last year and the subsequent decline in banking stability this year has officially ended this era, meaning companies must make a consistent profit if they wish to remain operable.
Many stocks of "high growth" companies are fundamentally unprofitable. As borrowing accessibility has decreased, most stocks in such companies have lost considerable value as their solvency risks mount. The coffee chain and beverage company Dutch Bros ( BROS ) is a notable example. When the company went public in 2021, many investors believed it would become the "next Starbucks" or "next Monster" due to its stellar revenue growth pace. However, more recently, the stock has lost tremendous value, losing half of its value as its financial debt and liquidity deficiencies offset its growth pace.
BROS has racked up a high short interest level of 21%, implying that many speculators believe the company will not survive this storm. JP Morgan downgraded the stock and lowered its price target this week after its Q1 results showed a rapid decline in the company's growth pace. The stock subsequently fell by around 16%, below JPM's "lowered" price target of $32. With this in mind, I believe it is an opportune time to take a closer look at the company to determine its rebound or survivability potential better.
Growth is Temporary, but Cash is King
In my view, most investors and market analysts are highly conditioned to the "easy money" financial conditions that persisted from ~2011-2021. During this era, a company's solvency was unimportant since borrowing costs were so low, causing the valuations of "high growth" stocks to rise dramatically. BROS went public during the end of that era and still managed to go public at a very high price-to-sales valuation of around 4.5X, with no consistent profitability. Since then, the company has continued to grow while raising significant financial debt and deteriorating its working capital. See below:
In my view, the most significant red flag is the massive decline in Dutch Bro's working capital level. At a $130M deficit, the company has very few liquid assets to compensate for its current liabilities. At its current market capitalization of $5B, the company can undoubtedly dilute equity to raise sufficient cash, as it has done. However, the firm will have no options if its market value declines as it generally loses money. Since it went public, the company's operating costs usually have been near or slightly above its gross margins while its interest expenses have soared. See below:
Dutch Bro's best operating income level in any given quarter is generally around $3M to $7M, though it is more often negative. At the same time, its interest costs per quarter have risen dramatically due to the increase in its financial debt and interest rates, sufficiently to wipe out any potential operating profits. Of course, many believe that Dutch Bro's could significantly improve its profitability if it focused less on growth; however, its gross margin level is roughly the same as Starbucks ( SBUX ). The critical difference is that Starbucks has much lower operating expenses-to-revenues of ~12% -- half the level of Dutch Bros. Its operating costs-to-sales should slide if the company continues to grow; however, I believe it would need to expand sales dramatically before that occurs. Dutch Bros' growth pace has been slow and inconsistent, depending on significant capital expenditure investments each quarter. See below:
On the one hand, Dutch Bros is indeed growing at a decent pace. It is also true that if it expands revenue by 2-3X, its operating costs-to-sales may fall sufficiently (through "economy of scale") for the firm to make a more consistent profit. However, on the other hand, Dutch Bros is not growing organically by reinvesting profits; it is growing through equity dilution and debt financing - both of which are real costs to investors. Since it is not earning a profit on these investments, it usually generates a negative return on invested capital.
The acceleration in labor and essential commodity costs creates more significant barriers to Dutch Bro's road to profitability . Combined with the massive increase in interest rates and the minor (thus far) rise in corporate credit spreads, more of the company's potential profits will go to its lenders and not equity investors. Further, with its working capital at such an extreme low, it may soon need to pursue larger equity dilutions or debt financing to the detriment of its future profitability per share. Lastly, although the company is expected to grow rapidly, it will likely always need to compete with Starbucks, potentially hampering its profitability for the foreseeable future.
What is Dutch Bros Worth Today?
The consensus view shows Dutch Bros' expanding its annual EPS to $1.45 by 2030 and expanding its sales to $3.25B by then. This outlook is generally reasonable but depends significantly on uncertainty regarding future borrowing costs and its ability to continue to grow despite consistent unprofitability. The current projection shows Dutch Bros finding consistent profitability around 2024-2025, which I believe may be too soon given the sharp increase in borrowing costs and its external financing dependence.
Even at those optimistic projections, BROS seems a bit overvalued today. As a rough estimate, based on historical precedent , a company with no organic growth potential should be valued at a "P/E" of around 12-15X with some variation depending on real interest rates (lower valuation when real interest rates are higher, as in today). A stock with higher EPS growth could have a higher fair valuation of 15-20X, with rare stocks with extreme growth potential fairly valued at even higher valuations. Assuming Dutch Bro's earns an EPS of $1.45 in 2030 and would still be growing at that time (allowing for a "P/E" of 18X), I believe BROS could fairly trade around $26 in 2030 (given it manages to reach a $1.45 EPS around then). However, we must discount that price to today's interest rate level of ~3.5% based on the current seven-year Treasury rate. Compounded over seven years, this equates to a 27.2% total discount, giving BROS a fair target valuation of $20.4 today based on the firm's current consensus EPS growth outlook.
I believe BROS is currently overvalued by around $7 per share today, meaning it may decline by another ~26% before reaching a more reasonable valuation. That said, if I were to buy the stock, I would prefer a more significant discount due to the current uncertainties regarding its capacity to grow in the increasingly tight credit financing environment. If financial conditions continue to tighten, BROS may become too reliant on equity dilutions to manage its growth, impairing its future EPS potential.
I believe the company may be wiser to pursue slower organic growth, focusing on profitability and reinvesting profits into new projects instead of relying on external financing for growth. While it may not grow as quickly with that strategy, it would ensure the company does not expand operations into hardly profitable investments, as is often the case with fast food companies. All public companies have "agency risk" since CEOs generally benefit from revenue growth and are sometimes willing to pursue excessive equity dilutions in that pursuit. As a brand, Dutch Bros should focus on "quality over quantity," and I believe its current aggressive growth strategy could compromise its historically strong brand popularity. Accordingly, I am bearish on BROS and think it will likely fall further, but I would not short the stock as it seems unlikely to face bankruptcy for now due to its high growth pace. However, if it does not refocus on profitability soon, this could become a risk as external financing becomes more costly.
For further details see:
Dutch Bros: Dependence On External Financing Jeopardizes Growth Strategy