2023-06-09 05:01:49 ET
Summary
- Dutch Bros is a story stock with recent updates suggesting caution in investing.
- Concerns arise from the company's stretched balance sheet, significant debt, and negative free cash flow due to aggressive expansion.
- High interest expenses and declining same shop sales limit profitability for shareholders.
- While the company has high contribution margins, they are offset by declining same-store sales and significant capex requirements exceeding EBITDA. Uncertainty remains regarding future labor cost improvements.
Investment Thesis
The way I summarized my investment thesis for Dutch Bros ( BROS ) a few weeks ago was this :
Dutch Bros is a story stock. The problem with story stock is when its narrative starts to lose some of its shine.
Then, all of a sudden, investors start to look under the hood and ask all kinds of difficult questions and suddenly, before we know it, it's easier to just say no, rather than to part with hard-earned capital and invest in the stock.
I believe that this stands today. In fact, since I wrote that thesis a few weeks ago, Dutch Bros has updated its quarterly results, and I'm even more convinced that investors should sideline BROS stock.
Why Dutch Bros? Why Now?
Dutch Bros is a coffee chain known for its drive-thru hand-crafted beverages. The Dutch Bros experience is driven by its core values of quality, speed, and service, with baristas providing personalized and fast service to customers.
According to their SEC filings, about 50% of its sales are coffees, with energy drinks making up 25%, and teas, lemonades, and smoothies making up the last 25%.
In the next section, I'm going to first highlight the key reasons why I don't like this investment. Then, I will highlight some aspects from the bull side, to allow you to make up your mind with both points of view.
Revenue Growth Rates Remain Strong, With a But
Dutch Bros is rapidly growing its revenues . Nobody doubts this. At what cost? That's the query that looms large over the bear case.
Dutch Bros' balance sheet is stretched to the brink. They hold more than $240 million of debt and less than $20 million of cash. At their current profitability pace, they will not improve their financial position for more than 5 years. If by then.
Indeed, keep in mind, that Dutch Bros' business model is only able to post these impressive revenue growth rates, for as long as they continue opening stores. That's why their free cash flow in Q1 was negative $40 million. Because they are making a small profit, but they are very aggressively deploying it to roll out more stores.
There's really no more room to maneuver on their balance sheet. Consequently, I believe that 2024 will be extremely challenging for the company to live up to its growth narrative.
Furthermore, their interest expense alone is running at about $25 million per year. And that's before further interest hikes that have happened since March.
Let me provide some more context.
What you see above is that, as of Q4 2022, the interest payments on the term loan and the revolving loans were 6.92% and 6.87%, respectively.
And the most recent quarter it increased to approximately 7.30% for both of these debt structures.
If Dutch Bros with its razor-thin operating margins pays out more than 7% in interest, there's simply no room left for shareholders to make a profit. In actuality, Dutch Bros barely making a profit, as it is.
What's more, consider this,
Same shop sales are coming down with time. There's no need to overthink what's plainly obvious.
Next, let's turn to the bull case.
Bull Case: High Contribution Margin
The bull case for Dutch Bros is that its company-operated contribution margins are very high. This is the best case scenario, that its contribution margins reach around 25%.
However, the counterargument to this is what we see above, that Dutch Bros strives for higher company-operated contribution margins - it's losing on its same-store sales.
Another bullish consideration is that I don't believe that paying 40x forward EBITDA is an exaggerated multiple for a rapidly growing business. However, the problem here is that, below its EBITDA line, the capex that Dutch Bros requires is nearly double the EBITDA it makes.
Finally, another improvement this quarter was a 400 basis points improvement in labor cost. Here's a quote from the earnings call providing context,
I think last year when we saw labor creeping up and getting into a spot where it was becoming too large of a percentage of our business, I think the team attacked that and it's running much more efficiently today and doing a better job across the board.
Naturally, going forward into next year, I'm forced to question whether Dutch Bros will be able to find further improvements in labor performance or not. I believe this may be a one-off improvement, because, after all, their baristas want to make a profit too.
The Bottom Line
I assert that Dutch Bros is a story stock, where recent updates suggest caution in investing.
While revenue growth rates remain strong, the bear case highlights concerns about the company's stretched balance sheet, significant debt, and negative free cash flow due to aggressive expansion.
Further, interest expenses are high, leaving little room for shareholders to profit. Also, same shop sales are declining, indicating challenges ahead.
On the bull side, Dutch Bros boasts high contribution margins, but this is offset by declining same-store sales. Paying a high multiple for a growing business is justifiable, but the company's capex requirements exceed its EBITDA. Although labor costs improved this quarter, it remains uncertain if further improvements can be sustained.
For further details see:
Dutch Bros: Walking A Tightrope Between Success And Struggle