Dutch Brothers (New York Stock Exchange:BROS) is a solid company. It continues with its aggressive expansion plans, driving solid revenue growth. But the company is struggling to increase same-store sales. The demand outlook is also uncertain. This would be fine for a typical business. But Dutch Bros is trading at a high valuation. I don’t think there is enough safety margin to buy at the current price.
A compelling growth story
The Dutch Bros bull case is pretty straightforward. The business has a strong brand and a solid product. The company also has a large untapped market in the eastern United States.
The company has based its growth plans on the opening of new stores. You are on your way to meeting your goal of opening of 130 new stores this year. This would bring the brand’s number of stores to about 670, an increase of more than 50% from 2020. These new openings fueled a strong systemwide sales expansion of 23% year over year. Management wants to increase its store openings by 15% each year.
The brand can grow with geographic expansion. The company has begun to make larger investments outside of the Pacific Northwest. It does not yet have a presence in the eastern United States. I don’t see any clear barriers to Dutch Bros’ continued eastward expansion.
The company is also changing its ownership model to increase profits. You are moving away from your previous franchise business. Now, he focuses primarily on opening and operating his own stores. In this way, the company obtains a greater participation in the gross profit of each store.
Expensive investment plans
The market has been pulling back for some time. Multiple high-growth stocks have taken a hit as the cost of capital rises. Many of these companies have pivoted to prioritize profitability. But Dutch Bros is going ahead with its aggressive expansion plans. This is a clear and compelling growth story. But it is also quite expensive. I have some problems with the way the company finances this expansion.
The business is spending heavily to finance these new stores. In the last twelve months, the company spent $167 million on capital expenditures. It plans to increase this spending to a midpoint of $187 million this year. I want to point out that the tangible book value of the business is only $76 million. These expenses are also far more than the company’s $41 million in LTM operating cash flow.
The company is currently financing these capital expenditures with debt. Free cash flow loss of $26 million last quarter was covered with a variable rate line of credit. Dutch Bros is requesting more than $100 million in capital expenditures in the second half. The company only has $21 million in cash on its balance sheet.
Dutch Bros has not articulated clear plans to increase its operating cash flow in the near future. This means that your expansion plans may require more debt or dilution. I think this is a problem for a company with such a high valuation price.
Low store level growth
The company is seeing lackluster performance at the individual store level. During the second quarter, the system’s same store sales growth was 3.3%. The company reported that same-store sales were down nearly 10% in some California markets. Management attributed this to high gas prices. Dutch Bros’ car-centric business model is especially vulnerable to fuel headwinds. These losses moderated in July, but same store sales decreased 8.7% in real terms.
Part of this is because Dutch Bros is a discretionary purchase. The main products of the business are relatively expensive coffee drinks. These could be reduced during an economic downturn. Management has hinted that they are hesitant to accept larger price increases due to fear of losing customers. This has left the company unable to pass on its rising costs.
We are already seeing some evidence of reduced customer spending. The business is reporting a decline in purchases from low-income customers. Management discussed this on their second quarter earnings call.
Definitely our younger, low-income customer base is where we’re seeing the impact. We’ve seen that if you have a customer base of 40,000, household income of $40,000 or less, we’ve seen declines of up to 45% in California in the rate of visits from those people, and actually actually in Oregon and California. And customers earning between $40,000 and $60,000 are also 27% lower in those markets. So it’s definitely indexing higher on low-income consumers.
This is a dramatic decline in these segments. Dutch Bros is not as exposed to these cohorts, isolating it from backlash. But spending trends in lower income cohorts may spill over to higher income cohorts over time. This presents a clear risk if the economy contracts or unemployment rises.
I’m not saying the business is in imminent trouble. The company has a good brand name and strong customer loyalty. the Dutch Bros App reported 2.6 million active users at the end of the last quarter. This is an increase of 450 thousand users quarter over quarter. These members drove almost 63% of the transactions. However, I don’t see a major catalyst for revenue expansion at the store level.
An expensive appraisal
This brings me to valuation. There are headwinds and tailwinds to the fundamentals of Dutch Bros. But the biggest problem I see is the company’s high price.
Dutch Bros has a forward P/E of almost 200x. The company is trading at more than eight times its forward earnings guidance. This valuation is pricing extremely high sustained growth. These multiples are generally reserved for high-growth technology companies. What worries me is that Dutch Bros is unlikely to make the same margins as a software or media business. In the most recent quarter, the company generated a 20% gross margin at company-owned stores. I am not convinced that the business can generate high margins of free cash flow.
I like Dutch Bros as a company. But analysts expect the company to earn $1.6 billion in revenue by fiscal 2025. After adjusting for net debt, the business is valued at nearly $6.5 billion. I just don’t see a way to justify paying four times the 2025 revenue.
From a broader perspective, Dutch Bros is a profitable growth company. It’s still spending a lot on its expansion, which isn’t covered by its operating cash flow. I don’t think there is a catalyst for a sustained upside in the current environment.
Dutch Bros has promising fundamentals and exciting expansion plans. But the valuation of the shares is exorbitant. I don’t think this price has any safety margin. Any unforeseen issues could cause this review to stall.
Overall, Dutch Bros shares have the potential for a solid upside. You also have the potential to incur permanent capital losses. I feel that the risk to reward is unfavorable. After considering all of this, I don’t see much potential at the current valuation.