Dutch Brothers: Inflationary Pressures Could Act as a Tailwind to Expansion (NYSE:BROS)

Investment thesis

Dutch brothers (New York Stock Exchange: Bruce) It has a competitive advantage in the US coffee chain industry due to better profit margins at the restaurant level and lower operating costs compared to its competitors. Management has set a conservative target IPO time. The market has also set a similar tone for this. However, I see that the company’s potential will be great and that pandemic and inflation pressures should act as tailwinds to accelerate the company’s growth. I expected the stock to be repriced soon.

Company background

Dane and Travis Boersma launched Dutch Bros in Oregon in 1992. Over the years, the company has expanded into 876 Stores in 17 states. It was invested by private equity firm TSG and went public in 2021. Despite going public, Travis It retained ownership of 12 million Class A, Class B and TSG shares He owns a stake of 30 million shares, representing 34.5% of the outstanding shares.

During the IPO, the company revealed plans to open 4,000 stores in the United States. During the IPO, Dutch Bros revealed plans to open 4,000 stores nationwide. This ambitious expansion strategy likely contributed to the founder and private equity firm’s decision to retain a significant ownership stake, viewing the IPO as the beginning of the company’s growth trajectory rather than the end.

Competitive advantage

I believe the company has a distinct advantage for growth within the sector due to its unique business model, which features higher profits at the restaurant level compared to its larger competitor, Starbucks (NYSE:SBUX). Higher profit at the restaurant level should give the company a competitive advantage, allowing it to succeed at the micro level.

Economics unit

Starbucks does not disclose restaurant level margins but does disclose segment operating margins, which includes licensing revenue in margin calculations. However, licensed businesses usually have higher margins than company-operated stores. As a result, with this high-margin business included in the calculations of its North American business, Starbucks’ operating margin is just 18% as of Q1 2024, which is lower than Dutch Bros’ restaurant-level margin of 21.9%. (For comparison, we used a margin of 21.9% instead of a contribution margin of 29.8%.)

Additionally, Starbucks discloses store operating expense statistics to our accounts. As a result, we can compare this metric to Dutch Bros and conclude that Dutch Bros has a much lower operating expense ratio than Starbucks (44% vs. 53%).

How can a company obtain lower operating costs and higher profit margins? The answer is that drive-thru represents about 90% of Dutch Bros.’s business. Its retail lot sizes are also typically smaller than Starbucks store sizes.

The company believes that its business strategy prioritizes consumer convenience while achieving cost savings and maintaining a personalized experience.

Low occupancy costs can also be explained by the site’s location strategy. Using Washington state as an example, Dutch Bros has opened stores in rural areas, unlike Starbucks, which has more stores in urban areas. This also results in lower rental and occupancy costs for Dutch Bros.

As a result, Dutch Bros can price its products more cheaply than Starbucks. For example, in the Renton, Washington area, Dutch Bros charges $4 for a medium-sized latte, while Starbucks charges $5.45 for a similar size, representing a 36% increase in price.

Mobile application strategy and loyalty program

Dutch Bros’ success could be linked to the rise of mobile ordering. The company used its app as a powerful customer acquisition and retention tool to drive traffic to its stores. The epidemic in 2020 also accelerated the expansion of take-out restaurants and promoted mobile ordering. Dutch Bros jumped at the opportunity to launch its own loyalty program in 2021, and the company estimates that as of the end of 2023, Dutch Rewards members account for approximately 65% ​​of all purchases. A loyalty program helps a company retain customers and also strengthens the company’s low-cost moat.

Luckin coffee comparison

Dutch Bros is well positioned for growth in the U.S., benefiting from high mobile demand, fresh coffee, and lower occupancy costs. Additionally, Dutch Bros is not alone in adopting this strategy. In fact, Chinese coffee company Luckin Coffee ( OTCPK:LKNCY ) has already implemented this business model in China. Luckin had a restaurant-level margin of 22% in 2023, which is similar to Dutch Bros. Luckin Coffee was founded in 2017. It went public in the US in 2019, setting a record for one of the fastest IPOs. Despite being delisted in 2020 for financial fraud, Lucking Coffee continued to grow rapidly, eventually surpassing Starbucks in China in 2023 with more than 10,000 stores.

Expansion speed comparison

When Dutch Bros went public, it set a goal of opening 4,000 stores in the United States. As of the end of the first quarter of 2024, Dutch Brothers had 876 stores while Starbucks had 18,065 stores in North America. This represents significant upside potential for the company. However, Dutch Bros has not expanded as quickly as its Chinese counterpart Luckin, which opened an average of 1,500 stores each year. Dutch Bros planned to open 150 in 2024 as it tried to achieve profitability and expansion at the same time. This is also partly due to the difference in the pace of construction and regulatory requirements between the United States and China.

Expansion opportunities

Dutch Bros is currently established in 17 states. I see the company has a lot of opportunities to expand into both emerging and existing markets.

Inflationary pressures

Dutch Bro comp sales accelerated in 2023 and reached an impressive 10.9% in 1Q2024.

I believe the accelerating corporate trend is driven by inflationary pressures on consumers. While overall inflation fell, many people’s wages did not continue to rise, causing some to decline. Retailers like Walmart (WMT) have taken notice. As a result, Dutch Bros appears to be benefiting. Its strong first-quarter performance led the company to raise annual guidance.

Evaluation of discounted cash flows

When evaluating high-growth companies, I prefer to use the discounted cash flow (DCF) valuation model. It gives you better long-term insight rather than just looking at short-term metrics. To calculate the required equity rate of 19.1%, I used a beta of 2.44x, a risk-free rate of 4.5%, and a risk premium of 6%. When combined with a cost of debt of 15.7%, it comes to an average cost of equity of 19%.

Basic scenario

My base scenario was a 10-year forecast based on management’s projection of 4,000 stores, with a gross value of $2 million and 2% inflation. This translates to a compound annual growth rate of 23% for the next ten years. I also assume that the company can maintain a 20% free cash flow margin. These assumptions are considered modest considering that the company’s revenues expanded by 39% in the first quarter of 2024 while its contribution margin reached 29.6% (excluding depreciation and amortization expenses).

With net debt of -$29 million and a terminal growth rate of 3%, it reached a market capitalization of $5.5 billion, or $31.2 per share, which is 13% higher than the current price.

Taurus scenario

Based on my analysis, I believe management’s forecasts are conservative. In the first quarter of 2024, the company’s revenues increased by 39% while the number of its stores increased by 22%. Franchise store growth of 33% outpaced company-operated outlets. This indicates that there is potential for additional market penetration and increased interest from franchisees due to strong returns. The company is likely to raise guidance in the next two quarters.

As a result, my assumption is that the company will reach 6,000 locations within ten years, representing a third of Starbucks’ North American presence. The free cash flow margin is 30%, which is equivalent to the contribution margin. This translates to a sales CAGR of 30% and a valuation of $8.8 billion, or $50 per share, an increase of 40% from the current level. The sensitivity analysis below shows a strong margin of safety.

If Dutch Bros can replicate Luckin’s success in China and outperform Starbucks in the US while maintaining similar margins, my current assessment would be conservative, as I assume eventual growth of just 3% after 10 years.

Bear case scenario

My view is that the company has not expanded as quickly as I expected, bringing the CAGR down to 17% (in line with 150 stores per year at the current rate) while maintaining a 25% free cash flow margin. This translates to a market capitalization of $3.3 billion, or $19 per share, with a downside risk of 47%.

Competition risks

If Starbucks or other small businesses, such as gas station grocery stores, replicate the idea of ​​building convenience stores in rural areas using a similar mobile app strategy, Dutch Bros.’ expansion could slow. This should not only reduce its upside potential, but could hurt its margin.

This is exactly what happened in China, where many convenience store chains recognized Luckin’s success. However, Luckin was able to defend against the competition and retain its customer base by introducing a loyalty program, which Dutch Bros. is currently implementing. Therefore, investors should monitor competition risks while paying close attention to the growth of Dutch Bro’s loyalty program, which measures the retention of its customer base.

Catalyst

I understand why the market believes the stock is worth around $6 billion, which is consistent with my base scenario. This is because the management is committed to its plan of opening 150-165 stores in 2024. Although the company’s comp sales are accelerating, the market has not fully realized its growth potential in this inflationary situation. Even if the company maintains its current growth rate, I believe it will attract more customers looking for lower-priced options due to inflation. This can lead to an increase in the number of sales, leading to improved profit margins. Hence, I expect the market to recognize its growth potential over the next six to nine months. The stock should be repriced accordingly.

Editor’s Note: This article discusses one or more securities that are not traded on a major U.S. exchange. Please be aware of the risks associated with these stocks.