Dutch Bros (BROS) analysis: Great company but high valuation limits appreciation potential
Based on my estimates, BROS offers a 5-year CAGR of just 10%
Operates 503 drive-through shops (241 owned and 261 franchised)
Potential to expand to 4,000 shops across US
14 years of positive same-store sales1
Weak competitive advantage, low barriers to entry
The stock offers a 10% 5-year CAGR based on my valuation
Founded in 1992 by brothers Dane and Travis Boersma, Dutch Bros began with a double-head espresso machine and a pushcart in Grants Pass, Oregon. Travis’s brother Dane unfortunately passed away in 2009 and Travis is now the main driving force behind DB (as it’s called by its fans).2
The brothers soon expanded from one pushcart to five and in 1994 bought the first drive-through. One of their early customers wanted to replicate the experience in a neighbouring town, so they sold him a license and thus created the first DB franchise.
In 2008, Travis made the decision to stop offering franchise licenses to anyone except for DB employees. In 2017, they stopped offering licenses altogether. The company now focuses only on opening its own stores.
Dutch Bros serves hot and cold espresso-based beverages, cold brew coffee products, the proprietary Dutch Bros. Blue Rebel energy drinks, tea, lemonade, smoothies and others. C. 82% of beverages are served cold.
BROS offers a balanced mix of beverages and almost 40% of sales are recognized before 12pm.
DB roasts its own private reserve coffee blend in-house at their roasting facility.
The company has grown steadily over the past 10 years, by adding both company owned and franchise stores. The franchise store count increased despite the cancellation of new licenses, because old franchisees are still expanding.
Franchise revenues consist of initial franchise development fees, marketing contributions, and the sale of products such as coffee beans or the Blue Rebel energy drink.
The company has proven that the concept works across 11 states: Oregon, Washington, Idaho, California, Arizona, Nevada, Utah, Colorado, New Mexico, Texas and Oklahoma. I believe they can expand on the East coast as well
In fact, California and Arizona have much higher AUVs than average.
Revenue growth has come mainly from company-owned stores3, as the fees from franchisees stagnated since 2019 despite store growth.
The revenue per store for company-owned stores has increased steadily, going from $1m to almost $1.5m by Q32021 and has increased during last year as well.
The difference between the company reported AUV and my calculated revenue per shop is that the company includes franchise sales, and I look only at company owned stores to get a better picture. This would suggest that franchisees generate higher sales per shop than the company itself.
The cost to open a new shop ranges from $0.5m (build-to-suit) to $1.35m (ground lease). The company expects to achieve $1.7m in sales per unit (AUV) and 30% contribution margins within 2 years of opening.
In a build-to-suit scenario, the whole cost is recouped within the second year of operation, which are impressive economics.
Most of shops open more than 15 months have contribution margins of at least 20%. Contribution margin is a Non-GAAP metric calculated by the company to demonstrate profitability on a shop level. It’s calculated as gross profit plus depreciation.
It’s a nice number, however taking out depreciation doesn’t make sense, as the company still must invest in capital expenditures to maintain the stores.
Furthermore, it doesn’t take into account headoffice expenses, advertising costs, taxes, interest and so on. The net margin on a corporate level will likely be much lower.
COVID-19 impact
The COVID-19 pandemic hit BROS in Q1 and Q2, despite the fact that drive-throughs usually benefited during that period. Wildfires in Oregon also caused a decrease in same shop sales.
The company mitigated the effect and was able to grow thanks to cancelling their stamp reward program, which resulted in lower discounts on its drinks.
Recent developments
The company has developed a new optimized shop prototype, which they claim attracts 40% more volume than the legacy shops. The new shops are fairly small at 865 to 950 square feet, usually situated on lots that have at least 25,000 square feet.
The shops have usually one or two windows, customers can also walk up there and order directly.
The company has a strong retention rate at the manager level, 100% of all the shop managers at stores opened since January 2018 having been promoted from within.
Dutch Bros launched a “Dutch Rewards” program through its app and recorded 2.7 million member registrations in the first 9 months of 2021. The app has a 4.9/5 rating on both Google Play and App Store and is #30 in the Food and Drink category.
The company donated $5.2m to various causes in 2020.
Inflation is not a big worry for the firm this year, as they have hedged the coffee supply several years out4. Dairy, which represents a large part of input costs hasn’t seen inflationary pressures similar to other commodities, so margins will be protected in the foreseeable future.
DB has raised prices in November, and generally raise them by 1-2% per year.
Financials
Dutch Bros reached record revenues of $327m in 2020, up 37% YoY. Revenue for first 9 months of 2021 is already higher, at $358 million (up 51% YoY).
It’s driven mainly by the new shop openings, as franchise revenues and same shop sales are growing by 10% and 7% respectively.
Gross margin declined by 5% during 2020, due to Oregon fires and COVID-19. Franchise margins were hit harder, offset by higher margins at company-owned stores. This was mainly due to the fact that they stopped accepting stamps after 2020 (to minimize contact with employees), and this meant less discounting and higher margins.
Balance sheet
The company leases its shops for a typical period of 20 years. DB has only $26m in cash on the balance sheet, as it was used to buy out existing shareholders.
The company has significant liabilities: $36m in debt, $75m in capital leases, $139m in operating leases and a $110m tax receivable liability. The tax liability is tied to the Tax agreement with founder and Sponsor.
So that’s $250m in “operating” liabilities and another $110m in legacy liabilities. This compares to cash of $26m.
The company expects it will need additional capital to finance its expansion, which would mean either more debt or dilution to equity.
Cash flow
The company generated $50 million in operating cash flow during 2020 and $72m in 9M 2021 (up from $43m in (9M 2020).
Free cash flow actually turned negative during first 9 months of 2021, influenced by the costs of reorganization and public listing.
This might seem very low given their valuation, however both Starbucks and Home Depot showed very little or no free cash flow during their early years, as both companies invested heavily into growth.
But the contribution margin figure (29-30%) stated in filings can be very misleading, as both operating and free cash flow are way below that.
Management
The CEO Joth Ricci has been with the company for only two years, but has 21 years of experience in coffee retail. Here is a recent interview with him:
Dutch Bros has a 4.2/5 rating on Glassdoor with an 85% CEO approval rating. These are much better ratings than those achieved by peers such as Starbucks, Peet’s Coffee, McDonald’s or Wendy’s.
Following the offering, both the founder and TSG (Sponsor) will hold 70% of Class A Common units.
TSG is a private equity firm with $11 billion under management and a focus on consumer companies.
Travis Boersma holds 74% voting power in the company, which effectively gives him control of the business.
Competitive advantage
DB focuses on quality, speed and convenience. Their competitive advantage is the maniacal focus on customer experience.
Both brothers were inspired by In-N-Out Burger and Les Schwab Tires. The company has created a very unique culture, promoting “love and humility”.
By constantly trying to create a great experience for customers, they increase the lifetime value as happy customers keep coming back. Furthermore, BROS products can only be bought at their shops and nowhere else.
Advertising costs represented only 4% of revenue during 2020, suggesting that a lot of traffic is driven through word-of-mouth advertising.
DB has built a great brand over the years, however they have very limited pricing power.
The barriers to entry are extremely low in this market and competitive advantage is very difficult to sustain. Only a few coffee chains have maintained a competitive edge for decades (Starbucks, Peet’s).
Dutch Bros has been very successful in the past and will grow further, but margins will remain under constant pressure from competitors.
McDonald’s, Tim Hortons, Starbucks, Peet’s, Biggby, Dunkin Donuts and many others offer drive-through coffee in their shops.
Market size
The company states an addressable market of $36 billion (coffee) and another $36 billion (convenience store). These numbers are totally off the hook and don’t reflect anything significant.
The company occupies a niche in the coffee market (drive-through) and is not present in the convenience store market, so the numbers presented in their S-1 filing as “TAM” should be disregarded.
More importantly, Dutch Bros has stated its goal to achieve 4,000 stores in US, which is probably more realistic than the crazy numbers presented above. They already have a pipeline of 250 sites identified for future development.
Almost 75% of new shops opened during the last 3 years were in existing markets. This didn’t cannibalize the legacy shops as same store sales remained positive.
The company also plans to add a second roasting facility in the Midwest. This would help them expand into the East coast.
According to Statista, 48% of coffee drinkers utilize drive-throughs, up from 42% in 2015. DB should further benefit from this trend in future years.
Valuation
I have built a very simple P&L forecast to estimate DB stock intrinsic value. I have assumed DB opens 80 new company-owned shops per year.
I am forecasting 40% gross margins (in-line with 2019), 14% EBIT margin by 2026 and 10% net margin by the same year. Given that Starbucks has average EBIT margins of 21% and net margin of 13%, these assumptions seem reasonable.
I have also assumed 3% stock dilution per year, as the company will probably issue shares to compensate employees and finance its expansion.
Given that both net income and free cash flow are likely to be negative or break-even in the next few years, I have used forward P/E to estimate potential value.
My 2026 implied price is $85, or 60% above current price. This implies a 10% CAGR in the share price, which is a bit too low for me. There are a lot of risks in the execution of the growth plan, and 10% p.a. is not enough compensation for those risks.
In addition, BROS is selling for a large premium to both SBUX and MCD, which is explained by their faster growth rate. However, even if they achieve $1.4 billion in sales by 2026, using a P/S of 7 I get a valuation of $10 billion (2026), which is just 18% above the current price.
Org structure
DB underwent a reorganization before the IPO. The transactions were fairly complicated, fortunately the company provided these org charts to make it more simple:
Previously, the company conducted its business through the Dutch Bros OpCo.
This was reorganized under a holding company as shown below:
The founder has direct economic interest in the Dutch Bros OpCo, but voting power over the holding company. Public shareholders, management and the Sponsor (TSG) own the majority of the economic interest in Dutch Bros Inc, which in turn owns 28.4% in the Dutch Bros OpCo.
This is a highly unusual structure and haven’t seen many IPOs like this. I’m not a lawyer, but there could theoretically be conflicting interests between the co-founder and Sponsor (labeled as Continuing Members in the S-1) as holders of Dutch Bros OpCo and Public shareholders.
Both the co-founder and Sponsor can exchange the class A common units for class A common stock at the IPO price.
Risks
Three of the founder’s family members are executives at the company
Complicated ownership structure
Very little from the IPO proceeds went to the company, debt is still very high
Material weakness in financial reporting
Dutch Bros will pay 85% of benefits realized from certain tax receivables to Continuing Members and Pre-IPO Blocker Holders
Intense competition, very low barriers to entry
Conclusion
Dutch Bros is a great business with significant growth potential and attractive unit economics. However the market is intensely competitive, with plenty of other brands offering drive-through coffee.
There is a lot of hype around the stock, which resulted in very high valuations. At current prices, I only see an upside of 60% until 2026, or 10% p.a.
That’s a very low return for a business with weak competitive advantages and low barriers to entry.
I am staying away from the stock for now, but will revisit it, should it decline in the future.
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https://www.sec.gov/Archives/edgar/data/1866581/000162828021017441/dutchbross-1.htm
https://www.builtoregon.com/2015/02/love-fuels-dramatic-dutch-bros-success/
https://s28.q4cdn.com/741412594/files/doc_financials/2021/q3/2021.11.22-Dutch-Bros-(Q3-Investor-Presentation)-vF-(2).pdf
https://www.qsrmagazine.com/fast-casual/dutch-bros-dodges-full-impact-inflation