Dutch bros stock analysis and valuation - Could it be the next Starbucks?

This week's casual valuation is Dutch Bros. It has an interesting business model and has been growing rapidly, but I find it a bit expensive. Hence, disclaimer, I do not own any shares of Dutch Bros (Ticker symbol: BROS)

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I hope you enjoy these weekly posts and feel free to add your take as well as agree/disagree with what is mentioned below.

The post is divided into the following sections:

• Introduction
• How can Dutch Bros increase in value?
• Historical financial performance
• The balance sheet
• Assumptions & valuation
• Valuation based on assumptions different than mine

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Introduction

Dutch Bros, is an operator and franchisor of beverage drive-thru shops, founded by two brothers of Dutch descent (hence the name). It is public as of September 2021, roughly 3 decades after it was founded.

They provide a split of their revenue based on the beverages sold:

- 50% Coffee

- 25% Energy-related drinks (including their own proprietary Blue Rebel)

- 25% Other (Teas, lemonades, sodas, smoothies)

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As of 2008, the company has transitioned to a so-called internal franchising model requiring the franchisees to have at least 3 years of experience within the company. This was a huge success as the closure rates have been below 3%. If we take a look at the last 3 years, only 1 shop has been closed permanently.

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How can Dutch Bros increase in value?

Taking into account the nature of the business, I've identified 3 ways that the company can increase in value over time:

1. Increase the # of shops (assuming these shops are profitable)
2. Increase the revenue per shop
3. Improve margins

At the end of 2019, there were 370 shops. As of December 31st, 2022, there were 671. This includes their own company-operated shops, but also the franchised ones. The management aims to reach 1,000 shops during H1 of 2025 and 4,000 shops within 10-15 years. The first point, definitely check.

The revenue per company-operated shop has been increasing over time, partly due to increased volume, and more recently due to some extent due to inflation and slightly higher prices. The revenue per shop in 2019 was $1.28m and grew to $1.62 in 2022. The second point, check.

Now for the third one, we need to look into a bit more detail.

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Historical financial performance

The company's revenue grew from $238m in 2019 to $739 min 2022. This doesn't come as a surprise as they have been increasing the # of locations significantly every year.

In addition, there's no revenue impact that is clearly visible due to Covid-19 during 2020/2021.

However, over the same period, their gross profit declined from 40% to 24%. This was due to 2 reasons:

1. Higher rent
2. Increased prices of beverage, food & packaging costs

There are two ways to look at this:

The first one is seeing this as a red flag: Dutch Bros did not pass the costs to the final consumer, because they have no pricing power. This was applicable both to the company-operated stores, but also to the franchised stores.

The second one is seeing this as building a good relationship with the customers: Over the last few years, the company also started a loyalty program. As such, someone has to bear the costs and it is most of the time the company. It could be benefiting the company in the long run in the form of loyal recurring customers and the price increase could come at a later point.

One thing is clear, this won't be sustainable and price increases are a must.

The other operating expenses that the company reports are Selling, General, and Administrative ("SG&A") reduced from 28% to 25% of revenue between 2019 and 2022.

This leads to the company's operating margin decreasing from around 12% to pretty much breaking even.

Going back to the segment "How can Dutch Bros increase in value?", well, the 3rd point isn't there yet.

The revenue growth is there, but the profitability isn't yet.

The management is targeting 30% Adjusted EBITDA as margin. How does this translate into operating margin? After adjusting for depreciation/amortization of around 6% of revenue as well as share-based compensation for another 6%, that's roughly 18% operating margin.

This is quite comparable to Starbucks. However, they are a long, long way to get there.

The balance sheet

The majority of the assets on the balance sheet are related to the property, plant, and equipment, which has increased due to the opening of new locations, as well as right-of-use assets, for their leased properties and equipment.

On the other side of the balance sheet, other than the capital leases, there are a couple of interesting topics, such as certain tax receivable agreements and non-controlling interest. I won't get into all the details as this post will become too long, but I do adjust for this when I value the company.

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Assumptions & valuation

For 2023, the management is guiding 150 new shops (an increase of 22%) and revenue of $950m to $1b (an increase of 34%).

To those of you who find this discrepancy strange, here are the two main reasons for this:

- The shops that were opened in 2022 didn't reflect a full year of revenue in the same year, hence, some of the increase due to these new shops will be reflected in 2023.

- The increase in revenue due to an increase in prices is not captured in the # of shops.

Hence, the revenue will grow at a slightly higher pace compared to the # of shops.

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Here are my assumptions:

Revenue growth: 30% in 2023, followed by 25% in 2024, and decreasing over time to 5% in year 10. In 10 years' time, the revenue will have increased by 514%, which can be translated to 3,300 shops in total and a 20% increase in revenue due to an increase in prices.

Operating margin: 4% in 2023, increasing over time to 16% - Although the management is aiming for 18%, I think that it might be a stretch. It can even be argued that the 16% I'm using is already a stretch.

Discount rate: 11.17% (WACC-based) decreasing to 9.88% by year 10

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After adjusting for what is on their balance sheet, as well as the equity options outstanding, the value of Dutch Bros is $3.3b ($19.49/share).

For comparison, the company's market cap is $5.3b ($32.63/share).

Based on my assumptions, the return that Dutch Bros offers at today's share price is 6.2%.

For those who are interested in multiples, based on my assumptions, at year 10, the terminal value is multiple of the FCF at year 10 x 26.2.

Valuation based on assumptions different than mine

Of course, the future is uncertain and my assumptions could be significantly wrong. Let's take a look at how the valuation (per share) changes if we use different assumptions related to the revenue 10 years from now as well as the operating margin.

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Overall, I do like what the company is doing and how they're growing. The company has been focused primarily on growing in terms of # of shops and customers while delaying capitalizing on these numbers.

I can see myself holding shares of Dutch Bros at some point in the future but would like to see expansion in margins as well as a more reasonable price.

Based on the table above, even if the company expands to 4,000 shops and has an operating margin of 18%, it is close to fairly valued today.

What are your thoughts?

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As always, thank you for reading the post and for all the support. I'll be traveling back home for about a month, hence, there won't be any weekly casual valuations for a while. However, should you have any suggestions for companies you'd like me to look into, feel free to share them below.