Description

Executive Summary

Dutch Bros is a short. Dutch Bros (“BROS” or the “Company”) is an underappreciated COVID beneficiary experiencing mean reversion in an increasingly competitive category, which will translate to persistent weakness in comps, new store economics, and margin.

Since COVID, BROS’s company operated AUV has increased ~30% from $1.46mm in 2019 to $1.9mm in 2022 and restaurant level margin (contribution margin) expanded from 22.3% in 2019 to 24.6% in 2022. With improving unit economics and accelerating growth, BROS stepped on the gas pedal and accelerated new unit opening significantly, more than quadrupling company-operated new store openings from 27 in 2019 to 120 in 2022. With a TAM of 4,000+ stores that boasts 10–15-year runway and the Company hitting its stride during COVID, investors became believers of the Company’s growth prospects as the “next Starbucks.” Despite emerging signs of giving back COVID boost, market continues to capitalize the business near the highest multiples amongst peers. I believe that the market will be significantly disappointed in the Company’s ability to profitably grow and execute on its TAM as structural headwinds emerge.

BROS’s long, but ultimately temporary benefit from COVID and its spillover effects is slowly coming to a stop. Market’s underappreciation of the music stopping for the Company and the implications of such has created an attractive mispricing. The unwinding of COVID benefits will bring to surface:

1. Persistent headwinds on AUV and SSS comps
   1. COVID drove traffic growth and discounting improvement that has significantly improved AUV and inflated comps
   2. Traffic reversion has already begun, and management team discounting will return in full force as the business reverts to promotions for traffic
2. Margin pressure from operating deleverage and cost inflation
   1. Operating leverage of the company operated model will magnify the impact of AUV pressure on margin
   2. Labor market is secularly tight, and BROS will see outsized impacts of labor inflation given its labor-intensive drive-through model and reliance on hourly/lower wage employees
3. Deteriorating new store economics will feed into new store growth deceleration
   1. New store AUV reversion and margin pressure will translate into disappointing restaurant level margin
   2. Construction cost inflation and mix shift towards more capital-intensive ground-lease will further aggravate new store economics deterioration
   3. Company’s ability to sustain current levels of new store growth momentum will be jeopardized

I believe the market continues to assign an elevated valuation multiple to BROS as investors view much of the recent downdraft as a cyclical/transitory phenomenon, although they will be crystallized as structural headwinds. This is a classic case of investors mistaking structural downtrend as cyclical phenomenon and BROS presents an attractive short opportunity with favorable risk skew. I expect that BROS could trade down ~30% near-term with potential to trade down as much as 50+%, with limited loss at risk.

Thesis Deep Dive

BROS is a multi-unit concept decelerating due to pullback of COVID benefits in an increasingly competitive category. Investors will be disappointed as 1) AUV and SSS comps lag peers, 2) margin pressure sustains, and 3) new store growth decelerates as new store economics weakens.

1) BROS is a “hidden” COVID beneficiary that will see persistent comps pressure driven by reversal of work-from-home trends

• AUV productivity saw step-function growth during COVID, with improvement most pronounced for company-operated stores as drive-through coffee became the preferred channel for coffee consumption during COVID lockdown. With demand exploding, BROS saw meaningful improvement in traffic trends as well as significant improvement in discounting
• Despite the significant benefit seen during COVID lockdowns, market is not identifying BROS as a COVID beneficiary as AUV sustained at increased levels long after lockdown ended. Market is confounding work-from-home benefits with permanent step-function growth. During COVID, consumers formed new habits and the habits were sticky if external conditions permitted. Habits of utilizing drive-thru coffee stores stuck even as COVID receded as prevalent work-from-home situation provided consumers the needed freedom and flexibility to maintain drive-through coffee consumption. BROS is a major beneficiary of the work-from-home environment that has been conducive to BROS keeping the AUV gains. As elevated AUV sustained, market (incorrectly) judged BROS to be a permanent winner
• Unsurprisingly, the Company’s SSS comps started to disappoint and fall short of peers as return-to-office slowly started. On a 2-year stacked basis, the Company started to meaningfully underperform peers starting in CQ1 2022, which coincides with pick up of more permanent return-to-office environment. As return-to-office continues, slowly but surely, BROS will underperform peers on comps as such will be an idiosyncratic headwind for the Company

2) BROS’s margin pressure will sustain as easing commodity input cost inflation will be offset by a combination of operating deleverage from secular AUV pressure and persistent labor inflation

• AUV growth during COVID drove significant restaurant level margin expansion. Restaurant level margin expanded from ~22% in 2019 to ~29% in 2020 and margins are still elevated compared to pre-COVID levels at ~30% today. Much of the margin expansion came from volume driven operating leverage, temporary benefit from discounting reduction, and extreme operational optimization, as opposed to structural margin improvement. As store productivity and consumer demand backdrop weakens, the Company’s sources of historical margin expansion will become drivers of margin pressure
  • Having significantly expanded into company-operated model since COVID, company-operated segment’s contribution to profit has increased from 27% to ~70%. Given the mix shift in business, BROS has built a higher operating leverage in the business today that will amplify the impacts of AUV pressure and labor inflation.
  • Given the importance of maintaining volume for each locations given inherent operating leverage in the business today, the Company will be more willing to engage in promotional tactics to maintain customer traffic. While promotions and discounts could help maintain topline strength, this will further catalyze margin pressure.
    • The Company started rolling back its Fill-A-Tray promotions since March. While successful, the ~21-31% total discount (incl. reward points) provided is reducing contribution margin by ~20-30 percentage point to regular business (contribution margin for incremental/decremental sales estimated to be 60+%)
• Furthermore, the Company will see outsized labor inflation pressure given its 1) labor-intensive drive-through model and 2) reliance on minimum-/low-wage employees. Blue collar job market has experienced the most acute supply-demand imbalance and the secular tightness has been translating into strong wage growth. The Company has successfully managed wage inflation to date by optimizing staffing, reducing over-time, and relying on customer tips to supplement employee income. However, the Company has pulled nearly all levers that are available and has no further levers to pull to combat incremental wage inflation that may persist in today’s secularly tight labor market. If further labor cost inflation materializes and AUV pressures sustains, BROS will start disappointing on margins again
  • The Company looks to be pushing its labor cost saving initiatives close to its limit. Restaurant level employee sentiments have deteriorated, and turnovers are elevated as stores are being staffed without enough cushion and/or employees are struggling to make living wage given shift reductions

3) New store economics have been deteriorating meaningfully and persistent weakening of new store economics will eventually lead to deceleration of new store growth

• BROS has been hailed as the next Starbucks and its current valuations are holding as investors continue to expect highly attractive unit economics with a large TAM of 4,000+ stores. Since IPO, management has consistently targeted 30+% year 2 CoC return for ground leases and claims that new stores have been meeting their expectations
  • With new store AUV having been significantly elevated during COVID, market likely has underwritten even a higher CoC return
• Current new store economics have significantly deteriorated and likely are running below management target levels as a) new store AUV is weakening, b) restaurant margins are below expectations, c) upfront costs are increasing, and d) there is a mix shift towards lower ROI ground lease
  • a) New store AUVs have come off its COVID highs and have been on a gradual decline, which is likely a function of COVID benefit pullback, less attractive go-forward new market opportunities, and increasing competition in the category
    • Texas has been touted as an exemplary success story of new market expansion for the Company with AUVs running above systemwide average given the ideal market fit for BROS. However, a disclosure in June ’23 noted that Texas stores have been running at $1.7-1.8mm AUV recently, compared to $1.9mm company-operated/systemwide AUV. With a strong market like Texas seeing new units run below systemwide-average, go-forward new store AUVs are unlikely to be much higher than $1.7-1.8mm in other new markets (let alone other in-fill markets)
    • Increasing competition in the drive-through coffee category will further pressure new store AUV. Large chains such as Starbucks, Dunkin’ Donuts, Panera, as well as emerging brands such as Caribou and Bad Ass Coffee of Hawaii have been increasingly building out drive-through models, naturally increasing number of drive-through coffee shops available per capita and creating incumbents in regional markets. With BROS no longer becoming a first mover or commanding as much craze, new store expansion execution will become more difficult
  • b) Management team target returns have been derived from ~30% restaurant-level margin and management claims that new store margins have been in-line with their expectations. However, company-operated restaurant margins have been consistently below 30% and revenue growth flowthrough math also suggests that new store margins have fallen short of 30%
  • c) Upfront costs for new stores experienced meaningful inflation since IPO. The $1.5mm of all-in costs for a ground lease new stores quoted during IPO are now running at $1.8-1.9mm (+20-27%) despite having over-indexed to in-fills in recent periods. With overall construction market continuing to stay hot and BROS needing to shift back to new market stores, upfront costs will likely increase higher from current levels and prove to further deteriorate ROI
  • d) The Company has also significantly shifted towards the ground-lease model from build-to-suit model, which is significantly less accretive investment with nearly ~40% CoC return difference. Historically build-to-suit represented 70-80% of store development model for BROS, which has now shifted to 65-70% ground-lease. Mix shift alone will contribute to ~13% point of headwind for CoC return.
• I estimate that the combination of the above variables is drove the blended current new store economics down to ~32% blended CoC return compared to ~60+% as of IPO. While still an attractive CoC return, there is more room for new store economics degradation and there are implications to new store growth. As more upfront investments are needed and timing of positive FCF is pushed out with worsening ROI, this could impact headroom for BROS to continue to accelerate new store growth. With much of the growth story conditioned on new store rollout, further pressure in new store economics could be the catalyst to the unraveling of its high-flying growth prospects.

Outlook

Consensus and embedded expectations remain overly optimistic. On EBIT, the Company trades at 50+x FY2025E EBIT consensus and consensus estimates that the BROS will continue to be negative EBITDA - CapEx through 2025. The Company will require continued external funding to fund growth and embedded expectations suggest that the Company needs sustain 45+% ROIC for continued new store investments. With deteriorating new store economics/ROI and likely deceleration, the Company is set to disappoint. 

Risks

Extreme market rotation into growth. Meaningful economic acceleration resulting in cyclical uptrend offsetting structural headwinds, SSS comps surprises from promotional events.

Catalyst

1) Deceleration of new store opening due to inability to further fund new store CapEx, 2) dilutive share offering to raise capital to fund growth, and 3) disappointing comps or restaurant level margin print