Restaurant Stock Hammered in Q3
I gave Dutch Bro's (NYSE:BROS) stock a buy rating when I wrote about it in June. Following its Q2 earnings, the stock was down more than 25% at the opening, but the loss gradually decreased to about 20% at the close.
Unfortunately, restaurant stocks have suffered greatly this quarter as a result of the 350 basis point decrease in restaurant-level margin reported by Kura Sushi (NYSE:KRUS) due to an increase in labor costs in California. The market anticipated that businesses with significant exposure to California would suffer greatly. Chipotle's (NYSE:CMG) shares had likewise fallen more than 20% from its July peak.
Q2 Earnings Review
Despite the company's 30% revenue growth, net income, and adjusted EBITDA growth of 120% and 34%, respectively (see the below chart), the market was concerned about a possible plateau in same-store sales.
Same-Store Sales Analysis
Sales at the same outlets increased by 4% in Q2, according to management, with a 7% price rise offsetting a 1% shift in the product mix. This suggests a 2% decrease in traffic. According to management, there will be more promotions in Q3, and price increases will only raise same-store sales by 1%. Therefore, the company may have flat or negative same-store sales growth if the traffic declines in Q3.
Store Expansion and Real Estate Strategy
Additionally, the management cited the 2024 new store opening guidance of 150 stores as opposed to the prior guidance range of 150-165 stores. This is due to two factors: (1) the company is changing its real estate strategy and eliminating several locations from its original plan; and (2) to better optimize its capital consumption, the company would like to investigate a sell and lease back arrangement.
These two factors were very detrimental since they may lead to operational leverage and margin reduction if the company's same-store sales declined. In the restaurant industry, the company's restaurant-level margin of 23.7% was deemed low (Chipotle, for instance, had a restaurant-level margin of 28%). Therefore, if the margin declines, it may put more strain on the business. Secondly, the company's present scale is still small, and they may not be able to add stores at the rate they had hoped. It can also imply that company's the total addressable market is not as huge as expected. The growth stock valuation may be significantly impacted by any scenario.
Comparison with Starbucks
The good news is that the company was still able to increase its margin in this quarter, despite the management mentioning that the company is also impacted by the implementation of California's minimum wage law. This is remarkable, particularly when contrasted with Starbucks' (NYSE:SBUX) North American operations. Due to a 6% decrease in transactions, Starbucks saw a fall in comparable store revenue and operating margin in the quarter. (see the below exhibit) Therefore, as compared to its rival, Dutch Bros did better in this area.
Future Growth Drivers
Competitive Advantage Intact
While indicating that fewer stores would open in 2024 than previously anticipated, the company increased both its revenue and EBITDA ranges. Therefore, it would appear that the company does not anticipate a significant obstacle from the rise in labor expenses in California. Because Dutch Bros. concentrates on smaller storefronts, it does not recruit as many retail employees at a single shop as Starbucks. As a result, I anticipate that this restaurant chain will be one of the least affected by the increase in minimum wage. A national salary increase should therefore strengthen the competitive advantage that the company has over its competitors.
Mobile Order System
By the end of 2024, the company planned to have all of its stores using the mobile order system. The system is currently complete at its 200 stores. If the plan goes as expected, this should enhance the customer experience and boost traffic.
Additionally, the mobile order system has the potential to enhance the transaction penetration of its reward program. This quarter, the company raised the transaction percentage of its reward program to 67%. An increased reward program turnover rate can aid in customer retention and facilitate the launch of new products and informational materials.
Valuation
Because the market believes that Bros's growth potential is far greater than that of its rival, the company trades at a higher valuation multiple. (see the below exhibit) Therefore, the lower after-earnings due to same-store sales declines and margin compression make some sense, at least in part.
However, I would not assume that the company's growth narrative is gone because the aforementioned analysis demonstrated that it continues to outperform its peer Starbucks in this challenging climate.
Further, analysts projected a 20% sales increase for the company in 2025–2026. (see the below exhibit) I believe that a growth rate of more than 20% maintains the long-term growth narrative. Therefore, given its long-term potential, I saw the recent low as a purchasing opportunity.
Risk
The company anticipated a promotional environment in Q3, and current data indicates that although US consumer spending growth has slowed, it is still far over the pre-pandemic level. However, this could lead to future pressure from competition.
In addition, the Sahm rule was activated when the unemployment rate increased to 4.3% in July.
The Sahm rule states that when the three-month moving average of the unemployment rate (that is, an average that combines the rate of the three most recent months) rises by half a percentage point or more from its lowest level over the past 12 months, the US economy is in the beginning of a recession.
Notwithstanding Sahm's analysis, there's a possibility that the post-pandemic labor force rebound will cause this rule to fail. Her rationale is as follows:
The pandemic has altered the nature of work in the at-home economy, which has encouraged workers who had retired to reenter the workforce. Additionally, because they have exhausted their COVID funds, consumers who drop out of the workforce return. As such, these may result in higher unemployment rates, but they may not necessarily bring about an economic recession.
In addition, the overall employment rate is still rising, albeit more slowly.
More, in July, the leisure and hospitality industries continue to be significant contributors to job growth.
Therefore, I conclude that the economy is slowing down but is not now in a recession. Nonetheless, there is a chance that Dutch Bro could come under further pressure from the competition if the slowdown has a detrimental effect on their restaurant-level margin.
Conclusion
Despite the initial market reaction to the Q2 earnings report, which saw a significant drop in stock price, Dutch Bros has demonstrated resilience in a challenging environment. The company’s ability to grow revenues and expand margins, particularly in the face of increased labor costs in California, positions it favorably compared to its peers like Starbucks. While concerns over same-store sales and a potential slowdown in store expansion are valid, the long-term growth prospects remain intact, with analysts still expecting strong revenue growth in the coming years. The recent pullback in stock price may thus represent a buying opportunity, especially for investors with a long-term perspective.
Twenty Alpha
As an equity and banking investment veteran, I've spent a significant amount of time immersed in financial markets. Over the years, I've appreciated the collaborative nature of the investment community and value the opportunity to exchange opinions and learn from others' perspectives. While I analyze companies across various sectors, I tend to focus on consumer discretionary and technology firms. I find these industries particularly interesting to study in-depth due to their complexities and evolving landscapes. My analysis aims to identify companies that are well-positioned to withstand disruption or those driving innovative changes that could reshape their industries. Additionally, I look for opportunities where companies could improve operational efficiencies to expand profit margins. The goal is to provide fundamental investing concepts that could help investors make more informed decisions. Drawing from my experiences, I strive to offer an analytical perspective on these dynamic sectors. Associated with another author at LEL Investment LLC.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of BROS either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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