Every growth investor is looking for those diamonds in the rough, but one way to spot future winners is to look for growing companies with a degree of skepticism on Wall Street.
Shares of high-growth companies with above-average short interest (the percentage of a company’s tradable shares sold short) can sometimes point to an undervalued growth stock on the verge of rocketing higher. This is what’s known as a short squeeze. It’s when investors who have bet against the stock are forced to buy back shares they sold short to exit their positions.
Toast (NYSE: TOST) and Dutch Bros (NYSE: BROS) are two fast-growing businesses that have high short interest right now. Let’s look at what is driving the negative sentiment and why these companies could prove the doubters wrong.
Shares of Toast, a leading restaurant software provider, are down about 73% from the previous high in 2021. Toast is capitalizing on the growing demand for cloud-based solutions in the industry. That’s reflected in its numbers, with revenue up 37% year over year in the third quarter. Despite strong demand for Toast’s software, almost 10% of Toast’s tradable shares are held by short sellers.
Wall Street analysts are focused on the industry’s competition, Toast’s weak profitability, and slowing growth in average revenue per user. The percentage of locations using at least six products on the company’s platform has climbed from 28% to 43% over the last two years, but it flattened out in recent quarters. This contributed to slowing revenue growth.
This industry is highly competitive, with multiple vendors vying for restaurant customers, but Toast’s 37% year-over-year revenue increase is still strong.
Toast has several advantages that I believe are getting overlooked by analysts and explain why the business is still growing at high rates in a difficult macroeconomic environment. It distinguishes itself with excellent customer support, a tailor-made software solution for different restaurant types, and an easy-to-use platform that helps onboard new employees quickly — the latter is a huge benefit for restaurant owners. These reasons explain why approximately 20% of Toast’s new customers are referrals from other restaurants.
Toast added more than 6,500 new locations in 2023’s third quarter but still only controls about 10% of its total addressable market. It’s got a long runway.
Improving profitability is another catalyst that could push the stock higher. Losses narrowed from $98 million in Q3 2022 to $31 million in Q3 2023. The stock could take off within the next few years as the business continues to win over new locations, grows revenue, and turns a profit.
2. Dutch Bros
Dutch Bros is a promising restaurant growth story. It has a distinguished menu focused on coffee, energy drinks, smoothies, and more. It has consistently posted year-over-year revenue growth above 30% in recent quarters, mostly driven by new openings. The company started by selling espresso from a pushcart in 1992, and today, it operates shop locations in 16 states.
Dutch Bros is on a clear growth trajectory, but the stock is about 68% off its previous peak. Wall Street analysts are focusing primarily on weak same-store sales, which don’t compare well with the market leader, Starbucks. Dutch Bros’ comparable sales were up only 2.8% in 2023’s third quarter, with three quarters in the last two years showing negative comp sales.
Almost 15% of the tradeable shares are currently held short, but this means a few better-than-expected quarters of earnings results could jolt the share price.
Dutch Bros was growing same-shop sales closer to 10% before the macroeconomic headwinds last year. It’s important to note that the company’s footprint is currently concentrated on the West Coast. This explains why it’s not maintaining higher comp sales like a globally diversified Starbucks. Dutch Bros is in the process of expanding nationally, and its restaurant-level economics indicate it could be a rewarding investment over the long term.
Company-operated shops are earning a contribution margin of 31%, which is a key measure of shop-level profitability. This is moving in a positive direction over the 25.6% margin in Q3 2022.
The company benefits from leverage on pre-opening costs for each shop it opens. The average Dutch Bros shop is only about 900 square feet. Once these shops are generating revenue, the company will earn back the opening costs quickly, which will put the business on track to grow profits over the long term.
Dutch Bros ended the third quarter with only 794 total shops — 510 company-operated and 284 franchised. Because these shops are small in footprint, it could open up thousands over the long term.
Should you invest $1,000 in Toast right now?
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2 Highly Shorted Growth Stocks That Could Rocket was originally published by The Motley Fool