Investment Thesis
Fast-casual restaurant chains are having their moment in 2024. Usual suspects like Shake Shack (SHAK) and Wingstop (WING), along with category leader Chipotle Mexican Grill (CMG), have been on a tear since the start of October last year. This year, they were joined by fast-casual salad chain Sweetgreen (SG). But another fast-casual restaurant chain has been steadily outperforming many fast-casual and quick-service restaurant ("QSR") chains.
As seen in Exhibit A above, CAVA Group's stock (NYSE:CAVA) has enjoyed the success few restaurant stocks can boast of over the past eight months. On a year-to-date basis as well, Cava has delivered ~94% returns, only being bested by Sweetgreen.
I believe CAVA has been a beneficiary of the recent trends in consumer behavior that have shifted from QSR to fast casual. Younger consumers, led by GenZ's and millennials, seem to be leading this charge, which is benefiting most fast casual restaurants, especially CAVA's restaurant chain.
With such strong tailwinds, CAVA's stock may look appealing, but I believe its nosebleed valuation multiple desperately needs a reality check at the moment. I currently recommend a Hold on CAVA.
About CAVA's Restaurant Business Model
CAVA has been around for over a decade, having been initially founded in 2006. The restaurant chain operates in a fast-casual setting within Mediterranean cuisine. The restaurant resembles its larger peer, Chipotle, in many ways, such as serving format as well as in-store look and feel. Again, similar to Chipotle, CAVA owns all its restaurant locations and does not offer franchising opportunities. As the company grew, they acquired another small direct category-level competitor, Zoe's Kitchen, in 2018. I have attached a timeline of the company's activity in Exhibit B below, which I have borrowed from their S-1 filing to get a sense of pre-IPO activity.
Based on the Q4 FY23 call with investors, CAVA operates in ~25 states in the U.S., plus D.C., as seen in Exhibit C below. The company has set itself an ambitious target of opening over 1,000 store locations in the U.S.
CAVA has been growing at a robust pace
Over the past 12-15 months, CAVA has been posting blazing growth in its fast-casual Mediterranean format business. As seen in Exhibit D below, CAVA's revenue has been growing at a 25% growth rate on a trailing twelve-month basis. In FY23, the company grew its revenue by almost 60% to $717 million, consistently beating estimates for all the quarters that it reported in FY23.
In addition to the demand that the company is seeing for its health-focused Mediterranean food menu items, the company has also opened restaurant locations at a rapid pace to keep up with the demand. Per its S-1, the company is following its "coastal smile" strategy and opening locations on both sides of the coast and along the Sun Belt.
As seen in Exhibit E above, CAVA has been adding restaurants at a double-digit growth rate, which I believe has been instrumental in supporting the strong demand the Mediterranean-focused fast casual restaurant chain has witnessed so far. It recently opened its first location in the Chicago area, bringing the total number of stores in the U.S. to 325, per its latest filing.
It also generates a high unit volume per restaurant location, as seen in the table below, although it's not as high as some of its peers operating in other fast casual restaurant categories. The figures below are the latest Average Unit Volume numbers on a trailing twelve-month basis I could glean from company sources.
CAVA Chipotle Wingstop Shake Shack Sweetgreen Trailing twelve-month AUV $2.6M $3M $1.9M $3.9M $2.9M
CAVA's core consumer segment driving demand
One of the main reasons I believe fast casual restaurants, such as those listed in this post, have seen a surge in sales and a consecutive market cap is because their core consumer segment, GenZ's and millennials, have gravitated towards health-focused restaurant food items. A lot of these trends, I believe, were further pronounced after the weight-loss drugs pushed the narrative higher in late September last year.
Per its S-1, CAVA reportedly says almost half of its target consumers are GenZ's and millennials. At the same time, over 55% of CAVA's target consumers earn over $100K on an annual basis.
These are ideal consumer targets for CAVA who can help buoy the company during marginal economic slowdowns. A separate survey by PYMNTS also showed that CAVA was continuing to win appeal among GenZ's.
CAVA's management is focused on profitability and a strong balance sheet
I am encouraged by management's focus on delivering profitability. The company has always had a keen focus on maintaining costs, based on the limited history that I was able to analyze. Management reportedly uses analytics and data science to run forecasting models and recommendation algorithms to increase operational efficiency. For example, this old interview outlines how management relies on data science to forecast the price of its ingredients and source ingredients from its supply chain at lower prices.
A further inspection of its costs shows how management is tracking its larger peer, Chipotle, in keeping its costs as a percentage of its revenue in check. I have compiled this from the company's 10-k's in Exhibit G below.
In 2023, the company posted its first net income of $13.3 million, or 21 cents, on a per-share basis. Gross margins expanded by seven percent to 37% while the company broke even on an operating basis, with operating income more than doubling to $15.7 million. During the year, the company's restaurant-level profit, which accounts for operating costs such as food, beverage, packaging, and labor, expanded by 71% y/y to $39.3 million.
What I am also excited about is the company's balance sheet. Based on their FY23 10-K, CAVA's balance sheet is net cash-neutral. The strength of the balance sheet provides a strong base for management to continue on its path forward to open 1000 locations across the U.S. by 2032.
Unfortunately, CAVA looks overvalued
In 2023, the company opened a massive 72 locations across the U.S., increasing the number of its serviceable locations by 28% to 325 locations, far above the average 15% growth in restaurant openings. Based on its projections, management expects >15% growth in locations in FY24 and FY25. In 2023, its AUV grew 13% to $2.6 million. Management expects at least 48 openings in FY24.
- Based on these assumptions, I expect the company to be growing in the 19-21% range over the next few years, as detailed in Exhibit H below.
- On the margin front, I expect FY24 margins to drop to high single digits, which include higher marketing costs, store opening costs, as well as a 30 bp headwind from California's minimum wage increase act.
- Since the balance sheet is strong, I will use an industry metric of an 8% discount rate.
- I have assumed a 3-4% share dilution rate since it just went public last year.
Based on this model, I estimate adjusted EBITDA to grow at a compounded growth rate of 23% between FY23 and FY26, outpacing the top line growth rate of 19-20%. These growth rates would warrant a forward earnings multiple of ~45 if I compare its pace of growth with the long-term growth rates of the SP 500. This implies a 13-15% downside from current levels, implying elevated levels of optimism in the stock.
Since the company has a robust growth model, expanding margins, I am optimistic about the stock and will keep it a Hold currently due to its elevated levels of valuation.
Risks & other factors to know of
Economic slowdowns and recessions are an immediate headwind to the company's growth story. Any deep slowdowns would force its consumer base to alter spending patterns, although its higher-income consumers, as shown in Exhibit F, may still continue to spend at the restaurant chain, albeit at slower rates.
The other immediate headwind is valuation itself. As I pointed out in the previous section, the company looks overvalued. Some market analysts have resorted to using sales multiples to justify buying the stock here. But I disagree. CAVA currently commands a forward EV/Sales of 10.3x, for a ~20% increase in FY24 sales. This is higher than Chipotle's forward EV/Sales of 8x for sales, which is projected to grow by 15% in FY24. This implies ~1-2% upside in CAVA. Here again, on a peer valuation basis, there is risk.
NOTE: CAVA reports its earnings on May 28, after the market closes.
Takeaway
CAVA presents a compelling case for investors to deploy capital into its growth story. The company has a solid growth story, with operating margins expanding rapidly on a GAAP basis, a robust balance sheet, and strong inherent demand for its Mediterranean-based health food.
Unfortunately, the company's stock has run ahead of itself, and I believe it would be prudent for investors to be patient before entering this stock.
For now, I rate CAVA Group as a Hold.
Uttam Dey
Uttam is a technologist at heart, deeply fascinated by the numerous advantages sustainable adoption of technology brings. He has led product teams for some of the largest consumer technology firms in the world and uses his background in technology, passion for data analysis, and expertise in valuation to find companies that are sustainably building long runways to robust growth. Apart from technology, Uttam is also focused on uncovering opportunities in Defense, Energy & MedTech sectors. He is also the author and cofounder of The Pragmatic Optimist newsletter, which he cofounded with his wife, Amrita Roy, who is also an author on this platform.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Long position through a purchase of the stock, or the purchase of call options or similar derivatives in CAVA over the next 72 hours. 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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