Description

Summary

As of this writing on 8/13/2024, this company is trading at the following FY2025 multiples: 202x PE, 80x EV/EBITDA and 261x EV/EBIT. And 10x EV/Sales! You would have thought this is some kind 90% gross margin software business. But it is not. It is actually the restaurant company CAVA. 

I believe market is pricing in an almost 100% probability that this will the next Chipotle when we know what happens to most restaurants. Most restaurants DO NOT become Chipotle. The base case is customers get bored eating at the same chain, and the growth wither away. I think many “long-term investors” who missed out making a shit ton out of Chipotle’s amazing success are now FOMO-ing into the CAVA story. Restaurants are so easy to model that it almost tricks many sellside and buyside analysts into justifying the crazy share price. It’s so easy to want to believe the numbers they are keying into their excel and that competition doesn’t exist in reality. 

Are you really ready to underwrite that CAVA will grow from 323 units today to 1100 units in 2032 and so the valuation might seem reasonable? This means they need to accelerate restaurant openings 50-60 annually today to 120-140 units nearer to 2032. Yes, Chipotle did it but is it that easy? Bill Ackman claiming “we never lose money investing in restaurants” doesn’t mean CAVA will necessary succeed. Let’s dig a bit deeper below.

I do not deny CAVA has been a success thus far and it is a decent business today. But I believe expectations have gone too optimistic and it will most likely not become reality in the time frame investors expect. I think precisely because it’s so easy to claim and to pitch to your PM that CAVA is a good long that it is overdone at this earnings multiple. And that there are more risks ignored than most analysts would be willing to admit.

Business Description

CAVA is basically the Mediterranean version of Chipotle. They are a fast casual chain that got started in 2011. To accelerate growth, they acquired Zoes Kitchen in 2018 and converted 150+ stores to CAVA. As of 2024 Q1, they have 323 CAVA stores (conversion completed) in mostly suburban areas. As a result, they weathered the urban slump due to work from home much better than some peers (think Sweetgreen that are more urban focused). They IPO-ed in June 2023. Their biggest individual shareholder is Ron Shaich who created Panera in the 1990s.

A few basic stats:

What is the bull case?

There’s no denial what CAVA has done thus far is very respectable. As of 2024 Q1, there are 323 CAVA stores (excluding digital stores) in the US and they have a goal of making it 1000 stores by 2032. Bulls claim this is slower than what Panera and Chipotle did. And to make the numbers work in their excel models, they assume CAVA can do another 1000 stores through 2042. And then hit 3000 stores in another 10 years. Nice round beautiful numbers for sure. Note that 152 of the current store base (so almost half) were converted from Zoes kitchens, which accelerated store openings massively. But conversion is much easier than real new builds and could CAVA miss out on the learning experience some other chain gets from building from the ground up? It’s not rocket science but institutional memory and learnings are important and could they mess up as they accelerate real store builds? Even in their filings management acknowledged Zoes conversion accelerated growth and gave them a large portfolio of quality real estate. Is it that easy to replicate without conversion or would they make another acquisition?

Bulls also think unit economics have been super compelling and should continue. In their S1, they claim cash on cash return is 40%. This seems hard to tell because there are Zoe related conversions that would mean lower cash outlay upfront. Also, even though many analysts only care about adjusted EBITDA and growth numbers today, I believe their EBIT margins are inflated by lower D&A today as the conversions had much lower capex than real new stores. 

They even tell you this in their S1:  In addition, while conversions require initial capital investments, such costs are typically significantly lower for a conversion as compared to a new restaurant opening. Therefore, following the completion of conversions of all remaining Zoes Kitchen locations, which we expect to complete by the fall of 2023, we expect that the capital expenditure requirements to open a new restaurant will be significantly higher than we have experienced in the past few years.

Again from their S1: We plan to target year 2 AUV of $2.3 million, year 2 CAVA Restaurant-Level Profit Margins of 20%, net capital expenditures (representing capital expenditures incurred to open a restaurant, net of tenant allowances) of $1.3 million and year 2 Cash on Cash Returns of 35%. Our target new unit economics are substantiated by our strong track record of AUV growth and our aggregate Cash on Cash Returns of approximately 40%, which is calculated on a combined basis for all CAVA restaurants opened prior to fiscal 2018 to exclude the impact of the COVID-19 pandemic.

I don’t know what the exact cash return might be for real new builds, but based on experience (Shake Shack, sweetgreens), management tend to overestimate on store level returns. When SHAK went public, they were doing store level margin of 29% and now at 22% (even lower before recent improvements). 

Recent trends: Same restaurant sales

Same-restaurant sales have been weakening as they lapped extremely strong numbers a year ago.

Actually the thesis here is simple. At this point, it is still hard to determine how big/sustainable the market for Mediterranean. And I think basic competition will erode margins. 

Is the Mediterranean category sustainable?

Mediterranean cuisine is really nothing new in America. You have to give it to Cava for making it fast casual and growing rapidly via conversions. But the extent to which Americans will choose Mediterranean over burgers, chicken and pasta – that’s still too early to tell right? Also, do not forget, Chipotle was riding on a tailwind of the increasing Spanish population in the US and became the “defining” restaurant for the category. Mediterranean might or might not take off plus there are still only 300+ CAVAs in the entire country, with such low barriers to entry, it doesn’t take much for someone else to enter the space. I cannot even remember the number of Mediterranean “chains” I ate in NYC which then disappeared within a few years. 

Competition, competition, competition

One thing I don’t get is why market is obsessing over CAVA being more likely to be the next Chipotle than becoming one of the past restaurant failures (Noodles, Zoes, Pot Belly, etc.). The base case for any restaurant concept is NOT Chipotle right? In my view, market is allocating too high a probability that Cava will be a Chipotle, and it is much higher likelihood that Cava will become one of the long forgotten food stories. Of course I cannot prove this, but is it possible that both companies with names starting with a  “C” and with the investment bankers writing such a beautiful story about Cava being the next Chipotle, this might be confusing investors in a psychologically manner?

I just don’t know what CAVA’s competitive advantage is. Why can it sustain its great margins? Seems like they have used TikTok very well, but any restaurant chain, new or old, can go viral on TikTok and get the few million views. The cite the 17B combinations of ingredients – I mean does this matter? Most Americans I know get the same Chipotle meal every time they go (we are just lazy to think and too fearful to mess up what we are used to) and if we are sick of a certain kind of food, we just switch restaurant! We don’t switch our Cava or Chipotle combination. 

This is again not a case where I can prove with hard numbers but let’s think through a few scenarios.

• If CAVA does grow, and there’s only so much fast casual we can eat, and if CAVA is taking share from Chipotle, why wouldn’t Chipotle react, why would there be no new entrants, it doesn’t make “capitalistic” sense right?

• If you are underwriting this growth, this margin for 10-20 years, you are really believing that the food industry is suddenly not competitive. You’re saying the odds are really high they can maintain this margin for the next 20 years. 

• Again the base case for any new restaurant chain is not the few success stories we see on our way to work or that shows up on stock charts (McD, Dominos, etc.) because they have become so successful, but the base case should be the 90% of chains that are now forgotten because they are dead and out of our mind already

• Fast casual is also a lot more competitive today than when Chipotle got started. When there’s competition, things are unpredictable (bad). 

Just one case in point: Naya, most likely because it operates more in NYC today, earns $3.2M AUV, and aims for 200 stores by 2030 from around 23+ today. The question is how many more NAYAs will we see? With a bit of VC funding or even friends/family money, it really doesn’t take much for a rich college graduate or someone with restaurant experience to enter the space. And they just pull out the CAVA investor presentation to prove their point! Let’s invest XX dollars and perhaps it’ll be $10B market cap like CAVA!

https://www.qsrmagazine.com/story/naya-seeks-200-locations-and-elevation-of-middle-eastern-cuisine/

Valuation

If you look at the typical sell side model today, they are basically expecting 20+% revenue growth for the next 10 years (it just looks great on excel isn’t it!), 1100 stores by 2032, uninterrupted same store sales of 5-6% forever, reach Chipotle like EBIT margin, and everything about the business just gets better. How many (restaurant) businesses actually become better every year for 10-20 years? Even if all these happens, these guys are trading at ~27x 2032 PE, 30x 2032 FCF based on current share price, which you can argue is a “fair” multiple for a “great” business! So you won’t make any money even if CAVA becomes the best after Chipotle. Say they are trading at a “fair forward multiple” in 2031, discounting current share price at 10% discount rate (not outrageous when risk free rate is 4% today) for 7 years, you are getting a fair price of $49 or half what it is today, and again that’s if EVERYTHING GOES PERFECT LIKE EVERYONE IS MODELING THIS.

These are the consensus multiples as of 8/13/2024

To end this writeup, I just leave it at this: Do you believe it’s a 95% probability that CAVA will be as good as Chipotle or a 95% probability that CAVA will NOT be as good as Chipotle? 

Risks

There’s nothing stopping this trading to 300x, 400x earnings, or they can pull off huge earnings beats, but expectations are not pessimistic today and I’m writing this for someone who has staying power that can stick through 40-50% increase in share price before this becomes normal.

Basically, I am describing a perfect story that market believes and if you’ve been here awhile, you know the perfect story usually don’t happen and if it does happen, you will not lose much. But what is most likely to happen is they will miss numbers and the stock will go down 30-40% from here over the next 1-2 years. Growth will rerate to lower expectations, multiples will be less crazy. At the meantime, you get paid 4% risk free from the cash proceeds you generated while you wait as borrow cost for CAVA is 0.25% today. That’s not a bad hedge in the current environment for any long-short portfolio. Obviously, I am describing a case where you have staying power to weather any upside in the short term. 

Catalyst

• Same stores sales slowing or even turning negative 

• Store development targets miss as management lack experience opening real new stores at scale

• Revenue and/or store level margin miss expectations