A True Peter Lynch-Style Investment
A couple months ago, I published my flagship, introductory note on CAVA Group, Inc. (NYSE:CAVA). If you’ve not already, I would highly encourage you to read it prior to reading further today.
In the note, I shared that I would be trying the restaurant for the first time in the weeks ahead. I did indeed try CAVA a few times in subsequent weeks, and I have since genuinely become smitten with CAVA’s cuisine.
The closest CAVA to me is about an hour away, so I do not have access to the cuisine on a regular basis. That said, over the last 45 or so days, I have often found myself craving CAVA, and this has been doubly the case as I’ve been working on the company following its Q2 2023 results!
I’ve often thought, “I love this product so much that, irrespective of making it a Top Idea [BTM] for the community and associating it with my long term track record, I want to own this business. This is like buying Apple (AAPL) because I bought the first iPhone, and I adored the product.”
I often share that I stand on the shoulders of giants, one of whom is Peter Lynch. One of his central teachings in the renowned book, “One Up On Wall Street” (which I highly recommend that you read), was to “buy what you know.” He urged his readers to buy the businesses and products that most resonated with them.
To this end, after now having eaten CAVA a few times, and after craving it days and weeks after eating it, I’ve come to love and know the product well. Further, I understand the economics well after writing the Chipotle (CMG) thesis over and over again over the last half decade or so.
Chipotle, as many of my readers know, has been a business that I’ve owned because I’ve eaten its offering weekly, excepting periods in which I served in the U.S. army overseas, for over a decade, and I still look forward to eating at the restaurant on an almost weekly basis (worth noting that I exercise seven days a week via weightlifting/running, for those concerned about my health due to elevated caloric intake).
At this point, I think I like CAVA better than Chipotle from a taste perspective! Though, to be sure, I have a very adventurous palate, and unequivocally, Mexican food will always have the larger TAM between the two businesses. In short, I think both could coexist and become much larger franchises than they are today over the next 5, 10, and 20 years.
With these ideas as our platform, let’s quantitatively consider CAVA’s Q2 2023 earnings report.
Adding Pieces To The Puzzle
Heading into the report, the key question I had was related to quarterly revenue seasonality. We were not given much data on the company’s quarterly sales in its S-1. What we were given you may review below.
CAVA’s Reported Revenue (Ex Zoes Kitchen)
As we can see, we only really had yearly reported revenue and Q1 2022 and Q1 2023 reported revenue. Following CAVA’s recent report, we now have more pieces to what CAVA’s annualized revenue looks like; as a result, we have a better grasp of its current valuation.
And this growth has been driven by steadily growing restaurant count, detailed below.
We now expect 65 to 70 net new CAVA restaurant openings this year and have built our 2024 and 2025 pipeline to support annual unit count growth of at least 15%.
With these pieces of financial data, we can better understand CAVA’s valuation as of today. Let’s now perform an analysis of the business through this lens.
Assessing CAVA’s Valuation In Light Of New Data
The above data imply total restaurant count of 304 by year end; at AUVs (average unit volume, i.e., total annual sales for each restaurant) of $2.6M, this implies CAVA will exit the year with about ~$790M in restaurant sales. My projection/timing here likely will not be perfect (we’re still in August of 2023), to be sure, in terms of revenue recognition, but it gives us insight into where full year 2023 sales will land.
With the data we formerly had, we were basically flying blind. That is, in my original note, I speculated that CAVA could achieve $1B in sales based on the growth rate it experienced in Q1 2023. I now know that this will not happen. Note that we did not invest based on that speculation. We waited for this quarter to roll through, which gave us more pieces to the puzzle.
Further, CAVA has a cash balance that’s about $40M lower than I originally calculated, at $350M, though it officially has no debt.
Shifting to liquidity. At the end of the quarter, we had 0 debt outstanding, $352.8 million in cash on hand and access to a $75 million undrawn revolver, with an option to increase our liquidity, if needed.
Tricia Tolivar, CFO, Q2 2023 CAVA Earnings Call.
So the cash hoard remains fairly giant and there’s no debt to worry about, which is a central component of virtually all of the businesses in which I choose to invest.
We opened 16 net new CAVA restaurants this quarter, bringing our total CAVA restaurant count to 279. We have strong unit-level economics across every geography as well as in suburban, urban and specialty markets, and our overall AUV is now above $2.6 million.
All geographies are over $2.2 million. CAVA restaurant-level profit in the second quarter was $44.6 million or 26.1% of revenue versus $23.3 million and 22.1% of revenue in the prior year, representing a 91.9% increase. The margin expansion was largely a result of sales leverage on labor and occupancy and improved food, beverage and packaging costs.
Tricia Tolivar, CFO, Q2 2023 CAVA Earnings Call (emphasis added).
Lastly, I maintain that, over the long run, akin to Chipotle, CAVA will achieve a 15% free cash flow margin. The modeling below makes this assumption, among others:
TTM 12-month revenue [A]
Potential Free Cash Flow Margin [B]
Average diluted shares outstanding [C]
Free cash flow per share [ D = (A * B) / C ]
Free cash flow per share growth rate (conservative)
Terminal growth rate
Years of elevated growth
Total years to stimulate
Discount Rate (Our “Next Best Alternative”)
Notably, the company will have about 300 units by the end of 2023, and they’ve stated that they’re prepared to grow units at 15% in 2024 and 2025 (and through the end of 2032/2033).
I personally believe that they will be able to grow at this rate for a sustained period of time (barring a very deep recession and execution issues), as the product is just that good, and there’s genuinely nothing else like it that I’ve ever tried, except Chipotle, but even Chipotle really isn’t like CAVA (the formats are identical, to be sure). I believe this differentiated product offering poises CAVA to achieve its 1k unit count target by 2032-2033.
All of this being said, no matter how I slice it, I still want to wait until ~$30/share, at which point our reasonable assumptions will yield a ~20% annualized return profile over the next 10 years (this was originally written when CAVA was in the $40s/share, so we’re getting closer).
Exceptional Unit Economics
In our original consideration of CAVA, I mostly focused on quantitatively dissecting the business. What we found (as in you and me together) was that CAVA’s financials and specifically its unit economics were virtually identical to those of Chipotle.
After having studied the business for roughly a couple months and after having eaten at both CAVA and Chipotle now, it appears that CAVA is marginally more expensive on a $/calorie basis, and I believe, because it is so unique, it commands slightly higher pricing power.
This pricing power has resulted in CAVA, despite being a relatively new food concept, especially relative to Chipotle, achieving an incredible restaurant level margin, which I illustrated for us below.
CAVA And Chipotle’s Restaurant Level Profit Margin
|Restaurant Level Margin (Today)||Restaurant Level Margin (Yr 10)|
Incredibly, restaurant level margins for Cava and Chipotle are virtually identical (precise numbers used in lefthand column above).
Here’s further context for CAVA’s margins:
I believe that these robust margins on a unit (restaurant) basis buttress an achievable long run free cash flow margin of 15%, which I depicted below:
|Long Run FCF Margin||Shares Outstanding||Net Cash|
|Cava||15%||120M (Fully Diluted)||~$350M|
|Chipotle||15%||28M (Fully Diluted)||$1.8B|
Interestingly, we learned in Chipotle’s Q2 2023 earnings report that it achieved a 27.5% restaurant level margin, and it is likely that this margin can continue to expand to 30%; potentially beyond, thereby justifying our long held assumption that Chipotle would achieve 15% free cash flow margins long term, downstream of its ~20%, or more, operating margins.
David Palmer: And in the past, you’ve talked about an incremental margin framework. Maybe something like 35% to 40% would be normal. Obviously, the first half has been below that, particularly in the first quarter, maybe catching up to a bit here in the second quarter. With the four points of price that you’re talking about, do you feel like you’re going to be getting back to that incremental margin from here on out?
Jack Hartung: That’s right, David. In fact, that’s exactly why we did what we did. We still have some additional going to see carry into Q3 for tortillas, dairy, packaging and some known increases related to beef that we’ve known for a while all those roll into Q3.And really, what this allows us to do is, when we get up to this, we’ve talked about a $3 million average volume, and then our margin should be somewhere in the 27% range that gets us back to that kind of a situation. And the pass-through for every incremental sales dollar we get in should be right back to that 40%-ish flow-through that we’ve talked about in the past.”
Chipotle, Q2 2022 Earnings Call.
Chipotle’s Operating Margin Since IPO (Dip Due To Ecolapocalypse)
Below, we can see CAVA’s updated restaurant-level profit margin at 26.1%.
On CAVA’s Q2 2023 earnings call, however, its CFO announced that its restaurant level profit margins would decline to 23%, which makes sense as the business continues to scale rapidly, implying that new restaurants may not immediately reach those margin levels and further investment may be necessary to enhance the current fleet of restaurants.
I’ve reached out to CAVA’s investor relations, and I plan to discuss what long term margin structure may look like, though the data we received in Q2 2023 was very heartening to me. [here’s what they responded ex post facto:]
So we’re really working for our pay here in terms of assuming long term free cash flow margin, though I believe Chipotle and CAVA’s pricing power provide a fantastic roadmap for making this assumption.
Here are CAVA’s Q2 2023 business highlights, underpinning our above discussion, consolidated into one chart:
As I mentioned, I plan to wait to begin accumulating CAVA; however, I am quite content with the pieces of the puzzle that we received in this report.
Chipotlanes But CAVA
As can be seen below, CAVA has expanded to a healthy degree, which the company says “demonstrates its portability nationally.”
It seems like they could add 500 to 1,000 locations in California alone in the decades ahead, which I say solely based on how much I personally love the cuisine.
Like Chipotle, CAVA has decided that it’s not above drive thru lanes at its locations, as they are, in some basic sense, just what the customer wants. They also create AUV lifts, to be sure, and increase margins at each location.
We have more than 20 pickup lanes, digital pickup lanes in our pipeline today — or excuse me, in our fleet of restaurants today. And the AUVs are typically 10% to 15% higher than other locations in their market as a result of that.
Certainly, as we look at our pipeline of new restaurant openings in 2023 — the rest of ‘23 and ‘24 and beyond, we do anticipate that our drive-thru digital pickup lanes will be a larger portion of the portfolio. We just want to make sure that we’re being thoughtful around investing in those and delivering the right returns as we move forward.
Tricia Tolivar, CFO, Q2 2023 CAVA Earnings Call (emphasis added).
For those that would like to hear from CAVA’s management, I would, of course, invite you to listen to the company’s earnings calls. I also found the video below worthwhile.
As something of an aside, unrelated to the long run prospects for CAVA, I found CEO Brett Schulman’s commentary on CAVA and the environment in which it operates insightful for our entire coverage universe.
Brett Schulman: Yes, David, it’s Brett. I think from a macro perspective, we’re really mindful of a lot of pressures facing our guests outside of their CAVA experience, whether it’s the gas prices Tricia touched on that have spiked recently, some of the utility build cost pressures related to the extreme heat that’s hit a lot of the parts of the country. You have student debt loan repayment hanging in the wings this fall. And you have a hawkish Fed that has also signaled that they’re looking to temper growth to ensure they tamp out any potential inflation reigniting. So we’re mindful of those pressures, which is why we’ve leaned into our value proposition.
And as Tricia noted, have no plans to take price the rest of the year and have taken minimal price increases year-over-year to put forward a really great value proposition for our guests regardless of what the macroeconomic conditions bring.
Q2 2023 CAVA Earnings Call.
We, indeed, operate in rather unprecedented times following the expansion of our (America) money supply by 40% in the span of two years. While many may prognosticate as to the future of our economic conditions, nobody has the faintest idea precisely what will come to fruition on the 12-24 months to come.
To conclude, I’d like to share something that I wrote about two weeks ago: “
To close, I love the business, but at $4.8B in enterprise value on $790M of full year 2023 sales, there’s a lot of room for error here. I plan to wait until either $30/share or a year or so has passed (during which sales growth catches up to enterprise value) to begin buying in earnest.
As of today, here is the current state of CAVA’s valuation:
|Share Count||120M (fully, fully diluted)|
|Cash & Debt||$350M/$0 (note operating lease liability accounting)|
|Fwd. 12 Month Sales||~$850M|
I personally believe this to be quite attractive, but I believe this to be so because 1) I love the cuisine and 2) believe it can achieve a 15% fcf margin long term, which is far from a foregone conclusion.
I do plan to wait until $30/share or lower to begin buying in earnest, but, today, CAVA is undeniably quite interesting, and I am excited to see the share price continue to decline.
Thank you for reading, and have a great day.