{"id":13861,"date":"2023-05-25T19:17:59","date_gmt":"2023-05-25T23:17:59","guid":{"rendered":"https:\/\/ifintechworld.com\/markets\/dont-bailout-this-ipo-cavastrophe\/"},"modified":"2023-05-25T19:18:01","modified_gmt":"2023-05-25T23:18:01","slug":"dont-bailout-this-ipo-cavastrophe","status":"publish","type":"post","link":"https:\/\/ifintechworld.com\/?p=13861","title":{"rendered":"Don\u2019t Bailout This IPO \u2018CAVAstrophe\u2019"},"content":{"rendered":"
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Cava Group (CAVA), the Mediterranean focused fast-casual restaurant filed its S-1 on May 19, 2023. The company has not provided share price information yet, but the business is expected to be valued at ~$1.5 billion, at which point the stock earns an unattractive rating.<\/p>\n

I do not think investors should buy Cava Group\u2019s stock if the IPO valuation is anywhere close to the expected valuation. Despite rapidly expanding its store count, Cava Group is running out of good expansion opportunities. I find the timing of this IPO curious given the expected increase in the cost of the company\u2019s operations. Additionally, without the cash infusion provided by an IPO, Cava Group would qualify for my Zombie Stock list, which features high-risk stocks with heavy cash burn and limited cash reserves.<\/p>\n

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Cava Group\u2019s IPO reminds me of Sweetgreen (SG), a fellow fast-casual restaurant Zombie Stock that has been in the Danger Zone since its IPO in November 2021. Don\u2019t get left holding the bag by bailing out the private equity owners of this overvalued and unprofitable fast-casual restaurant.<\/p>\n

Unprofitable Business From the Jump<\/strong><\/h3>\n

Cava boasts impressive top-line growth, as is common with most IPOs. The company has grown revenue by 52% compounded annually from fiscal 2016 to fiscal 2022 and increased its store count from 22 in fiscal 2016 to 263 as of April 16, 2023.<\/p>\n

However, this growth has come with no profits. In the two years I have full financial data, Cava has not generated positive net operating profit after tax (NOPAT) or economic earnings, the true cash flows of the business. In fact, even as revenues grew 13% year-over-year (YoY) in fiscal 2022, economic earnings fell from -$49 million to -$62 million. See Figure 1.<\/p>\n

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Figure 1: Cava Group\u2019s Revenue & Economic Earnings: 2021 \u2013 2022<\/strong><\/p>\n

Last Chance to IPO Before the Business Gets Worse<\/strong><\/h3>\n

Astute investors may question why a fast-casual restaurant would have an IPO in the current economic environment: the U.S faces a possible recession and the global economy looks shaky. The likely answer: the business will only get more unprofitable as time goes on, so now is better than later.<\/p>\n

In 2018, Cava Group acquired previous Danger Zone pick and unprofitable Mediterranean restaurant Zoes Kitchen (ZOES). Since the acquisition through April 16, 2023, Cava has converted 145 Zoes Kitchen\u2019s locations to Cava restaurants, which represent 55% of all Cava Group\u2019s locations. These conversions represent a cheaper way to expand Cava\u2019s footprint, with the S-1 noting \u201cwhile conversions require initial capital investments, such costs are typically significantly lower for a conversion as compared to a new opening.\u201d Unfortunately for Cava and its path to profitability, this cheap source of store expansion is coming to an end.<\/p>\n

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In its S-1, Cava Group notes that it plans to close or convert the remaining 34 Zoes Kitchen locations in 2023. After completion, investors should expect Cava\u2019s expenses to increase substantially. Don\u2019t just take my word for it either, Cava notes specifically in its S-1:<\/p>\n

\u201cWe anticipate that our operating expenses will increase substantially in the foreseeable future\u201c<\/p>\n

and<\/p>\n

\u201c\u2026 following the completion of conversions of the remaining Zoes Kitchen locations\u2026 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.\u201d<\/p>\n

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Cava\u2019s S-1 also notes that a \u201csignificant portion\u201d of new restaurants will have drive-thru capabilities, which \u201crequire significant additional capital expenditures.\u201d Because drive-thru restaurants are generally larger, they result in \u201chigher real estate costs as well as incremental infrastructure and construction costs.\u201d<\/p>\n

Put these statements together and the situation is clear \u2013 Cava\u2019s expenses are going to rise in the near future, and its current margins may be the closest it gets to breakeven for quite some time, which helps explains the odd timing of this IPO.<\/p>\n

IPO Needed to Avoid Zombie Status<\/strong><\/h3>\n

Not only is Cava running out of a cheaper source of store expansions, but it is also running out of capital to sustain its business.<\/p>\n

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In 2022, Cava burned $120 million in free cash flow (FCF) and, as of April 16, 2023, had just $23 million in cash and cash equivalents on its balance sheet. Cava Group can only sustain its 2022 burn rate for 2 months from April 16, 2023. In other words, Cava needs a capital raise to remain a going concern, which further explains why its private owners are looking to raise money via an IPO.<\/p>\n

Without the proceeds of the IPO, Cava Group would qualify as a Zombie Stock, or a company with high FCF burn, negative interest coverage, and a real chance of going to $0\/share. Again, no wonder the current investors in Cava want to raise capital.<\/p>\n

Figure 2: Cava Would Be a Zombie Stock Without IPO<\/strong><\/p>\n

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* As of 4\/16\/23<\/p>\n

** To calculate \u201cMonths till Bankruptcy\u201d I divided the 2022 FCF burn, excluding acquisitions, by 12 to get the monthly cash burn. I then divide reported cash and equivalents and long-term investments in the most recent S-1 by the monthly cash burn.<\/p>\n

Local Sourcing Makes It More Difficult to Scale\u2026<\/strong><\/h3>\n

Cava operates Mediterranean focused restaurants that aim to appeal to consumers by providing \u201chealthy, flavorful, and filling\u201d food with most ingredients locally sourced.To provide this experience, Cava typically relies on a limited number of suppliers, and in some cases, single-source suppliers for several ingredients. The suppliers are small family-owned businesses or sole proprietors that will have more difficulty scaling production.<\/p>\n

By not using national distributors, Cava adds complexity to its supply chain, which will make it more difficult and potentially more costly to scale. This inefficiency leads to higher operating costs. Cava\u2019s restaurant operating costs were 83% of revenue in 2022. Chipotle\u2019s restaurant operating costs, on the other hand, were just 77% of its food and beverage revenue in 2022. R estaurant operating costs include food, beverage, and packaging, labor, occupancy, and other operating costs to match Cava\u2019s restaurant operating costs, which include food, beverage, and packaging, labor, occupancy, and other operating expenses.<\/p>\n

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\u2026So Does Intense Competition<\/strong><\/h3>\n

Cava Group isn\u2019t the first restaurant to offer consumers \u201chealthy, flavorful, and filling\u201d food. Subway\u2019s \u201cEat Fresh\u201d concept helped the company grow to more than 21,000 stores in the U.S. Chipotle has advertised the freshness of its offerings for years. The market for fresh, fast casual food is crowded, and, consequently, intensely competitive. See Figure 3. With just 263 store locations, Cava Group is a minor player and will have to spend mightily if it hopes to achieve the scale needed to generate the profits earned by many of its direct competitors.<\/p>\n

In this context, potential IPO investors must ask themselves why they would buy stock in a cash-burning business that:<\/p>\n

    \n
  1. will have to burn a great deal more cash to have a chance at scaling and<\/li>\n
  2. must be more profitable than Brinker International (EAT) to justify the expected IPO price.<\/li>\n<\/ol>\n

    Figure 3: Cava Group\u2019s Store Count Vs. Competitors<\/strong><\/p>\n

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    This list is a sample of Cava\u2019s competitors and is not exhaustive, but serves to illustrate the crowded nature of Cava\u2019s potential market.<\/p>\n

    Online and Delivery is Not a Differentiating Feature Either<\/strong><\/h3>\n

    Cava\u2019s \u201cDigital Revenue\u201d made up 35% and 37% of revenue in 2022 and in the sixteen weeks ended April 16, 2023, respectively. Cava notes in its S-1 that the \u201cexpansion of digital and delivery business is important to the growth of our business.\u201d However, delivery and digital orders are no longer a differentiating feature in 2023, but they do create additional branding and customer experience risk.<\/p>\n

    Nearly all of Cava\u2019s delivery orders are fulfilled through third-party delivery partners, over which Cava has no control. The use of third-party services can facilitate sales, but it can also create unsatisfactory experiences for consumers and drive users away from Cava restaurants.<\/p>\n

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    Only Sweetgreen Has Lower Profitability Than Cava<\/strong><\/h3>\n

    Given Cava\u2019s more expensive supply chain and the intense competition that it faces, it comes as no surprise that the company\u2019s fundamentals are much worse than peers. Peers include traditional, fast-food, and fast-casual restaurants.<\/p>\n

    Compared to its peer group, Cava\u2019s NOPAT margin and return on invested capital (ROIC) of -3% are second to last. Only Sweetgreen, fellow Danger Zone pick and Zombie Stock, has a worse NOPAT margin and ROIC. See Figure 4. Peer group in this analysis includes the 32 other Restaurant and Bar companies under coverage.<\/p>\n

    Figure 4: Cava\u2019s Profitability Vs. Competitors: TTM<\/strong><\/p>\n

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    Cava Group Is Priced to Grow as Fast as Chipotle<\/strong><\/h3>\n

    When I use my reverse discounted cash flow (DCF) model to analyze the future cash flow expectations baked into Cava Group\u2019s current valuation, I can provide clear, mathematical evidence that the expected valuation of $1.5 billion appears too high and offers unattractive risk\/reward.<\/p>\n

    To justify its expected IPO valuation, my model shows Cava Group would have to:<\/p>\n