Chipotle Has A Viable Challenger: CAVA Is Up And Coming

seekingalpha11-19 22:51

Potential for entry into new markets underpins our "Buy" rating for CAVA Group, Inc. and our "Hold" for Chipotle Mexican Grill.While CMG has massive benefits of scale, continuing growth by CAVA will ...

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EMS-FORSTER-PRODUCTIONS  NEW YORK (November 18) - Chipotle (NYSE:CMG) is facing a rising challenger in Mediterranean fast-casual chain, CAVA Group, Inc. (NYSE:CAVA) About CMG CMG is a national restaurant chain that was mentored and funded from its entrepreneurial roots by the McDonald's (MCD) system before going public on January 26, 2006. It serves what came to be known as \"Mission Style Burritos\", named for the Mission District of San Francisco, but which actually originated in the Sonora state of Mexico. They are comprised of meat, vegetables, and toppings like guacamole, sour cream, and salsa wrapped in a flour tortilla. Roughly a decade ago, CMG began serving what they called \"burrito bowls\" for customers seeking a lower carb diet. It has since added more items to its menu, like quesadillas, tacos, and other Mexican-style fare. About CAVA CAVA serves Southern Mediterranean fare, with meat proteins like steak, chicken and lamb, as well as legume proteins like falafel and humus, and milk proteins like feta. They are served along with an assortment of vegetables and fruits like lettuce, tomatoes, avocado, and olives. It also serves its fare in bowls, as well as pita wraps. The company was founded in 2006 as a 1,700 sq. ft. full-service restaurant in Rockville, MD and went public on June 15, 2023 after enjoying multiple rounds of private financing. It is up 270% since its debut at $38. Both chains bill themselves as \"casual dining\" restaurants, which is a term chain restaurateurs and their marketing teams created to upscale what amounts to cafeteria-style fast food, rather like New York real estate developers upscaled the \"Clinton\" neighborhood in Manhattan from its former moniker, \"Hell's Kitchen\" to charge higher rents in a more fashionable neighborhood. (The Sunday brunch I used to enjoy at Luby's Cafeteria during my time in the Texas oil patch had no such guise; it was \"Luby's Cafeteria\" (LUB) and as fine and wholesome a meal at as fair a price as one could ever ask, delivered quickly from steam tables and chilled display stands. Wish they were in NY!) COMPARISONS Let's turn to some key metrics, keeping in mind that those from CAVA must be tied to its short life as a publicly held company: Key 2024Q3 Metrics for CAVA and CMG (The Stuyvesant Square Consultancy (compiled from earning releases)) Let's look at the estimated revenue growth of the two chains: Data by YCharts CMG currently dominates in financial performance metrics like Funds from Operations (FFO), EBITDA for the trailing twelve months (TTM), and EBITDA per share (TTM) Data by YCharts CMG is obviously well ahead of CAVA, for now, in terms of growth of EBITDA and growth in Funds from Operations [FFO]. CMG also wins on profit margin. But CAVA is clearly punching above its weight in gross profit margin. Data by YCharts SIMILAR, NOT THE SAME CAVA and Chipotle are, essentially, in the same line of business: making food that consumers perceive as fresher and healthier than quick serve restaurants in the aforementioned \"fast casual\" space. But how do they compare? I found this review, written by a disinterested editor of a high school student newspaper in 2018, to be insightful: ...CAVA just tastes fresher whereas Chipotle seems to have good and bad days. One day the guacamole goes bad because it was left out for three seconds longer than it should have been, the next day the steak is too fatty. Not to mention, it’s getting a bit old after years and years of school fundraisers being hosted there, as well as being your default dinner/movie night spot. There are scores of anecdotal evidence in social media sharing the view that CAVA tastes better, and that CMG is inconsistent. RISKS, CHALLENGES, AND COMPETITION The Risk of Fresh Food Safety at Scale The better taste of CAVA may come with risk. Doing fresh food at scale, and safely, has always been a challenge. It was one of the many things the former CEO and founder of CMG, Steve Ells, and his notoriously inept management team (\"the single most incompetent leadership team in the history of restaurants\", as one analyst called them) couldn't do well. I discussed that failure at some length here. When CMG's former management moved more food preparation to central kitchens to ensure better food safety, the company did not arrest the shortcoming in taste that resulted. As I wrote here in 2017, when I went from \"bear\" to \"bull\" on CMG, there was a consensus that CMG simply did not taste as good as it once did, when the food was mostly prepared at the restaurant level. It's a \"fixable\" shortcoming, as I wrote, but CMG has apparently not done so. That may be why CMG doesn't seem to measure up to its previous incarnation, taste-wise. (I understand, but cannot confirm, that CAVA fruits and vegetables are prepared at central kitchens, but everything else is prepared at the restaurant level.) A check of CAVA at the foodborne illness site, \"I Was Poisoned\" shows several self-reported cases of customers reporting illness after eating at CAVA of recent vintage. CMG also has several.  What is critical, though, both in these two chains and in the chain restaurant business generally, is that best practices like the Norwalk Protocol (named for Norwalk, OH, town where the first instance of Norovirus gastrointestinal illness was identified in 1968, that requires symptomatic workers to stay home; deep cleaning of restaurants in an outbreak, etc.), blanching, no-notice safety audits by companies like Ecosure, rigorous food safety training, monitoring of steam-tray temperatures to ensure food is kept sufficiently hot or cold, and a protocol that requires food handlers to wash hands regularly (generally at timed intervals) and in specific circumstances. It's not clear that CAVA has been as rigorous in its food safety as CMG has been; that's understandable, as they have not had the same unfortunate food safety experiences. Sometimes, imminent demise is the best agent of change. That seems to have worked for CMG. A report from September took CAVA to task for a number of food safety issues for which it was cited by the New York City Department of Health. The \"C\" grades cited in that report seem to have been corrected for subsequent inspections, but it's troubling the chain would receive even one at this state of its expansion. The rigid food safety infrastructure I described above should have already been in place. Penetrating a Market with \"Fatter Wallets\"  Zoe's, another fast-casual restaurant, was acquired by CAVA in 2018. Its locations have either been closed or converted to CAVA outlets. The former Zoe's locations allowed CAVA to readily expand what it calls its \"coastal smile strategy, which started by  building out from CAVA's base locations in and DC, Maryland and Virginia; then, opening in California.   States with Zoe's Kitchen locations as of the end of 2017 (SOURCE: Zoe's Kitchen 2017 10K) CAVA now has 366 locations as of this month, as illustrated in this data map provided by data company ScrapeHero. Note that New Mexico and Mississippi both have no restaurants, thus leaving CAVA's coastal \"smile\" missing some \"teeth\". They're notable as both states are well below the US median income. Some other states where CAVA has locations are similarly situated in terms of average income, but I attribute that mostly to Zoe's having commenced in Alabama and spread to neighboring states. CAVA also is targeting suburban locations in an attempt to build out in customer bases that have \"fatter wallets\". CMG, on the other hand, has locations in every state of the continental US. Pre-pandemic, there was anecdotal evidence CMG had, frankly, oversaturated some of its urban markets. (In my Manhattan, NY, neighborhood, there were something like four or five within about a 5-minute walk; there are still three. I can't help thinking they're cannibalizing some of the sales of each other.) While CMG has a wide moat, it is also a mature company insofar as growth is concerned. The Challenge of Cuisines I grew up in a small community in western New York in the 1960s and 70s; closer to Ohio than Manhattan. Back then, I think I knew, vaguely, what tortillas and burritos were, though quesadillas were likely not on my radar. I never encountered a falafel until freshman year at NYU, when I was introduced to Mamoun's, a Greenwich Village institution since 1971. I didn't like it, though I love it now and eat it regularly. CMG already has a market for its pseudo/faux \"Mexican\" cuisine, especially along the \"coastal smile\" territories where CAVA is built. But most Americans aren't really familiar with Mediterranean fare. I think it's fair to assume that condiments like Harissa (from Tunisia) and Tahini Sauce (from Lebanon), and much of the rest of CAVA fare, are mostly unknown to Middle America outside some cities and university towns. It will take some marketing to educate them. Competitors and Dark Horse \"Unknown Unknowns\" Local restaurateurs are (or can be) abundant in the fast casual space. I much prefer a local deli's burritos to those of CMG, for example. Local CAVA competitors are less common, but, then, so is Mediterranean fare generally. You can find Greek salad, souvlaki, and gyro sandwiches in many places here in the NYC region, including many of the remaining Greek coffee shops. There is even a small Greek restaurant chain that has locations here and in Florida. That's less so when you move into Middle America. The CAGR of fast casual dining is projected at 6.6% through 2032, according to Straits Research. That's in the upper tier of growth for consumer discretionaries. But while that growth rate is superior, it's fragmented, and innovation - in the form of new cuisine styles - may well displace large incumbents like CMG. Thai and Indian cuisines are increasingly popular, according to a survey of Google search terms compiled by Statista and another reported, but unsourced compilation of Instagram data. There is already a small fast casual chain specializing in Indian cuisine called \"Choolah\" that has six locations in three states. But perhaps the biggest risk is that a start-up chain of a more popular ethnic cuisine -- and \"unknown unknown\" -- could arise and steal market share. In a city that speaks over 800 languages, and 12 are quite common, we have a wide variety of ethnic fare, including Cuban, Ethiopian, Halal, several varieties of Eastern European fare, and even Ecuadorian guinea pigs. Some of those are already small chains. Some are quite tasty. (But I'm not trying the guinea pigs for SA or anyone else.) Margins and Technology CMG's scale allows it considerable advantages in purchasing, training, obtaining leased space, and other factors. It also allows for it to exploit new technological innovation, such as this dual manual and digital burrito bowl. make line that Chipotle introduced earlier this year and the Autocado, the robotic guacamole machine. Such productivity increases will drive higher CMG margins and lower its labor costs. SUMMARY INVESTMENT THESIS Chipotle enjoys a wide moat and advantages of scale that well exceed those of CAVA. That scale will improve CMG margins going forward. But CMG is a mature brand that is well-saturated in many major cities in the US. CAVA, on the other hand, will be able to expand more readily into new markets, develop greater scale and, eventually, be able to compete on level ground with CMG with respect to technology. CAVA also has the challenge of introducing Middle America to Mediterranean fast casual fare. Both chains face similar competitive challenges, particularly from other diverse, up-and-coming, fare, but potential investors should demand more stringent food safety protocols from CAVA and, likely, all those newer chains that would displace these incumbents. Nevertheless, growth favors the Mediterranean brand. Thus, retail investors in the fast casual space should hold CMG, but should move new investments to favor CAVA.  ______________________________________ NOTE: Our commentaries most often tend to be event-driven. They are mostly written from a public policy, economic, or political / geopolitical perspective. Some are written from a management consulting perspective for companies that we believe to be underperforming and include strategies that we would recommend were the companies our clients. This approach lends special value to contrarian investors to uncover potential opportunities in companies that are otherwise in downturn. (Opinions with respect to such companies here, however, assume the company will not change.) 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