Is Cava Group the Next Chipotle Mexican Grill?

Long-time reader Zach writes in asking if Mediterranean fast casual restaurant chain and recent IPO Cava Group (CAVA) “is the next Chipotle?”

I think there are two core questions here; 1) does Mediterranean cuisine have the same mass appeal and guest frequency potential as Chipotle, and 2) can management execute a rapid growth nationwide rollout without making major mistakes (the chain plans to grow from under 300 locations to 1,000 over the next ten years).

If I were contemplating investing in CAVA (I’m not currently) I would be more concerned with #1 above, even though both are core risks. Let’s see how the stock market currently values CAVA stock, to get an idea of whether the bar is set high for its future growth potential:

Much of Chipotle’s success has been due to extraordinarily low build out costs relative to the sales volumes and unit-level margins the locations deliver. I believe CMG has the highest four-wall profit margins of any publicly traded dining company. That said, CAVA’s 26% in Q2 of this year is pretty darn solid. I would be concerned about volatility on this metric though, as the company currently projects only 23% for the full year 2023 and last year was more like 20%. Chipotle has been much less varied.

I would point out two more things when it comes to the quantitative comparisons above. First, much of CMG’s outstanding stock market performance has come from multiple expansion (2x price to sales post-IPO to more than 5x price to sales today). Conversely, CAVA stock today already fetches more than 6x sales and has only traded publicly for 2 months. The potential for similar multiple expansion simply isn’t there - which means they will have to grow units quickly and maintain volumes and margins while doing so in order to impress investors.

Secondly, notice that the market is valuing each existing CAVA location more than each Chipotle unit, despite CMG outposts earning about 20% more in profit dollars. Has CAVA earned enough trust to warrant that relative valuation? As an investor, if I could only pick one would I want own a CMG for $15M or a CAVA for $16M? Easy answer for me, personally (the former).

Another interesting point to consider is that CMG is so big and profitable that it generates a ton of free cash flow (I estimate about $1.2 billion for 2023) for management to use for stock buybacks, whereas CAVA is still burning cash because they are choosing to open new locations faster than the existing ones book profits. So at least in the near term, CMG’s share count will likely fall, while CAVA’s will likely rise - impacting future stock performance.

To get excited about investing in CAVA today I think you need to be really bullish about the concept and its ability to be successful with hundreds, if not thousands, more units across the country. Additionally, you need to feel like you are getting a low enough price that the stock’s upside potential is worth the executional risk.

My personal view is that at current prices CMG could quite possibly outperform CAVA despite it already being more than 10x larger in terms of locations opened. But even if they merely track each other, or CMG trails a bit, given the higher risk profile of a chain with fewer than 300 locations (versus one with 3,000+), I believe a risk-reward assessment still favors Chipotle. Time will tell whether that view proves prescient.

Full Disclosure: No positions in the stocks mentioned at the time of writing, but that is subject to change at any time without further notice

As of the publication date, CAVA stock was quoted at $43 with CMG at $1,860

Data sources: CMG: Q2 2023 10-Q, 2022 10-K CAVA: Q2 2023 10-Q, 2023 IPO Prospectus

Amazon Showing Further Signs of Expense Controls

About four months ago I wrote about how Amazon (AMZN) was doing lip service about operating more efficiently coming out of a time of rapid expansion during the pandemic. I figured that the stock, trading at $102 at the time, would need to see words translated into actual financial results in order to sustain a big move higher. Well, here we sit with the shares up 40% to $142 each, aided by a blowout second quarter earnings report. The early signs are good, but it will take a string of quarters in a row to convince skeptics.

I say that because although Amazon’s operating margins are running at about 5% right now, that remains below the levels seen during the 2018-2020 period (5.2%-5.9%). To truly be convinced that Amazon has permanently moved into a higher margin business model, I think they need to reach record-high margins and prove they can keep them there (and hopefully grow over time).

There are signs anecdotally as well that the company is serious about running leaner. About two years ago the company launched “Amazon Day” delivery - a feature that allowed Prime members to combine multiple orders into a single delivery on a day of their choice each week. For shipments that didn’t require 1-2 day delivery, it gave the company more flexibility with delivery speed and cost, and helped customers manage their deliveries more easily (and maybe even reduce porch pirate activity on their property).

As a loyal Amazon customer and shareholder, I loved this idea - until I tried to use it. I would frequently place multiple orders in a given week and specifically ask them all to be delivered together the following Monday. They never did. Orders placed on Tuesday, Wednesday, and Thursday would all arrive early and packaged in separate boxes. From a customer satisfaction perspective, at least get the single package part right. If you want to spend more for them to arrive earlier than expected, fine, at least non-shareholders would probably be impressed. I was so annoyed that they offered this service and then refused to honor it whenever I opted in.

But a strange thing happened yesterday. I received 5 Amazon orders - placed Sunday, Monday, and Wednesday of last week - in 1 box, on the day I requested. I have never been so happy to get an item 8 days after ordering it in my life. Coupled with the company’s second quarter earnings report, it sure seems like we can comfortably say something is going on here. Hopefully management keeps the focus on efficiency because for the stock to keep rising materially from here, I think we need to see even higher profit margins in the coming quarters (the holiday season will be very telling on that front since big volumes should make it easier to dramatically impact the bottom line). While I am cautiously optimistic on that front, paring back the stock’s weighting after a huge run makes sense too.

Full Disclosure: At the time of writing the author was long shares of AMZN (current price $142) both personally and on behalf of portfolio management clients, but positions may change at any time.

Managing Discretionary Spending When Partners Think Differently

An interesting article in the Wall Street Journal published yesterday asks “Your Credit Card Has A Spending Limit. Should Your Marriage? (paywall).” This is a fairly common question and one I have discussed numerous times with clients even though it fits more into personal finance generally than investing specifically. The author offers the suggestion that partners have an agreed upon spending limit under which any purchase need not be signed off on by the other person. For example, as long as you want to buy something for less than $500, just go ahead and both partners agree to never question it.

This solution seems like a simple way to avoid arguments about excessive spending by one particular partner in a relationship, but it has an obvious drawback that the article fails to mention; usually one partner engages in the bulk of the problematic (real or perceived) spending. A simple per-item spending cap would likely work well when both partners spend roughly equally on discretionary purchases, but the bulk of the arguments about money will occur when spending patterns diverge. If one of you buys 10 $500 items per year and the other only buys 2 such items, you might not actually avoid having an argument about excessive spending.

Is there a better solution? Every relationship is different, but I think there is a near-perfect alternative. What if each partner gets their own monthly stipend that they can spend however they want with no questions asked? As long as each person is given the same amount each month, and the total allowance fits within the family’s overall budget (and thus does not impact your long-term financial goals), this set-up can work extremely well.

My wife and I combine our finances, except for this key item. All of our income goes into a shared account but we also each have our own bank accounts that are solely funded equally by automatic monthly deposits from the shared account. No spending limits, no questions asked. And our differing spending patterns (I tend to buy fewer, more expensive items, whereas my wife is the opposite) never come into play because we are each treated equally in such an arrangement.

I call this a near-perfect solution when I recommend it to others because I can think of at least two possible criticisms. One, if each partner automatically gets their “allowance” sent over to their account each month, you can pretty much assume it will all be spent eventually, which means total spending over time might be higher than it otherwise would (this is the same argument for zero-based budgeting in the corporate world). While true, as long as the monthly amount fits nicely into your budget and doesn’t impact other goals, I think it’s okay to spend a reasonable amount on yourself.

The other potential issue comes into play if each of you has a personal credit card that is used for these purchases. In that case, one partner could actually spend more than their allowance by racking up a credit card balance and just make partial monthly payments from their own bank account. If this system is to work, you need to have enough discipline to not rack up debt individually. If both partners aren’t okay with that, then simply scrap the credit cards and rely on debit alone for personal spending.

All in all, I think this idea works great for most couples, especially when compared to alternatives such as the spending limit concept from the WSJ article, which seems to have a glaring flaw.

Will Amazon's Efficiency Push Finally Prove That E-Commerce Is A Good Business?

Last year, for the first time since I originally started to invest in Amazon (AMZN) stock back in 2014, my own sum-of-the-parts (SOTP) valuation exceeded the market price of the shares. If you are wondering why I owned it at any point when that was not the case, well, the company’s growth rate was high enough that I would not have expected it to trade below my SOTP figure - which is based solely on current financial results.

That discount got my attention, as Amazon took a drubbing in 2022 like most high-flying growth companies in the tech space coming off a wind-at-their-backs pandemic. What is most striking is just how much of Amazon’s value sits in its cloud-computing division, AWS. If one takes a moment to strip that out (everybody knows it’s insanely profitable and a complete spin-off in the future would be an enormously bullish catalyst for the stock) and focus on the e-commerce business by itself, the picture becomes a bit murky. More specifically, is that part a good business or not?

We have heard for many years - since the company’s IPO in fact - that management is focused on long-term free cash flow generation and thus does not shy away from reinvesting most/all of its profits in the near-term. But one has to wonder, at what point is “the long-term” finally upon us?

Amazon began breaking out AWS in its financial statements back in 2013, so we now have a full decade’s worth of data to judge how the e-commerce side is coming along. The verdict? Not great actually. Between 2013 and 2022, AMZN’s e-commerce operation had negative operating margins 30% of the time (2014, 2017, and 2022) and in the seven years it made money, those margins never reached 3% of sales. As you might have guessed, they peaked during 2020 at the height of the pandemic at 2.7%.

Now, do low operating margins automatically equate to a poor business? Probably not. Costco (COST), after all, has operating margins only a bit better. The difference is that Costco is a model of consistency and grows margins slowly over time, which indicates just how strong their leadership position is within retail.

For fiscal 2022, COST booked 3.4% margins, up from 2.8% in 2012. During that time they only dropped year-over year one time and even then it was only a 0.1% decline. Compare that with Amazon, which had margins of 0.1% in 2013, negative 2.4% in 2022, and year-over-year margin declines in five of the past ten years. Costco appears to be the better business.

Like many tech businesses that loaded up on employees and infrastructure during the pandemic, only to see demand wane and excess capacity sit idle, Amazon CEO Andy Jassy is focusing 2023 on operating efficiency. They are in the process of laying off extra workers and subleasing office and warehouse space they no longer need.

I think Amazon has a real opportunity to prove to investors that its e-commerce business actually is a good one that should be owned long-term in the public markets. If the company takes this efficiency push seriously, it could come out of the process with an operation that going forward is able to produce consistent profits and a growing margin profile over time with far less volatility than in the past. If that happens, I suspect the stock rallies nicely in the coming years.

If they don’t hit that level of clarity and predictability, but settle back into the old habit of ignoring near-term results and preaching the long-term narrative, I am not sure investors will have much patience. After all, Amazon has now been a public company for more than 25 years and the market wants to finally see the fruits of all that labor pay off on no uncertain terms for more than a few quarters at a time.

Full Disclosure: At the time of writing the author was long shares of AMZN (current price $102) and COST (current price $491) both personally and on behalf of portfolio management clients, but positions may change at any time.

Despite Run on SVB, Bank Deposits Appear Safer Than Long-Dated Treasuries

Given the dramatic events of the last week in regional bank land, I will share a few points that I think are interesting given where we stand right now.

1) The $250,000 insurance limit is a mirage

There is a lot of discussion about the FDIC insured deposit limit of $250,000 (whether it is high enough, should be raised, etc) but let’s be honest, the limit is meaningless. The U.S. government has repeatedly shown it is willing to take extraordinary steps to prevent cracks in the financial system from cascading into catastrophe. It only took a weekend for leadership to guarantee 100% of all deposits held with Silicon Valley Bank and Signature Bank. Thus, in this political climate, there does not seem to be any reason to worry about which bank your personal cash is held with.

2) Government-backed bonds are generally safe, but still carry risk

Despite the fact that everybody in the industry knows that long-dated bonds carry plenty of interest rate risk if you are forced to sell them before the maturity date, problems still arose here. After the Great Recession of 2008-2009, banks were encouraged to park deposits in safe securities like treasury bonds and government-backed MBS - securities that were considered safe and got you high marks during stress tests. SVB seems to have taken that to heart, in the sense that they bought lower risk stuff, but they ignored the fact that their liabilities were mostly short-term in nature and thus could very well be in position to be forced to sell them early at a loss.

The problem here was simply mismanagement - or the lack of risk management. Matching short-term deposits (VC and tech companies need to rely on short-term cash reserves much more than larger, mature, profitable businesses) with 10, 20, or even 30 year debt makes absolutely no sense. The blow could have been muted had they hedged the interest rate risk (somehow they didn’t) - or rebalanced their bond portfolio after it was clear the Fed was not slowing down the rate hikes. The fact that the yield curve was inverted during most of this period is even more shocking - as it means they were getting paid less in return for holding the riskier, longer dated bonds.

3) Contrary to the political narrative, this is definitely a bank bailout

The government announcement over the weekend was quick to highlight that any losses incurred by backstopping 100% of bank deposits at the failed institutions will be covered by the insurance fund and not the taxpayer. While true, this ignores the other part of the rescue plan. For banks that remain operational, but hold underwater positions in the same types of long dated bonds that tripped up SVB, the Fed will lend against that collateral at 100 cents on the dollar. This will minimize future bank failures by letting banks realize full value for an investment that is currently marked well below par value. Of course, this is a bank bailout using taxpayer funds (via the Fed). It may very well make a profit for the government - a la TARP - assuming they charge interest on these collateralized loans, but make no mistake - this is not private capital creating a solution but rather than Fed using its power as lender of last resort.

Much like 15 years ago, when the Fed accepted bad assets as collateral when nobody else would, SVB and Signature were the first to fail (a la Lehman and Bear) and in response those who lasted longer will reap the benefits (the other regional banks today are like Goldman and Morgan back then). So yes, it’s accurate to say the management and shareholders of failures like SVB will not get a government bailout, but their competitors will by being allowed to access newly created government-backed financial resources to keep them afloat.

4) It is likely that the Fed’s rate hiking cycle has indeed “broken something” in the economy.

But it’s not what we might have thought (the job market or GDP growth) but rather the balance sheets of the banking sector. After having been told they should hold more “good assets” like treasuries, the banks now require financial support to prevent these very securities from rendering them insolvent - even if sound risk management would have prevented problems. If this means the Fed hiking cycle will quickly come to an end, we might avoid an even bigger economic shock down the road, which could be the preferred alternative. If they keep raising rates now that banks have enhanced financial backing, well, then we’ll need to watch out for what else they will break.

How Well Will Earnings Hold Up? Watch The Job Market...

With corporate profits set to fall for calendar year 2022 (final results won’t be known for weeks), the big question for equity investors is whether 2023 will bring stability on that front or not. Wall Street strategists largely expect another decline as economic headwinds accumulate, but the sell side is staying rosy (current consensus forecast is earnings growth of ~10%) and likely will continue that stance until companies explicitly give them 2023 guidance because they have very little reason to go out on a limb and make their own forecasts.

The economic and investment climate today reminds me a lot of 2015-2016. Back then earnings also showed a year-over-year decline (2015) during a time when overall economic indicators remained bright. The U.S. unemployment rate fell that year, and GDP growth actually accelerated. The biggest culprit for profits was energy prices, which fell dramatically and sparked a wave of financial distress for much of that sector and the lenders who funded their operations. Fortunately, the energy bear market eventually resolved itself through normal supply and demand rebalancing and overall U.S. corporate earnings rose in 2016 and set a new record in 2017. The result was only a single down year for the U.S. stock market.

From my vantage point, tech is the new energy in this comparison. The pandemic brought forward a ton of growth for digital businesses and now that pent-up demand is waning, growth has slowed materially (going negative for many companies) and layoffs are mounting. But as was the case back in 2015, the rest of the economy is pulling its weight just fine. There are labor shortages in many areas, which has resulted in the U.S. unemployment rate actually dropping over the last 12 months (4.0% to 3.4%) despite the Federal Reserve raising the Fed Funds interest rate by a stunning 450 basis points during that time.

You can tell the stock market isn’t really sure what to make of all this. After a sharp drop in 2022, this year has started with a bang as earnings are holding up so far and GDP growth remains in the black with more jobs created every month. The thesis that corporate profits fall in 2023 may still play out, but the timetable on which that becomes obvious keeps getting pushed out, which means stock prices can start to discount the possibility that such a scenario doesn’t materialize (what we are seeing this week).

I think watching the job market is the key. What if we can get through a full rate hiking cycle with the unemployment rate staying below, say, 5%, and most of the firings come from big tech companies? Could most of those workers find new jobs with “smaller and older” tech businesses who previously couldn’t compete with posh offers from the likes of Google and Facebook? If so, we might just see a soft landing after all. With the consumer always the main driver of the U.S. economy, they will tell the story this cycle as well. Without strong incomes, the negative impact on the bottom lines for lenders and sectors like hospitality, retail, and entertainment becomes a downhill wipeout.

Where do I think we wind up? Hard to say, but I definitely think the current 2023 earnings forecast of $223 (versus $200-$205 for 2022) is overly optimistic. If we can’t push much past $200 with the current backdrop today’s S&P 500 quote of 4,100+ appears quite rich with a 3.5% 10-year bond yield. For the bullish scenario to play out we would probably need to see growth in 2023 (say, $210+) with a clear path towards an acceleration in 2024 to $230+ (after all, 18 times $230 equates to 4,140 on the S&P 500). Buckle your seatbelts… if January was any indication the range of outcomes is quite wide.

Snowflake: Don't Let The Insane Stock-Based Compensation Fool You

The stark contrast between tech stock valuations in 2022 vs 2021 has been a welcomed development for those of us in the camp that is quite sensitive to earnings multiples when making investment decisions. As share prices across the sector started to collapse I was eager to step in for long-term holding periods even though I knew the bottom would likely be below my initial entry point. Now that the shakeout has occurred, there are many bargains, but not everything is cheap.

I was struck by an interview on CNBC yesterday with Brad Gerstner, who runs a tech-focused hedge fund called Altimeter Capital. Brad has been super bullish on Snowflake (SNOW) since the IPO given the company’s strong competitive position in a fast growing market. What I found odd was that as the market shifted away from the idea that almost any price can be paid for the best growth, Altimeter didn’t shift its positioning. SNOW was the fund’s largest holding when it reached $400 in 2021 and traded for 100 times sales and it remains so today with the shares at $150 (a meager 28 times sales).

During the same interview Gerstner made the compelling argument that in a highly inflationary economic climate with rising interest rates the market will not reward companies that seek growth over profitability any longer. Oddly, he then turned right around and pounded the table on SNOW because the valuation has compressed so much (from insane, to just extremely rich, I might add).

He repeatedly pointed to SNOW’s free cash flow growth, which he expects to double from $350 million in 2022 to $700 million in 2023. That would seem to imply that SNOW is indeed one of the tech firms that has pivoted from growth to profitability and thus may deserve a high sales multiple due to high profit margins. The problem is that SNOW’s income statement is littered with red ink. Take a look at their financial results from the first three quarters of 2022:

No, you are not misreading that income statement. So far this year SNOW’s revenue has grown by more than 75% and its net loss increased. Pre-tax profit margins are negative 41%.

So how on earth is SNOW reporting positive free cash flow, to the tune of hundreds of millions annually, when in reality it is bleeding red ink on the books? Well, they have learned that the key to getting their large investors to buy into crazy valuations is to generate cash even when you have accounting losses. And the only way to do that is to pay the vast majority of your compensation in stock and not cash.

Here is SNOW’s stock-based comp figure for the first 9 months of 2022:

$633 million! That equates to 40% of total operating expenses! No wonder it’s so easy for a large investor in your company to go on television and rave about your free cash flow generation. You are excluding 40% of your expenses from the equation!

Now, let me be clear. Snowflake’s market position is very strong; nobody is refuting that. This funding strategy says nothing about the company, other than how it is doling out shares and then ignoring that fact when it discussed profitability. The company is not profitable today, which makes a near-30x sales multiple look silly.

That said, they will make money at some point. With gross margins rising and approaching 70% right now, the business could easily earn 20% net margins in the future once they get their cost base in-line with other more mature software firms. Those future margins could command a valuation above the market overall (a 30x P/E with 20% margins implies a 6x sales multiple).

Bur the reality today is that the company is growing without any regard to expenses and the only way it is worth this price is if everything goes wonderfully for the next 5-10 years. Many believe that will happen. Gerstner claimed in his interview that SNOW will grow free cash flow 50% annually for many years and that the valuation will stay where it is today - for a total stock return of 50% annually over the same period. Neither of those seem like reasonable hurdles to clear in my eyes, but we’ll have to see how it plays out.

Bottom line: don’t get fooled into thinking that in tech land “free cash flow = profitability.” Normally it does, but not when you use stock-based compensation to a degree never seen in prior economic cycles (not even in Silicon Valley). And for investment managers who don’t hesitate to make their largest position something fetching 100 times revenue, ask yourself if that’s is what history says is a wise move financially, or if more likely that was what their investor base at the time wanted - and thus they had to figure out a way to justify doing it. Why they are still sticking to their guns is a question I can’t answer.

Now Available: Bear Market Blue Chip Bargains

One of the best things about bear markets in stocks is that investors can get pretty good prices for blue chip stocks that trade at material premiums during most of the business cycle. As the market declines we can find more and more examples. Here is one I took a screenshot of a few days ago. Cut in half year-to-date, for a company of this caliber? Wow, despite it being quite overvalued near its peak. Looking back five or ten years from now, how will it look if we put some shares away for the long haul today? Feels like an interesting add to a youngster’s college fund, for instance.

Starbucks Buyback Plan Highlights Why Opportunistic Corporate Buying Is Rare

There are a lot of mixed feelings about corporate stock buybacks depending on which group of stakeholders one polls, but one thing is clear; finding instances when management teams choose to buy mostly when their stocks are temporarily and unfairly depressed is a difficult task. When times are good (and share prices reflect this sentiment), buybacks seem like an easy capital allocation decision for ever-optimistic CEOs and CFOs. When the tide turns cash is conserved and debt repayment takes precedent even as the stock price tanks to attractive levels.

Coffee giant Starbucks (SBUX) is the latest example. With union pressure coming at them in full force, the company suspended buybacks in early April so they could improve operations and employee morale without taking a political hit from returning more cash to shareholders. This week they announced they will resume buybacks in about a year, after their turnaround plan is largely completed. You can probably guess what happened to the stock price during the last five months:

See that wonderful chance for the company to retire shares in the 70’s while sentiment about their relations with employees was at its absolute worst? Yeah, sorry everyone, buybacks were suspended. Yikes.

So if we can’t rely on management to repurchase shares at the best prices, should we swear off the notion that buybacks are shareholder-friendly? A lot of people take that view, but I don’t think it’s entirely fair. Buybacks remain a way to return capital to investors in a tax-efficient manner. Dividend payments force investors to sell a portion of their investment and often results in a tax liability. If you own stock it is safe to assume you want to keep it so forcing a partial sale every three months is not ideal. If you want to sell some, you can do so on your own, and in today’s world for zero commission.

As an investor, it is probably best to think of stock buybacks as equivalent to a tax-free dividend reinvestment program. Your capital stays invested and taxes are avoided, which leaves you and you alone to determine the timing and magnitude of any position trimming. The dividend analogy also rings true because just as dividend payments are executed every quarter no matter the price of the stock, so too are most buyback programs (unfortunately).

All in all, buybacks are probably here to stay even with the new 1% federal tax that begins next year. While I prefer them to dividends (for growth companies especially), it is still pretty annoying when companies don’t match their buyback patterns with the underlying stock price volatility. When a cash cow business like Starbucks adopts the same shortcomings, it’s a good reminder that they are the rule more than the exception.

Full Disclosure: Long shares of SBUX at the time of writing but positions may change at any time

Is It Time To Swipe Right On Match Group Stock?

A little over two years ago, IAC completed a full spin-off of its interest in dating app giant Match Group (MTCH) with the stock around $100 per share and a ~$30 billion equity value (a partial spin was consummated in 2015). As a holder of IAC at the time, I felt MTCH was priced fully and sold the MTCH shortly thereafter.

Lately though the stock has been trading extremely weakly as revenue growth slows down (Tinder and other apps are reaching a more mature state). Match’s stock chart looks more like a profitless tech stock in the current market environment, but in reality this is a really “GARPy” situation because MTCH generates prolific free cash flow and has ever since it started trading on its own in 2015.

At the current $59 price, the equity is valued at about $17 billion with annual free cash flow of $800-$900 million, which means it trades at a market discount on that metric. Given their dominant position in the dating space, this company doesn’t need to trade based on revenue growth to work very well for investors. I expect robust share buybacks and strategic M&A to aid in growing per-share cash flow and earnings for many years to come and it appears the current sell-off is letting new holders get in at a very good price if they are so inclined. Count me as part of that group.

Full Disclosure: Long shares of MTCH at the time of writing, but positions may change at any time