The restaurant industry tends to be a sleepy sector in the stock market. There are a handful of stalwarts like McDonald’s and Starbucks that investors rely on for steady growth and dividend income, and occasionally, a breakout growth stock emerges as well. Chipotle and Domino’s Pizza are two of the better examples over the last decade.
One recent restaurant initial public offering (IPO) that’s caught investors’ eyes is Cava Group (CAVA -0.47%), the fast-casual Mediterranean chain that is growing rapidly. However, the stock has fallen since the post-IPO rally this summer, potentially setting up a buying opportunity.
Should you add Cava stock to your portfolio? Let’s take a look at the buy, sell, and hold cases for this hot new restaurant stock.
Buy Cava: It could be the next Chipotle
Shares of Chipotle Mexican Grill are up a whopping 4,800% since their 2006 IPO, and for years, investors have been looking for the next Chipotle. Plenty of fast-casual wannabes have come and gone since then, proving that finding the next Chipotle isn’t as easy as investors thought.
However, Cava bears a striking resemblance to Chipotle both in its business model and in its financials.
In many ways, Cava resembles a Mediterranean version of Chipotle, and its menu is strikingly similar. Like Chipotle, Cava offers bowls, salads, and rolled-up pitas that are functionally burritos.
That, in and of itself, wouldn’t be cause for celebration, but Cava’s results show the product is clearly resonating. In its third quarter, revenue jumped 49.5%, driven by 14.1% same-store sales growth. Its restaurant-level profit margin reached a Chipotle-like 25.1% in Q3. By comparison, Chipotle reported a restaurant-level profit margin of 26.3% in its Q3. Similarly, Cava’s average unit volume, meaning the average annual sales per restaurant, was $2.64 million as of Q3, compared to Chipotle at $2.97 million
Cava also reported a generally accepted accounting principles (GAAP) profit in Q3, and margins should expand as the company adds more locations. Based on those numbers, there’s a lot to like about the business.
Sell Cava: It’s still too expensive
Probably the strongest argument for selling Cava stock at this point is that its valuation is still too high. The stock trades at a price-to-sales ratio (P/S) above 5, and its profits are still minimal, meaning its price-to-earnings ratio isn’t meaningful.
Chipotle is actually slightly more expensive at a P/S of 6, but the burrito maker is much more profitable.
Investors shouldn’t expect Cava’s current growth rate to continue at the current pace. Restaurants have enjoyed a boom year as customers return to eating out following the pandemic, but there are already signs that that momentum is slowing. It’s rare for any retailer or restaurant chain to maintain double-digit comparable sales over the long term, and Cava’s recent comparable-sales growth owes partly to a price increase, which is not a sustainable way to grow sales.
While Cava’s valuation has gotten more reasonable, this is still an expensive stock and profits are negligible.
Hold Cava: It’s too early
Buying an IPO stock is generally a risky proposition. It often takes several months for the stock to reach an equilibrium point in the market, and investors sometimes need to see a few earnings reports to get a sense of how the company is performing and where it’s headed.
It’s still been less than six months since Cava’s IPO, and the economic landscape is fast evolving as is that of the restaurant sector. Waiting for the story to develop doesn’t seem like a bad idea at this point.
What’s the verdict?
Cava shares are down nearly 50% from their peak this summer, but investors should expect volatility to continue, considering this is still a recent IPO.
Given the options above, the best move is to open a small position in the stock. Cava shares could fall further, but its growth rate and restaurant-level profit margins are clearly impressive and should put a floor on the stock unless they suddenly change. Buying a small stake in Cava stock is a great way to gain exposure to a fast-growing restaurant chain with a lot of upside potential while limiting your downside risk to the new IPO.
Jeremy Bowman has positions in Chipotle Mexican Grill and Starbucks. The Motley Fool has positions in and recommends Chipotle Mexican Grill, Domino’s Pizza, and Starbucks. The Motley Fool recommends Cava Group. The Motley Fool has a disclosure policy.