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Cava Needs to Keep This Number Strong if It Wants to Keep Growing

Motley Fool - Tue Sep 19, 4:25AM CDT

Recent IPO stock Cava Group(NYSE: CAVA) has hit the ground running, offering a Mediterranean food concept that appears to be resonating with consumers. That's great news and could turn the brand into a hot growth stock.

Still, investors with an interest in this restaurant stock need to make sure that this doesn't turn into a "growth at any cost" story, which would be bad for the company and its shareholders. Store-level profit margin is one number that can help you figure it out.

Cava: It's easy to grow when you are small

If there's a big-picture story with Cava, it has to be the fact that it is still small. At the end of the second quarter, the restaurant company had just 279 restaurants. That's pretty tiny. By comparison, Chipotle(NYSE: CMG) had roughly 3,250 locations. This is great news on the growth front because each new Cava location meaningfully adds to the top line.

A person rating their experience at a restaurant using an app on a cell phone.

image source: Getty Images.

Cava is expanding quickly and plans for more growth ahead. To put some numbers on that, the store count stood at 195 at the end of the second quarter of 2022. So in a single year, management increased its store footprint by a huge 43%. That's not a sustainable rate of expansion and was probably related to the initial public offering the company initiated in 2023. Basically, management wanted to start off with a bang to attract investors.

Wall Street loves a growth story, and the easiest way to grow a small food concept is to open new locations at a rapid clip. But management is still eyeing fairly rapid store growth, explaining during the second quarter 2023 earnings call that it is focused on a 15% expansion each year for the next few years.

Trust but verify Cava's success

That rate of expansion should keep Cava's top line growing nicely as long as the company can keep it up. But there are risks that shouldn't be ignored. For example, opening new locations too close to one another could lead new stores to cannibalize older ones. In addition, the company could saturate key markets, which might mean less demand overall for the brand if customers begin to see it as less exciting. These are issues into which same-store sales will provide some insight. If same-store sales are weak, the pace of expansion might be too fast.

However, there's another issue you'll want to watch closely. Opening a lot of new stores is not easy. Cava will have to find locations, build out the stores, and hire and train employees. If the company pushes too hard on the accelerator, it could make a misstep here that ends up causing new stores to be less profitable than expected. For example, poorly trained employees (or high employee turnover) could lead to awful service that drives customers away and/or creates costly food waste. There's also the risk that a focus on new stores draws attention away from ensuring strong performance at already-opened locations. In this case, existing stores could start to be less efficient and profitable than hoped.

To track that, investors should monitor store-level profit margin. Right now, things are going very well for Cava, with store-level profit margin rising to 26.1% in the second quarter compared to 25.4% in Q1 and 22.1% in the year-ago period. Management's doesn't expect this success to last and is targeting 23% for the metric.

Investors should make sure to hold the company to this self-imposed standard. Anything less will indicate that management's efforts to open new locations aren't going according to plan. That will remain true even if the top line keeps expanding, which it likely will given the revenue being added by the new stores even if they are poorly run. Indeed, a growing top line can hide weak execution, and you'll want to dig in a bit deeper to make sure that Cava's growth story isn't changing for the worse.

There are a lot of failed restaurant concepts out there

This isn't meant to dissuade investors from buying Cava, only to warn that Wall Street's desire for growth can lead companies to make bad decisions. This actually happens a lot in the restaurant space, and it usually takes the form of opening too many new locations too quickly. If you own Cava, make sure you keep close track of the growth it achieves. That means looking beyond revenue at things like store-level profit margin to gauge the company's actual success.

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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Chipotle Mexican Grill. The Motley Fool has a disclosure policy.

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