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When it comes to a delicious and relatively healthy lunch, it’s hard to beat CAVA (NYSE:CAVA).
The fast casual restaurant chain is loved by many, but the stock has only recently begun to find its footing, up more than 140% following a protracted price trough that occurred post-IPO last year:
For reference, we came out with our initial ‘Buy’ rating last September when the stock had just been cut in half, and shares were at $31:
Thankfully, the stock is no longer trading in the doldrums, but some now fear that the risks have piled up in the other direction – that the multiple is now so expensive as to prohibit new investors from entering into the story.
We’re not blind to this, which is why we are following up our initial coverage with today’s article which will focus on a specific trade idea that has the potential to generate strong returns for investors, reduce risks, and plot an entry in the stock at a 23% discount to where the shares currently trade.
With earnings approaching, and the Price / Sales ratio recently reaching all-time highs, we believe that an option trading strategy utilizing a ‘short put’ approach is the best way for income-oriented investors and prospective growth investors alike to maximize risk-reward in the stock.
Let’s dive in to explore this further.
CAVA’s Financials
Before we get to the option trade idea, let’s first recap CAVA’s financials and potential.
In short, in case you haven’t read up on the company or didn’t read our last article, CAVA is a fast-casual restaurant serving up Mediterranean lunch and dinner dishes in a highly customizable format. Think Chipotle (CMG), for Gyros and Chicken bowls:
As an aside, and anecdotally / in our opinion, the food is excellent, if a little pricey and high in sodium.
However, no matter our preferences, the chain has been a hit with diners in many of America’s largest cities. CAVA currently owns and operates 309 restaurants across 24 states, which contrasts with other companies in the space, like McDonald’s (MCD), which primarily franchise.
This has led to an interesting financial profile. Choosing to avoid the asset-light route, CAVA does have weaker margins than some competitors, but it does have more vertical control over growth and quality.
Looking at specifics, the company has done a good job with unit costs, keeping gross margins in the mid to high 30% range, which slightly lags more established companies like CMG but comes in well ahead of other owner-operator outfits like Sweetgreen (SG):
On the operating side, the company has only just begun to produce positive operating margins, but this is mostly a result of higher spend on company growth. CAVA’s restaurant-level profit margins stand around 22.4%, which is encouraging:
Our results in the fourth quarter of 2023 were outstanding with a more than 52% increase in CAVA revenue; 11.4% CAVA same-restaurant sales growth, including a 6.2% increase in traffic; 19 net new restaurants, ending the quarter with 309 restaurants, a 30% increase year-over-year; adjusted EBITDA of $15.7 million, a $12.2 million increase over the fourth quarter of 2022; and net income of $2 million.
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CAVA restaurant-level profit in the fourth quarter was $39.3 million, or 22.4% of revenue versus $23 million, or 20% of revenue in the prior year, representing a 70.7% increase.
This means that growing footprint is a clear path to earning high ROI for shareholders once the company’s economics mature.
Additionally, with strong traffic and same store sales growth, the company’s growing brand and pricing power are both trending in the right direction.
In short, things are going well for the company.
Looking ahead at Q1 earnings, we’re expecting a beat, a belief that is buttressed by CAVA’s straightforward business model and proficient cost controls, as well as strong analyst EPS revision momentum, which has sent the stock higher in recent weeks:
All in all, we’re bullish on CAVA’s operations.
CAVA’s Value
That said, from a value perspective, the stock appears to be anything but a deal right now.
When we first published on CAVA last September, we noted that the stock appeared somewhat rich, trading at ~6x sales, which was more expensive than many other, more well established brands. This is no doubt due to CAVA’s strong growth profile, and their financially feasible plan to reach 1,000 stores (triple the current footprint) by 2032.
However, much of the stock’s recent 140% rally has been due to multiple expansion, as opposed to improved business results.
Since September, TTM revenue has grown from $640 million to $730 million, impressive growth of 14% in only a few short quarters.
However, the company’s top line valuation has doubled, to nearly 12x revenue, which is responsible for a lion’s share of the stock’s gains:
At these prices, there’s serious optimism baked into the stock, and the risk of multiple mean-reversion lower is very real.
If growth slows, or the company sees pressures on margins, then the valuation could easily come back in to where it was – 50% lower than where it sits now.
Overall, we love the company, but we’re concerned about the prospect of new investors entering the stock at this elevated price. Even if the company can sustain growth, it seems likely that the high multiple will hamper upside returns in the stock going forward.
The Trade Idea
Thus, our trade idea – selling put options on CAVA stock.
If you’re new to options, selling a put is essentially like selling insurance. First, the option buyer pays you a premium for taking on some of his risk.
Then, if the stock goes up, sideways, or down a little, you keep the cash premium.
If the stock goes down a lot, you’re forced to buy the option buyer’s stock at a pre-determined price (Strike Price) by a pre-determined date (Expiration Date).
Thus, one of two things always happens when you sell a put – you keep the cash, or you keep the cash, and you need to buy the underlying stock.
If the underlying stock is something you were ok with owning anyway, it can be a really solid win-win.
Right now, we like the July 19th, $60 strike put options:
These contracts are currently trading for $1.50, which represents a 2.56% cash-on-cash return over the next 67 days. This annualizes to a 14% return.
Risks
The purpose of utilizing puts in this situation is threefold. First, it allows investors who may otherwise be on the sideline waiting for a better price (due to valuation risk) to get paid to wait, aiming for an entry that’s 23% below where the stock is currently trading. Selling puts ameliorates this risk and allows for an entry at a better core price.
Additionally, with earnings coming up later this month, this trade cushions investors in the event of a drop. If shares drop considerably following the report, then selling puts would be a far more optimal strategy for investors, cushioning significantly against losses. With the elevated optimism, even a strong beat, which we expect is likely, could send the stock materially lower.
Finally, with a strike price at the recent local low, one could expect a slightly higher level of confluence should the strike price be challenged. A local low at $60 could provide support to shares before or after expiry.
There are some risks to this strategy specifically, including the fact that if the stock collapsed to zero overnight, you’d need to purchase shares at $60. That said, it’s no riskier than buying and holding shares outright.
Summary
Overall, despite the unique risks that accompany selling puts, we think that this trade idea does a good job of balancing risk and reward for investors currently on the sidelines of CAVA. The company’s operations are highly attractive, but the valuation risk, earnings risk, and potentially overbought stock could lead to a retracement that might be better navigated with a short put position.
With a strong cash-on-cash return, we think this trade idea is nothing short of a solid win-win for investors.
We re-iterate our ‘Buy’ rating on the stock. That said, if you’re already long, consider selling some calls on your position to generate income and lower your cost basis.
Good luck out there!
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