2023-11-09 17:00:48 ET
Summary
- Since the Q3 earnings report, Sweetgreen's stock has fallen by 16%, bucking the trend as restaurant stocks generally underperformed the S&P 500.
- Macro risks include a potential decline in consumer spending in 2024, which is pressuring the valuations of high-growth restaurant companies like Sweetgreen.
- Sweetgreen's conservative outlook for 2024 includes a reduced store count growth and a slower deployment of Infinite Kitchens compared to 2023.
- Sweetgreen's Sweetpass membership program has so far had a marginal impact on comparable sales growth.
- Despite a cautious growth outlook, Sweetgreen expects restaurant margins to continue expanding in 2024, thanks to initiatives like the new protein menu. Sweetgreen remains attractive on a relative valuation basis compared to its peers.
Investment Thesis
Our original hypothesis stated that Sweetgreen, Inc. ( SG ) was differentiating itself from its competitors with the launch of the Sweetpass Plus membership program, having strong revenue momentum, and trading at a relatively low comparable valuation. This quarter, the company forecasted that its store count growth in 2024 would be slower than in 2023 and that Sweetpass would not contribute growth comparable near term. When combined with the industry's general pessimism regarding restaurants, these factors have caused the stock to decline by 40% from its peak in July.
First, even with the recent decline, we still think the valuation is attractive when compared to peers.
Second, the business launched protein menus and an Infinite Kitchen format store, to the delight of customers. Long-term margin improvements and an expansion of its addressable market should result from these actions.
We observe that the business is maintaining its margin growth in spite of immediate pressure. We conclude that the stock is still appealing at this price. We continue to rate it as bullish.
Sweetgreen's Q3 Earnings Amid Weak Consumer Sentiment
Sweetgreen reported its third-quarter earnings results on November 2, 2023. The company's revenue grew by 24% compared to the same quarter last year. Same-store sales grew by 4%. Sweetgreen achieved a restaurant-level margin of 16%. These results are impressive given the weak consumer environment in the United States right now. However, since reporting earnings on November 2nd, Sweetgreen's stock price has dropped by 16%.
Sweetgreen Outshines in the Restaurant Sector
In general, restaurant companies grew revenues at strong double-digit rates in the quarter. However, stocks in the restaurant sector actually underperformed the S&P 500, which was up 5.94% in the same period, with one exception. Sweetgreen was the only restaurant stock that outperformed the S&P 500, with its stock price up 7.8% in the quarter. Other than Sweetgreen, restaurant stocks as a group lagged the broader market, even though their business fundamentals showed strong double-digit growth in the quarter.
Macro Risks
One of the primary reasons for the weakness in Sweetgreen's stock performance seems to be pessimism about the consumer spending environment in 2024. We view this negative sentiment as having a negative impact on the high valuations of high-growth restaurant companies. Restaurant companies are still experiencing strong growth in their financial results this year. However, as the chart below suggests, the growth rate of consumer spending (red line) has been gradually trending down over the course of 2023. Further, US consumer credit card balances (blue line) have also slowed down as banks have started to slow lending in response to negative deposit growth (green line). This softening consumer environment is likely to slow down the growth of restaurant companies.
However, if inflation further slows in 2024, consumer spending patterns may also change. Thus, we view the current pessimistic sentiment as something that could shift if consumer spending reaccelerates in 2024.
Company Specific-Risk Factors
Looking at company-specific factors, we attribute the selloff in Sweetgreen's stock to muted growth drivers for the following:
1. Store count growth in 2024 will be lower than in 2023.
2. The deployment strategy for Infinite Kitchens, Sweetgreen's network of urban kitchens for digital orders, is progressing at a pace lower than expected.
3. Sweetpass will not contribute to comparable sales growth in the near term as much as previously thought.
Conservative 2024 Growth Outlook
Sweetgreen's management guided a slowdown in restaurant count growth in 2024. They expect to open only 23-28 new restaurants in 2024, down from 35 opened in 2023. Management also remained cautious in their outlook for the uncertain economic environment in the fourth quarter of 2023. This reduced store growth guidance for 2024 should have a negative impact on Sweetgreen's valuation.
We kind of head into the fourth quarter and we are kind of cognizant of all the consumer uncertainty that we hear and read about.
Infinite Kitchen Deployment and Margin Growth
In addition, Sweetgreen's management is taking a conservative approach to developing its Infinite Kitchen concept in 2024. They plan to open only 7-9 new Infinite Kitchen units and retrofit just 2-4 existing restaurants into the Infinite Kitchen format.
Looking ahead to 2024, we anticipate deploying approximately 7 to 9 Infinite Kitchens into new units and 2 to 4 retrofits.
This also implies that margin improvement could be lower than what the market was expecting following Sweetgreen's second-quarter results. In the Q2 report, management had expressed excitement about the first Infinite Kitchen having a 26% restaurant-level margin, similar to Chipotle Mexican Grill, Inc.'s ( CMG ) level.
However, with updated plans for new Infinite Kitchen deployments in 2024, the pace of margin improvement for the overall company is likely to be more modest than anticipated after the Q2 announcement. The Infinite Kitchen format offers labor efficiencies and higher margins compared to traditional Sweetgreen locations. However, with fewer locations coming online, the positive impact on overall margins will not be as significant in the near term.
Today, the Sweetgreen Infinite Kitchen has the capability to produce between 400 and 500 bowls, plates, in size narrowed 50% more than a restaurant's front and digital make line combined... While we do not plan to disclose this metric quarterly, the restaurant-level margin for Naperville in June was 26% significantly higher than any new restaurant opening in its first month.
We checked Google ratings of Sweetgreen's Infinite Kitchen in Naperville and saw it currently has 4.3 stars, which is considered great. However, there are some negative reviews related to food safety complaints where consumers reported finding hairs in their food. Given this, management's conservative approach toward expanding Infinite Kitchen makes sense.
Google
The excitement after the Q2 earnings call about the high margins for the first Infinite Kitchen was muted on the Q3 call. Management mentioned they would prioritize deploying Infinite Kitchens only in high-volume urban stores. This suggests they may not achieve a system-wide upgrade to the Infinite Kitchen format. Hence, long-term margin expectations should be lowered.
The retrofits will be in high-volume urban stores, where we are most interested in understanding how fast their throughput will translate into higher revenue and flow-through, and thus a higher return on capital.
So while the Infinite Kitchen concept shows promise, management is taking a measured approach to expanding it. This has caused a reassessment of the potential for margin improvement in 2024 and beyond.
Sweetpass Contribution
Moreover, Sweetgreen introduced a membership program called Sweetpass to help retain customers. However, despite charging $10 per month for Sweetpass Plus, customers also get $3 off per day. Hence, the discount should lower the revenue. Based on management's comments, this membership program is expected to have limited contribution to comparable sales growth in the near term.
Analyst:
what impact Sweetpass has had on comps so far, or is it too early to say?
Sweetgreen management:
I would say very marginal so far. As I mentioned earlier, we are very much in the enrollment and acquisition period, more of an investment period. And as we build that membership base, we will move into leveraging it.
On the bright side, we think the above issues dampening growth are near-term in nature. Management still expects restaurant margins to expand next year, even without factoring in the additions of new Infinite Kitchen stores.
We do see our restaurant level margins to continue to expand year-over-year. We believe next year in 2024, they will exceed 2023.
One compelling reason for optimism is Sweetgreen's recent launch of a protein menu, which should expand its addressable market. Management said the protein menu has received great feedback since launching and can increase the percentage of customers dining at Sweetgreen for dinner. Currently, only 35% of Sweetgreen's customers visit for dinner, as salads are a more popular lunch choice than dinner. The protein menu additions are likely to drive higher average order values and lift restaurant margins.
It really removes the veto vote in many cases, which we are really focused on driving that with our kids meals. And it does help us on dinner as well. We have talked about the fact that dinner is about 35% of our business today.
So while Sweetpass membership and scaled-back growth plans have weighed on the stock, positives like the new protein menu show that Sweetgreen still has avenues to drive growth ahead. The near-term growth headwinds appear transitory, with the company well-positioned for margin expansion and increased dinner business in 2024.
Sweetgreen's Relative Valuation Appeal
Despite the lack of clear growth drivers currently and overall pessimistic sentiment around the restaurant sector, we think Sweetgreen's valuation remains attractive on a relative basis. Compared to its high-growth peers that are generating strong margins, Sweetgreen's stock trades at a lower Price/Sales ratio.
In addition, the company is still expected to increase its restaurant-level margins in 2024 through the additions of Infinite Kitchen locations and the new protein menu. We don't view the slowdown in restaurant unit growth as a major negative for the stock. The market still expects Sweetgreen to improve earnings and grow revenue by 14% in 2024, even with more modest unit expansion plans.
In addition, Sweetgreen currently generates revenue of $549 million, which is much smaller than peers like Shake Shack Inc. ( SHAK ) that have broader menu offerings beyond salads. We think Sweetgreen's revenue scale is impressive considering its primary products are salads. The total salad market is $4.9 billion , far smaller than the $595 billion fast food market. This indicates the potential for Sweetgreen to significantly expand its reach as it moves beyond just salads.
Conclusion
The primary risk we see is a general slowdown in consumer spending in 2024. However, we believe the market's expectations for Sweetgreen are more pessimistic than warranted. As such, we still view Sweetgreen as a relatively safer bet compared to others in the restaurant group.
While the market is forecasting a slowdown in growth next year, we see positives like the newly launched protein menu enabling Sweetgreen to expand its addressable market over the long term. This menu expansion provides a great opportunity for the company to move beyond salads into the larger fast casual segment.
Given the long-term growth potential from initiatives like the protein menu, we believe the current negativity around the near-term unit growth slowdown is overblown. Sweetgreen still has levers to drive growth despite economic uncertainty.
While slowing consumer spending presents a risk, Sweetgreen is relatively well-positioned in the restaurant sector in our view. We maintain our Strong Buy rating as the company's long-term growth prospects remain very strong, especially with recent menu innovation opening up new opportunities.
For further details see:
Consumer Spending Fears And Their Impact On Sweetgreen's Valuation