2023-08-14 09:47:59 ET
Summary
- Sweetgreen has strong revenue and gross profits growth of a new start-up.
- But its earnings and free cash flow actually fare worse than some of its competitors that it aims at overtaking market shares from.
- The company's debt profile change will erode medium term cash flow.
- Market is overly optimistic about its growth pace and potential.
Investment Thesis
Company Overview
Sweetgreen ( SG ), founded in 2006 with headquarter in Los Angeles, CA, is a salad restaurant chain that provides fresh salad and grain bowls with locally sourced ingredients to customers ordering online or in-store. It has over 204 restaurants in the US. Its menu includes Core Menu, Custom Menu, and Sides & Attachments, from a selection of salads, frozen yogurts, nutritional specialties, and seasonal options.
Strength
Launched not too long before the pandemic, Sweetgreen catered to a need among health-conscious customers to eat organic food daily in a convenient way. As the company touted, Sweetgreen's advantage can be summarized in one word - fresh. Its ingredients are plant-forward, locally sourced, and prepared fresh daily, "free of highly-processed preservatives, artificial flavors, and refined or hidden sugars", etc. This is, along with meeting strict ESG standards, making it "sweet". The need for healthy salad and grain bowls was greatly boosted during the pandemic and the company has seen steady growth since it went IPO. The company has doubled its revenue since Q3 of 2021 from around $250 million to currently $520.18 million. And its gross profit went from negative $8.7 million in 2021 to currently $80.97 million on a TTM basis. It is a rapid growth that
Sweetgreen's currently 204 restaurants are mostly concentrated in the bi-coastal and mid-west states with also a presence in Texas, Colorado, Georgie, and Florida on the South. The company is aligning its growth potential with other fast food household names such as McDonald's ( MCD ), Chipotle ( CMG ), Panera Bread ( PNRA ), and Shake Shack ( SHAK ), stating that its size is only a fraction of its potential. These names also happen to be its direct competitors, since all of them provide at least to some degree healthy food selections. To further expand into other urban or rural areas, the company will face competition from established restaurant chains and local restaurants that it will increasingly need to differentiate itself.
Sweetgreen: Restaurant Location (Company Presentation)
Sweetgreen has been able to gradually cut down the restaurant operating costs from over 96% in March 2021 to currently about 79%. Its total operating expenses, which do not include the restaurant operating costs, have been fluctuating between 40% to 60% since its IPO. The past quarter recorded the lowest level at 40.87%. To add them up, the costs and expenses account for about 120% of its revenue, down from almost 140% two years ago. We applaud the company's efforts in slashing costs while maintaining the topline growth, but would expect the company eventually bring them down to less than 100% of the revenue in order to gain a positive earnings margin.
Sweetgreen: Restaurant vs General Operating Expenses (Charted by Waterside Insight with data from company)
Although it is still firmly in the negative, there has been a gradual improvement in the company's free cash flow. Apart from the seasonal fluctuation, a YoY improvement of about 20% can be accounted for.
The company's cash flow from operating activities has seen some decline after its IPO, while the company reported large financing activities in the year it went IPO, and its cash flow from investing has gradually increased in the range of $70 to $100 million annually. But so far in 2023, its operating cash flow has turned slightly positive.
Sweetgreen: Net Cash Flow breakdown (Bloomberg)
Weakness/Risks
Both Sweetgreen's net income and EBITDA on a TTM basis, not only haven't grown but actually decreased. While its TTM net income was negative $141.22 million in '21, it is down to negative $162.12 million. And its TTM EBITDA went from $117.39 million in '21 to $142.54 million in '22. Although its Q2 this year's data seemed to be better YoY, we look at it on a TTM basis because the company has seasonality embedded in its performance. The concern here is without a substantial improvement in net income and earnings, it is hard to see it become sustainably free-cash-flow-positive. This is important to the market's expectations, which we will delve into later.
For Sweetgreen, the fast accumulation of its debt in 2022 became noticeable. In Q4 last year, the company tripled its total liabilities, increasing mostly by long-term obligations. Although this is a wise construction of the debt profile as its ST debt remains a quarter of LT debt, the ST debt is still 50% more than where it was. However, in comparison to its earnings, its debt-to-EBITDA ratio in 2021 was negative 1.33x, and negative 3.75x in 2022. Now after the large increase, it stood at negative 6.33x. In comparison, Shake Shack ((SHAK)) has a 6.09x for debt-to-EBITDA but it is a positive ratio since it has positive EBITDA.
Sweetgreen: Debt Accumulation (Charted by Waterside Insight with data from company)
Although they are not exactly a one-to-one comparison in terms of their serving menus and customer bases, Sweetgreen is benchmarking its growth potential against Shake Shack in its company presentation, we decided to take it up at face value. Since 2021, Shake Shack's EBITDA seems to have a more steady growth rate with an upward trajectory on the margin than Sweetgreen's. The affordability of Sweetgreen's debt from this perspective renders a less optimistic picture.
The company extended five different sales channels to serve customers, including In-Store, Marketplace, Native Delivery, Outpost and Catering, and Pick-Up. The multi-channel way to serve its clients could get the food much more quickly and conveniently to its customers. But the marketplace delivery, which includes utilizing Caviar, DoorDash, Grubhub, Postmates, and Uber Eats, risks the third-party vendors not only possessing the customer data but also could encourage the customers to look elsewhere from its competitors for meeting their future demand. We don't know what portion of its sales go through the Marketplace, but even if it is one-fifth of the total sales, it still has an impact in urban areas with stiff competition.
Big Picture
The packaged salad market in the US is expected to grow at 7.6% CAGR in the next ten years, according to Grandview Research. This could serve as a broader demand indicator on the particular venue of salad and grain bowls Sweetgreen is serving in. To achieve a higher growth rate than that, the company will not only need to take away competitors' market share but also create more organic growth of its own.
US Packaged Salad Market Growth Trend (Grand View Research)
Financial Overview
Sweetgreen: Financial Overview (Calculated and Charted by Waterside Insight with data from company)
Valuation
In order to properly value Sweetgreen, we ask, when will the company turn free cash flow positive? Judging by its performance YTD, its free cash flow for the first two quarters this year has improved by 21% compared to the 1H of last year. The company's same-store sales change was 25% in 2021 and 13% in 2022. If we assume the average of such growth, which would be 19% annually, combined with the restaurant operating cost to decrease by 1% per year, the average of its past two years, it is not unreasonable to say it will grow by 27% per year for its cash flow. Without other dramatic changes, it will still not reach positive cash flow in ten years.
But that assumption is too optimistic. Its annual net loss from operation is widening by 8% in 2021, and again by 24% in 2022. With its added debt load, even though it is dominated by long-term debt, it will still gradually erode into its earnings and cash flow.
The most likely scenario its current market price in the low teen's implies is FCF turning positive within the next five years, which requires the company to have at least one triple-digit annual growth event before 2028. Currently, we don't see a strong catalyst that will catapult the company to achieve so. Without such an event, it is likely that it will not meet the market's expectations within the five-year horizon.
Conclusion
The overall growth trend of Sweetgreen is turning upward with strong momentum in its topline performance. But the speed and scale of the company's growth that the market is currently pricing in is too high. We have doubts that the company will be quick enough to achieve that in order to make the current valuation valid. Bar a dramatic change within five years' time, the current price is far overvaluing the stock. We recommend a sell at this point.
For further details see:
Sweetgreen: Waiting For A Catapult Event