Motley Fool Hidden Gems Investing - The Next Chipotle or the Next Sweetgreen?

Episode Date: May 22, 2023

Mediterranean restaurant chain Cava has filed for an IPO later this year. Will investors be as satisfied as Cava’s customers? (00:21) Jason Moser discusses: - The growth of Cava and the company’s plans for capital raised during the IPO - How Cava could end up as the next Chipotle (or not) - What another big week of retail earnings portends (12:43) A lot of companies are talking about artificial intelligence on their conference calls this earnings season. Ricky Mulvey talks with Motley Fool analyst Meilin Quinn about a business that may be getting a genuine tailwind from AI. Companies discussed: CMG, SG, COST, LOW, BBY, HD, WMT, TGT, CHGG, DUOL Host: Chris Hill Guests: Jason Moser, Meilin Quinn Producer: Ricky Mulvey Engineer: Dan Boyd Learn more about your ad choices. Visit megaphone.fm/adchoices

My name is Shannon Maldonado. I'm the founder of Yowie, a gift shop from the lens of artists and handmade objects. I chose Shopify because when I was testing other platforms, it was definitely one of the most user-friendly. It was important to me to think about where we would be in the future. All of the tools for reading your sales, like planning inventory, they're just right there on your dashboard. For anyone starting a small business, the biggest thing I can tell you is it doesn't have to be perfect. Shopify can help you build upon it. Start your free trial on Shopify.com. Chris Hill. One company is walking the walk on AI, and another company is getting ready for its debut in the public markets. Motley Fool Money starts now.

I'm Chris Hill. Joining me in studio, Motley Fool Senior Analyst, Jason Moser. Happy Monday. Jason Moser. Hi, Eddie. I'm excited about a potential IPO. And potential, I mean, barring something unforeseen, Kava, the Mediterranean restaurant chain, will be going public later this year. They have filed the requisite paperwork. I think we talked about this on MarketFoolery five years ago, because Kava is a private company. But in 2018, they bought Zoe's Kitchen, which was a publicly traded chain that was struggling. And $300 million is the price tag, I remember. And I think we said at the time, it kind of seems like they're basically buying the real estate.

They're going to turn all of these Zoe's Kitchens into Kava's, which they have methodically done. To the extent that you've had the chance to look over the S-1 filing, what stands out to you about this? I mean, I'm excited about it because it's a restaurant I've into. That's how my animal brain works. What would you say you frequent more, Cava or Chipotle? Chipotle. But it's a location-based thing for me. If there was a Cava closer to me than currently exists, I'd be going there more often. Yeah. Where I live, they're kind of right next door to each other almost. I would say I personally favor Chipotle a little bit more, but Cava's right there. And it's the same restaurant concept. It's

For those who are like, what's Cava? I've never been there. It's Chipotle with Mediterranean food. Exactly. Much like I've learned how to make my own Chipotle burrito bowls at home, I've done very much the same thing with Cava. From that perspective, they're onto something. They make good food. You're right. The acquisition of Zoe's back in 2018, I guess, it gave them, ultimately, that intention was the portfolio of real estate. It wasn't to roll in another restaurant concept and be Cava and Zoe's. So, this has ultimately been a multi-years-long transition to basically rid the market of Zoe's, make them all Cava's. And so far, it's working OK. Cava just opened up their 263rd restaurant. And that's along with making all of these Zoe's

transitions along the way. They should have 300 Cava's by the end of the year. So, still, Still, when you look at it compared to something like a Chipotle, it's still a much smaller concept today. For investors, I think that's encouraging. One of the big problems you see with so many of these IPOs, these companies like Uber and Airbnb, is they're going public and they're already so big, you have to question how much growth is actually there. In the case of Kava, it's going public. It will still be relatively small. Good to know that they intend to use the proceeds from the offering for new restaurant openings in general corporate purposes, so this doesn't sound like it's to pay off someone else. But I mean, the company itself

is, I wouldn't say I'm all in, but I definitely am interested to learn more. I mean, reading through this S-1, I mean, the business itself has grown very quickly. The CAVA revenue, and I'm just excluding the Zoes for a second here, but CAVA revenue has grown from $41.2 million in fiscal 2016 to $448.6 million in fiscal 2022. That's just under a 50% CAGR there. Digital revenue, around 35% of sales, which is really strong. You look at the stores themselves, very productive, $2.4 million in average unit volume in 2022. You compare that to something like a Chipotle, which their goal is to try to push it beyond $3 million this year and next. A lot of similarities there. But clearly, Kava, much, much smaller and still just getting the growth engine going.

In the interest of full disclosure, I think of this as a local business. Brett Schulman, who's the co-founder and CEO, is here in the greater D.C. area. He has the experience of running this business for the past 13 years. He does not have the experience of running a public company. But I believe Ron Shaik's group made an investment in Kava Group to help fund that Zoe's acquisition. I think I have that right. And Ron Shaik, who ran Panera all those years, I'm assuming he is advising and helping Shulman as he prepares to be a public company CEO.

And you're right. It seems a little bit like a Goldilocks S1. Do you want to look for the good, or do you want to look for the bad? On the bad side, it's like they've been operating at a loss since 2016. But as you said, they appear to be planning to use the money in the right way. There is this opportunity. And the question on my mind is, is this the next Chipotle, or is this the next sweet green? Because one of those is a much better investment than the other. Yes, you are right. So far, that is the case. I'm going to have to defer my answer here. Oh, yeah, we're not going to know. I don't know. I am hopeful that this is more Chipotle than not. Looking at some comparables, again, you look at these two

businesses side by side to see where one is and where one could go one day. Looking at loyalty members, for example, I mean, Kava, as of April of this year, they had approximately $3.7 million. Chipotle's got $33 million, right? You look at, again, I had mentioned just the sales per store year in and year out. But looking at the market opportunity itself, right? I mean, You see Chipotle with something better than 3,000 stores today versus Kava with hoping to have 300 by the end of the year. In longer term, they see that there's a market for 1,000 or more stores by 2032. I think if you're looking at it from the investing perspective today, that's a fair timeline there. Let's look at this thing out over the next decade and see where it could go.

I mean, if they get to 1,000 stores by then, I mean, it's certainly possible. It's a far more competitive landscape today than it was back when Chipotle came to market. But, I mean, you have 1,000 stores, and maybe they can bring in $2.5 million in revenue per store. I mean, you've got a business that are bringing in $2.5 billion in revenue, and you compare that to the margins of the Chipotle. Maybe it's bringing in $250 million in net income by that point. Nothing to sneeze at there, but it would definitely take some time to get there. One more interesting wrinkle about this business that I think investors will want to watch is, they have a consumer product division. I'm glad you brought that up.

Unlike Chipotle, unlike Sweetgreen, there are hundreds of locations across America that sell kava dips, hummus, all that sort of thing. So, it'll be interesting to watch that part of the business, and to the extent that they can grow not just the footprint in terms of locations, but maybe the product suite as well. Yep. I'm glad you brought that up, because that really does play into their growth strategy. The growth strategy is to open up stores in existing markets, to open up stores in new markets, and then to try to grow this CPG business. Now, is it elite? I don't know. We'll find out in time. But we've seen other companies do a pretty good job with this. You look at something like Panera or Starbucks that have

done pretty well getting that CPG business out there. With Kava today, there are Kava dips, spreads, dressings. I think they sell in more than 650 grocery stores nationwide, including Whole Foods markets. Now, Whole Foods, as we know, owned by Amazon. You just never know. There can be interesting tie-ups there in regard to distribution that could help take this thing to another level. But primarily, the growth is Cava and that CPG segment. It doesn't mean that management can't pursue other opportunities later. But remember what happened with Chipotle, whether it was Shop House or whether it was Pizzeria Locale, all of these different ideas of being able to take that throughput format into different concepts.

We saw how that worked out with them. If we saw Cava's management indicating they wanted to go that direction. I feel like, hey, fool me once, shame on you, but fool me twice. I think I'd look at that one a little bit more closely and maybe not give them as much credit upfront for that if they decided to go that way. It is another big week for retail earnings. Last week, we had Walmart, Target, Home Depot. This week, we've got Costco, Lowe's, Best Buy, Gap. I was saying to you this morning, last week, not awesome. Not necessarily terrible, but not awesome. I'm curious if you think there's any reason to think what we're going to see this week is dramatically different, either to the upside or the downside. I'll just throw out there

that the commentary that we got last week around consumer discretionary spending and big ticket items, particularly from Home Depot, really makes me worried for Best Buy. That's what they do, right? I don't think many people are going to Best Buy for DVDs anymore, are they? Not for a while, no. No. I don't expect really any surprises. I think we're probably going to get information that more or less reinforces what we just learned last week. Ultimately, my takeaway from last week, while I don't know if there are any operations out there that really lit the world on fire, we're certainly seeing this move from products to services. But what

we're also seeing, and I think this is a light at the end of the tunnel here, We're starting to see inventory levels get back to normal. We're starting to see retail inventory levels come back down. Some examples, Target's inventory down 16%. TJX down 8%. Walmart down 9.4%. Raw Stores down 16%. Home Depot was even flat. But ultimately, what that means is, we've been talking about this excess of inventory of the past year plus, and these companies having to really resort to deals in order to just move this stuff. The longer it sits on those shelves, the more obsolete it becomes. It becomes a real challenge. It's encouraging to see these inventory levels coming back down. Maybe things are starting to

normalize. We're working our way through this COVID hangover. I said this to Bill Mann the other day, and I'm going to say it to you now. This is not my last episode of Motley Fool Money. It's not your last, but it is our last together. I just wanted to thank you again for being so game to do the show so many times. I think we've been in the studio together more than anyone else. And I really appreciate that. So, thank you for that. Well, I could go on, and I'm not going to, because I'd probably get a little bit teary. But you're right. I think we probably have been at this together more than anyone here. And that was just because of the good fortune when I got here to just fall ass-backwards

into this concept that you and Mac had come up with back when it was just market foolery. And it was not in the job description when I was hired. I can't tell you how grateful I am to have these past 13-plus years with you, because it's been a lot of fun. You have made me a better investor. But really, at the end of the day, you're just a great friend, and I'm going to miss you tremendously. Jason Moser, thanks for being here.

Thank you. If there's one theme that has emerged on conference calls this earnings season, it's the number of times CEOs have used some version of the phrase artificial intelligence. But one company isn't just talking the talk, and they may have a real tailwind from generative AI. Ricky Mulvey has more. Generative AI has some exciting possibilities, but some companies are going to take a hit as this change shakes out. Joining us now to talk about some of the companies who may be feeling that risk from those chatbots is Motley Fool analyst, Mei-Lin Quinn. Welcome.

Mei-Lin Quinn Hi, Ricky. Great to be here. Great to see you. Great to see you. It's really tough, I think, to guess what the ripple effects of generative AI are going to be, reminds me of those old newspaper cartoons when they would envision the future and you would see helicopter spinners on top of cars and elevators up to Mars. But as we think about the future of generative AI, what are the signs to you that a company could face a real threat from those chatbots? A company could face real threats from chat gbt or other language models if their business model is exposed to

essentially ai's language modeling skills so some of these professions include copywriters tutors copy editors consultants or if a business is exposed to ai's image and video generation skills such as graphic designers and artists and even voice narration there are now AI tools that let you upload an audio sample of anyone you want it could be Ariana Grande and then ask it to narrate text or sing and it'll sound just like Ariana Grande so you can have AI read anything in someone's voice and you'll notice that many of the tasks that i had mentioned these are tasks that people would typically use websites like fiverr and upwork for these are two companies that definitely are at risk from the proliferation and the advancements in ai but fiverr and upwork

they have a pretty diverse set of categories and tasks that they facilitate on their platform. So I don't think AI is an existential risk to these two companies just yet. There are other companies, however, like Chegg, the homework help platform, whose business model relies solely on a pretty straightforward task, which is explaining the answers to homework problems. This is something that AI can already do well and can do for free. So I do not have high hopes for Chegg's ability to keep up with this trend without it completely reinventing its business model. Yeah, Chegg, the education tech company, basically, you could plug in homework problems and they'll give you detailed solutions. In its latest quarter, CEO Dan Rosenzweig

said that ChatGPT was impacting customer acquisition, but not necessarily retention. The retention numbers were still strong, they can still keep their customers. It's going to introduce something called Chegg Mate, which they are describing as homework help with ChatGPT. Apparently, it's better to have their proprietary dataset with ChatGPT to help people with homework. But I don't know if that's enough of a moat or if that dataset can be easily replicated by OpenAI and what ChatGPT already has access to. Yeah, that's a very fair concern. I generally agree. I actually had used Chegg in college. I'll explain how it works quickly for members who might be unfamiliar. Basically, it's used by students and they pay a monthly membership.

So right now, the highest tier costs 20 bucks a month, and that includes a Q&A area where you can ask questions to tutors, which on the platform they call experts. And this membership also includes explanations for homework problems and popular textbooks. And to put it bluntly, almost everything you can use Chegg for,

you can use ChatGPT for. In fact, GPT is even nicer for homework because like I mentioned, it's free, but it's also unlimited. So with Chegg, you're limited to 20 questions a month to ask these experts. And 20 questions might sound like a lot, but I remember encountering this limit a lot in college. And I remember students would try to work around it by asking multiple questions in one post.

And then the experts would get really annoyed and explain that you can only ask one question at a time, I think, because they only get paid per post that they respond to. but with chat gbt is you can really ask it an unlimited amount of questions you can ask it to dumb things down for you you can ask follow-ups you can ask it to go in as much detail as you need to to really understand the problem that you're trying to work through and if i were a student it really wouldn't even be a question that i'd be using gpt instead of chag for homework help And there's something really funny that I want to share. I had actually asked a series of questions on Chegg about three years ago. And in the past month, I've been getting notifications that these questions have been finally answered. They had been unanswered all these years, and they've just now been answered. And so I wonder if that means that perhaps there is not enough of an inflow of questions on the platform because students are going straight to GPT.

So maybe in order to get paid, experts are scrubbing the platform for old questions that have gone unanswered. Or maybe it's just that it's so easy. It's just a matter of copying and pasting into GBT a question that experts are going back and answering questions that might have been too complicated. Yeah, just a funny observation. And I actually did go back to one of those questions that I had asked and put it into chat GBT because I was curious and it gave me a pretty thorough explanation. so you touched on this um i don't see their new customer growth improving much at all even with the addition of this new gpt solution even with uh they have pretty have had pretty solid retention i don't see them being able to sustain this as the current generation graduates from college and there's no new cohort to replace them i don't think it'll be able to pull this off and I'm not exactly sure what this like mysterious proprietary data entails. Chegg hasn't exactly spelled it out and it hasn't explained why exactly this data will enable it to come out

with something more powerful than chat GPT. The way that I see it is that homework is homework and unless it's a written prompt, there's usually only one answer to a homework question and so it could be that Chegg is implying that it can come out with even more accurate answers than GPT with its data, because GPT is known to sometimes spit out false information. But ChatGPT is only getting better. And if I were a student, I would still be inclined to start with ChatGPT. Yeah, it's got a churn problem, because in most cases, your max life for a customer on Chegg is about four years. Now, I'm always hesitant about full paradigm shifts. No one's ever going to go to the gym again would

be an example, or hotels shutting down during the pandemic. No one's ever going to get out of their home again. Chegg is down more than 90% from pandemic highs, and it's facing slower revenue growth. It does have a high retention. It does solve a problem. It's also free cash flow positive and is trading for less than 10 times earnings. Is this a value story? Do you think this is a buying opportunity for long-term investors? I don't. The Warren Buffett quote comes to mind that goes like, it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Chegg is free cash flow positive, but it has a high level of debt. It has $1.2 billion

in debt, which is actually more than its market cap right now. I think it's going to have to make a lot of investments as it works out how it's going to get ahead of these advancements in AI. Plus, it's going to have to pay OpenAI for API access for its Cheggmate feature, and I know that this won't be cheap. I think this will bring down its margins for a while, so I would rather hold off, and I'd rather wait to see whether anything actually materializes in Chegg's plans for Cheggmate. When you think of the signs of a company that could experience more of a long-term tailwind from generative AI, and maybe the CEO is not just filling in the AI square on every analyst's bingo card right now, what

are the signs of those companies that could be seeing those long-term tailwinds? If they're working to adapt and incorporate AI into their business in a way that makes sense and in a way that still gives it an unrivaled value proposition compared to ChatGPT. And I actually think of Duolingo in this way. The language learning app, they're rolling out something called Duolingo Max, which is powered by GPT. And this will couple Duolingo's unique proprietary data. This is data which Duolingo has actually explained. This data includes info on the best ways different categories of users learn and stay engaged on the platform, which order to ask questions in to different users in order to optimize their learning and

keep them on the platform. This isn't data that GPT has, but even more exciting, Duolingo Max will allow users to have role play conversations in either text or speech with a tutor in the language that they're learning. And the speech part I think is what's critical because this gives people a low stakes way to practice speaking a language. I used to actually pay a tutor on Fiverr 10 bucks for 30 minutes, super cheap by the way, but I stopped doing that because I got so embarrassed. We would essentially have conversations in French, but I had to keep saying, you know, can you repeat that? Or I would mingle in, you know, English words in my sentences because I didn't know how to say them in French. I just got so embarrassed and I felt that it wasn't

exactly productive. I think a lot of, you know, beginners, even introverts, even advanced language learners who just want, you know, a speaking partner in their pockets, I can see a lot of people opting for Duolingo Max, especially as it is combined with Duolingo's data on how people optimally learn languages. And especially once Duolingo makes this feature available for more languages. It's also a completely different service, right?

Like, you're looking for a singular text-based solution with Chegg in most cases. Yes. And with Duolingo, it's more of that service where Google Translate is significantly better. You can even use Google Lens to translate signs around the world into your preferred language. Yeah.

But I don't think there's going to be a decrease or maybe there will be a decrease, but I think there always will be a demand for people to learn different languages to connect with others in a more human to human way. Absolutely. And you know what? Duolingo does it so well. It's really got that gamified system down to a T. It's almost made it addictive to learn a language.

I mean, there's a competitive aspect to it with their scoreboard and they're really good about those notifications that they send you. I mean, there are memes about it. They'll send like a literal crying duo bird and something really sad like, oh, like you're not leaving, are you? Like, come back and learn Spanish. But it works. Their marketing has worked really well for them. So, yeah, Duolingo's data to me makes a lot of sense and it's always been one of their moats. So, I'm excited to see them couple that with ChatGPT. Malin Quinn, appreciate your time and your insight. Absolutely. Thank you so much, Ricky.

As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill, thanks for listening! We'll see you tomorrow! you