Sweetgreen doesn't seem to resonate with consumers across the US and the stock will likely continue to struggle

2023 has been a great year for the restaurant industry. Cava ($CAVA), the Mediterranean restaurant chain went public in June, and its IPO was a big success. Other restaurant brands like Chipotle ($CMG) and Wingstop ($WING) have also delivered solid results this year, amid resilient consumer spending and falling inflation. A rising tide lifts all boats and this is the main reason Sweetgreen's ($SG) stock has rallied 62% this year.

However, this solid performance is primarily driven by the overall market rebound rather than the company's fundamental performance. In fact, SG is facing serious growth issues. It's the only high-growth restaurant chain that is seeing a decline in traffic, which is a red flag for a restaurant brand and it may be a sign that the company doesn't have the potential to become a national player. On top of that, it still remains unprofitable.

The rapidly slowing growth and lack of positive income is a toxic combination for investors, making Sweetgreen a risky investment, at least for now. Let's delve a little deeper.

Underperforming In The Post-Pandemic World

SG is primarily an urban brand. The founders opened their first restaurant in Washington DC to offer busy professionals quick and healthy lunch options. The company has become very popular in densely populated cities and regions with a younger and health-conscious demographic such as NYC and LA. In fact, one-third of the restaurants are located in these two cities, suggesting that the company has concentration risk.

Millennials and Gen Zers are more health-conscious than older generations, benefiting Sweetgreen's business. However, other trends are not so favorable. Before the pandemic, salad bowls were a popular and convenient choice for a quick lunch. Yet, with remote and hybrid work becoming the norm, the demand for these salads has waned. This shift in consumer behavior poses a real challenge to Sweetgreen's growth prospects. Fewer full-time office workers mean lower demand for Sweetgreen bowls as office workers were the main Sweetgreen customers before the pandemic.

The company has likely started to see the negative impact of the growing work-from-home trend in big cities. In Q2, same-store sales were up only 3% y/y, missing analyst estimates of 4.1%. Even worse, same-store sales were entirely driven by a 4% increase in menu prices and were partially offset by a 1% decline in traffic. The decline in traffic is a concern because it’s a company-specific issue. For example, Wingstop saw a 16.8% jump in same-store sales in Q2, which was almost entirely driven by transaction growth. Over the same period, Chipotle's same-store sales rose 7.4%, driven by a combination of price increases and increased traffic. In other words, SG's traffic decline is a sign that the company might have already saturated its most lucrative markets, and the post-pandemic boom has limited its growth prospects.

While the current trends are not very encouraging, SG could reaccelerate its same-store sales growth by introducing new products that appeal to a broader set of diners. In fact, they’ve already started to do just that. They've recently introduced salami and barbecue sauce to appeal to non-salad folks and increase their traffic. They also plan to launch new warm menu items for the winter months. These are interesting initiatives that could yield positive results and potentially boost the weak same-store growth figures.

Artificially Improved Bottom Line And Slowing Growth

Sweetgreen missed analyst estimates across the board in Q2. Its revenue grew 22% y/y in the second quarter but missed estimates by $3.6 million. Same-store sales growth also missed estimates and the average unit volumes were flat y/y at $2.9 million. These are all red flags that Sweetgreen may not have the potential to become a national brand like Chipotle and Wingstop. Instead, it may remain a niche restaurant chain, popular in big metropolitan areas where affluent office workers are primarily based.

The company opened 10 new restaurants in Q2 and exited the quarter with a total of 205 locations. It opened 19 new restaurants in the first half of the year and expects to open between 30 and 35 for the full year. This translates to between 11 and 16 new units in the second half, which is a significant slowdown in footprint expansion both sequentially and yearly. In the second half of 2022, SG opened 20 new restaurants, meaning that their 2023 guidance suggests a y/y slowdown in unit expansion of between 20% and 45%. This may be another sign that the company has saturated its most lucrative markets and is now struggling to grow in rural America where there are fewer high-paid office workers.

SG is also deeply unprofitable primarily because of its very high general and administrative (G&A) expenses. In Q2, the company spent 26% of its revenue on G&A. While this is significantly improved compared to the 41% G&A spend in the year-ago quarter, it’s still much higher than most other financially healthy restaurant brands. For example, Chipotle spent only 6.2% of its revenue on G&A in Q2, and Kura Sushi USA ($KRUS), another high-quality niche restaurant chain, spent 14% of its revenue on G&A in Q2. This shows that for some reason, SG is spending too much money on administrative stuff, keeping its bottom line in the red.

The company delivered an adjusted profit of $3.2 million in Q2, translating to an adjusted profit margin of 2%, versus a negative income margin of 6% a year ago. However, this is an artificial profit. The company added back $5 million in restructuring expenses in Q2 to achieve this adjusted income of $3.2 million. If we exclude this one-time expense, we'll see that SG's adjusted income margin for the quarter was actually -1.2%, meaning that the company is still unprofitable even on an adjusted basis.

What About Valuation

SG stock has plunged 72% since it went public in November 2021 because of the concerning underlying trends. It now trades at a PS ratio of 3x, which is much cheaper than the PS ratios of other high-growth restaurant chains like Chipotle ($CMG) and Kura Sushi USA ($KRUS). This is a fair valuation for the company considering its uncertain growth prospects and its lack of profitability. If same-store sales growth reaccelerates and profitability improves, the stock has multiple expansion potential. Yet, if same-store sales figures continue to disappoint, the stock will continue to struggle despite the reasonable valuation.

What Else

Sweetgreen is a questionable growth story as the company has yet to prove that its restaurant concept resonates with consumers across the US. It does have a loyal customer base in large metropolitan areas, but data shows that it may have already saturated its most profitable markets. The declining traffic amid a strong period for other restaurant chains is a concerning sign. On top of that, the lack of profitability shows that the company doesn't operate efficiently enough.

However, a new restaurant concept called "The Infinite Kitchen" has the potential to significantly improve unit economics. The Infinite Kitchen is SG's first fully automated restaurant, which opened earlier this year in Naperville, Illinois. This restaurant can operate with one-third of the workers of a typical store with a similar volume, meaning that it can boost the company's unit economics and, as a result, its overall profitability.

On the top line, menu innovation can help reaccelerate same-store sales growth by attracting a wider customer base. In other words, SG has the potential to become a turnaround story. But, for now, it's a risky investment with downside risk.

I'm long WING.

The boring Disclosures: Newsletters express the opinion of the authors. Nothing in this email is a buy or sell recommendation. I'm not a financial advisor; make your own decisions.