As institutional investors specializing in IPO investing, our team at IPO Prophet have observed how macro forces like interest rates, market risk appetite, and valuation influence new offerings. Over time, we have developed a trading framework that treats IPOs as repeatable events, allowing us to focus on market dynamics rather than just company-specific fundamentals. In this framework we have developed tools to help us navigate volatility such that we can handle risks associated with volatility while companies help the market identify a fair valuation for their stocks. The following “case study” is a post-trade reflection on a 2023 IPO and how we at IPO Prophet navigated it.
The recent earnings release from Cava Group, a relatively new Mediterranean fast-casual restaurant chain, that went public in June of 2023 is a great case study in IPO dynamics, fundamental analysis and valuation. Cava went public June 15, 2023 pricing 14.4 million shares at $22.00. Trading opened at a jaw-dropping price of $42.00 and held strong throughout the day to close at $43.54. This one-day performance was one of the few bright lights in the IPO market last year. From the first day of trading for the company, and even prior to the IPO, investors questioned the lofty valuation the company had received and if it was sustainable. Quickly investors began building short positions and the short interest as a percentage of the float exceeded 10%. Short interest has remained high throughout the stock’s public market existence and this became increasingly painful for CAVA bears when the company delivered its Q2 2024 results with the fourth consecutive estimate beat last Thursday night.
Cava reported a blowout Q2 2024 earnings report Thursday night. Revenue came in at $233.5 million, up 35% compared to the same quarter last year. This exceeded the consensus estimate of $219.47 million by 6.4%. EPS landed at $0.17, beating the $0.13 forecast. That’s a 202% surge in net income, with margins improving to 8.5% year-over-year.
In IPO investing, we do fundamental and valuation work on prospective IPOs but we have also come to appreciate the idea that valuation work serves as a disqualifying factor for companies when growth and margin metrics are inferior to their peers and the company is trying to attain a comparable valuation to superior companies. In short, if the company’s valuation cannot be supported at the prices in the proposed offering range, we get skeptical of the offering. When we look at the growth profile of a company and can see it trading at least at the same multiples of its peers, we become less concerned about valuation. In fact, many success stories in the IPO market tend to trade at ridiculously high valuations to their peers for quite some time. In general, we believe this happens for two reasons. First, companies typically float a relatively small number of shares in an IPO creating a scarcity premium in the shares – especially if they execute on their growth strategy. Often this scarcity premium draws short investors who are skeptical of the valuation and the company’s ability to execute. Secondly, a level of conservativism in growth and earnings forecasts is in the company’s, underwriters’, and investors’ collective best interest. This is where Cava is a great illustration of how these dynamics can play out.
The aspect of a small offering creates a dynamic that if the company’s story is well-received, investors’ demand will not be fully met through the offering and there will be follow-on interest for shares. These are steps one and two toward the successful float of a new issue – a completed initial offering and subsequent demand sending those shares toward higher prices. This aspect almost immediately creates valuation concerns in the short-term as basic supply and demand forces drive the stock above initial valuation measures. Often this gets compounded by early desires for conservativism in initial earnings forecasts, but this conservativism is part of the third critical step toward a successful initial share float – exceeding expectations. Here Cava offers a great illustration:
These increases highlight how difficult valuation can be in newly issued companies. This stock, from a valuation perspective has been expensive throughout its existence but it hasn’t been as rich as it has appeared by virtue of the company’s outperformance in delivering results. So how do we look at situations like this at IPO Prophet? We use quantitative signals in an effort to anticipate where we might expect situations like this to appear but we employ risk controls to identify when that momentum might turn. We get into trades like this knowing that the valuation is elevated but we believe the winners will deliver results like Cava has. These types of scenarios do occur with some frequency and if you know how to play them, they can work very well. Cava was flagged by our systems as a bullish opportunity, and it has proven to be a strong performer. If you'd like to learn more about how our platform can help you navigate IPO trading, we’d be happy to arrange a call or demo of our tools.
Sample View: IPO Prophet CAVA screen on day of IPO. Pre-open Bullish Indicator No Bearish Signals