More Buying Opportunities in an Expanding Restaurant Niche

Reuben is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Fast casual restaurants have been all the rage. Sitting above fast food on quality and below casual dining on price, they offer customers a desirable alternative to existing fare. Investors have driven up the shares of Chipotle Mexican Grill (NYSE: CMG) and look set to do the same with the recent IPO of Noodles & Company (NASDAQ: NDLS).

Top, Bottom, Middle, and...

At the top of the restaurant industry are chains like Capital Grill, which sells expensive steaks. In the middle are companies like Olive Garden and Red Lobster, which are often described as casual. All three of these chains are owned by Darden (NYSE: DRI). While the high end of the company's business, which includes more than just Capital Grill, has been doing fairly well recently, the casual dining segment has been a laggard.

Since Olive Garden and Red Lobster make up the vast majority of the company's sales, that's meant weak earnings and relatively poor stock performance. The shares yield around 4.4%, however, which might interest income investors looking for an out of favor industry giant. Still, the weakness of the company's core brands speaks volumes about the middle layer of the restaurant industry.

Wendy's (NASDAQ: WEN) has always pitched itself as selling the best fare at the low end of the spectrum, otherwise known as fast food. Although some of the company's problems have been self inflicted corporate actions, like the ill-fated merger with Arby's, it has had an increasingly difficult time differentiating itself.

Wendy's has been barely profitable for the last four years as it tries to reinvent itself. Although there's upside potential for aggressive turnaround investors, the risks are too large for most. The big problem is that Wendy's is stuck in the bottom of the industry when it wants to be something more.

...Fast Casual?

The problem that both Wendy's and Darden have faced is the emergence of the fast casual space. These restaurants use a fast-food like format to sell higher quality fare. That's a combination that has captivated customers and investors. There's opportunity, but only for the aggressive and fleet footed.

Chipotle Mexican Grill is the best example and, up until recently, the only option investors had in the space. Although coming off of a small base, the company's revenues and earnings have grown rapidly. That's drawn in investors as quickly as the company's high-quality Mexican fare has drawn in eaters, leading to a swift stock price advance.

What Goes Up...

However, in Chipotle's swift ascent is also the warning. The shares ran up to over $400 by mid 2012 and then quickly fell to below $240 by late October of that same year. Hot stocks are great, but investors can sour on them quickly. That usually leads to drops that are even more rapid than the previous stock advance. Chipotle shares have since resumed their climb and now sit at around $375 or so.

Chipotle's price to earnings ratio is around 40, which prices in a continuation of the company's impressive revenue and earnings growth. It is also high for the industry, but as long as the company can grow profitably, aggressive growth investors should like the shares. And its an indication of what could be to come from newly public Noodles & Company.

The Hot IPO

Noodles & Co's shares doubled on their first day of trading. That pent-up demand has a lot to do with it being only the second company to come public in the fast casual space. The concept is an odd amalgam of noodle based fare from around the world, including pastas and soups from spaghetti to pad Thai.

The company has almost 350 restaurants in 26 states. Its top-line has grown from $170 million in 2008 to $300 million last year. However, with the money from the IPO, it should be able to pick up the pace of its expansion. And, with so few stores and operations in only about half the country, there's plenty of opportunity for organic growth.

Look Out Below

That said, both Noodles and Chipotle are hot concepts in an industry with fickle customers. Moreover, restaurants are prone to overbuilding and the use of too much leverage. Aggressive investors looking to get in on a hot trend should like both stocks, though Noodles might be more interesting right now because it is so new to the market.

That said, Chipotle's recent and swift fall, despite the subsequent recovery, should be a warning sign for investors. If things head south, at the business level or in investors' perceptions of the stocks, then either of these fast casual chains could sell off quickly. This pair will need close monitoring.

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Reuben Brewer has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill. The Motley Fool owns shares of Chipotle Mexican Grill and Darden Restaurants. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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