It's Showtime for This Fast Food Chain!

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

Nothing can stop investors from falling in love with a great growth story. Not even highly volatile markets and a looming financial environment. Shares of fast casual restaurant  Noodles & Company (NASDAQ: NDLS) more than doubled in their first market session following their public offering, valuing the company at as much as $1.07 billion. Demand for shares was so strong that Noodles ended up selling shares at $18 a piece, above the top end of its increased price range of $15 to $17 per share. All in all, the company raised $97.2 million by selling 5.4 million class A shares. Now, when shares are fully priced for robust growth, it's the company's own duty (and obligation) to prove that it can truly become the next Chipotle (NYSE: CMG) or the next Panera Bread (NASDAQ: PNRA) of the restaurant fast food sector. 

It's all in the growth

To become the next Chipotle or Panera, Noodles' business must grow... and fast. Chipotle, for example, has doubled its sales in the last five years, while earnings have risen 270%. The number of restaurants of the Mexican fast-food chain is up 30% in the last three years. That's a very remarkable growth story. Panera isn't far behind, with an annual earnings growth of roughly 16% and 123 new stores in 2012 alone. Panera is committed to its growth. The company plans to add another 195 new franchises that will open in the next four to five years.

And Noodles is on the right path to deliver growth. Even before seeking public money for additional growth, Noodles has already added more than 120 restaurants during the downturn years, from 2008-2012, and reached $300 million in sales in its most recent year. That's a pretty good head start. 

Economic moat

Many opponents to investing in the high-growth fast food sector say that it's a saturated market and that there isn't any real economic moat in the restaurant business. After all, they say, anyone with a taco truck can compete with Chipotle. I believe this isn't the case. The fast food sector, as a whole, is very competitive. But once you are able to establish your brand, distinguish it from the rest and make people return to you - then is when your business becomes highly lucrative.

For example, both McDonald's (NYSE: MCD) and Chipotle enjoy a high profit margin of 30% and 20%, respectively. Such a high profit margin is a great indication of having a sustainable economic moat. In all other cases, such high profit margins aren't supposed to exist in a truly competitive environment. Panera, for example, lags in that aspect -- it's only able to show an operating margin of 13%, which means that some of its rivals are slowly biting into its bottom line. What economic moat Noodles will have still remains to be seen. 

Valuation matters 

In the most recent quarter, Chipotle reported earnings of $2.45 per share. Earnings grew almost 24.4% from the prior-year quarter, driven by higher revenues, lower taxes and share count. This commands a price-to-earnings of 40x for the company. Definitely not a low one, but it could be a lot worse. At a current price-to-earnings of 40x, Chipotle trades at a little more than twice the average S&P of 18 times earnings. It's high, yes ... but it also grows at four times the rate of an average S&P company. Whereas McDonald's, for example, increases its earnings by 1% year-over-year, Chipotle is able to show a magnificent 14% increase in earnings. Panera, though, trades at a more acceptable price-to-earnings of 30x.

But the valuation of Noodles is currently sky high. Noodles saw a $5 million net profit on nearly $300 million in sales in its most recent year. This commands a price-to-earnings of 105x on the share price at the open. But shares have already doubled since then. This means that at a current share price of $36, the company's P/E is a staggering 210x. That's out of this world expensive. 

Management

Most people probably don't remember this, but Chipotle was spun off from McDonald's. The people running it are some of the world's best in the quick-service restaurant industry. And they're also shareholder oriented -- in the first quarter of 2013, Chipotle bought back 164,000 shares worth $51 million. During February, the company announced the addition of $100 million to the existing share repurchase program. It is of great comfort for me to see that executives at the helm of Noodles have all worked for major brands including Chipotle and McDonald’s.

The Fool looks ahead

It remains to be seen whether Noodles will live up to its expectations. If it does, the return on investment will be fabulous. But if it doesn't, the crash will be hard, especially considering the top-dollar that investors have been paying for its shares. 

If you're an investor who prefers returns to rhetoric, you'll want to read The Motley Fool's new free report "5 Dividend Myths... Busted!" In it, you'll learn which stocks provide premium growth and whether bigger dividends are better. Click here to keep reading.


Shmulik Karpf has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill, McDonald's, and Panera Bread. The Motley Fool owns shares of Chipotle Mexican Grill, McDonald's, and Panera Bread. 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!

blog comments powered by Disqus

Compare Brokers

Fool Disclosure