The Next Big Casual Dining Stock?

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

When casual restaurant chain Noodles & Company (NASDAQ: NDLS) debuted in its IPO last week the stock promptly doubled. It continued to increase, closing at $47.20 on July 2, a full 162% above its IPO price. Why are so many people excited about Noodles? Perhaps the success of companies like Chipotle (NYSE: CMG) and Panera (NASDAQ: PNRA), both casual dining stocks which have done extremely well over the past five years, has led investors to believe that Noodles is the next big thing.

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Is it? Does Noodles have the right formula to grow into a dominant national chain?

Noodles, and other things

Given the name of the company the most prominent menu items are noodle-based dishes. In terms of variety the menu runs the full gamut, from Italian style dishes to Pad Thai and Japanese noodles. In addition to noodles the restaurants offer sandwiches, salads, and soups. The menu offers both healthy, low-calorie items as well as high-calorie, richer items and everything in between. If you want to eat 1,000 calories worth of macaroni and cheese, Noodles is the place to do it.

I've been to a Noodles, and I found it pretty average. I think the issue is that when a restaurant tries to do to many things it ends up doing them all in a mediocre way. I'd much rather go to a real Thai restaurant to get Pad Thai than go to a place that also serves macaroni and cheese. The non-noodle dishes seem like an afterthought to some degree, since who exactly is going to a place called Noodles & Company to get a sandwich? It's like going to a Mexican restaurant to get a cheeseburger.

There's a focus on health, but given the carb-heavy nature of almost everything on the menu some people will likely be driven away. You can't really cut the carbs on a noodle-based dish. To its credit Noodles does offer rice noodles in many of its dishes that cater to the gluten-free crowd.

Is Noodles the next Chipotle?

Chipotle has grown quickly and seen success nationwide for a few reasons. First, the menu is extremely simple. You can get a burrito, tacos, or a bowl, all of which contain the same ingredients. There is a singular focus. Second, you get to choose exactly what goes into your food, and it's made right in front of you. Chipotle didn't invent this concept but it took it nationwide.

Noodles has a more complicated menu, with myriad possible substitutions available. What's worse, Noodles doesn't have a singular focus at all. The problem can be summed up pretty nicely by considering the location of the Noodles & Company closest to where I live. In the same plaza there is a casual-dining Vietnamese restaurant and two sandwich shops, and across the street there is a Thai restaurant and an Indian restaurant. Noodles competes directly with all of these because it offers the same types of food.

Noodles doesn't have the focus to see the same kind of success which Chipotle has seen. My feeling is that Noodles will do poorly in markets with a strong diversity of restaurants already in place. In areas where that's not the case Noodles should do fairly well, but this limits the growth prospects substantially.

Is Noodles the next Panera?

Panera is a bakery/cafe, with fresh baked goods like bread and pastries as well as sandwiches, salads, and soups. Panera is a very popular lunch spot, as the restaurant feels comfortable and upscale. Quality is the focus with fresh ingredients and a high level of customer service.

While Panera has a diverse menu there's nothing too exotic. Standard types of sandwiches such as Smokehouse Turkey or Italian are the norm. Panera just does it better than many other sandwich shops, with higher quality and better service. That's really the key here. A restaurant with identical food but bad service and an uninviting interior would not do nearly as well as Panera does.

Noodles & Company just tries to do too much. If you want Thai food you go to a Thai restaurant, not Noodles & Company. I wouldn't expect Panera to have an authentic Thai sandwich, for example. That's not why I go to Panera. What I do expect are quality ingredients and traditional lunch fare. Panera delivers.

This is why Noodles will likely not match the success of Panera. It's too scattered of a concept to truly succeed at that scale.

The best case scenario

Noodles & Company is being valued at about $1.3 billion after the additional run-up on July 2. This is a company which, in 2012, recorded $300 million in revenue and $5 million in net income. According to the company's S-1 management believes that they can grow Noodles from the 339 current stores to 2,500 stores over the next 15-20 years. Let's do some basic math.

The average annual revenue per store is about $1.2 million right now. Let's imagine that that number grows to $2.5 million over the next 20 years, representing a reasonable rate of same-store growth. At the same time the number of stores grows to the expected 2,500. This would give the company $6.25 billion in annual sales. With a Panera-like net income margin of 8%, this would lead to a net income of $500 million.

The market is valuing this company at about 2.6 times earnings in 2033. If the stock at that time trades at 15 times earnings, reasonable given that growth will have essentially stopped at that point, the company would be worth $7.5 billion, 5.7 times more than it's worth today. Over 20 years that gives you an annualized return of about 9.15%, not all that much better than the long-term historical return of the stock market as a whole.

That's the best case scenario. If everything goes as planned you can expect slight-above average returns. That's how overpriced this IPO has gotten. Now, if you were able to pay $18 per share that annualized return rises to 14.5%, a much better showing. So if you really believe in the Noodles concept then the IPO price was reasonable. But the current price is not.

The bottom line

I don't think the Noodle's concept will succeed in enough markets to make the company the next Chipotle or Panera. The company tries to do too much and ends up muddling its menu and its message. The price has risen so much that even under the best case scenario the stock is not very attractive. If you really believe in the Noodles concept, wait for the price to fall substantially.

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Timothy Green has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill and Panera Bread. The Motley Fool owns shares of Chipotle Mexican Grill 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!

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