Fast Casual Restaurant Stocks: 2 to Avoid and 1 to Buy

By Markets Fool.com

Continue Reading Below

McDonald's is no longer the de facto leader among fast food providers. Source: McDonald's

It is hard to imagine that 20 years ago, the whole concept of fast casual dining was likely just the nightly dream of some entrepreneur. Fast food chains likeMcDonald'sruled the day, and everyone wanted their food fast and cheap.

But those days are long gone. Sitting comfortably between fast food and full-service restaurants, fast casuals are satisfying the many consumers looking for a little more quality, healthier ingredients, and a more enjoyable dining experience. Fast casuals are now in the driver's seat. But just because this sub-industry is doing well does not mean that every player is a good investment. Below, our analysts highlight two fast casuals to avoid --Potbelly andNoodles & Co-- and one that is worth buying, Chipotle Mexican Grill.

Brian Stoffel(PBPB): I have enjoyed many a Potbelly sandwich in my time, so this is not a knock on the food itself. Instead, I think Potbelly stock is an example of what happens when the market gets overly excited about a company that is not firing on all cylinders.

Currently, shares of Potbelly trade for almost 60 times adjusted earnings -- a very heady premium. Although the company can still grow its store count considerably -- there are just 363 locations worldwide -- for a valuation like that, sales need to be growing by leaps and bounds.

Continue Reading Below

But that is simply not the case. Over the past twelve months, revenue grew by just 9%. Not terrible, but much of that growth was fueled by a 14% increase in the number of Potbelly stores.

When it comes to comparable store sales -- the metric that truly indicates what direction a restaurant is headed -- Potbelly still has a long way to go. In 2013, comparable store sales were up just 1.5%, and last year, they were essentially flat at 0.1%. Both of those fall well below the rate of inflation, telling us that the company is just not connecting with customers in a way that will lead to growing market share among fast casuals.

Dan Caplinger(NDLS):One fast casual restaurant stock that has proven to be a victim of its own hype isNoodles & Co. After going public back in 2013, Noodles has seen its stock lose half its value, as growth has slowed dramatically and its core concept has not resonated with customers.

In its most recent quarterly report, Noodles saw comparable-store sales growth slow to just 1.3%, leaving the bulk of its revenue increase at the mercy of its aggressive store opening strategy. Even though the company gave guidance for better results in 2015, even its projected growth rates left Noodles shareholders doubting whether future financials will justify the hefty multiples where its share price currently trades -- over 40 times earnings.

One big challenge the company faces is developing a cohesive identity. Unlike many of its fast casual competitors that identify strictly with one particular type of cuisine, the Noodles & Co. name does not immediately tell would-be diners what kind of food they will get when they walk in the door. Noodles embraces that diversity, claiming to be all things to all people. Yet few would expect a full line of sandwiches, salads, and soups to go with namesake noodle dishes, and that confusion might be holding the restaurant chain back.

Noodles is an interesting idea, but it does not present a good risk-reward profile. Investors would be better served going with restaurant stocks with better growth prospects in the long run.

Bob Ciura(CMG):And that leaves us with Chipotle Mexican Grill as a fast casual stock to buy -- the trend setter and dominant player in this subcategory. With its streamlined ordering process, Chipotle has mastered the concept of customization. This one-of-a-kind experience has led to amazing growth, and the financial results speak for themselves.

Comparable restaurant sales rose 16% in 2014, a year that also saw revenue and earnings per share soar 28% and 35%, respectively. Profits also benefited from a 60 basis point improvement in operating margin.

The company also opened another 192 restaurants during that period, bringing the total to 1,783 locations. That number is still low enough to allow the company to remain aggressive in its expansion plans. Chipotle expects to open another 190-205 restaurants in 2015, as restaurants continue to enjoy increasing customer visits.

Despite rising food costs -- up 120 basis points as a percentage of revenue -- and nationwide price increases last year, the burrito slinger still managed to maintain sales growth and margin expansion. Its strength in the face of such a competitive environment is a testament to its pricing power and customer loyalty.

With that said, some investors may argue that the valuation is cause for concern. According to data from S&P Capital IQ, shares trade at about 39 times earnings. However, this is on par with or cheaper than its lesser competitors above, and that is a reasonable premium to pay for the leading company in this fast-growing industry.

The article Fast Casual Restaurant Stocks: 2 to Avoid and 1 to Buy originally appeared on Fool.com.

Bob Ciura owns shares of McDonald's. Brian Stoffel has no position in any stocks mentioned. Dan Caplinger has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill and McDonald's. The Motley Fool owns shares of Chipotle Mexican Grill. 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.