The 1 Reason Potbelly and Noodles Will Not be the Next Chipotle

It seems that every new restaurant that goes public surges to absurd levels, with investors hoping to find the next Chipotle. The most recent is sandwich shop Potbelly which doubled on its first trading day. Earlier this year Noodles & Company saw an equally impressive rise. At the same time, established restaurants are struggling with weak consumer spending. Ruby Tuesday , for example, got crushed after posting a big loss and declining same-store sales, with disappointing guidance to boot.

Everything is not the next Chipotle
It seems that investors are buying every new restaurant stock in the hope that one of them is the next Chipotle. This seems like a bad strategy. Most will never even come close to the success of the burrito chain. But investors are paying prices which assume that every new restaurant is going to see that kind of success, and that's a dangerous game.

Potbelly is the latest example of this trend. Shares quickly doubled from an initial price of $14 to over $28 per share, valuing the sandwich chain at somewhere around $750 million. In 2012, Potbelly's sales totaled $275 million and the company had net income of $24 million. Potbelly operates around 300 shops, a 13% increase from twelve months ago.

Potbelly sandwiches are good, but do they merit such attention. There are plenty of sandwich shops out there, and it's hard to pinpoint Potbelly's unique competitive advantage. It certainly has the capacity to expand, but the competition is fierce.

What's a reasonable price to pay? Let's try to create a realistic scenario. If the company grows its store base by 10% annually while also increasing same store sales by 5% per year during that time, the company will be doing roughly $1.1 billion in sales in ten years. At a 10% net profit margin this is $110 million in net income, putting the current price at about 7 times this.

Chipotle grew faster than this, but Potbelly faces a lot more direct competition. Now, if the above scenario actually plays out, the return an investor would get by buying the shares today would be a bit above the average. This assumes that everything goes right. How many promising chains failed to meet expectations? More than I can count. Optimism is too high, and I would wait for the price to fall significantly before thinking about Potbelly.

Another recent restaurant IPO is Noodles & Company . Noodles also surged on its first day, and now the company has a market cap roughly twice that of Potbelly even with similar sales and worse profitability.

Growth is strong, sure, but the chance that Noodles will see the same success as Chipotle is slim. The food is mostly noodle-based dishes such as macaroni & cheese and pad thai, with some sandwiches and salads tacked on for the sake of variety. Chipotle has a compelling product, the burrito, along with various customization options. Noodles is taking the shotgun approach by offering Italian, Thai, Japanese, Indonesian, and everything in between. The lack of focus concerns me, and it makes me think that Noodles will never reach the widespread success enjoyed by Chipotle.

Turnarounds are hard
Ruby Tuesday is on the higher end of the casual dining spectrum, and weak consumer spending has caused the chain significant problems. Same store sales fell by a staggering 11.4% last quarter in company-owned stores, a miserable result no matter how you look at it.

The problem with Ruby Tuesday is that it's very similar to other casual dining chains. How do you turn around a restaurant which has nothing differentiating it from the competition? You make changes until something sticks.

Ruby Tuesday is introducing new items, such as flatbreads and pretzel burgers, blatantly copying the success of Wendy's. Will it work? Maybe, but Ruby Tuesday's margins are far below the pre-financial crisis high. The company needs a roaring economy more than anything, and that doesn't look like it's in the cards any time soon.

I wouldn't bet on a turnaround. Buying shares of Ruby Tuesday is a gamble.

The bottom line
The restaurant industry is extremely competitive. Only a select few companies rise out of the fray to achieve above-average results. Neither Potbelly nor Noodles have what it takes, and the stock prices of both are supported by unrealistic optimism. Ruby Tuesday needs to figure out how to turn a profit, and I see nothing that points to this happening any time soon. Instead of trying to find the next Chipotle, investors should be more focused on avoiding the next Ruby Tuesday.

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The article The 1 Reason Potbelly and Noodles Will Not be the Next Chipotle originally appeared on Fool.com.

Timothy Green has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.

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