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The rise of fast-casual restaurants has changed the landscape of the restaurant industry, as leaders such as Chipotle Mexican Grill and Panera Bread continue to expand rapidly and more traditional players such as Wendy's revamp their operations to keep up with the trends. But while this shift may be a delight for consumers, it doesn't mean every stock is a winner. Let's look at three restaurant companies that may have gotten overheated.
1. Noodles & Company (NASDAQ: NDLS )
The upstart fast-casual chain shot out of the gate, going from an IPO price of $18 to as high as $51, but its first earnings report seems to have revealed that investors got a little carried away. Shares fell 11% even though the company beat earnings estimates as guidance turned off investors. Even at $40, however, the stock still looks overpriced, with a 2013 P/E of 100 and a 2014 top-line growth rate of just 16%. Throw in its operating margin of 7%, and it's clear Noodles will have to both significantly improve its revenue growth rate and profit margin, which will be difficult with same-store sales growth increasing around 4%. At its current pace, Noodles won't hit $1 billion in sales until 2020. If its operating margin improves significantly, which won't happen without a significant comparable sales increase, the upside potential for the stock between now and then seems limited. Noodles has also drawn favorable comparisons to Chipotle and Panera, but a look at Noodles' reviews on Yelp indicates that it may not have as strong a following as its two peers. The pasta chain's locations generally receive just a mediocre three stars on the review site.
2. BJ's Restaurants (NASDAQ: BJRI )
Like Noodles & Company, the bull argument for BJ's seems to be in its ambitious expansion plan, as management intends to grow the casual-dining chain from 136 locations today to as many as 425 domestically. But with a lofty P/E of 30, the financials at BJ's don't look so appetizing. In its most recent quarter, same-store sales were flat, indicating flagging demand for its food, and operating income fell from a year ago despite an 11% revenue increase, as occupancy costs grew disproportionately. BJ's has operating margins near 6% and draws similarly mediocre reviews on Yelp, generally receiving just three stars. Management has 12 more openings planned for the quarter and can continue moving toward its goal of 425, but there's no guarantee that the expansion will drive profitability. Plenty of other restaurant chains have followed a similar path, expanding to several hundred or thousand units with little profits to show. Considering the price tag for shares right now, the flat same-store sales and declining operating income should be red flags for potential investors.
3. Tim Hortons (UNKNOWN: THI.DL )
The Canadian coffee-and-doughnut chain has dominated the market north of the border but has never found much success in the U.S., where the coffee market is dominated by Starbucks and Dunkin' Brands' Dunkin' Donuts. With nearly 3,500 restaurants in Canada, Tim's seems to have saturated the market in its native country. In other words, there is one Tim's location for every 10,000 Canadians, or in a city of 1 million there would be 100. That's a higher penetration rate than any restaurant chain has achieved in the United States. By comparison, there are about 13,000 Starbucks domestically, or roughly one for every 25,000 Americans, and Starbucks closed several hundred underperforming stores a few years ago after expanding too ambitiously. Revenue at Tim Hortons, meanwhile, grew just 1.9% in its most recent quarter, or 5% on a constant-dollar basis, with same-store sales up 1.5% after negative comps in the previous quarter. Operating income was up 10.7% in its latest quarter, but it will be difficult to grow the bottom line if sales are stagnant. Tim Hortons continues to expand, growing its footprint by 5% in the past year, but with the level of saturation it's reached in Canada and poor results in the U.S., the ceiling for growth seems low.
Foolish bottom line
Nearly every restaurant chain is expanding domestically, some faster than others, but competition will increase along with it, as there just isn't room in the market for every chain to triple its number of locations. And while stalwarts such as McDonald's may not be adding so many locations, they're certainly not going to give up market share with a fight. New locations alone won't be enough to drive these stocks to future growth. These expanding chains will have to offer quality along with a fair price to stand out in the crowded field.
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