Should You Buy Zoe’s Kitchen’s Long-Term Investment Prospects?

Source: GlassDoor

Shares of Zoe's Kitchen  (NYSE: ZOES  )  have soared by nearly 30% since its April 14 IPO as investors have piled into shares of the latest entrant into the fast-casual space. However, does a comparison with fast-casual restaurants such as Noodles & Co (NASDAQ: NDLS  ) or Chipotle Mexican Grill  (NYSE: CMG  )  suggest that investors are wise to buy stock in Zoe's or are they playing with fire?

Why bet on Zoe's?
The fast-casual segment has been the fastest growth space within the restaurant industry, and Zoe's Kitchen falls into this category as a company that focuses on Mediterranean dishes. Its market capitalization of $585 million represents quite a premium for a company with revenue of only $131 million in the last 12 months.

The key with Zoe's Kitchen is that investors are betting on future performance rather than current fundamentals and believe the company can grow significantly in size. In 2013 the company grew its revenue by more than 45% and in 2014 analysts expect that revenue to increase 44% to $167.5 million .

Year-over-year growth can be misleading
Noodles & Co, or Noodles, is a company that serves dishes that draw inspiration from throughout the world, or at least those that contain noodles. While its market capitalization of $980 million far exceeds that of Zoe's, it's important to note that Noodles also has annual revenue of $360 million.

Source: Restaurant News

As for Zoe's, $360 million in annual revenue remains many years away, as its 2015 outlook calls for sales of $208 million with growth decelerating to just 24% year-over-year. If accurate Zoe's outlook would confirm common sense in that year-over-year growth as a percentage declines as a company grows larger.

Hence, the 17% growth that analysts expect from Noodles in 2015 along with revenue of $477 million is more impressive than Zoe's 24% expected growth which would result in less than half the gain in annual sales. Because after all, who's to say that Zoe's will ever reach $477 million in annual sales or grow at a double-digit pace if it achieves this?

Investors should feel far more secure with Noodles at 2.7 times trailing 12-month sales versus the 4.7 times multiple of Zoe's.

Chipotle makes Zoe's look mediocre at best
If the Noodles's versus Zoe's comparison isn't enough to illustrate why the latter is overvalued, then check out a company that makes all other restaurants look mediocre: Chipotle. This is a company that set the trend for fast casual and now has annual revenue of nearly $3.4 billion.

Yet despite its size, Chipotle completely defies all rules of growth and size, as its comparable-store sales increased a whopping 13.4% in the first quarter while total revenue grew 24.4%. Looking ahead, analysts expect Chipotle to grow at 21.6% and 16.7% in the next two years, respectively . At 5.4 times sales this incredible growth and proof of longevity and sustainability makes Chipotle worth the premium.

One more reason to avoid Zoe's
Zoe's is clearly overvalued due to the unknowns surrounding its business, including the fact that its year-over-year growth may be misleading because of its size. But perhaps the worst thing for Zoe's is the fact that its operating margin of negative 4% significantly lags others within the fast-casual space.

Noodles and Chipotle have operating margins of 5.8% and 16.3%, respectively, with the latter providing further support for the valuation premium. Conversely, Zoe's lack of profitability supports the notion of an artificially inflated stock price that will eventually come crashing down.

Foolish thoughts
The bottom line is that investors can find far better values within the fast-casual space besides Zoe's. While investors might prefer to invest in smaller companies with more to gain, there are never any guarantees as to how large a company can become.

Meanwhile, Chipotle continues to break barriers and increase revenue per existing store on a quarterly basis. Given this fact and its opportunities to expand internationally and domestically with new concepts it might still have the most upside potential within the space despite an $18.5 billion market capitalization.

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Brian Nichols

Brian Nichols is the author of "5 Simple Steps to Find the Next Top-Performing Stock: How to Identify Investments that Can Double Quickly for Personal Success (2014)" and "Taking Charge With Value Investing (McGraw-Hill, 2013)". Brian is a value investor, but emphasizes psychology in his analysis. Brian studied psychology in undergrad, and uses his experience to find illogical value in the market. Brian covers technology and consumer goods for Motley Fool. Brian also updates all of his new and current positions in his Motley Fool CAPs page. Follow Brian on Twitter and like his page on Facebook for investment conversations and recent stories.

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