The Collapse of Noodles & Company and Potbelly: What Should Investors Do Now?

Last year, both Noodles & Company (NASDAQ: NDLS  ) and Potbelly Corporation (NASDAQ: PBPB  ) , small casual restaurant chains with a few hundred locations each, saw their shares initially surge after successful IPOs. Noodles & Company more than doubled on its first day of trading,  and shares of Potbelly did even better. After Potbelly's IPO, I wrote that both stocks were far too expensive to consider and that optimism among investors regarding both companies was far too high. Since then, both companies' stocks have collapsed.

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Noodles & Company is down about 33% since its IPO, while Potbelly has declined a staggering 62%. After these epic collapses, let's revisit both companies and determine if either one is attractive now that the extreme optimism has faded away.

Noodles' valuation is still too high 
Here's a quick comparison of some key pieces of data for Noodles and Potbelly:

Company

2013 Revenue (Million USD)

Market Capitalization (Million USD)

P/S

2013 Revenue Growth

Noodles & Company

$351

$930

2.6

17%

Potbelly

$300

$330

1.1

9%

Source: Morningstar

While both companies are roughly the same size, Noodles is valued at 2.6 times sales, a significant premium compared to Potbelly. A faster growth rate justifies this to a degree, but does the potential of Noodles & Company really make it a nearly $1 billion company today?

Noodles & Company's menu includes noodle-based dishes, salads, soups, and sandwiches, and the items span many different cuisines, like Thai, Italian, Mediterranean, and more American style dishes. I stated in my previous article that I wasn't a fan of Noodles' scattershot approach, and I'm still not. Instead of choosing one thing and doing it well, Noodles' menu attempts to appeal to everyone. Noodles is unique in that other casual dining restaurants don't offer that kind of variety, but I suspect there's a good reason why they don't.

Noodles' most recent quarter was a disappointing one. Systemwide comparable-store sales slumped 1.6%, with poor weather being the reason cited by the company. Guidance for the year was unchanged, however, and the company still expects to grow comparable store sales by 2.5%-3%.

In the long term, the company aims to grow its store base by 12%-13% per year and increase comparable store sales by 2.5%-3% annually, with a goal of eventually having 2,500 restaurants.

At a 13% rate of store growth, it will take 15 years to reach 2,500 stores. If revenue increases by 16% annually during that time to reflect both unit growth and comparable-store sales growth, the company will have revenue of about $3.25 billion at the end of this period.

Looking ahead
The return for investors buying Noodles & Company at the current stock price will depend on the company's profitability. On the high end, if Noodles becomes as profitable as Chipotle is today and commands a P/S ratio of around 5.5 in 15 years, then an investor's annualized return would be just about 22%. That's exceptional, but it requires the absolute best-case scenario to play out. If Noodles can't manage Chipotle-level margins and instead trades at around 1.5 times sales (similar to Wendy's today), the expected annualized return falls to just 12%. This is still well above the average market return, but it also requires the company to succeed in growing to 2,500 stores. If that doesn't happen then the story falls apart.

The odds of Noodles succeeding depends on the strength of the concept, and as I've said, I'm not a fan. While Chipotle has a focused, simple menu, Noodles has the opposite; as a result, the potential for the company may be far smaller than management is suggesting. Even after a large decline in the company's stock price, I don't think there's enough of a margin of safety to consider Noodles & Company as an investment. If the best-case scenario needs to happen for an investment to succeed, it's often best to look elsewhere.

Potbelly looks a bit better
Potbelly has a far more focused concept compared to Noodles, but there's also a lot more direct competition. Potbelly will face plenty of local and regional sandwich shops as it attempts to expand into new markets. About a quarter of Potbelly locations are in the Chicago metropolitan area, and 65% are located in Illinois, Texas, Washington D.C., Michigan, Minnesota, and Ohio. This heavy dependence on a small number of markets, especially Chicago, creates risk in that trouble in a single market can disrupt the company as it attempts to expand. It will also be building its brand from nothing in many new markets.

Shares of Potbelly have fallen far harder than those of Noodles & Company, and the company now trades at a P/S ratio of roughly one. If Potbelly can continue to grow revenue at around 10% per year, then this seems like a perfectly reasonable price to pay.

Like any small restaurant chain, however, this investment only works if Potbelly can actually become a national chain. There's nothing truly unique about Potbelly, so it's difficult to predict whether it will succeed or not. Regardless, the company's stock is far more attractive today compared to how it was before the 60% drop.

The bottom line
The extreme optimism surrounding Noodles & Company and Potbelly has faded, with both companies' share prices collapsing since their respective IPOs. Noodles & Company still looks too expensive given its unfocused concept, and the 2,500 store target seems extremely optimistic to me. Potbelly is now far more reasonably priced, but expansion will be an uphill battle as there's not much differentiating it from other sandwich shops. If you truly believe in the Potbelly concept, though, now would be the time to buy.

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