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Chipotle Mexican Grill, Inc. (CMG): The Practically Perfect Pasta IPO

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Noodles & Company looked like it might be the perfect pasta IPO, but sadly has a few flaws that keep it from being the next Chipotle Mexican Grill, Inc. (NYSE:CMG). Everyone is always looking for the next Chipotle and each new restaurant chain going public makes us hope this is the one. Noodles & Company comes close but falls a little short. It may still be investment-worthy depending on the opening price.

Chipotle Mexican Grill, Inc. (NYSE:CMG)

Chipotle Mexican Grill, Inc. (NYSE:CMG) is a freak of nature – I’m convinced. What other restaurant has been able to create double-digit growth in same-store sales quarter after quarter, all the while maintaining some of the highest margins in the business? Granted it has slowed a bit in recent quarters, but it still has numbers that are the envy of the industry.

The best restaurants have:

Food that creates high traffic – at present, high quality ingredients are a successful fast-casual concept

Positive same-store sales – higher is better

Traffic increases that are higher than price increases. This makes stronger comps – hard to do

Stores that are relatively inexpensive to build with low costs before opening

Increasing average weekly/yearly sales

Ability to add a substantial number of stores without saturation

Low costs/high margins

Noodles is built on a model similar to Chipotle and has most of the “best of” features:

Cheap-to-build stores fitted to locale

Mostly fixed menu with a stable of fresh ingredients mixed and matched to the customer’s order

Open kitchen

Low-priced fast-casual menu

Fast order fills

Double-digit growth

Two of Noodles’ executives — Chairman and CEO Kevin Reddy, 55, and President and Chief Operating Officer Keith Kinsey, 58 — came to the company in 2005 by way of McDonald’s and then Chipotle Mexican Grill, Inc. (NYSE:CMG).

Low saturation at outset and room to grow

Margins are disappointingly low and while same-store sales are positive, they only hit mid-single digits. Margins and comps don’t come close to rivaling Chipotle.

Noodles IPO and concept

The company just filed its prospectus and hopes to raise $75 million with an unknown number of shares (at present). The cash will mostly be used to pay down debt, helping low margins by removing interest expense. The buzz is it will raise far more than this and will be a hot and much-anticipated IPO. Investors love restaurant IPOs. Expect the initial offering to be bid up quickly, but it may correct when (or if) the reality of its industry-trailing margins and average comps materializes. Management may anticipate and work to improve both margins and same store sales proactively. The CEO and COO have put time in at two industry leaders, Chipotle Mexican Grill, Inc. (NYSE:CMG) and McDonald’s, and presumably have the skills to understand and fix problems.

The restaurant is a fast-casual concept serving lunch and dinner that opened in 1995. The menu is noodles and pasta made with fresh ingredients offering everything from Pad Thai to Mac & Cheese. Noodles also does soups, salads and sandwiches. Every meal is cooked to order and can be customized to personal tastes. The food is made to go or eaten at the restaurant. Sit-down service is on china plates with silverware — not plastic baskets and sporks. This is probably one area where it can’t compete with cost-controlled Chipotle margins. These restaurant operating costs are high for Noodles and the expense of plates and flatware is an expense Chipotle Mexican Grill, Inc. (NYSE:CMG) doesn’t have.

Noodles features open kitchens that are becoming quite the rage in the restaurant world, presumably because guests can see the freshness of ingredients and watch their food being cooked.

A meal is a value with the single check averaging around $8. Noodles has 339 restaurants with 288 company-owned and 51 franchised locations across 25 states. There is room to expand and the concept does not run up against a lot of other fast-casual concepts. I would hazard an opinion the pizza and burger spaces are reaching saturation. Between 2008 and 2012, the compound annual growth rate was 15.2% for revenue and 67.5% for operating income.

There has been steady (if not spectacular) growth in comps in 28 of the last 29 quarters due primarily to an increase in guest traffic. Increasing traffic is a much stronger indicator of quality growth rather than increasing menu prices. System-wide comp growth for 2010, 2011 and 2012 was 3.7%, 4.8% and 5.4%, respectively. Between 2008 and 2012, the compound annual growth rate was 15.2% for revenue and 67.5% for operating income. Average unit volumes (AUV) grew from $1.1 million at the beginning of 2010 to $1.2 million at the end of 2012. For comparison Chipotle has a 2012 AUVs of $2.1 million up from $1.8 million in 2008. Chipotle  has been able to  build traffic across restaurants, creating a $300,000 average increase per unit over 5 years.

New Noodles restaurants cost approximately $725,000 to build, net of tenant allowances. This is cheap capex for a fast casual building. Chipotle spends $800,000, BJ’s Restaurants are $4 to $5 million per unit and an Olive Garden can be built for $1.5 to $2 million. This allows the company to start collecting a cash-on-cash return of 34% after three years. Operating cash flow does not cover capex yet even with the relatively low construction costs. They built 37 stores in 2012, up from 27 in 2011. The increase was 15% matching the 15% increase in cash from operations. It still fell short of covering capex by $15 million. They may need to use debt at some point to build new stores. The company anticipates an annual 15% new store growth rate up to 2,500 locations. Increasing debt risks decreasing net margins. Investors can anticipate that proceeds from the IPO used to pay the current debt will eliminate or at least decrease interest expense providing a catalyst of sorts for margin expansion and faster net growth. More debt could reverse that.

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