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Looking Back and Looking Forward: Noodles & Company

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December 26, 2013 – Comments (1) | RELATED TICKERS: NDLS , CMG , PNRA

It’s been a little while since Noodles & Company (NDLS) took the market by storm with its IPO. And to be very clear let me get this out in the open in saying that I’ve NEVER eaten at a Noodles & Company before. So this is not an examination from the consumer’s perspective at all. With that said, I’ve also never had anyone tell me that I need to go eat there because of the quality of the offering or experience. They’ve all said the same thing, from “It’s OK I guess.” to “It wasn’t all that good.”

Noodles & Company IPOd on June 28, 2013 but it’s worth noting that the company opened its first store back in 1995, so it’s not new. Shares were priced at $18 and closed for the day at $36.75. It has since reported two quarters as a publicly traded company and today holds a market capitalization of $1 billion. Noodles has a dual share class structure with 23.1 million A shares and 6.3 million B shares as of the most recent 10-Q. There is no founder ownership interest to speak of. From the prospectus filing:

“The rights of the holders of Class A common stock and Class B common stock are identical, except that our Class B common stock does not vote on the election or removal of directors unless converted on a share-for-share basis into Class A common stock.”

Below are some of the pros and cons I’ve come up with this morning in regard to Noodles and Company as an investment.

Pros:

*Per person spend of approximately $8 keys in on an attractive price point for consumers.

*Focus on throughput (getting people through the line) is encouraging, but Chipotle has set the bar here. Everyone else is playing for second.

*Company owned-to-franchise ratio is 5.3 (310 company-owned and 58 franchised); franchise model will continue to be a significant growth driver.

*Company-owned average annual sales per store clocked in at $1.2 million in 2012.

*CEO and Chairman Kevin Reddy has been with the company since 2005 and before that served as the Chief Operating Officer and Restaurant Support Officer of Chipotle from 1998 to March 31, 2005.

*According to Technomic, in 2012, fast casual concepts in the 500 overall largest restaurant chains grew sales by 13.2% to $24.2 billion, compared with 4.9% for all of the 500 overall largest restaurant chains in the US.

*Translation for the above statement: Fast casual is picking up a lot of market share on casual dining.

Cons:

*Company-owned comps of 2.4% in 3Q is less than inspiring and top line growth of 15% while not bad at all will need to continue to grow if we’re to believe the growth story here.

*Huge menu requires tremendous upkeep and ordering which plays out on margins. This will be a big point of focus in the coming quarters.

*From the most recent call: “We do anticipate that long-term debt will increase a bit over the next few quarters as our operating cash flow is modestly lower than the capital we deploy investing in the restaurants.”

*Franchise model is a sword that cuts both ways. It can help you grow, but loss of quality control becomes an almost certainty.

*I’m reminded of the time Jerry Murrell (founder of Five Guys) spoke to us here at Fool HQ. I’m paraphrasing, but he said in no uncertain terms that while franchising did help them grow quickly, the one thing he wished he had was the money to buy every one of them back because they are cash machines and ownership means control of the product and the experience.

*Today’s share price implies a full year earnings multiple of 84…pretty optimistic considering what this company still has to prove.

*Company-owned average annual sales clocked in at $1.2 million in 2012; not bad but still a far cry from Chipotle’s $2.3 million with its larger store base and superior margins.

*As mentioned previously, there is no founder or insider-ownership worth even discussing.

My bottom line

The market opportunity is really the biggest question for Noodles & Company. Going forward store count will grow by maybe 15% annually for company-owned and 20% for franchise (these are really best-case numbers by the way) but for how long? At some point the implication is that they will be stealing share from your Chipotles and Paneras of the world. Or else they’ll stop growing. When that happens, is this something you still want to own? At 84 times full year estimates, I don’t see a compelling reason to buy the stock today.

Based on what I’ve heard to date between the experience and quality, Noodles & Company is OK but nothing to write home about and that’s where it loses me. Restaurants are such a competitive business and while I do appreciate the fact that it offers up a diverse menu with a tremendous number of offerings, it’s almost like it loses its identity in the process. You go to a Chipotle because you know what you want. You go to a ShopHouse because you know what you want. You go to a Buffalo Wild Wings because you know what you want. And I’d even say you go to a Panera because you know what you want. But maybe you go to a Noodles & Company because you’re not sure what you want? That’s what it kind of sounds like. Heck I’d even argue that Panera may suffer from this a little bit with its ever-growing menu trying to become more things to more people.

It’s not that this is necessarily a bad thing, but it’s something to think about when considering allocating some of your investment dollars to a restaurant. The more offerings, the more involved the menu becomes and the bigger the management challenge (I'm pretty sure management drools over Chipotle's 17% operating margin). It’s not easy to overcome and it’s one of the reasons why I'm such a believer in what Steve Ells and Monty Moran have built at Chipotle. It’s an unbelievably efficient operation in an industry where efficiency is just tough to come by. And not only does the customer not suffer from that, the customer actually benefits from it because there are owners who have taken a tremendous amount of time to develop a simple offering made from quality ingredients that has bred an insuperable customer loyalty thereby affording it a modicum of pricing power in an industry where that is easier said than done.

While Noodles & Company seems like an interesting story and one that I’ll continue to follow, for now I don’t see it as it worthy of consideration but that’s not so much because of what it has or hasn’t done. It’s more because there are better options out there. There may be a point where the stock pulls back to a point where it looks more attractive from a valuation perspective and I reserve the right to take another look. But for now I’m gonna take a pass.

Foolish best,

Jason

1 Comments – Post Your Own

#1) On December 31, 2013 at 11:33 PM, Mary953 (74.68) wrote:

Jason,

There is only one area of your blog that I would disagree with.  My daughter has told me that I should go to Noodles.  She has had wonderful experiences there and anyone who goes with her has also had wonderful experiences.  The difference is that my daughter is a chef who creates her own recipes.  She knows what flavors and textures should go together.  If Noodles decides to take advice from someone like her and put together a list of suggested combinations, they will go from "It's okay" to "It's really great" overnight.  Only then will they become a contender.  As for me, for now I will only go to Noodles with my daughter and will follow her lead unswervingly. 

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