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Noodles & Company: Promising



November 20, 2013 – Comments (3) | RELATED TICKERS: BWLD , CMG , NDLS

Board: Pencils Palace

Author: pencils2

I had never heard of Noodles & Company (NDLS) until I happened upon the stock while strolling around the CAPS community. Besides having a wicked cool name, I was inclined to do some more digging into the company. Noodles just had its initial public offering (IPO) in June 2013, bringing ambitious growth projections and what could very well be a promising and innovative long-term player, a la Chipotle Mexican Grill and Buffalo Wild Wings, in the restaurant field. In fact, Noodles has some interesting connections with Chipotle that I will explore below.

What in tarnation is Noodles?

For those of you who are like me and do not know much about Noodles off the top of your head, Noodles is a fast-casual restaurant that offers various dishes including pasta (that's too be expected), pizza, salads, soups, and sandwiches. Noodles offers a customizable menu of over 25 ingredients, similar to the model of Subway or Chipotle, where customers can choose ingredients for their noodles (or other items), place an order, and received the final product in several minutes. With this customizable global menu for pasta and other dishes, Noodles is carving a niche as "the fast-food pasta chain." Noodles is building a reputation for using fresh and global ingredients, offering a family-friendly environment, and providing fast service.

As of October 1, 2013, Noodle's has 368 locations in 29 states (as well as the District of Columbia). 310 of those locations are company-owned, with only 15.76% (58) of Noodles restaurants being franchised. This puts Noodles in a similar camp with Chipotle, which does not license or franchise any locations, versus other traditional chains which tend to emphasize franchising restaurants rather than owning and operating the restaurants themselves.

Noodles was founded in 1995 in Colorado (seriously, are these guys trying to mimic Chipotle however they possibly can?). Prior to 2004, Noodles only operated company-owned restaurants; since 2004, Noodles intentionally began to add franchised restaurants to its mix to boost margins. Between 2004 and 2012 Noodles grew its restaurant base from 100 to 327 locations, representing a compounded annual growth rate of 16%.

The Financials

Following its IPO in June, Noodles has managed to reduce its debt load from $93.73 million to $1.71 million. However, its cash stands at just over $500,000, offering a glimpse into the financial life of a young restaurant chain climbing into the national spotlight. The fact that management utilized the cash generated from the IPO ($100.2 million) to pay down debt raises them a notch in my book.

Over the first three quarters of this year, Noodles' cash flow provided by operating activities increased 27.5% to $32.36 million compared to $25.38 million in the first three quarters of 2012. Management is plowing net cash flow into capital expenditures, another strategy consistent with Chipotle's management practices. Year-to-date Noodles' adjusted net income has increased 21.4% to $4.3 million from $3.6 million in 2012, while revenue increased 16.6% to $295.5 million from $222.5 million in 2012.

There is little doubt Noodles is growing at an impressive pace. One potential downside is that this growth is driven largely by new restaurants, rather than increasing sales at its existing locations. So far this year comparable restaurant sales, sales only from locations that have been open more than 18 months, have increased 2.7% system-wide (3.1% for company-owned, 0.3% for franchise restaurants) compared to the same period in 2012. For 2013, management is projecting higher company-owned comparable restaurant sales of 3.25%-3.75% (with 3.75%-4.25% in the upcoming fourth quarter).

To contrast, when I first invested in Chipotle in 2007 its comparable restaurant sales often ranged from the high single-digits to low double-digit percentage increases. However, Chipotle had over 500 restaurants at the time of its IPO in 2006, which could mean that Noodles simply needs to build its exposure and customer base to generate stronger comparable restaurant sale increases. Regardless, currently Noodles heavily relies on new restaurants to increase sales and earnings; thus, it would be difficult to justify a high premium on the stock should Noodles slow the opening of new restaurants in the foreseeable future.

Noodles & Company Key Statistics:

Market Cap: 1.25B
Employees: 7,000
Qtrly Rev Growth (yoy): 0.15
Revenue (ttm): 337.38M
Gross Margin (ttm): 0.21
EBITDA (ttm): 39.56M
Operating Margin (ttm): 0.059
Profit Margin (ttm): 0.017
Net Income (ttm): 5.82M
EPS (ttm): 0.22
P/E (ttm): 193.11
PEG (5 yr expected): 3.93
P/S (ttm): 3.79

Noodles’ margins are not at the same level of Chipotle or Buffalo Wild Wings either (1.72% profit margin versus 10.07% for Chipotle and 4.38% for Buffalo Wild Wings), but opening more franchised locations should ease margins. It would be fair to say that Noodles has respectable growth numbers but is not yet near the financial caliber of Chipotle, which has had remarkable margins and cash flow production since its 2006 IPO. Until Noodles can improve margins and comparable restaurant sales, the company is heavily relying on the success of continued expansion and the opening of new locations.

Kevin Reddy, Noodles’ CEO, believes Noodles can open 2,500 restaurants in the United States. This is obviously a long-term outlook, but given the company's quick and consistent expansion over the past decade there might be some merit to Noodles' potential to open over 2,000 restaurants in the U.S. In its IPO Prospectus, management states 2,500 restaurants as a goal to achieve over the next 15-20 years. This equates to opening an average of 82-111 restaurants annually for the next 15-20 years.

Keep an eye out for a Noodles opening soon near you: 42 new Noodles restaurants (35 company-owned, 7 franchised) have been opened thus far in 2013, with one more quarter remaining. In Kentucky, where I am currently going to college, there is only one Noodles restaurant with a second franchised location opening in early 2014.

(N)oodles of Knowledge: Management

While Noodles' management team does not include anyone quite like Steve Ells, the young fellow who founded and continues to lead Chipotle, there is a considerable experience on this management team.

CEO Kevin Reddy has been with Noodles since 2006. Before he joined Noodles, in fact, Reddy spent seven years working as a manager at Chipotle in numerous positions including chief operating officer, chief operations officer, and restaurant support officer. In 2009 the Restaurant Business magazine named Reddy the Entrepreneur of the Year, calling Reddy "the right guy at the right time for the globally inspired noodle shop concept."

Keith Kinsey, Chief Operating Officer, has been with Noodles since 2007, and used to serve as the Pacific Regional Director for Chipotle Mexican Grill; Kinsey has also worked in the restaurant field with McDonald's, PepsiCo, and others.

Curiously enough, Noodles has yet another management connection with Chipotle. Phil Petrilli, a young buck at the age of 43 years old, serves as Noodles' Executive Vice President - Operations. Before he joined Noodles in May 2012, Petrilli spent thirteen years with Chipotle in various operations positions (including a Regional Director for the Northeast Region). Petrilli is the person who helped recruit Nate Appleman, a Rising Star Chef from the James Beard Foundation, to work as a chef for Chipotle's test kitchen.

Noodles' management team is noteworthy due to its members' extensive experience either with the company or the restaurant industry as a whole. By having top-level managers who have significant experience with Chipotle, arguably the fast-casual restaurant success story of the past decade, this Noodles management team has the appearance of an all star cast. Keith Kinsey and Phil Petrilli spent their time with Chipotle as Regional Directors (focusing on the pacific and northeast regions, respectively), meaning they have specialized experience in certain regional markets of the U.S. This knowledge and experience from Chipotle is invaluable and bodes well for the future expansion of Noodles.

Is the stock too pricey?

Despite these overall positives, Noodles stock seems to be anything but cheap. The stock has not exactly flown under the radar, with Noodles' IPO considered one of the "hottest IPOs" for Wall Street this year. Noodles is currently valued at $1.25 billion, trading at a P/E of 193.11.

This reminds me of when I invested in Chipotle in January 2007. Chipotle was valued at $1.8 billion and traded at a P/E multiple of 49 (the ‘A’ shares traded at a multiple closer to 58). This scared away some investors from opening a position in Chipotle, which today (6+ years later) is valued at $16.63 billion with a P/E of 54.44. Chipotle nearly tripled its amount of restaurants in operation since 2007.

Noodles’ numbers are not quite as hefty as Chipotle’s, as I touched upon above. Chipotle's ability to generate cash flow and consistently increase earnings, while expanding at an incredibly quick pace, is unparalleled for many businesses and not just restaurants. With that said, Noodles is increasing its rates of growth, improving comparable restaurant sales, and marking impressive increases in its cash flow production.

Growth often comes with a premium. Most importantly, a niche concept, combined with an innovative (and experienced) management team and increasing rates of cash flow production, can be worth the premium in the long run. I must admit that I am most impressed with Noodles management team. If anyone is qualified to further execute a successful national roll-out of Noodles, it is this group that has been assembled under CEO Kevin Reddy. Fast-casual restaurants like Chipotle and Buffalo Wild Wings succeeded due to their niche concepts and management teams who could profitably execute the long-term national expansion of those restaurants.

However, because of its pricey valuation, Noodles’ stock will be volatile and is likely prone to get hammered on the slightest negative or unexpected news. Mr. Market is an irrational fellow, though, and there is no telling what the stock will do, especially in the short-term. From my experience, it does a long-term investor little good to fret about what the market (or a certain stock) might do in three weeks, three months, or even one year. For instance, many of those who questioned the valuation of Chipotle’s stock in 2007, despite recognizing Chipotle’s impressive fundamentals and growth rates, would have highly doubted that six years later the stock would still be trading at a P/E ratio above 50. And yet here we are, one 10-bagger later. Similar things could be said about Starbucks,, and other great long-term investments of the past 10-15 years.

A long-term investor’s focus should remain on the business, not the stock or the overall market. Is Noodles more than a passing fad? Can this management team continue to profitably execute aggressive nationwide expansion of Noodles restaurants? Can Noodles generate adequate cash flow to fund capital expenditures and fuel future growth? These are the important questions long-term investors must ask about Noodles. I lean toward answering “yes” to all three questions.

Here is another question worth asking: if Noodles continues with this rate of growth, as management has successfully done over the past decade (including the period of the recession), can this become a $10-$15 billion company over the next fifteen years? I want to look beyond the current price tag and consider the potential of Noodles to fully emerge as a national player and, perhaps, trendsetter in the niche of fast-casual dining. A lot banks upon whether management can manifest this vision in the coming.

Were I to invest in Noodles, I would do so with an outlook of at least ten years; anything less loses the full potential of Noodles expansion. Noodles manages to produce increasing positive cash flow while expanding at a quick pace, holds a stellar management team to guide the fledgling fast-casual restaurant, and over the past ten years has built a base of restaurants which help demonstrate the concept’s validity on an expanding national scale. Because the company is still adjusting to the spotlight, some of these items require further analysis in the coming quarters and years to determine if Noodles is indeed self-sufficient and capable of funding future growth from within the company.

This is not to say that I am jumping all-in and investing in Noodles, yet. Investors can be weary of investing in a company so soon after its IPO, a process which can be followed by what might be called “market jitters” for a chunk of time. A lot of people are still learning about Noodles and struggling to see how to value this company and its long-term prospects. Despite some of these more superficial shorter-term concerns the long-term outlook for Noodles is, in my mind, very bright and will result in a market-beating stock.

I aim to closely follow Noodles and would be inclined to open or add to a position if the stock gets knocked down a peg. Early- to mid-stage growth businesses can get slammed by the market for petty reasons in the short-term. I remember an occasion when Buffalo Wild Wings’ quarterly earnings report beat analyst estimates and B-Dubs raised future guidance, and yet the stock still got walloped by 20% in the course of 1-2 days. Maybe we will be lucky enough to get that opportunity with Noodles.

I take close notice when a management team of this caliber joins forces to profitably expand an innovative product and service. The short-term price tag will resolve itself either through a decrease in share price, rapidly expanding earnings, or perhaps (the best option of all for long-term investors) a combination of both. Either way, I would be surprised if Noodles does not beat the market over the next 10+ years. I am excited by the long-term prospects of Noodles and might open an initial position in the stock soon.

Noodles is oodles of fun, am I right?

David K

See this post in CAPS for links to some of the stories mentioned here.


3 Comments – Post Your Own

#1) On November 21, 2013 at 1:31 PM, ikkyu2 (98.57) wrote:

I think it might be a good idea to take a closer look at that multiple.  Handwaving a P/E of 193 - in a debt-free, cash-flow-positive company - as being similar to a P/E of 49 doesn't make much sense.  That's like saying that a $5000 car is similar to a $20000 car.  You can say it, but it doesn't make it true.

I opined in a recent blog post that NDLS is already fairly valued for all its future growth.  The logic went something like this:  "fair value" for a large mature fast-casual chain is a P/E of 20.  Noodles has 500 restaurants and will eventually, in 10 years, have 2500 - according to its own CEO - so it can be expected to increase revenue fivefold.  Let's assume that earnings track revenue - i.e, that margins don't change much.  Therefore, if the stock price never changes, the multiple will come down by a divisor of 5 - in other words, from 200 down to 40.

OK, now NDLS has opened every store that its optimistic CEO says it can support - and its stock hasn't gone up in 10 years - and it's still twice as expensive as 'fair value' says it ought to be.

Can you point out a flaw in my analysis?  I don't find one. 

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#2) On November 21, 2013 at 1:33 PM, ikkyu2 (98.57) wrote:

I have never, by the way, been interested in comps.  Comps are something good restaurant managers have to focus on, but they're not something I as an investor have to worry about.  I, like you, am looking for the next ten-bagger.  Comps are never, never, never going to get us there.

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#3) On November 22, 2013 at 8:30 PM, TMFPencils (99.85) wrote:

Hi ikkyu2,

I attempted to address that Chipotle was much more solid financially (and still is) than Noodles is today. Both are innovative players in fast-casual restaurants; I wasn't aiming to limit the comparison to the P/E multiple. Relatively few people thought Chipotle was a good value 5-7 years ago, and the comparisons to Chipotle can be helpful potentially for the reasons you mentioned: maybe Noodles simply isn't (or can't be) up to par with Chipotle. 

I wrote this blog post explaining why I think comps are important for investors: 

If Noodles can increase its comps, as management is projecting for this year, it can have a significant impact on revenue growth going forward. With your projections you are assuming that current restaurants will see little, if any, revenue growth. If Noodles' comps and margins increase, something I think is feasible long-term, the company could see substantial earnings growth in the coming years. Comps alone won't produce a ten-bagger, but high comps contributed to Chipotle's financial success. (Comps are especially important for companies who avoid or limit franchising, like Chipotle and Noodles.)

However, you are absolutely right that Noodles is selling at a premium. The company is still at a relatively young stage of growth, certainly younger than Chipotle was at its IPO in 2006, so there is still room for improvement particularly with margins and comps. Noodles will need to do a lot of things exceptionally well in the coming years to justify today's stock price. 

Noodles will be an interesting one to follow. At some point I may become a shareholder, but for now aim to evaluate the business's progress in the coming months. Should the stock get clobbered I'd be tempted to open a position.  

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