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Summary

  • Noodles and Company had negative comparable restaurant sales in Q1.
  • The food is rated below key competitors only scoring a 3 on Yelp at many locations.
  • Noodles and Company plans to expand its store base 15% a year.
  • Noodles and Company may be overvalued by 50%.

Noodles and Company (NASDAQ:NDLS), is a fast-casual restaurant whose menu consists of globally inspired noodle-based meals including beef stroganoff and penne rosa pasta. It has a Yelp score at its Cupertino, CA location of 3 stars and the same rating at its Crystal City, Virginia location. Started in 1995, NDLS has grown as of April 1st 2014 to a total of 394 locations. NDLS made its debut as a public company on June 28th, 2013 at a price of $18 and rallied 104.2% on its first day of trading closing at $36.75. After its initial IPO pop, NDLS traded to a high of $48.30 and has slowly drifted down to $27.22 where it currently trades at its 52-week low. NDLS's next earnings report is due August 13, 2014 and investors should do their due diligence to determine if the slide in price will gain momentum or reverse course on the back of a good earnings release.

Determining the direction and magnitude of crucial comparable restaurant sales is key to projecting the future prospects of NDLS. For the past 5 quarters, NDLS has been able to scratch out 2.06% comparable restaurant sales growth. For Q1 2014, NDLS posted a negative 1.6% comparable restaurant sales growth, which is calculated using only locations open at least 18 months. Average unit volume for the quarter ending April 1st, 2014 was 1.163 million for company-owned locations. This is down from Q1 2013, when AUV was 1.180 at company-owned locations a trend. For FY 2014, NDLS projects 2.5 to 3% average unit volume but unless they can rebound from Q1 this number will be out of reach. Falling comparable sales should concern investors because it will have a larger impact on profits; because for every drop of revenue, profit will drop more due to the fixed costs of operating a location.

(click to enlarge)

Source:SEC EDGAR

Over the past 5 years, NDLS has steadily expanded the number of both its franchise and company-owned locations. At the end of FY 2009, NDLS had 229 total locations, which is a little more than half the current end of year forecast of 438. For the past 2 years and for 2014, NDLS seeks to grow its location base at about 15%, providing revenue growth in place of falling comparable restaurant sales. In the past the growth rate of company-owned locations outpaced that of finished locations but this trend has recently been reversing. For FY 2014, growth in franchised locations is poised to be 500 basis points higher than company-owned location growth. This trend is worth noting because the revenue growth generated by NDLS from each franchise location rose from 12% from Q1 2013 to Q1 2014. This may suggest that NDLS will open more franchise locations, because that stream of revenue's growth has outpaced company-owned location revenue growth. The downside of the growth mixed shifting towards franchised locations is the limited revenue upside for NDLS, as each franchise 16k in revenues is paltry compared to the 1.1M for company-owned locations. This plan does not account for possibly difficulties finding franchisees, because although system-wide comparable restaurant sales growth has been decent, comparable restaurant sales growth for franchise locations has been poor. For each of the past 5 quarters, comparable sales growth at franchise locations has lagged growth at company-owned locations. This trend does not bode well for attracting new franchisees and may be explained by franchises being offered substandard locations compared to company-owned locations. It could also be due to poor management by franchisees, which would have a negative impact on consumers' overall view of NDLS. In Q1 2014, NDLS opened 13 company-owned restaurants and 1 franchise location.

For 2014 total, NDLS aims to open between 42-50 company-owned locations and 10-15 franchise locations, thus in Q1 company-owned restaurant openings were 1.5 units above guidance on an annualized basis. Franchise locations were 2 units below guidance on an annualized basis.

(Source: SEC EDGAR)

Revenues at NDLS have grown steadily over the past 5 years, averaging an annual increase of 16.3%. Recently, the trend in revenue growth has showed signs of slowing with FY 2013 growing at 17% down from 17.2% in 2012. The slowdown is more apparent when looking at the past quarter compared to the previous year's quarter. Revenue in Q1 2014 grew at 10.1% over the previous year's quarter down from 17.1% quarter-over-quarter growth in Q4. With the expected shift in expansions towards franchises and weak comparable restaurant sales growth, revenue growth in FY2014 will almost certainly be slower than 17% in 2013. Judging from the Q1 results, revenue growth for 2014 will likely average between 10 and 15%.

Cost of goods sold determines an ability of a company to control costs, as well as the ability of a growing restaurant chain to take advantage of economies of scale in order to reduce fixed costs as a percentage of revenues over the long term. A large cost for all restaurants is labor, which was 30% of revenue in 2013 down from 30.1% in 2012. The trend for labor cost at NDLS will be slightly higher as a percentage of revenue as additional revenue growth is increasingly derived from increasing the number of locations. This is also due to the nationwide trend of increasing minimum wages and the need to pay higher wages in order to slow employee churn. Cost of sales, which includes food, beverage and packaging expenses. These expenses fell to 26.5% from 26.6% of revenue in 2013 to 2012 respectively. It can be expected that as commodity costs for corn and wheat fall while meat costs spike, this will cancel out roughly keeping cost of sales between 27 and 26% of revenue. Occupancy costs rose from 9.9 to 10.1% of revenue likely due to an increase in the total number of restaurants and an hike in commercial rents as the economy begins to accelerate. For the most recent quarter, occupancy costs rose to 11% of revenue, suggesting the trend may continue if average unit volumes decline. Other restaurant operating expenses rose from 12.2 to 12.7% of revenues in 2013 as utility costs increased, as well as repair costs. Overall costs as a percentage of revenues will stay relatively flat for 2014, allowing for minimal operating margin expansion curtailing earnings per share growth.

The balance sheet of NDLS is strong with minimal cash totaling 668K. This was caused by NDLS paying down a substantial amount of debt post IPO draining their cash reserves. The low level of cash compares to a debt of 6.6 million, a mere 5% of shareholder equity as of Q1 2014. With a positive net income and significant non-cash costs, NDLS has been able to generate a positive operating cash flow each of the past three years. It is possible that cash flows from operations will not provide enough cash to pay for planned restaurant expansions. This would then mean that NDLS would have to take a loan, sell bonds or sell shares to pay for its expansion potentially increasing interest expense or diluting existing shareholders. No secondary offerings that were significantly dilutive have occurred since NDLS has been a public company, and no buybacks have been announced.

NDLS Historical Chart

(Source: Yahoo Finance)

Conclusion:

NDLS may seem like an attractive stock due to its market share in the rapidly growing fast-casual segment. Looks may be deceiving, because NDLS trades at 2.25 sales, a fair ratio but not significantly underpriced considering the low profitability of NDLS. NDLS earned 25 cents per share in 2013 giving NDLS a current price to earnings ratio of 108. In order to justify that high of a price to earnings ratio NDLS will need to grow earnings at a rapid rate. Given the current lack of strong restaurant comparable sales growth and little sign of improving margins it is hard to see NDLS justifying its current 108 times earnings multiple. For the first quarter NDLS earned 5 cents putting it far behind its goal of 25% earnings growth for 2014. Even if NDLS is able to sustain 25% per year earnings growth, it would take until the end of 2017 for the price-to-earnings of NDLS to be under 50. This was also calculated with no increase in share price or shares outstanding. For the next twelve months, I expect the share price of NDLS to trade downward from 27 as the market sells shares due to the high price to earnings and inability of management to grow comparable restaurant sales. I expect comparable restaurant sales to average between 1 and 2% on the year due to the fact that the trend in comparable store sales has been weak and the first quarter put NDLS in a hole for 2014. I would increase the target price of NDLS if it was able to increase comparable restaurant sales or able to increase margins, something it needs to do in order to justify its price to earnings. Even with a good concept, NDLS has an uphill battle, and unless it can improve certain metrics, its shares will continue to decline.

NDLS' next earnings report is due on August 13, 2014, and should provide confirmation that NDLS is in a potential multi-year decline. This would be confirmed by sub-2% comparable restaurant sales growth or poor margins.

Disclosure: The author has no positions in any stocks mentioned, but may initiate a short position in NDLS over the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: Noodles & Company's Earnings Preview

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