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Summary

  • Noodles & Co.'s second quarter was horrible and shares were decimated on the news.
  • NDLS is still trading at 40 times next year's earnings as expectations are still far too high.
  • Shares are still far too expensive based on fundamentals.

Shares of Noodles & Company (NASDAQ:NDLS) got absolutely decimated late last week after the company reported a downright terrible quarter. Shares fell from $26 to $20 in one day on top of enormous declines in the past year prior to that. With shares carving out new lows since its IPO, is Noodles worth a look for your portfolio? In this article, I'll attempt to answer the question of whether or not there is any value in NDLS at ~$21 per share.

(click to enlarge)

To do this, I'll use a DCF-type model you can read more about here. The model uses earnings estimates, which I've sourced from Yahoo!, dividends, which I've set at zero for the foreseeable future, and a discount rate, which I've set at the 10 year Treasury rate plus a risk premium of 9%, reflecting the risky nature of Noodles' business and the choppiness of its operating results. This is a case of high risk/high reward and the model should reflect that.

 

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

       

Prior Year earnings per share

 

$0.40

$0.45

$0.53

$0.68

$0.87

$1.12

x(1+Forecasted earnings growth)

 

12.50%

17.80%

28.25%

28.25%

28.25%

28.25%

=Forecasted earnings per share

 

$0.45

$0.53

$0.68

$0.87

$1.12

$1.43

        

Equity Book Value Forecasts

       

Equity book value at beginning of year

 

$4.44

$4.89

$5.42

$6.10

$6.97

$8.09

Earnings per share

 

$0.45

$0.53

$0.68

$0.87

$1.12

$1.43

-Dividends per share

 

$0.00

$0.00

$0.00

$0.00

$0.00

$0.00

=Equity book value at EOY

$4.44

$4.89

$5.42

$6.10

$6.97

$8.09

$9.52

        

Abnormal earnings

       

Equity book value at begin of year

 

$4.44

$4.89

$5.42

$6.10

$6.97

$8.09

x Equity cost of capital

11.40%

11.40%

11.40%

11.40%

11.40%

11.40%

11.40%

=Normal earnings

 

$0.51

$0.56

$0.62

$0.70

$0.79

$0.92

        

Forecasted EPS

 

$0.45

$0.53

$0.68

$0.87

$1.12

$1.43

-Normal earnings

 

$0.51

$0.56

$0.62

$0.70

$0.79

$0.92

=Abnormal earnings

 

-$0.06

-$0.03

$0.06

$0.18

$0.32

$0.51

        

Valuation

       

Future abnormal earnings

 

-$0.06

-$0.03

$0.06

$0.18

$0.32

$0.51

x discount factor(0.114)

 

0.898

0.806

0.723

0.649

0.583

0.523

=Abnormal earnings disc to present

 

-$0.05

-$0.02

$0.04

$0.11

$0.19

$0.27

        

Abnormal earnings in year +6

      

$0.51

Assumed long-term growth rate

      

3.00%

Value of terminal year

      

$6.09

        

Estimated share price

       

Sum of discounted AE over horizon

 

$0.28

     

+PV of terminal year AE

 

$3.19

     

=PV of all AE

 

$3.46

     

+Current equity book value

 

$4.44

     

=Estimated current share price

 

$7.90

     

As you can see, this is pretty ugly. With shares trading for around $21 as I write this, I'm calculating a fair value of $8. That is the largest discrepancy I've ever seen when doing this kind of analysis so we'll need to spend some time understanding why the gap is so large.

First, we must understand that the model is producing a fair value and not a price target. A price target is forward looking, multiplying future earnings by some earnings multiple to come up with a price on some future date. The fair value I've computed is for today, stating that the present value of NDLS' future earnings stream, based upon the inputs I described above, is around $8. That essentially means the model is implying you should only buy NDLS if the price is lower than $8, which of course isn't even in the realm of possibility right now. So should we believe the market or the model? The answer to that question is always the market because the market is the venue that selects the winners and losers. However, I still think the model is instructive in the case of Noodles in terms of offering a cautionary tale.

Noodles is a classic case of a hot concept that came to market at just the right time. I like Noodles from a consumer's perspective. The food is good, it's affordable, the atmosphere is decent and it's quick. When spending $7 or $8 on a meal, you can't ask for much more than that. In addition, employees, in my experience, are always knowledgeable and quick to assist. I also don't really see Noodles locations, of which there are many near where I live, that don't have customers at most times of the day. The menu has also been extremely well designed in terms of ingredients. In the mold of a Chipotle (NYSE:CMG), Noodles has some core ingredients it can leverage for many different dishes; it simply compiles them in different ways. In short, Noodles' business model is terrific and I have no issues with this company from a management perspective or as a consumer of the business' services.

So if Noodles, the company, isn't broken, why are shares down from $50 to $20? The answer is simple; expectations were in the stratosphere for this company's future earnings. Given the number of locations the business could have at some point - I heard an estimate I laughed quite hard at of 2,500 - and the amount of profit each restaurant can earn, not even a fully built out, mature state Noodles with 2,500 thriving locations was worth $50, let alone the growth state company we see before us today that has so much inherent uncertainty. The fact is that Noodles timed the IPO perfectly and took investors' money that didn't perform due diligence; those investors have gotten annihilated since NDLS went public.

The cautionary tale is to never pay too much for a business, even if the business is great at everything. We have seen what happens when that is the case; expectations that are impossible to meet are never met and the stock gets crushed. This has happened over and over and over again and will continue to happen in the future. I'm not certain how investors saw Noodles at $50 and thought I was a good idea but here we are. So let's evaluate NDLS now that we see $21 as the current price.

NDLS' quarter was awful; comp sales fell during the quarter and contribution margin from its restaurants also fell precipitously (200 bps to 20.4%). Neither of those things are excusable for a company with the earnings multiple that NDLS has, let alone both at the same time. Companies that have stratospheric earnings expectations must keep comp sales blistering and margins expanding in order to keep investors happy. When that doesn't happen, shares crash.

So does Noodles have systemic problems or was the second quarter just bad? We won't know until probably sometime next year but I'm willing to bet the business of Noodles is just fine. The way Noodles runs its stores is exemplary but if traffic continues to wane, the menu will need a revamp in order to stoke traffic once more; I suspect management is working on that sort of thing already. Whether this translates into success will be interesting to see going forward. We'll also need to see that NDLS is maintaining its ability to have some pricing power; if we see NDLS cut prices we'll know there are some deeper issues occurring.

Right now, even after shares have fallen by more than half from their highs, Noodles is way too expensive. Even with the ridiculous earnings growth rates you can see in my model (28%!), Noodles is too expensive. Imagine what will happen if the company continues to miss earnings; we could literally see this stock at the $8 fair value I computed here. I know I sound crazy and I am sure I'll receive plenty of vitriol from NDLS longs in the comments but it's true; Noodles should fall farther than it has because it doesn't deserve to trade for 40 times forward earnings. This company is terrific from a consumer's perspective but it has operational issues it needs to correct and its earnings multiple should be halved as well. We may see a bounce in NDLS after the crash but the long term trend for this stock is down, down and down some more until we get to a more reasonable valuation.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within 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 & Co. Fair Value: $8