Noodles & Company: Reviewing The Bull And Bear Cases For Investment

| About: Noodles & (NDLS)
This article is now exclusive for PRO subscribers.

I have recently begun to analyze some of the restaurant IPOs from 2013. In my recent article, PotBelly: More Downside Ahead, I noted that I don't see much leverage in the PBPB business model as it expands and expect the chain to face competition both in their company-owned stores and in growing their franchise base. I am now moving onto Noodles & Company (NASDAQ:NDLS), which I believe has more upside than the PBPB brand. It's a unique concept that I was able to try out last week, and I enjoyed the product. As opposed to PBPB, I do see some same store sales upside, which means we could get operating leverage. Additionally, the stock has already sold off due a recent secondary offering. Though I am not a buyer in the stock at it current levels, I wanted to provide the same kind of sensitivity analysis I did with PBPB to give investors the opportunity to judge the investment merits of NDLS for themselves.

Business Overview

Noodles & Company is a noodles-based, fast casual restaurant concept offering lunch and dinner within the fastest growing segment of the restaurant industry. The company opened its first location in 1995, and currently has over 300 locations. The company sees the potential for 2500 locations nationwide.

Source: NDLS Investor Presentation

The company owns a fast dining experience at about an $8.00 average check. The company also has soups and salads. The company provides large and small portions, which I think is a good idea, with add-ons like different types of meats. I have provided a glimpse of the menu below.

The company's goal is to use its differentiated menu to drive AUVs and help the company find good real estate locations and strong franchisees. The competitive environment is tougher than it was in the early stages of fast casual, but the company still expects same store sales around 5%.

Overall, I like the business model, but I do have some major concerns (we will talk about these later in the articles). Let's get into our sensitivity analysis.

The Bull Case: A Unique Business With Explosive Growth

The company's unique business gives it the opportunity to grow aggressively throughout the United States. Comps remain strong in 5-6% range, which enables the company to leverage restaurant-level expenses. SG&A is also leveraged on a larger store base, and the company sees good franchise growth.

2013

2014

2015

2016

2017

2018

2019

2020

Total Co Units

318

369

417

472

530

596

665

737

Total Franchise Units

68

78

95

119

150

188

233

285

Total Units

386

447

512

591

680

784

898

1022

Revenue

348,241

389,007

467,698

554,527

656,569

773,907

910,025

1,052,288

Franchise Revenue

4,000

4,680

5,700

7,140

9,000

11,280

13,980

17,100

Total Revenue

352,241

393,687

473,398

561,667

665,569

785,187

924,005

1,069,388

COGS

90,032

100,753

121,134

143,622

170,051

200,442

235,696

272,543

Labor

103,285

114,987

137,780

162,804

192,107

225,665

264,445

304,734

Occupancy

34,432

38,512

46,302

54,898

65,000

76,617

90,092

104,177

Other

49,283

55,239

66,413

78,743

93,233

109,895

129,224

149,425

Restaurant Level Income

75,209

84,196

101,769

121,599

145,178

172,569

204,547

238,510

G&A

37,077

40,640

47,925

55,714

64,653

74,659

85,970

97,305

D&A

20,099

23,239

26,245

29,730

33,405

37,567

41,910

46,418

Pre-Opening

3,733

4,033

4,333

4,633

4,933

5,233

5,533

5,833

EBIT

14,300

16,284

23,266

31,522

42,187

55,109

71,134

88,954

Interest

2,000

-

-

-

-

-

-

-

EBT

12,300

16,284

23,266

31,522

42,187

55,109

71,134

88,954

Taxes

3,690

4,885

6,980

9,457

12,656

16,533

21,340

26,686

Net Income

8,610

11,399

16,286

22,065

29,531

38,577

49,794

62,268

EPS

$ 0.36

$ 0.47

$ 0.68

$ 0.92

$ 1.23

$ 1.61

$ 2.07

$ 2.59

Using this base-case scenario, we get a 2020 EPS figure of about $2.60 If the company can continue to grow earnings at 15% annually after this point, a 20x valuation on 2020 EPS gives us a value of $52, or 40% upside.

The Base Case: Strong Growth, But A Growing Fast Casual Segment

For my base case, I assume that the company find success in their business, but faces some challenges finding enough real estate for explosive growth. The company-owned store base doubles by the end of the decade, and the company slightly more than doubles the franchise store base off solid demand. The company keeps restaurant-level margins basically flat, and sees operating leverage on SG&A.

2013

2014

2015

2016

2017

2018

2019

2020

Total Co Units

318

366

410

458

511

571

632

700

Total Franchise Units

68

78

91

107

126

148

173

201

Total Units

386

444

501

565

637

719

805

901

Revenue

348,241

387,547

462,369

542,744

635,301

743,892

868,454

999,867

Franchise Revenue

4,000

4,680

5,460

6,420

7,560

8,880

10,380

12,060

Total Revenue

352,241

392,227

467,829

549,164

642,861

752,772

878,834

1,011,927

COGS

90,032

100,375

119,754

140,571

164,543

192,668

224,930

258,966

Labor

103,285

115,102

137,324

161,195

188,684

220,936

257,931

296,961

Occupancy

34,432

38,367

45,775

53,732

62,895

73,645

85,977

98,987

Other

49,283

55,032

65,656

77,070

90,213

105,633

123,321

141,981

Restaurant Level Income

75,209

83,352

99,321

116,597

136,526

159,890

186,676

215,033

G&A

37,077

40,487

47,379

54,530

62,558

71,764

82,043

92,458

D&A

20,099

23,039

25,844

28,839

32,199

35,948

39,812

44,125

Pre-Opening

3,733

4,033

4,333

4,633

4,933

5,233

5,533

5,833

EBIT

14,300

15,792

21,765

28,595

36,836

46,946

59,288

72,616

Interest

2,000

-

-

-

-

-

-

-

EBT

12,300

15,792

21,765

28,595

36,836

46,946

59,288

72,616

Taxes

3,690

4,738

6,529

8,579

11,051

14,084

17,786

21,785

Net Income

8,610

11,055

15,235

20,017

25,785

32,862

41,502

50,831

EPS

$ 0.36

$ 0.46

$ 0.63

$ 0.83

$ 1.07

$ 1.37

$ 1.73

$ 2.12

Using this base-case scenario, we get a 2020 EPS figure of about $2.10 If the company can continue to grow earnings at 15% annually after this point, a 20x valuation on 2020 EPS gives us a value of $42, or 15% upside.

The Bear Case: The Product Fails and Growth Becomes Tougher

I have a few big problems with the NDLS business model:

  1. It's importance on noodles goes directly against the growing trend of healthy/low-carb dieting. I just don't see the health aspect that Chipotle (NYSE:CMG) or Panera Bread (NASDAQ:PNRA) provides.
  2. If the business is successful, it will face increased competition, such as Panera's recent introduction of bowl meals. I just don't see a moat around the business model.
  3. There are so many fast casual concepts coming online, and companies that are already in the market expanding, which will put pressure both on comps and the company's ability to find good real estate and strong franchisees.

Considering these negatives, the bear case sees single-digit store growth with decelerating same store sales. The company will be unable to leverage costs, and becomes a weak unit growth company.

2013

2014

2015

2016

2017

2018

2019

2020

Total Co Units

318

359

366

402

438

474

509

543

Total Franchise Units

68

78

88

98

108

118

128

138

Total Units

386

437

454

500

546

592

637

681

Revenue

348,241

384,628

436,825

480,762

552,427

630,416

713,893

794,640

Franchise Revenue

4,000

4,680

5,280

5,880

6,480

7,080

7,680

8,280

Total Revenue

352,241

389,308

442,105

486,642

558,907

637,496

721,573

802,920

COGS

90,032

100,003

113,574

124,998

143,631

163,908

185,612

206,606

Labor

103,285

114,462

130,432

144,032

166,055

190,128

216,018

241,246

Occupancy

34,432

38,463

43,682

48,076

55,243

63,042

71,389

79,464

Other

49,283

54,617

62,029

68,268

78,445

89,519

101,373

112,839

Restaurant Level Income

75,209

81,763

92,387

101,267

115,534

130,899

147,181

162,765

G&A

37,077

40,771

46,303

50,961

58,557

66,824

75,673

84,232

D&A

20,099

22,638

23,039

25,303

27,607

29,884

32,093

34,185

Pre-Opening

3,733

4,033

4,333

4,633

4,933

5,233

5,533

5,833

EBIT

14,300

14,320

18,711

20,370

24,436

28,958

33,882

38,515

Interest

2,000

-

-

-

-

-

-

-

EBT

12,300

14,320

18,711

20,370

24,436

28,958

33,882

38,515

Taxes

3,690

4,296

5,613

6,111

7,331

8,687

10,165

11,555

Net Income

8,610

10,024

13,098

14,259

17,105

20,270

23,717

26,961

EPS

$ 0.36

$ 0.42

$ 0.55

$ 0.59

$ 0.71

$ 0.84

$ 0.99

$ 1.12

Using this bear-case scenario, we get a 2020 EPS figure of about $1.10 If the company can continue to grow earnings at 12% annually after this point, a 17.5x valuation on 2020 EPS gives us a value of $20, or 40% downside.

Valuation

Let's take a look at our weighted valuation:

Avg. Start-Up

Weight

Value

Base Case

$ 42.00

50%

$ 21.00

Downside Case

$ 20.00

20%

$ 4.00

Upside Case

$ 52.00

30%

$ 15.60

Total Valuation

$ 40.60

Upside/Downside

12%

All-in, I am using a base-case valuation of $42. On the upside, the company could be worth $52. On the downside, I am using a valuation of $52. Again, all these valuations were done on about 20x 2020 earnings, which could be aggressive in its own right, but if the business is successful in its expansion to 2500 locations, it might actually be cheap.

Risks

Risks for the company include:

  1. Competition to find good real estate and obtain strong franchisees
  2. Competition in the noodles/bowls segment from current and future fast casual concepts
  3. An inability to taking pricing on noodle-based products, which could result in margin deterioration
  4. A lack of successful on the national level due to the concept and trends towards healthy/low-carb dieting

Catalysts

Catalysts for the company include:

  1. High-single digit same store sales, which would beat expectations and allow the company to better leverage expenses
  2. The ability to expand nationwide with its differentiated product
  3. Product innovations that help drive unit level economics

Conclusion

Overall, I am more bullish on NDLS than I am on PBPB. Its differentiated concept has a really good chance of being successful, and I believe there is more earnings potential in the business. I am concerned about the importance on noodles in the menu and its lack of a moat to fend off competitors if the concept is successful. I hope that this article helps investors in their analysis on NDLS.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.