Noodles & Company: Long-Term Growth Richly In The Price

| About: Noodles & (NDLS)
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Summary

Noodles & Company is an emerging fast casual restaurant chain, with 380 restaurants as of Dec 2013..

The main attraction is its long term growth story due to organic growth and operating leverage..

However, on same restaurant growth trajectory, Noodles & Company lags rival Chipotle despite the former's much lower restaurant count..

Valuation (PEG of 1.90x) has richly priced in the long term growth story..

The bottom line is that Noodles & Company is unlikely to be a "can't miss opportunity" especially given rich valuation..

As a part of my research to find growth stocks, I looked at fast casual restaurant operators, starting with Noodles & Company (NASDAQ:NDLS). As we all know, fast casual has become the buzzword/hot segment in the mature restaurant industry over the past five years. Noodles & Company was listed on Jun 27, 2013 with IPO price of $18/share. On its first trading day, it doubled and rose further to touch all-time high $48.30/share on Oct 14, 2013. Since then, the share price has eased by 25%. Hence, in this article, I take a close look at Noodles & Company's fundamental/valuation to see if the buying opportunity has arisen. In particular, the big question for investors is whether Noodles & Company is the "next Chipotle" (replicating Chipotle's growth trajectory), which makes the former a "can't miss opportunity" in spite of trading at 57.1x 2015 PE.

Emerging fast casual restaurant chain

Noodles & Company is a fast casual restaurant chain offering a globally inspired menu including a wide variety of high quality, cooked-to-order dishes such as noodles, pasta, soups, salads, and sandwiches. These dishes are served on china by friendly team members. As of Dec 2013, the company has 380 restaurants, consisting of 318 company owned and 62 franchised restaurants, across 29 states.

Fast casual has been a high growth segment in the mature restaurant industry due to value for money menu (comparable to fast food restaurant prices) while offering some eat-in experience. Importantly, the food is perceived healthier as fast casual chains promote/emphasize high quality ingredients such as antibiotic-free meat or cooked dishes with fresh ingredients. In general, fast casual segment has become a mainstream last five years due to an oversupply of undifferentiated fast food brands. Moreover, the fast casual segment, in my opinion, benefits from consumers trading down from casual dining restaurants as well due to 2008-09 Recession and subsequent slow economic recovery.

I visit a Noodles & Company restaurant, which is located in Garden City, New York. My impression is that it is a typical fast casual restaurant with minimalist decorative style. Food serving time from the time of order at cash registers/counters is relatively short (5 minutes). Overall, what stands out to me, compared to other fast casual/fast food restaurants, is that 1) there is a store manager, that greets and talks to customers, to enhance eat-in experience and 2) the menu offers value for money given its globally inspired menu (according to its 2013's 10-K, average spend/person is only $8.00).

Long-term growth story

Noodles & Company is clearly in the early stage of its growth. As of Dec 2013, it has 380 restaurants only, vs. bigger fast casual operators such as Chipotle's (NYSE:CMG) 1,572 and Panera Bread's (NASDAQ:PNRA) 1,777. Moreover, the management has guided for 13-15% unit/restaurant growth and 3-4% same restaurant growth pa over the next four to five years. Specifically, management believes that 2,500 restaurants as its saturation point for the domestic market.

Hence, by 2016, in my modeling, I assume the company will have 556 restaurants, consisting of 458 company-owned and 98 franchised restaurants. This implies addition of 45-50 company owned and 10-12 franchised restaurants per annum. Clearly, the risk here is on the execution capability and real estate availability. However, this is in line with management's guidance, and during its 4Q13 earnings call, management reiterated a 13-15% unit/restaurant growth.

The greater attraction about Noodles & Company, I found, is that the growth story will be compounded at EBITDA or EPS level as higher economies of scale would produce operating leverage. In FY2013 (ended in Dec), EBITDA margin of Noodles & Company was only 11.2%, vs Chipotle's 19.8% and Panera Bread's 17.5%. Management guides for 30-50 bps operating leverage per annum over next four to five years. This would result in 25% EPS CAGR.

In the short term, though, management has warned that due to cold weather same restaurant growth in 1Q14 is likely to come in flat as 80% of its restaurants are located in weather-impacted regions such as Upper Midwest, Rocky Mountains, and Mid-Atlantic states. Note that the company has recorded 18th consecutive quarter of positive same restaurant growth until 4Q13.

Nonetheless, for full year 2014, management guides for 2.5-3% same restaurant growth. This implies 3.3-4% same restaurant growth for 2Q14-4Q14. In my view, this is attainable due to two main reasons. First, a cross check to Panera Bread reveals the same flattish restaurant growth story in 1Q14. Hence, this is not company specific, but overall industry weakness, just like how weather has impacted retailers. Second, 2009-13 same restaurant growth for Noodles & Company averaged 3.5%, which included flattish (0.4%) same restaurant growth in 2009 (recession-impacted). Excluding 2009, same restaurant growth averaged 4.2%.

The "next Chipotle"?

The big question for investors regarding Noodles & Company is whether it is the "next Chipotle" (replicating Chipotle's growth trajectory, in particular). As we all know, the emergence of Chipotle as fast casual operator in early 2000s has been spectacular as it has taken the mature restaurant industry by storm.

A comparison between Noodles & Company's and Chipotle's same restaurant growth, nonetheless, reveals that the former clearly lags the latter in terms of the growth trajectory. As said, in 2009-13, Noodles & Company's same restaurant growth averaged 3.5% (or 4.2% excluding 2009). During the same period, Chipotle posted 7.1% (or 8.3% excluding 2009) average same restaurant growth. Worth highlighting is that Chipotle's much higher average same restaurant growth was achieved on much higher restaurant count. As of Dec 2008, Chipotle already operated 830 restaurants, vs Noodles & Company's 200 restaurants only.

On a much lower restaurant count, during 2004-08, Chipotle delivered 10.8% average same restaurant growth. As of Dec 2003, Chipotle had 298 restaurants, similar to what Noodles & Company had in 2012. Hence, it is clear that Chipotle's growth trajectory is on a different level from Noodles & Company. A plausible explanation is that Chipotle is specialized in offering burritos and tacos, Mexican staple food, which has much longer history or closer proxy/association with Americans in terms of local taste/preference.

Meanwhile, Noodles & Company offers a combination of Asian, Mediterranean and American dishes (termed as globally inspired menu by management). This, in my opinion, puts Noodles & Company at a disadvantage in terms of starting point when it comes to local consumer taste/preference for staple food. In other words, Noodles & Company's case involves consumers adjusting or changing its eating preference.

Coming back to the growth trajectory, I found that Noodles & Company's same restaurant growth is more similar to what Panera Bread has experienced. As an illustration, Panera Bread, during 2009-13, averaged 4.8% same restaurant growth. In 2004-08, its same restaurant growth averaged 3.9%. This also highlights that Noodles & Company and Panera Bread exhibits more of normal growth story, while Chipotle's growth is simply spectacular (very rare). Needless to say, to have 3-4% same restaurant growth in a mature industry is pretty commendable.

Net-net, given different path of growth trajectory (from what has been unfolding), I think that Noodles & Company is unlikely to replicate Chipotle, same restaurant growth-wise. In particular, going forward, Noodles & Company will have a higher restaurant count. As stated, the local taste preference, which favors Chipotle's menu rather than Noodles & Company's, is a barrier to the latter's higher growth in the future. Another case in point is 1Q14 (weather impacted quarter) in which Chipotle delivers a strong 13% YoY same restaurant growth while Noodles & Company's management guides for flattish performance. Globally inspired noodle, in particular, could be just too exotic for Americans' staple food, in my opinion.

Valuation

Here, I attempt to value Noodles & Company with 1) Discounted Cash Flow (NYSE:DCF) method and 2) PEG multiple. On DCF method, worth highlighting is that the difficulty in valuing Noodles & Company is because it is in the early phase of its growth. Its free cash flow over the next four to five years (2014-18) would be negative mainly as capex exceeds after-tax EBITDA. Hence, in a typical 10-yr DCF model, most of intrinsic value (up to 86%) lies on present value (PV) of terminal value, vs more traditional 50-50 split between PV of explicit and semi-explicit forecast and PV of terminal value. Thus, assigning 10x EV/EBITDA and 12x EV/EBITDA as terminal valuation would give DCF fair value of $36.34/share (0.1% upside potential) and $42.44/share (17% upside potential), respectively. This is quite a swing in fair value due to change in the assumption used in terminal valuation, admittedly.

As for valuing on PEG method, I use 2015 PE and 2014-16 EPS CAGR. Noodles & Company trades a 1.90x PEG. This represents a 28-43% premium to Chipotle's 1.49x and Panera Bread's 1.33x. As described earlier, in the context of Chipotle's spectacular growth story, Noodles & Company's premium valuation could be a tad too steep. A 15-20% premium could be more reasonable as Noodles & Company has the advantage of lower base effect (translating into easier earnings gains, hence a clearer earnings growth visibility). Applying 20% premium (1.80x PEG), Noodles & Company's fair value is $34.32/share, a 5% downside potential.

PEG 2015 PE 2014-16 EPS CAGR PEG
Panera Bread 21.1 16% 1.33
Noodles & Co 57.1 30% 1.90
Chipotle 32.5 22% 1.49
Avg 36.9 23% 1.58

Combining the three fair values above, I would give more weight to PEG method given the DCF sensitivity to a change in terminal value assumption. At 50% weight on PEG and 25%/25% weight on DCF fair values, 12-mo PT for Noodles & Company would be $ 36.86/share or a mere 2% upside potential.

Fair value $/share Weight $/share
DCF with 10x EV/EBITDA in terminal value 36.34 25% 9.08
DCF with 12x EV/EBITDA in terminal value 42.44 25% 10.61
PEG with 1.80x multiple 34.32 50% 17.16
12-mo PT 36.86

Relating the valuation conducted above to local taste preference/Noodles & Company unlikely to replicate Chipotle's same restaurant growth trajectory, I would say that long term growth is richly in the price. In other words, Noodles & Company is unlikely to be a can't miss opportunity from investing perspective.

Brief company description

Founded in 2002, Noodles & Company is a high growth, fast casual restaurant chain, with 380 restaurants (consisting of 318 company owned and 62 franchised locations) as of Dec 2013. It offers more than 25 globally inspired Asian, Mediterranean, and American dishes together on a single menu. Management believes that it delivers value to consumers due to 1) menu variety 2) high quality food (fresh ingredients), 3) value for money menu and 4) unique eat-in experience (friendly team members). Its growth strategy mainly consists of organic growth (13-15% restaurant addition and 3-4% same restaurant growth per annum) given that it is in early phase of its growth. Management team, the CEO - Kevin Reddy - and COO - Keith Kinsey - in particular, is fast-food/fast casual industry veteran, with long working experience at McDonald's/Chipotle/Noah Bagel Corp.

Conclusion

Noodles & Company is clearly an emerging fast casual restaurant chain, with attractive long-term growth story. This is because it is in its early growth phase, with only 380 restaurants (approximately a quarter of much bigger fast casual operators such as Chipotle and Panera Bread) as of Dec 2013. Operating leverage due to much higher restaurant count and 3-4% same restaurant growth would result in 30% EPS CAGR over next few years (my estimate, vs company guidance of 25%). Nonetheless, on same restaurant growth trajectory, I found that Noodles & Company lags Chipotle despite the former's much lower restaurant counts. In my view, this illustrates normal growth story for Noodles & Company, as opposed to spectacular growth (very rare) for Chipotle. On valuation, I would say that the share price has richly priced in the long term growth story of Noodles & Company. My 12-mo PT is $36.86/share, a mere 2% upside potential from current share price.

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.