What’s the Deal With Noodles & Co (NDLS)

Noodles & Co (NASDAQ:NDLS) went public recently at price of $18. On the first day of trading the stock soared 100%+ to $36.75, and since then has continued to rise with the price at market closing on July 3 at $45 per share. The company has stoked the excitement for the stock through an aggressive media push at the expected venues — CNBC, WSJ, etc — which surely contributed to the run up. We need to ask, two questions — first using the current price of $45 per share, how does Noodles stack up against the competition on a valuation basis. Second, who does Noodles compete against both directly and indirectly, and how will that affect both their upside and downside going forward. In this article, I will explore these two questions in depth, and hopefully give investors some guidance on how to evaluate this stock.

Valuation

Noodles & Co (NASDAQ:NDLS) has joined a growing list of fast food chains trying to reshape the sector’s image from a greasy, low quality, cheap atmosphere to one that feels warm, inviting, and high quality. Chipotle Mexican Grill, Inc. (NYSE:CMG), and Panera Bread Co (NASDAQ:PNRA) already got the ball rolling on this sector and they continue to make inroads against the traditional fast food restaurants lead by juggernaut McDonald’s Corporation (NYSE:MCD). Using fundamental analysis, we need to ask ourselves what these companies’ P/E multiples tell us about market expectations regarding future earnings.

Simply put, this table tells us that the market expects Noodles to grow around ~30 times faster than McDonald’s, 15 times faster than Panera, and around 10 times faster than Chipotle. I think it goes without saying that those are some rosy expectations, but let’s take them seriously for a moment. What would Noodles need to do to meet these expectations?

First, we need to set a time horizon – over what period will the company outperform say, Chipotle by 10 times? On page 64 of their S-1 filing Noodles states, “From 2004 to 2012, we increased the number of our total restaurants from 100 to 327, representing a CAGR [compound annual growth rate] of 16.0%. If we continue to grow at our current rate, we believe we can grow to 2,500 restaurants across the United States over the next 15-20 years”. Noodles & Co seems to have a 15 year plan, so let’s use that as our time horizon.

In order to model out their growth over the next 15 years we need to figure out both how much revenue and how much profit Noodles & Co can generate from these stores.

Noodles & Co has both company operated stores and franchisees. Last year, Noodles & Co (NASDAQ:NDLS) generated $253 million in revenue from 239 company owned stores, and $2.6 million in revenue from 45 franchised stores – totaling $256 million in revenue from 284 restaurants. Together, these stores generated $3.8 million of profit, or 1.5% net margins for shareholders. Using the averages above, each company owned store earned about $1 million, and each franchised store earned about $60,000, with company owned stores representing 85% of total stores, and franchises the balance. Let’s first turn our attention to how much money Noodles & Co could generate from company owned stores, then to their revenues from franchisees, and lastly their net margins.

McDonald’s has 6,500 company owned stores which generated $18.6 billion in sales last year, or around $2.5 million per store, roughly 2.5 times the amount Noodles & Co generated. Without getting too bogged down in the details, McDonald’s stores serve breakfast lunch and dinner, but Noodles & Co only serves lunch and dinner – leaving them with only 2/3’s the revenue generating possibilities. Assuming Noodles & Co doesn’t get into the breakfast game, but can get their revenue somewhere in the range of McDonald’s – they could generate around $1.5 million in revenue from each store. This figure corresponds with their internal growth rates. Over the past four years, Noodles & Co revenue growth per restaurant has bumped along the 1.5-2% range (with a notable exception in 2010), which compounding over 15 years would give them just under $1.5 million in revenue per company owned store.

McDonald’s generates revenue from its franchisees in two ways – it owns the properties franchisees use and charges rent to its franchisees, and it gets a royalty from each sale. Noodles & Co does not own any of the real estate its franchisees occupy, so it only generates revenues from royalties. McDonald’s generated $3 billion in the royalty portion of the franchisee revenue stream, and had 27,882 franchisees – giving them around $100,000 in royalty revenue from each franchisee. As mentioned, Noodles & Co currently generates around $60,000 from its franchisees, severely lagging behind McDonald’s, but if they can deliver on their growth opportunity they might hit revenue streams of McDonald’s level.

Finally, we need to deal with net margins. Noodles & Co has around 1% net margins, consistent with Chipotle’s and Panera’s figures. However, McDonald’s has much higher net margins, close to 18%! The reason from this stems from the fact that franchisees operate over 80% of McDonald’s restaurants, which generate 83% margins.

Now we need to put all of this information together. If Noodles & Co (NASDAQ:NDLS) grows their restaurants at 16% CAGR over the next 13 years, they will have just over 2,252 restaurants by 2025. Assuming they maintain their 80/20 breakdown between company owned stores and franchise stores, they will have 1,801 company owned stores and 450 franchise stores. We predicted above that Noodles & Co could generate $1.5 million in revenue from each company owned store and $100,000 in revenue from each franchise store. Assuming 1% net margins for company owned stores, and 80% margins for franchise stores, around $25 million of the company owned revenue and $34 million in franchise revenue will flow to the bottom line. Net revenue from 2012 to 2025 will climb from $5.5 million to $60 million for a CAGR of 16.67%. And since everyone likes a good model, see below (and link to model in Google Spreadsheets here).

Now let’s bring this full circle, I think the story I told above represents the best case scenario for Noodles & Co, and it yields them a 16% CAGR. Now, using the current market prices, McDonald’s should grow at around 10% the rate of Noodles & Co, Panera around 6.8% and Chipotle at around 3.7%. Put differently, McDonald’s should only have a .5% CAGR, Panera should have a 1% CAGR, and Chipotle should only have a 1.6% CAGR (see table).

Let’s contrast this with the actual net income CAGR’s for the above companies from the past, say five years.

Assuming these companies do not crash and burn, and fast, they will continue their growth numbers at a fine clip, totally debunking the current Noodles & Co valuation.

Competition

As mentioned above, Noodles & Co competes directly with high end fast food chains like Chipotle and Panera, and more indirectly with fast food chains like McDonald’s. At this point, Noodles & Co has successfully ridden the wave of popularity, and coolness to propel themselves into the hundreds of millions of dollars in sales. However, we need to ask what happens if that juice runs out? What kind of landing would we see?

Simply put, if Noodles & Co cannot continue to ride out this wave of popularity they will fall and they will fall hard. In their S-1 filing, they list $160 million in assets, most of which consists of leasehold improvements and equipment. These assets don’t hold much value to anyone except for Noodles & Co, and as such would not generate much money in liquidation.

Contrast this with McDonald’s. In a similar article I wrote about Chipotle on Seeking, I noted that McDonald’s, even if they declined in popularity investors would still have significant downside protection. Specifically, McDonald’s operates 35,000 restaurants worldwide, and they either own or have a capital lease on all these sites. They generates revenue in two ways – from the rent they charge their franchisees and from royalties on their sales. To quote from that article:

The average McDonald’s restaurant measures 4,000 square feet, multiply that by 35,000 restaurants, and we find that McDonald’s owns 122 million square feet of real estate. Based on this metric, McDonald’s would rank as the third largest REIT — behind Simon Property Group (SPG) and General Growth Properties (GGP), who have 242 million and 139 million sqft of real estate, respectively. Put differently, McDonald’s generated $5.86 billion in rent last year, using this metric, McDonald’s would rank as the largest REIT in the world.

Considering the rise of other alternative fast food joints like, Shake Shack, Potbelly Sandwiches, Pret-A-Manager, Le Pain Quotdien Chipotle and Panera, we need to ask — can the marketplace absorb another operator in this market? Considering the fierceness of the competition, I think we should take pause.

Conclusions

I grew up in the late 90’s early 2000’s – around that time a popular alternative fast food restaurant opened up called Cosi Inc (NASDAQ:COSI)’s (COSI). Cosi’s went public in 2002 at a price of $30 reaching a high of $43 four years later. They had much of the same promise as Noodles & Co, today the stock sits at $2. I am not predicting that Noodles & Co (or others like it) will suffer the same fate as Cosi’s, but if you want to invest in the restaurant space, make sure that your investment can whether the good times as well as the bad.

Truthfully, the only way Noodles & Co (NASDAQ:NDLS) can justify its valuation only if it aggressively moves to the franchise model, and fast. If instead of having an 80/20 split between company owned vs. franchise, they could move more to a 50/50 model, then they could start accelerating growth at a rapid pace. However, the current numbers, do not justify the stock price in the short term, and in the long term Noodles & Co will need to continue to ride their wave of popularity, because they have no hard assets to break their fall.

Daniel Lauchheimer has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican (NYSE:CMG) Grill, McDonald’s, and Panera Bread. The Motley Fool owns shares of Chipotle Mexican Grill, McDonald’s, and Panera Bread.

The article What’s the Deal With Noodle’s & Co originally appeared on Fool.com.

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