Noodles & Company (NASDAQ: NDLS) is small-cap fast casual restaurant chain with 492 locations (422 company-owned and 70 franchised restaurants at the end of 2015). After going public in 2013, NDLS has continuously declined and a big reason was due to the fact that the company overstretched itself by expanding too fast. Since the IPO in 2013, Noodles & Company has opened almost 150 new restaurants. As Noodles & Company prepares to release Q1 earnings on May 3rd, a turnaround story is in the works for the restaurant chain.
The Overstretch of the company’s footprint has impacted the its bottom line significantly, primarily due to inefficiencies of new markets as well as structural pressure in labor, the company’s profit margin has deleveraged. According to the latest quarter Q4 2015 report, its same-stores sales fell 1.1 % YOY, traffic was down 1.3% and earnings before tax margin ( EBT margin) deteriorated and went negative for the first time since the IPO.
The company also accumulated long-term debt with debt to equity ratio of 72%. The short interest ratio approached to 28 days to cover. All the bad news surfaced around. Its stock price tanked from $45 per share at a peak to current $10 per share. The company is facing a tremendous challenge.
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Noodles has two major shareholders Catterton Partners Corp (26.1%) and Argentia Private Investments (29.83%), a vehicle of the Canadian Public Sector Pension Investment Board. These two private equity owners acquired Noodles in 2010 before it went public in 2013.
Fidelity Management and Research (FMR) own 14.99% of NDLS. Catterton has significant restaurant experience with Outback Steakhouse and P.F. Chang’s. Fidelity is heavily invested in Chipotle (NYSE: CMG), Buffalo Wild Wings (NASDAQ: BWLD) and Ruth’s Hospitality (NASDAQ: RUTH). Institutions own 94% of NDLS, and insider investors hold 1% of the outstanding shares, meaning the management team may have less incentive to improve its performance. Major shareholders may push the management team for further changes, especially due to the Board members and institutional owners sophisticated restaurant operation experience.
Noodles & Company has almost 40 different items on the menu. From the surface, it offers customers a wide variety of food choices that enhance the guest experience. While in reality, the extensive offerings have made it difficult to control the source cost and labor cost required to manage the menu.
As Steve Ells, CEO of Chipotle said, “It’s important to keep the menu focused, because if you just do a few things, you can ensure that you do them better than anybody else.” A wide variety of items may be appealing to attract new customers, but makes it difficult to manage for the rapidly expanding fast restaurant chain. The company may ultimately eliminate the underperforming dishes and focus on improving its favorite menus with limited options.
Since 2015, NDLS has closed 17 underperforming stores. In 2016, the company announced it would shift away capital allocation from new markets to existing markets. The existing mature market has a positive 20% margin on volumes 15% to 20% higher than average. The new strategy will help the company regain its bottom line to increase profit margin, traffic and same stores sales and is expected to start in late 2016.
Although the majority of expansion in 2016 is expected from company-owned stores in existing markets, strategic expansion from franchise restaurants into the new market is also welcomed. Experienced and well-capitalized franchise partners have the capability to leverage its local knowledge and infrastructure to help the expansion to new markets.
In the last quarter of 2015, Noodles announced “Made Different” brand positioning, detailing Real Food, Real Cooking, and Real Flavors initiatives to remove all artificial colors, flavors, preservatives and sweeteners from its core menus. It also committed to offering meat and poultry that has not received antibiotics or hormones by 2017, as the company attempts to capitalize on the increasing trend shift towards healthy fast casual.
Noodles will continue to execute a series of initiatives: media marketing, online orders and catering to enhance its brand awareness and customers’ experience. So far online ordering and catering accounts for 5% and 1% of its total sales respectively, both these segments are expected to grow this year.
In 2016, Noodles will slow down its new opening stores to 50 restaurants, in an effort to turn its profit margin and same stores sales growth to positive.
The Prospective Outlook
Noodles & Company would be a good turnaround candidate to watch because it is a small cap stock with sophisticated institutional shareholders. It would be easy to double in a five-year time horizon, once the company regains its strength on the bottom line.
To make this turnaround happen, the institutional investors may look to change the management team. One executive VP has resigned recently, while closely monitoring the shift in management is a key indicator to watch for. Potential investors also need to pay attention to the company’s operating cash flow to turn positive, which would be another key indicator. If insiders start to buy, then it would be a great sign to follow.
The charts listed below compare Noodles’ potential growth with Chipotle and Buffalo Wild Wing’s.
Noodles suffered significant low valuation ratio with P/B 3.3, P/S 0.7 and P/Cash Flow 7.4, which are lower than those of Chipotle and Buffalo Wild Wing’s in 2008 during great recession time.
It is not assumed that Noodles will mirror Chipotle’s growth in a similar fashion. Chipotle had unique attributes that contributed to its extraordinary success. Chipotle’s CEO is the founder and chef. CMG also split off from McDonald’s with the inheritance of a highly efficient inventory turnover and experienced real estate locators.
Although Noodles lacks these attributes, the company still has great potential to double within five years, since it is still at the early stage of a national expansion and is backed by sophisticated institutional investors with restaurant industry prowess. Currently, Chipotle and Buffalo Wild Wings have 1900 and 1175 locations respectively, which indicate Noodles currently with 490 locations may follow similar growth path once it turns around successfully.
An investment in Noodles offers patient investors a good bargain price with double growth potential, but it will be best to wait for the turnaround signals to be confirmed to initiate a purchase position.