Disappointing Growth at Noodles & Company

The market has placed high hopes on the growth opportunity that lies before Noodles & Company (NASDAQ: NDLS  ) as the company expands its footprint across the country. For this reason, Noodles trades at lofty valuation multiples often assigned to high-growth restaurant concepts that investors believe could be "the next Chipotle Mexican Grill (NYSE: CMG  ) ." As Peter Lynch famously noted in One Up On Wall Street, "the trouble is, the 'next' one rarely works."

Noodles' first quarter earnings release is a real world example of this sage advice. Just a week after Chipotle reported tremendous comparable restaurant sales growth of 13.4%, Noodles reported a 1.6% decline in comparable restaurant sales. Apparently, "unprecedented weather throughout the country, but particularly in the markets where we have our highest geographic concentration" affected Noodles while not clearly not affecting Chipotle in the same way. This explanation leaves more questions than answers for a company that was supposed to be a high growth concept.

Weak financial results
Compounding the weakness of the first quarter comparable restaurant sales decline of 1.6% was the unfortunate fact that the latest results also benefited from a 2.2% favorable impact of price increases; absent these price increases, traffic and average check size in existing locations was down close to 4%. In contrast, Chipotle's 13.4% increase came during the quarter before it begins its first price increase in over three years.

It should come as no surprise that weak comps led to first quarter revenue that missed analyst estimates. While 10.1% top line growth is not bad for the average company, it is certainly a disappointment in relation to the expectation that the company will grow revenue by 16.5% during 2014.

Noodles & Company new menu Items
Source: noodles.com/spring 

Management is standing by its full-year guidance, but weak first quarter revenue growth puts pressure on the company to perform even better as the year goes on. Thus far, management is hoping that a focus on service and new menu items will help the company recover from its first quarter deficit. 

In addition to weak results on the top line, restaurant level margins declined primarily as a result of food and occupancy costs; the decline was a meaningful 130 basis points to a margin of 17.3%. While rising food costs and shrinking margins are common trends among fast casual companies, this margin remains below the 19.5% Panera Bread (NASDAQ: PNRA  ) reported this quarter. 

Location growth remains intact
Noodles' financial results were lackluster, but the one aspect of the investment thesis that remains intact is the plan to grow the number of locations the company has during 2014; the company opened 14 new locations during the first quarter and remains on track to achieve full-year restaurant openings equal to 16% of the company's footprint at the beginning of the year.

By comparison, both Chipotle and Panera project much higher restaurant location openings (180-195 and 115-125, respectively) in an absolute sense during 2014, but both represent lower growth on a percentage basis.

Valuation remains the primary concern
Prior to Noodles' earnings release, the company traded at more than 58 times estimated 2014 earnings. Meanwhile, Chipotle's valuation was 31 times estimated 2014 earnings and Panera's was just estimated 21 times 2014 earnings; the difference is usually attributed to growth expectations. Given that Noodles reported 10% revenue growth and Chipotle reported 24% growth, does a valuation multiple that is double Chipotle's really seem warranted for Noodles? 

The short answer is "no," especially given the fact that the smaller size of Noodles carries not only higher upside, but also added risk. The company does not have a strong track record of comparable store sales growth or generating meaningful earnings growth. It is uncertain at this point whether these weaknesses will improve as the brand expands, gains national recognition, and benefits from increased scale. 

Meanwhile, these questions aren't nearly as relevant with Chipotle. Revenue growth continues from both existing locations and the opening of new locations. On the bottom line, earnings growth remains solid even as the company has opted thus far to absorb rising food costs rather than pass them along to customers. Quite simply, it is a proven growth concept.

Looking ahead
While the first quarter was a disappointment for Noodles, this does not mean that the company cannot live up to expectations over the long term. The concept is unique, the food is high quality, and there is plenty of room to expand from the current footprint of just 394 locations. However, this quarter is an excellent example of why it won't be a smooth ride for investors; weak performance is magnified with companies like Noodles that trade at a premium valuation.

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