Will This Noodle Go the Distance?

Victor is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Since its IPO in June, Noodles & Company (NASDAQ: NDLS) has more than doubled from $18 to over $40.  Some expect Noodles to become the next Chipotle, a restaurant stock that has risen by almost 10 times its offer price. However, taking a closer look at Noodles' fundamentals may lead people to question how much longer this stock's winning streak will last.

Financial Condition

Since equity investors are the first in line to take losses when a company goes under, it's prudent to evaluate a company's financial health to avoid potential problems. Red flags for possible financial trouble include high levels of leverage and low levels of liquidity.  

Based on Noodles' most recent balance sheet, the company has $91 million in long-term debt and liabilities, and a debt-to-equity ratio of 6.84. That's a lot of leverage for a company that just recently brought in a fresh round of equity by going public. As a point of reference, the average debt-to-equity ratio in Noodles' industry is 1.06.

At the same time, Noodles only has about $590,000 in cash, versus more than $15 million in current liabilities. The company's quick ratio -- which measures how much of its assets the company could quickly turn into ready cash -- is just 0.44, versus an industry average of 1.29. Noodles' financial health looks weak both in terms of leverage and solvency.

<table> <thead> <tr><th>Measure</th><th>Noodles</th><th>Industry</th><th>Sector</th><th>Market</th></tr> </thead> <tbody> <tr> <td>Debt / Equity</td> <td>6.83</td> <td>0.64</td> <td>0.63</td> <td>0.96</td> </tr> <tr> <td>Quick Ratio</td> <td>0.44</td> <td>1.29</td> <td>1.42</td> <td>0.36</td> </tr> </tbody> </table>


Typically, equity investors look to a company's stream of future earnings for returns. That makes earnings growth very important. Based on Noodles' most recent income statement, the company experienced negative year-over-year revenue and earnings growth: -15.50% and -11.72%, respectively.

Though Noodles' second-quarter earnings were in line with analyst estimates, the company lowered earnings guidance for the year, suggesting that it may not meet the growth rates that investors or analysts are expecting. In a situation like this, "better or worse than expected" may impact stock price more than whether the news is actually good or bad.

<table> <thead> <tr><th>Measure</th><th>Noodles</th><th>Industry</th><th>Sector</th><th>Market</th></tr> </thead> <tbody> <tr> <td>Revenue Growth</td> <td>-11.72%</td> <td>10.26%</td> <td>13.51%</td> <td>2.93%</td> </tr> <tr> <td>Earnings Growth</td> <td>-15.50%</td> <td>4.40%</td> <td>0.00%</td> <td>0.50%</td> </tr> </tbody> </table>


Regardless of how good or bad a company seems, valuation is always important. Even the most promising company may be a bad investment if its stock is already priced above perfection.

Based on traditional measures of relative valuation, Noodles looks expensive. For example, the stock's trailing P/E multiple of 242 seems high even when compared to the already high industry average of 40. The same can be said of other multiples based on sales, cash flow, and book value.

Of course, valuation can be challenging for a high-growth company like Noodles, particularly in the short term. Given the potential for high growth, today's seemingly lofty valuation could end up looking low by tomorrow. 

<table> <thead> <tr><th>Measure</th><th>Noodles</th><th>Industry</th><th>Sector</th><th>Market</th></tr> </thead> <tbody> <tr> <td>Price / Earnings</td> <td>242.00</td> <td>40.06</td> <td>15.34</td> <td>17.71</td> </tr> <tr> <td>Price / Cash Flow</td> <td>35.59</td> <td>16.21</td> <td>9.26</td> <td>12.71</td> </tr> <tr> <td>Price / Sales</td> <td>3.88</td> <td>2.20</td> <td>2.09</td> <td>1.73</td> </tr> <tr> <td>Price / Book</td> <td>64.08</td> <td>6.83</td> <td>2.60</td> <td>2.66</td> </tr> </tbody> </table>

The Verdict

Having only been public for a couple of months, Noodles hasn't earned a final verdict yet. However, based on fundamentals like financial condition, growth, and valuation, I don't think think Noodles is currently an attractive buy.

Frankly, I'm not a big fan of any restaurant stock right now, and I think the industry as a whole looks overvalued. Forced to pick, though, I'd prefer a name like McDonald's (NYSE: MCD). Sure, Mickey D's doesn't have the pizazz of international noodle cuisine. But it does have $2.3 billion in cash, a 19.5% average annual earnings growth rate over the past decade, and a trailing P/E of 17.9. Oh, and it pays a 3.20% dividend yield to boot.

I'd also prefer Starbucks (NASDAQ: SBUX) over Noodles. I do think the java giant is overpriced at 34 times earnings. But at least the the company has a strong balance sheet, $1.2 billion in cash, and less than $550 million in debt. Its average annual earnings growth over the past 10 years exceeds 20%. Starbucks' 1.20% dividend yield isn't fantastic, but it's still better than the goose egg that Noodles pays.

Again, I'm not saying I'd buy McDonald's or Starbucks right now, but I think they're better choices than Noodles as restaurant stocks. At $40-plus per share, and given its current concerning fundamentals, I wouldn't noodle around with Noodles & Company's stock.

Victor Lai is an investment adviser representative with Bellwether Capital Management LLC, a registered investment adviser. Victor Lai does not own any positions in the securities referenced in this posting. Clients of Bellwether Capital Management LLC may own positions in the securities referenced in this post.  This post is for informational purposes only and does not represent advice.

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