Simmering Noodles

Noodles & Company is already a hot concept. Can it be the next Wall Street darling?

By David Farkas, Senior Editor -- Chain Leader, 1/1/2005

Up in the air: If CEO Aaron Kennedy can match company performance with market conditions, 101-unit Noodles & Company will probably go public.

Aaron Kennedy’s eureka moment arrived with a bowl of noodles in a Greenwich Village restaurant. The bulb in his head illuminated a quick-service concept that showed off the world’s best noodle dishes.

He opened his first Noodles & Company in Denver in October 1995, with $250,000 raised from friends and family. A second unit opened six months later near the University of Wisconsin in Madison, where he earned an M.B.A. in 1989.

The success of these restaurants prompted the launch of Kennedy’s “saturate the heartland” strategy, and during the next 10 years, his noodleries popped up in Minneapolis, Milwaukee, Chicago and Detroit. Today, the 42-year-old oversees 101 units in 14 states. Sales grew 24 percent, to $90 million, in 2004.

Those numbers, however, pale compared to Kennedy’s grand scheme. “Most people in the industry would look at us and say Noodles & Company has the potential to be at least 1,000 units,” he boasts.

He’ll need help. The company predicts 370 units will be open by the end of 2008, 160 or so controlled by franchise area operators the company is trying to attract. As of December, three franchised units were open in Southern California, though the company’s six franchise area operators have a total of 155 units on their drawing boards.

Veterans Only
Mom-and-pop operators need not apply. Management wants battle-tested operators equipped with a marketing, development and managerial infrastructure.

Vice President of Franchise Initiatives P.J. Evans, who previously worked for Panera Bread Co., says he wants to find franchisees “who understand what we are about, a cultural fit.” It’s important because the brand has a smart, youthful and health-conscious image.

Kennedy describes Noodles culture as “a participatory leadership style. It’s not consensus. It’s not dictatorial. You still have accountability as a leader. You need to gather input, have a positive attitude and get things done.”

Michelle Cherrick, an investment banker at SG Cowen who informally advises the company, witnessed its camaraderie firsthand on the day Noodles opened its 100th restaurant, a company unit in Appleton, Wis. “Everyone [at headquarters] gets on the conference call and they talk about what they’ve done in terms of preopening programs, advertising and welcome to Noodles. The tight culture is something so strong that it can carry into a franchise system,” she says.

From the franchisee’s point of view, what’s the concept’s attraction besides a product nearly everyone on the globe grew up eating? It’s the chance to realize cash-on-cash returns of 52 percent on an investment of $540,000. The company also claims that store sales reach $1.1 million by the third year.

“You can make the same kind of money operating a Noodles & Company as a Burger King,” says Nick Janikies, a Cranston, R.I.-based franchisee whose family operates 78 Burger Kings in New England and Florida. “Plus, it’s easier to find locations and the rents are cheaper.” Janikies signed up to open 45 units in six New England states. The first of five scheduled this year will open by June, he says.

The franchise effort was given full throttle last year. The goal: to sign agreements for 80 units to open within the next five to seven years. By late November Evans predicted the number would be closer to 87. He says he’ll try to convince franchisees to sign on for another 80 units this year.

Good Credit
The chain has also rapidly added company stores, growing a compounded 43 percent to date since 2001. This year, Noodles & Company plans to open 20, paying for them with cash flow and bank debt. Unit-level contributions of 19.8 percent combined with $10 million of bank debt ($10 million remains on the credit facility) funded last year’s crop of restaurants.

“We will have to borrow against the credit facility to build new stores. It’s our best use of capital right now,” says Chief Financial Officer Mary Beth Lewis.

The concept’s initial success in different locations attracted 300 backers, 16 of whom are employees. Noodles & Company largely funded the construction of earlier restaurants with $23 million of equity raised over six offerings, the last in 2002.

Man made: To attract more men to the restaurants, the new menu features four dishes without noodles including the Shrimp Curry Saute, $6.95.

It won’t tap its 300 investors in the coming year. But it might go public. Management says it is prepared for such an event. Last summer a rumor floated that an IPO was imminent. Kennedy blames the hype on a quote he gave a local reporter about market conditions. “The newspaper picked up on the fact that we want to keep an IPO [possibility] open,” he says.

Despite attention from investment bankers, Kennedy says the company hasn’t hired any. But he is listening. “The people we rely on have said you go when the time is right and the market window is open,” he explains.

Based on recent successful IPOs of companies such as Domino’s Pizza and Texas Roadhouse, investors are well disposed to restaurant issues, according to former venture capitalist and Pasta Pomodoro board member Mark Saltzgaber. “You have a tailwind these days,” he explains. “But the bar has been raised.”

Today, he adds, institutional investors are interested only in restaurant brands with full-taxed net incomes of $5 million or more and market caps of at least $200 million. It’s not yet the case at Noodles & Company, which won’t share recent valuation data.

A public offering seems the most likely outcome for investors. At least three of the company’s eight board members have public-company experience, including newest member Betsy McLaughlin, chief executive of Hot Topic, a teen-clothing retailer.

Cherrick expects an IPO. “Not only is the story stronger,” she says, “but the company’s size is also greater, making it more attractive to institutional investors.”

Let’s Wait and See
Last October the board rejected Kennedy’s proposal to recapitalize the company. “They looked at the numbers and said the shareholders don’t want to sell a large stake,” Kennedy recalls. “They wanted to wait two years to capture the upside. ...Our net income is growing so quickly that it really pays to wait.”

Declares board member and second-largest shareholder David Duncan: “I’d say it’s two years on the outside.”

Kennedy, who owns 18 percent of the company (employees have a 10 percent stake), has avoided venture capitalists.

“Private-equity firms are going to invest in 10 companies and press the accelerator on all of them,” he explains. “They know that two of those will be very successful, three or four will be OK, and the rest will be failures. Those aren’t good enough odds for me.”

Say cheese: The perception that Noodles & Company is an Asian concept is wrong, the company says. Wisconsin Mac & Cheese, $4.95 entree and $3.75 small, is proof.

Kennedy would rather hedge his bets on a new menu and prototype. The new building has been designed with a “more recognizable” façade. Inside, he raised the menu boards above the counter, eliminating bottlenecks, and reconfigured the carryout counter to its own area. Noodles & Company believes the new design—now in test in Omaha, Neb., and Salt Lake City—will increase carryout business from 30 percent to 50 percent of sales.

The new menu boosted sales 7.3 percent and traffic 1.5 percent in November, the company reports. Changes include four new protein-only dishes, dubbed “Noodle-less,” which are attracting more men, Kennedy says. Same-store sales through September, when the new items were introduced, were flat.

In fact, comparable sales for restaurants open 18 months or longer have been flat or slightly positive for two years, undone by the events of 9/11 and low-carb diets, officials say. The company also blames gas prices, the war in Iraq, elections and Olympic coverage.

Sluggish sales forced Kennedy to shutter two company outposts in suburban Dallas late last fall. He blames former co-CEO Ken Keymer for picking the sites during a year the company entered three new markets, something Kennedy had never attempted. Keymer left in 2003.

Kennedy claims he never intended to share power; he and a recruiter simply couldn’t find a COO and president with enough skill to take over day-to-day operations in 2001. At the time, Kennedy, who lacked experience managing a fast-growing chain, wanted to oversee the brand and culinary issues, while a veteran operator directed expansion.

Eat more chicken and beef: In focus groups, men asked, “Where’s the meat?” The new Mediterranean Mixed Grill, $7.75 mixed and $5.75 solo, provides a double dose of steak and chicken.

Power Grab
As Kennedy remembers it, Keymer took the job with a last-minute demand: Make me co-CEO. “Ken wasn’t effective here. He didn’t have the confidence of the leadership [team],” Kennedy recalls. Keymer, president of Popeyes Chicken & Biscuits, declined to comment.

Those close to Kennedy say he has done a good job managing rapid growth on his own, allocating resources to build a long-term franchise program. Former board member Albert Baldocchi says management is experiencing a “fundamental change,” going from a company-run model to a franchise model. “Aaron is very focused on that,” he says.

One indication of that focus is Birchwood Resultants, a site-selection firm the company hired to find high-volume locations. Noodles & Company’s expansion strategy is now to open the first unit in a new market in a trendy, high-traffic area to create a buzz, then move to the suburbs.

“All these things are converging,” Kennedy says. “Let’s get 12 months of history down and then go to the market with their success. Let’s go with real numbers and say, ‘Look, same-store sales are 7 percent, new units are performing at $24,000 a week.’” Call it the boiling point.