Noodles & Company is Making a Big Mistake

By Markets Fool.com

Casual dining chain Noodles & Company has had a rough time since going public in 2013. After peaking at about $47 per share in late 2013, the stock has tumbled by nearly two-thirds, currently trading around $16.50 per share. Comparable-store sales have been weak over the past five quarters, with systemwide growth averaging just 0.3%. In the most recent quarter, Noodles reported a net loss, and the company expects adjusted earnings to be flat in 2015.

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Despite this poor performance, Noodles & Company announced a $35 million share buyback program earlier this month. Here's why it's a terrible idea.

Taking on debt to buy back shares
In the press release announcing the buyback program, Noodles & Company said funding for the buyback will come from cash on hand, cash flow from operations, and the company's revolving credit line. A quick look at the balance sheet and cash flow statement, though, reveals that new debt will be the main source of funding.

Noodles & Company keeps almost no cash on hand. At the end of the latest quarter, the company had just $1.6 million in cash on the balance sheet. And while Noodles does produce operating cash flow, about $52 million during 2014, the company's expansion effort eats up all of it, leaving negative free cash flow and nothing left over for buybacks.

This means Noodles will need to increase its debt to buy back any shares. Currently, Noodles has $22.4 million of outstanding debt, and the stock repurchase program will likely bring this number up closer to $50 million. This isn't an unreasonable amount of debt for a company this size to have.

There are two problems with Noodles' plan, though. First, Noodles is already using all of its available operating cash flow to expand, and the extra interest payments will reduce operating cash flow. In the company's press release, CEO Kevin Reddy said this buyback program wouldn't diminish the company's ability to grow its restaurant base, but that doesn't seem entirely true. The company might need to take on more debt in the future in order to expand as a result of the additional interest payments.

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Second, while Noodles shares have declined precipitously over the past year-and-a-half, the company still trades at a lofty valuation -- at a P/E ratio of about 44, based on earnings from 2014. With earnings expected to be flat this year, the market is clearly pricing in substantial growth going forward.

The company believes it can build up to 2,500 domestic restaurants, about five times its current store base, so there's still many years of growth ahead. But with comparable-store sales barely growing, and with profitability stagnating, the company could hit a wall well before reaching this number.

By buying back its own shares, the company is saying that its stock offers better opportunity than investing in new restaurants. That's not something that investors should cheer. Like many buyback programs, this appears to be an attempt by management to boost the share price in the short term, instead of a strategy to take advantage of undervalued shares. This means it's far more likely that Noodles' buyback program will destroy shareholder value.

Noodles isn't alone
Noodles & Company isn't the only restaurant company dubiously buying back its own shares. Chipotle has been repurchasing its own stock for years: From 2010 to 2014, the company spent $635 million on share buybacks, roughly 45% of its free cash flow during that period.

Despite these buybacks, Chipotle's share count has barely budged since 2010. The reason is stock-based compensation. Chipotle's buyback program simply counteracts the dilution caused by the company's stock-based compensation, doing nothing to reduce the share count.

Chipotle's buyback program allows the company to employ a nice accounting trick. Since stock-based compensation is a noncash expense, it is added back to net income when calculating free cash flow. But any cash that Chipotle spends to buy back shares and counteract this dilution doesn't show up in the calculation, inflating the company's free cash flow as a result.

Both Noodles & Company and Chipotle are buying back shares for the wrong reasons. Noodles is taking on debt to buy its likely overpriced shares, and Chipotle is simply counteracting the effects of its stock-based compensation. Neither buyback program creates shareholder value.

The article Noodles & Company is Making a Big Mistake originally appeared on Fool.com.

Timothy Green has no position in any stocks mentioned. The Motley Fool recommends Apple and Chipotle Mexican Grill. The Motley Fool owns shares of Apple and Chipotle Mexican Grill. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.