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Potbelly Analysis

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October 07, 2013 – Comments (0) | RELATED TICKERS: PBPB

Board: Value Hounds

Author: LeKitKat

Potbelly is a sandwich casual concept selling sandwiches, soups, salads and hand-dipped (Feet-dipped anyone?) milkshakes all made fresh to order and the specialty cookies are baked daily. The stores are inspired by the neighborhood they are built in (Applebee’s tries for the same effect) creating unique units each with its own distinct personality.

They have a sort of mission plan to make customers feel that the local Potbelly is the “Neighborhood Sandwich Shop” and spread the word. Their mission is to make people “really happy”, to make more money and to improve every day.

Make more money is the IPO mission

Potbelly sold 7,362,166 shares at the IPO and selling stockholders sold 137,834 shares. The offering price was raised to $14 from $9-$11.

After this offering, there will be 28,006,535 shares of common stock outstanding and 29,131,535 if the underwriters exercise their option to purchase additional shares. Insiders hold nearly four times as many shares as new investors buying the IPO and after seeing some of the special dividends and stock option deals, insiders with absolute control may not serve the little guys buying the IPO.

Options are going to be a lucrative deal for qualified insiders and vested (per SEC filings) at the IPO. There are 4,745,577 outstanding options with an $8.99 average price per share and 4,247,662 shares are at $8.62 --1,500,000 shares are reserved for future grants.

In August 2013, the board of directors generously granted a cash dividend of nearly $50 million to shareholders pre-IPO that includes corporate executives. Founding Chairmen Bryant Keil was awarded 60,000 options ($9.47) that were immediately vested and exercisable without restriction in February. He is a 7% shareholder. There are roughly 15 shareholders with between 1% and 28% of the shares that will be splitting the $50 million. Maveron Equity Partners (Howard Schultz’s angel investment seed fund) with 28% will see a payday of around $14 million.

The IPO

Potbelly debuted October 4 at $14 and the $75 million in proceeds anticipated turned in to over $100 million. That does leave a little more after the dividend than originally planned. Other uses include paying down debt, for working capital and general corporate expenses. They may find a few bucks in the extra $25 million to pay for some expansion and no more sweet heart deals.

At market close shares were $30.77 and 120% over the offering price. Is a stock that earned just 66¢ per share in 2012 going to grow into the optimistic expectations current share price reflects?

Growth, same store sales & new stores

Working backwards and starting with the 26 weeks ending June 30,2013, revenue was up 11.7% with same store sales of 1.5%. Price increases accounted for 2.6% of the comp indicating that traffic was down 1.1%.
Revenue increased 15.5% for the year in 2012 with comps at 3.4% --traffic was only up 0.2% and price increases accounted for 3.2%.

In 2011, revenue was up 7.9% on 1.7% comps and traffic increase (as counted by entrees) of only 0.3%

The trend shows the string of positive comps they cite in the press releases are largely price increases with very little rise in traffic that finally turned to negative numbers for the first half of 2013. Most of the growth for Potbelly has been new store openings and price increases.

[See post for tables.]

Some of these years look like spectacular growth in net income. In 2009-2010, net became less negative but was in the red 2009-2010. In 2012 they had a tax benefit of $15 million that skewed net income to $24 million. Had they paid the corporate tax rate on earnings, net earnings in 2012 would have dropped year-over-year.

Comps are uninspiring and don’t put Potbelly in the same league with other superstars in fast casual like Chipotle and Panera. Traffic is a small part of the comps and price increases make up most of the percentage. Even worse are the negative traffic numbers for the first half of 2013. The best restaurant chains have enthusiastic consumers and are capable drawing new traffic as the major component of comparable sales. Potbelly is not in this elite company.

A large part of growth is new stores and in 2013, shops increased 13% and revenue only around 12%--not a strong result and growth by new stores isn’t working well this year. There are no average unit volumes reported that would allow investors to assess the growth in revenue per store over time. If it’s increasing then growth through new locations would be defensible. If it’s in decline then rapid building of new stores is a less profitable strategy.

Margins

For a restaurant with a small menu serving sandwiches, salads and soups, the margins are disappointingly low.

The negative net margins are due to negative net earnings 2008-2010. The big increase is from a one-time outsized tax benefit in 2012. Margins in the first half of 2013 are some of the lowest (of the positive margin years) as the company settles into a more corporate level tax rate at around 40%.

Expenses are on the high side as a percentage of revenue for a fast casual and that impacts margins. Their occupancy expense is around 4%-5% higher than Chipotle and Panera (includes rent) and that is a fixed expense that is unlikely to improve until the restaurant revenue shows significant upward movement per restaurant. That’s a number that is best tracked by average unit sales and Potbelly needs to start reporting them.

SG&A is also high and can be improved by spending less or spreading the expense efficiently over the increasing revenue base. I would be looking for it to increase, as they need more marketing with expansion into new territory.

Other operating costs are in line with Chipotle and better than Panera. Other operating costs for Potbelly include supplies, utilities, credit card fees, shop level (not national) marketing, maintenance and repairs, and musicians fees. Most of these are consistent across different restaurant chains except most do not have musicians.

Panera has slowed growth in revenue and comps in the first half of 2013, but for much of the past six years revenue has grown in the high teens to low 20% range. Company comps range from5% to 7%.
Chipotle has also seen some slowing of its formerly torrid pace in 2013, but it still outperforms Potbelly.

From September 2010 to March 2012 Chipotle had a stretch of seven quarters of comps between 10% to nearly 13% built on traffic increases between 8% to 11%. Margins are some of the highest in the sector. When a new fast casual comes along with similar numbers, it will be worth 120% of its IPO price on day one. Until then, we have to beware of the optimism investors feel about every fast casual that comes to market.

Should we buy Potbelly’s story?

Restaurant stocks with mediocre growth and uninspiring comps and ratios are plentiful and a few have recently come to market—Noodles, Chuy’s, and Ignite to name a few. The real stars are few and far apart. It’s not unreasonable to define the qualities that make a chain a standout from the crowd and a great investment. The standouts in the fast casual space are Chipotle and Panera and when held to their standards, Potbelly fails on most counts.

Investors love fast casual and every new IPO gives them the chance to cash in on the hope this is the one that will be the next star. The share prices move up fast and most of the time, the move is not warranted. Being a fast casual restaurant chain is no guarantee that the next Chipotle and Panera are in the cards for Potbelly.

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