Potbelly Doesn't Look Delicious At Current Levels

After the extremely positive post-IPO fortune of fast food concept Noodles & Co (NDLS), the surging IPO of Potbelly (PBPB) caught our attention. Let's take a look at the prospects of this Chicago-based sandwich chain.

Background

Potbelly is a Chicago-based sandwich chain famous for its toasted sub sandwiches, fresh milkshakes, and in-store musical entertainment. The concept began in Chicago's Lincoln Park neighborhood as a toasted sub shop with eclectic decorations from the original owner's antique shop.

Current chairman and largest individual shareholder Bryant Keil purchased the original restaurant in 1996 and has since worked to turn it into a chain with 286 restaurants throughout the United States-280 owned by the company, and 6 owned by franchisees. The firm also has 12 franchised shops in the Middle East. It is also important to note that the company owns none of its restaurant buildings, so Potbelly can't be considered a real estate play like McDonald's (MCD).

Image Source: PBPB S-1

Why did the company go public?

Companies can go public for a variety of reasons, whether it is to solidify the firm's capital base, provide founders/long-time investors an opportunity to monetize their investments, or to provide a highly liquid form of additional compensation for employees. We figured we'd address this issue first because it is so transparent: the IPO is a way for large investors to make money.

Potbelly raised $105 million. Interestingly, Potbelly recently declared a huge dividend for existing shareholders which will be paid with the proceeds. The following statement comes directly from the firm's S-1 filing:

"We intend to use approximately $49.9 million of the net proceeds to pay a previously-declared cash dividend on shares of our common and preferred stock outstanding on the day immediately prior to the closing date of this offering, leaving us with n! et proceeds of approximately…Our executive officers, directors, beneficial owners of 5.0% or more of our outstanding shares of capital stock, and affiliated entities, will receive approximately $43.0 million, or 86.2%, of such dividend amount."

Thus, existing shareholders will receive a nice bounty--about half of the $105 million equity offering in cash. If existing shareholders thought internal growth opportunities looked strong at Potbelly, we think they would rather reinvest the cash in the business rather than receive a huge return of capital. Further, existing shareholders are eligible to sell stakes of the company, leaving the rest for Potbelly. Potbelly received much less capital than the headlines suggest by going public (a large portion of it was given to existing management)!

On top of insiders receiving a bounty from the IPO, existing option exercise prices were re-priced, meaning CEO Aylwin Lewis, CFO Charles Talbot, and COO John Morlock will be able to cash out large equity grants at a profitable price. Current chairman Bryant Keil was also issued additional shares at a lower exercise price, and was reimbursed $25,000 for out of pocket IPO-related expenses.

Insiders can also lock-up 79% of the company by exercising all outstanding preferred stock and warrants, leaving the current shareholder base firmly in control of the company. Insider owners milking the public equity markets for a large payday is almost reason enough for us to avoid this company.

Recent Financial Performance

(click to enlarge)

Image Source: PBPB S-1

For a self-declared, "fast-growing" company, Potbelly's growth track record over the past several years is uneven. Revenue growth was relatively lackluster from 2008-2011, but the company accelerated store openings in 2012 to achieve revenue growth of 15.5%. Performance has been consistent in 2013, with revenues for the first half of th! e year up! 11.7% compared to the first half of 2012.

The red flag is same-store sales growth. The common excuse for any company that has underperformed since 2007 has been the economy, or the consumer, or the consumer that is frightened by the bad economy. That excuse was acceptable for some companies, but we do not believe it's applicable anymore, nor do we think that excuse should be suitable for a company that fancies itself a growth story.

(click to enlarge)

Image Source: Valuentum, Company Filings

As we can see from the above chart, Potbelly not only performed worse than its peers during the Great Recession, but it also didn't recover as strongly. To us, this suggests that the firm doesn't have the same pricing power as Chipotle (CMG) or Panera (PNRA), nor do its individual restaurants have the same growth potential.

Growth Potential

Potbelly currently operates just under 300 restaurants in the United States, with the vast majority clustered in the Midwest, the east coast, and Texas. In our view, the most bullish part of the Potbelly investment thesis is that the firm could have years of growth ahead.

Not only does the brand have tremendous recognition and respect in its home state of Illinois, but the firm's restaurants in New York City also appear to be performing well and are receiving strong reviews. Shops in other states aren't quite as good, but the strong showing in New York and Chicago suggests the company has tremendous potential in urban markets.

The main problem we've identified regarding Potbelly's growth trajectory: capital. The firm is roughly breaking even (the company generated $2.8 million in net income for the 26 weeks ending June 30, 2013), while targeting 10% annual store growth. Unfortunately for shareholders, the IPO didn't raise as much capital as it initially appears on the surface, so the company will likely need to take on a! dditional! debt or grow entirely via operating cash flow.

Creating a robust franchisee system seems like a great option. The only problem is that Potbelly requires significantly higher capital costs than its peers.

Source: Valuentum

As we can see from the above chart, the cost of opening a Potbelly greatly exceeds several other proven sandwich franchises, making it more difficult for the company to attract franchisees. Still, we believe the concept could grow to upwards of 700 locations in the United States, though growth won't be explosive.

Valuation

Image Source: Company Filings, Valuentum

Comparing Potbelly's valuation to its peers reveals an interesting situation. Even though the firm sports an inferior EBITDA margin compared to its peers, both its trailing and forward P/E are much higher than those of peers. For perspective, Potbelly's P/E exceeds that of Chipotle-a restaurant known as one of the best operators in the fast casual space. Even more perplexing, EBITDA grew just 7.6% year-over-year in fiscal year 2012, while Chipotle's EBITDA surged 21% year-over-year off of a substantially larger base.

Valuentum's Take

At its current valuation, we think shares of Potbelly look overpriced. The firm is less profitable than its peers and is growing less quickly than its peers, but shares trade at a rich premium to said peers.

If we assume 15% annual earnings growth and the company garners a PEG ratio in-line with its peers at 2, then Potbelly shares could be valued at roughly a $23 price tag. However, given the uneven track record of growth and lackluster same-store sales expansion, we don't think an industry PEG ratio is vindicated.

Realistically, we think shares should trade at 25 times forward earnings. This multiple accounts for the p! remium th! e market generally ascribes to familiar brand names, as well as a chance that the IPO helps ignite Potbelly's growth. At 25 times 2013 earnings, the firm would trade in-line with the multiple of Panera, but at a premium to the slow-growing McDonald's. However, a generous multiple of 25 times puts shares of the sandwich chain at $19-43% lower than they are today.

(click to enlarge)

Source: Valuentum, Company Filings

As we can see from the above chart, an even more conservative 20 times P/E yields a share price of just $15.20. That may sound bearish, but it equates to a PEG ratio of 1.33 which is equal to that of Panera, though it remains a discount to Chipotle.

Ultimately, we believe Potbelly conservatively presents downside of more than 30% based on a 30 times forward P/E multiple valuation, with as much downside as 50%+ if the market were to ascribe it a PEG ratio in-line with that of Panera. Not often do we find companies with relatively weak EBITDA margins, weak same-store sales growth, and a slow growth track record trade at such a hefty premium to its peers.

When the post-IPO dust settles, we may consider establishing a put option position in the portfolio of our Best Ideas Newsletter. It may take a few quarters of disappointment, but we think the market will eventually catch on to the fact that Potbelly's growth doesn't justify its premium multiple.

Source: Potbelly Doesn't Look Delicious At Current Levels

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)