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Value Line has initiated coverage of Potbelly Corporation (PBPB) in its flagship product, The Value Line Investment Survey. As per the company website, Potbelly is a “neighborhood sandwich concept offering toasty warm sandwiches, signature salads, and other fresh menu items served by engaging people in an environment that reflects the Potbelly brand.”

Revenue in 2013 was just under $300 million, with the majority generated during lunchtime hours, but dinner and breakfast (in locations with high early morning traffic) helped too. Potbelly is headquartered in Chicago, Illinois and employees around 5,000 people, of which nearly 90% are hourly workers.

Potbelly started in 1977 as a small antique store on Lincoln Avenue in Chicago. To boost sales, the original owner began offering sandwiches and homemade desserts to customers. As time passed, Potbelly became a well-known neighborhood sandwich shop and in 1996 the original owner sold the restaurant to Bryant Keil. Mr. Keil had a vision to grow the concept and one year later the second location was opened. Today, there are nearly 320 restaurants in the United States, with about a dozen in the Middle East (specifically, in Kuwait, the United Arab Emirates, and Bahrain). Mr. Keil remains on the board of the directors, but has passed the Chairman position to Chief Executive Officer Aylwin Lewis.

The company completed its initial public offering on October 9, 2013 of 8,625,000 shares at $14.00 apiece. Net proceeds were about $108.8 million, with about $64 million used to lower indebtedness and pay a previously declared cash dividend. The remainder was retained for general corporate purposes. Upon going public, there was an initial surge in the stock price, but a general decline has since followed. Indeed, this issue has shed approximately a third of its value since October and a sizable short position has developed, sitting at about 22% of the float.

The restaurant industry is intensely competitive with low barriers to entry and many well-established companies that compete directly and indirectly with Potbelly in respect to food quality, ambience, service, price, value, and location. Competition comes from national, regional, and locally-owned restaurants, as well as from supermarkets, many of which now serve ready-to-eat meals in the deli section. Of course, individuals can eat at home, too. Competitors include Chipotle (CMG), Jimmy John’s, Panera Bread (PNRA), and Subway, among many others.

What separates Potbelly from other sandwich shops is its high-quality ingredients, superior customer service, and culture. The menu features items made from high quality ingredients such as fresh vegetables, hearth-baked bread and all-natural chicken. Moreover, a simple menu and freshly-made food offer ease of ordering and broad appeal. In terms of service, the company looks to hire employees that are outgoing and trains them to interact with customers in a genuine way while providing fast service.

Each shop features vintage décor and shared design elements, such as the use of wood, the signature Potbelly stove and locally-themed decorations. To enhance the customer experience, live, local musicians perform at least three times per week in the majority of its restaurants. Lastly, the company strives to emphasize its values of integrity, teamwork, accountability, positive energy, and coaching throughout all levels of the organization, forming “The Potbelly Advantage.” The company believes this allows it to deliver operational excellence and grow the business.

Shops are modeled to generate strong cash flow, attractive shop-level financial results, and high returns on investment. Potbelly aims to generate average shop-level profit margins of above 20% and targets cash-on-cash returns, on new company-operated shops, above 25% after two full years of operation. Thus far, Potbelly has achieved these targets in 2010, 2011, 2012 and through the first half of 2013 (second half data is not yet available).

Potbelly’s growth strategy mainly revolves around its shops. First and foremost, success will require continued excellence in shop-level execution. To support shop operators, the company invests in systems and technology to improve operations. Next, is the importance of finding the right location. This process is overseen by senior management and focuses on, among other things, demographics, traffic patterns and information gathered from local employees. The location-specific approach to development allows the company to leverage its versatile shop format to achieve strong returns across a wide range of real estate settings. Over the long term, Potbelly plans to grow the number of shops at least 10% annually. To help advance this goal, the company has undertaken a franchise program in selected U.S. markets and internationally. That said, with less than 10% of global shops franchised, this is seen as more of a long-term driver. All the while, margin enhancement will be a continuous effort, while aiming for general and administrative expenses under 10% of revenue.

Like all restaurants, the company is vulnerable to changes in economic conditions. Particularly, declines in consumer discretionary spending, which can happen for various reasons, could materially affect the business. Also, profitability depends in part on changes in commodity prices. Major risks specific to the company include the ability to successfully identify and secure appropriate shop locations in new and existing markets, and the company’s geographic focus. Restaurants in Illinois, Texas, Washington, D.C., Michigan, Minnesota, and Ohio make up over 65% Potbelly’s domestic shops. Further, the Chicago metropolitan area comprises about a quarter of its total shops. As a result, adverse economic conditions in any of these areas could have a material effect on operations.

All told, subscribers interested in this sandwich shop operator are advised to consult Value Line’s quarterly reports for Potbelly Corporation, as well as any supplemental reports and relevant articles as important news items arise.

The author did not have positions in any of the companies mentioned at the time of this article’s writing.