It Was a Beautiful IPO for Potbelly Insiders

Potbelly (NASDAQ: PBPB  )   shares hit the gas closing 120% above its IPO price of $14 to close its debut day at over $30 per share.  It was a memorable and profitable day for insiders, who shared a generous dividend of nearly $50 million that came from IPO proceeds. Investors who bought at the top on day one have not been as lucky with Potbelly shares slipping nearly 25% from the intraday high October 4. 

Potbelly is a fast-casual concept serving sandwiches, salads, soups, and specialty cookies. The menu is made fresh to order and cookies are baked daily. The stores are inspired by the neighborhood they are built in (Applebee's tries for the same effect) creating unique stores with their own distinct personality.

Its stated mission is  to make customers feel the local Potbelly is their friendly  "Neighborhood Sandwich Shop" and that happy customers will spread the word. Potbelly aims to make people "really happy," make more money, and improve every day.

Make more money was definitely in the IPO mission statement
In August, the board of directors generously granted a cash dividend of nearly $50 million to shareholders pre-IPO, including corporate executives. Founding Chairmen Bryant Keil was awarded 60,000 options, immediately vesting in February making him eligible for an even bigger slice of the IPO dividend. There are around 15 shareholders with between 1% and 28% of the shares that will be splitting the $50 million.

Potbelly sold 7.4 million shares at the IPO with selling stockholders unloading 137,834 shares. The offering price was raised to $14 from $9 to $11, and the IPO brought in more than $100 million -- considerably more than the original guided $75 million. Shareholders can hope the extra $25 million will be invested in growing the business. 

There are  28 million shares outstanding increasing to 29 million if the underwriters purchase additional shares. Insiders controlled nearly 21 million shares (74%) at the IPO and investors only 26.3% -- common shareholders have to hope commoner/insider interests become more aligned after the IPO, with no more sweetheart deals for insiders.

You can lead a diner to Potbelly, but...
In the first half of  2013, revenue was up 11.7% with a 1.5% increase in same-store sales. Price increases accounted for 2.6% of the comp indicating that traffic was a negative 1.1%. Revenue increases in 2012 were 15.5%; comps were  up 3.4%, and traffic increased only 0.2%. The price increases accounted for 3.2%. In 2011, revenue was up 7.9% on 1.7% comps, and traffic increased just 0.3%.

The numbers show the impressive string of positive comps is from price increases and disappointing traffic patterns that were in negative territory for the first half of 2013. Most of the growth for Potbelly has been new store openings and higher prices  -- a weaker and ultimately unsustainable strategy. 

  • gross #1 includes cost of sales
  • gross #2 includes labor

Operating income and net growth look spectacular with triple and even quadruple increases, but negative earnings are becoming just less negative from 2009 to 2011. In 2012, There was a tax benefit of $15 million that skewed net income to $24 million and net growth of over 200%. Had Potbelly paid the corporate tax rate on earnings, net earnings in 2012 would have dropped year over year. Potbelly is creating positive cash flow and  has money to spend to open new restaurants, creating growth opportunities. It just needs to figure out the magic formula to keep diners coming back for more.

Comps are low, keeping Potbelly from being in the same league as other superstars like Chipotle Mexican Grill (NYSE: CMG  ) and Panera Bread (NASDAQ: PNRA  ) . 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. Chipotle and Panera have enthusiastic guests who come back day after day. The best restaurants bring new customers in the door every quarter, making traffic increases the major component of comparable sales.

Revenue growth in 2013 was dominated by new store openings of 13.4%, but revenue increased only 11.7% suggesting either old units are underperforming, new stores are not seeing the buzz and busyness of a successful honeymoon period, or both. When Potbelly starts reporting unit volumes consistently, the areas of weakness will be clearer.

Marginal margins
For a restaurant with a smallish menu serving only sandwiches, salads and soups, you might expect bigger margins.  Margins trail Chipotle and Panera with Potbelly's net margin at 1.9% compared to 8.6% for Panera and Chipotle's 10.7%. Operating margins for Potbelly were only 3.3% -- on the low side.

Occupancy expenses (includes rent) were 4% to 5% higher than Chipotle's and Panera's. The fixed expenses (rent, utilities, credit card expense and general corporate spending) will keep margins low until restaurant revenue shows consistently higher growth per unit. It's a number best tracked by average unit sales -- something Potbelly does not report  in the initial filings. When investors begin to see average unit volumes rising every quarter, they can start to anticipate better margins and higher earnings will follow.

Panera's souper sales and growth

Panera has seen some slowing 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 with high single-digit comps, making it one of the stars in fast-casual restaurants.

Chipotle's big burrito business
From September 2010 to March 2012, Chipotle Mexican Grill had seven quarters of comps between 10% to 13% built on traffic increases of 8% to 11%. Margins are some of the highest in the sector. Revenue growth has been higher than 20% in six out of the last seven years. 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?
Investors love fast-casual restaurants and every new IPO gives them the illusion they will be cashing in on the next Chipotle or Panera, but those superstar stores are few and middle-of-the-road fast-casual restaurants are legion. Efficient, sustainable growth built on rising traffic and unit sales needs to become standard operating procedure to make Potbelly shine like a star. 

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