After Losing Some Altitude, Is Potbelly Finally a Good Bet?

Investors who bought into last year's IPO of restaurant chain Potbelly (NASDAQ: PBPB  ) are probably not the happiest lot right now, after a 40%-plus decline for the company's share price since its first-day close. The company was hyped as the next great fast-casual restaurant story, a la Chipotle Mexican Grill (NYSE: CMG  ) or Panera Bread (NASDAQ: PNRA  ) , but generating a similar sales and stock price trajectory to those sector leaders is easier said than done.

Despite generally better-than-expected results in its first two quarters as a public company, Potbelly hasn't been able to overcome a high market valuation, as evidenced by a current price-to-adjusted earnings before interest, taxes, depreciation, and amortization multiple of roughly 22. However, with its stock price at a fraction of its first-day closing price, is Potbelly now a good bet?

Chart forPotbelly Corporation (PBPB)

Source: Yahoo Finance.

What's the value?
Potbelly has a good thing going, with its quirky chain of sandwich shops, more than 300 at last count, that continue to embrace the look and feel of its roots as an antique shop. Like Chipotle, Potbelly keeps its menu simple, which allows it to economize on volume buying opportunities and keeps its store operations streamlined and efficient. Consequently, the company has been able to expand rapidly over the past few years, continuing to broaden its store base beyond its metro Chicago home market.

In FY 2013, Potbelly continued building on its multiyear growth story, reporting a 9% top-line gain that was primarily a function of a larger store base, as the company continued to expand in newer urban markets, like New York and Seattle. More important, Potbelly's stores enjoyed slightly higher per-store productivity, leading to a slight pick-up in its overall adjusted operating profitability. The net result for Potbelly was stronger operating cash flow, providing funds to continue growing its store footprint, especially in the Western U.S.

A long way to go
Of course, with a little more than 300 stores, Potbelly has a sizable disadvantage in the efficiency of its back-office operations relative to its larger named competitors, a fact that shows up in its relatively lower operating margin. In addition, the company anecdotally has some work to do in order to build the sense of community that has been at least partially responsible for the ascendancy of both Chipotle and Panera.

For its part, Chipotle continues to post torrid top-line growth, thanks to consumers' continued gravitation toward the company's trademark burritos as well its "Food With Integrity" mission that is long on local and organic food sourcing. More important, Chipotle's use of a simplified menu, a strategy that Potbelly has emulated, allows it to maintain efficiency even at its current size, leading to a healthy double-digit operating margin. The net result for the company is strong operating cash flow, helping to fund international expansion and its forays into related areas, like Asian and Italian cuisine concepts.

Similarly, Panera's sales have enjoyed a favorable multiyear growth trajectory, up 84% over the past five fiscal years. This has been thanks to its focus on high-quality ingredients, which has fostered customer loyalty, as evidenced by 15 million members in its MyPanera loyalty card program. The captive customer base affords Panera the luxury of limiting its overall marketing spending to around 2% of sales, helping the company to consistently record a double-digit operating margin. As is the case with Chipotle, Panera's strong profitability enables it to continue building out its supply chain ecosystem all the way to the farm, an important source of differentiation for customers that is likely to propel future growth for the company.

The bottom line
Potbelly's share price has come down a long way, likely much to the dismay of post-IPO investors, but that doesn't mean that the company's share price can't continue its descent. While Potbelly has found a successful store operating model, as evidenced by 20%-plus store margins, its cautious approach to growing its business doesn't seem to jive well with a market valuation that implies hypergrowth. As such, investors should feel free to chow down on Potbelly's tasty subs, but should probably avoid its shares. 

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