One Overlooked Reason Potbelly is Cheap

Investors lined up in October to get a bite of Potbelly (NASDAQ: PBPB  ) shares. Now there's a line for the door as the stock has shed half its value. Nearly down to its IPO price, is this sandwich shop a buy? Many analysts would say it's still overvalued based on its price-to-earnings ratio. But there's one metric that makes Potbelly look cheap in comparison with its fast-casual peers.

Price-to-sales ratio
While the price-to-earnings ratio is extremely helpful in determining a company's value, the price-to-sales ratio can provide additional perspective.

Company Market Cap TTM Revenue Price to Sales Ratio
Chipotle Mexican Grill $18.5 billion $3.4 billion 5.44
Noodles & Company $991 million $359 million 2.74
Panera $4.1 billion $2.4 billion 1.68
Zoe's Kitchen $572 million $131 million 4.45
Potbelly $459 million $305 million 1.51

Source: Yahoo! Finance

The average P/S ratio for the restaurant industry is 2.17, which raises two questions: 

  1. Why do Zoe's  (NYSE: ZOES  ) and Chipotle  (NYSE: CMG  )  have such high valuations?
  2. Why does Potbelly have such a low valuation?

First off, Zoe's and Chipotle have high valuations because of the speed at which they are growing their sales. Revenue for Zoe's rose 135% from 2011 to 2013. Chipotle's revenue rose 42% during the same stretch. These two companies continue to grow rapidly and therefore demand higher valuations on many metrics, price to sales included. 

Noodles & Company (NASDAQ: NDLS  ) grew its revenue 37% from 2011 to 2013, yet -- on this metric -- has a much lower valuation than Chipotle. I attribute this to one key difference between Chipotle and Noodles: the ability to convert revenue into pure profit. 

Company Operating Margin Profit Margin
Chipotle Mexican Grill 16.37% 9.84%
Noodles & Company 5.84% 2%

This is why Noodles has yet to capture Chipotle-esque investors. Chipotle has become a money machine that generates huge profits. Noodles has big expansion plans -- it eventually plans 2,500 locations compared to just around 400 now -- but hasn't shown the cash returns yet. The same holds true for Potbelly.

The deal with Potbelly
Generating and growing revenue hasn't been a problem for Potbelly. Its revenue per restaurant is high -- over $1 million per year -- but this hasn't turned into big profits. The culprit for this disparity is its lagging profit margin.

Company Operating Margin Profit Margin
Potbelly 4.21% 0.31%
Panera 12.41% 7.84%

Panera (NASDAQ: PNRA  )  is Potbelly's close competitor, and is operating more efficiently. But if we rewind the clock 15 years to 1999, it was a different story. Back then Panera had just 448 locations (including the then-bigger Au Bon Pain brand), relatively measly revenue of $157 million, an operating margin of only 2.3%, and a net loss of over $600,000.

Panera successfully increased its operational efficiency over the past decade. With high unit growth as well, this company is now a top dog in the restaurant space. Lately the bakery has struggled, but management is now rolling out Panera 2.0 which looks to shorten lines, make the menu more intuitive, and make orders more accurate. These things will lead to more profit.

Many of the arguments surrounding Potbelly's potential center on its unit growth and price-to-earnings valuation. These arguments assume that Potbelly will remain a cellar dweller in terms of profit margin -- an assumption that isn't realistic.

How Potbelly will fix its margins
First off, it's important to differentiate between shop-level profit margin and profit margin. The former relates to each individual Potbelly location's ability to turn revenue into profit. This past quarter, shop-level profit margin was 17.5%. That's down a little from the company's goal of besting 20%.

So each Potbelly location is turning $0.17 of every dollar into profit. But before this money can appear on the net income line, the majority of this cash gets eaten by the opening of new hub markets, like the one it's opening right now in Denver. Over the past couple years, the chain has branched out of Chicago and into New York, Seattle, Boston, and Phoenix.

CEO Aylwin Lewis admits that opening hub markets is expensive -- specifically the hiring and training of new talent to run the operations. But opening hub markets allows Potbelly to divide and conquer in terms of national expansion. Rather than just spreading out from Chicago, the company can expand out from several key locations around the nation. 

If the bulk of Potbelly's cash is swallowed up in opening hub markets as management claims, then the company's low profit margin is a short-term issue. Eventually this company will grow large enough that it will no longer need to open hub markets, at which time I expect its profit margin to drift toward its shop-level margin. Current unit growth will actually drive eventual profit-margin gains.

Final thoughts
Looking at several valuation metrics can help an investor gain perspective. Right now Potbelly has the lowest price-to-sales valuation among its peers. This suggests healthy revenue, but investors are shunning the stock because its net income isn't rising as fast as they'd like. As we've seen, this may be a near-sighted perspective and margins may improve drastically as the company grows nationally.

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