Why Potbelly May Be Worth Considering on Weakness

On July 9, small-cap sandwich shop Potbelly (NASDAQ: PBPB  ) provided preliminary results for the second quarter of its fiscal 2014 year. The announcement disappointed investors, causing shares to be halted in aftermarket trading and plunge more than 25% on the following day.

While the company still expects to grow revenue overall in the quarter, several warning signs have emerged, most notably the company's inability to increase comparable-store sales. With shares now pulverized, it is a good time for investors to consider the company's future potential.

Source: Potbelly 

Warnings signs
In Potbelly's first-quarter earnings announcement in May, the company posted some solid results including total revenue growth of 7.5% and 11 net new store openings. However, it experienced a 2.2% decrease in comparable sales growth. At the time, management projected Potbelly to post low single-digit comparable sales growth in company-operated stores for the 2014 fiscal year.

Unfortunately, things only appear to have gotten worse for Potbelly and its shareholders since May. In all regards, the second quarter, which will be officially reported after the market close on Aug. 5, is shaping up to be even worse than the first quarter.

Management expects the company to only grow total revenue 6.9% in the quarter, which is lower than first-quarter growth of 7.5%. Additionally, the company is expected to only have eight net new store openings, which is once again well short of last quarter's 11 openings.

The most disappointing metric, however, is its projected drop in company-operated comparable-store sales. Management expects that the company experienced a 1.6% decrease in same-store sales in the second quarter. This is a far cry from same-store sales growth of 3% in last year's second quarter. When combined with the first quarter's 2.2% decline, this indicates that management is consistently failing to increase foot traffic to existing restaurant locations.

The disappointing results for the first half of the year have also forced management to lower fiscal 2014 guidance overall. Management now expects flat- to-negative comparable sales growth for the year compared to its previous guidance of low single-digit growth issued only a few months ago. 

Potbelly Chairman and Chief Executive Officer Aylwin Leis explained:

We are disappointed by our performance during the second quarter, which fell short of our expectations. Comparable store sales growth improved as we moved throughout the quarter, but fell short of anticipated levels. Given our results in the first half of the year, we have revised our full year guidance to reflect current trends within our business.

Source: Company Facebook

Potbelly is not the only restaurant company struggling to grow same-store sales. Panera Bread (NASDAQ: PNRA  ) has experienced a significant slowdown in comparable-store sales as a result of customer service-related problems.

Panera management has implemented a strategy called Panera 2.0. It  is a series of integrated technologies designed to enhance the overall customer experience by decreasing customer wait times and increasing efficiency. While the program is not expected to meaningfully contribute to same-store sales growth until 2015, the program has now been embraced by all franchisees.

Belly up?
The most pressing question investors have to ask now is: Can Potbelly come up with a solution to reverse its comparable-store sales decline like Panera has? Management seems to think so and offered several reasons why.

CEO Lewis explained:

Our neighborhood marketing approach will continue to be our primary focus in the near-term, but we will also take additional steps to drive comparable-store sales growth.

Lewis sighted strong consumer demand for the company's new Flats food offering and expects continued growth in this regard. He also explained that Potbelly will "vigorously test a number of new marketing, menu[,] and operational tactics during the second half of the year."

Also, investors should keep in mind that Potbelly is still performing well in other regards, most notably new store openings. The company is still on track to open 40-48 new locations in 2014, although a majority of the openings are expected in the fourth quarter.

The potential for more stores is large, as CEO Lewis stated in the recent press release he believes the company can sustain at least 1,000 domestic stores. As of March 30, the company had only 330 total store locations.

Compared to Panera, which already has 1,800 total store locations, Potbelly could still be very early on in its domestic expansion process.

(Source: Company Facebook)

Bottom line
Compared to more established competitors like Panera, Potbelly is a risky investment. The company is having trouble growing same-store sales despite new product introductions.

However, if the company can better engage its consumers, as it plans to do through new marketing strategies, shares may be worth a second look. Since the company is still aggressively opening new stores while increasing revenue, Potbelly's current woes may prove to be short-lived.

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