Potbelly's Struggles Are a Reminder of Chipotle's Strengths

Shares of Potbelly recently lost 25% of their value after the company announced that it expected sub-par second-quarter results. Potbelly's struggles should caution any investors who hope the company has prospects anywhere close to those of Chipotle Mexican Grill.

Jul 17, 2014 at 6:30PM

On July 10, Potbelly (NASDAQ:PBPB) shares got sliced 25% after the company announced that it expects same-store sales to decrease in the quarter and mild overall sales growth of 6.9% year over year. When Potbelly had its IPO in October 2013, some were hopeful that the company's prospects and performance might compare to those of Chipotle Mexican Grill (NYSE:CMG), which has delivered a return of more than 1,300% to investors since it went public in 2006. Despite these hopes, Potbelly's latest struggles merely confirm that investors should exercise extreme caution when comparing the sandwich chain to Chipotle. 

Where Chipotle was in 2006 
Chipotle went public in February 2006 and the company quickly demonstrated its superiority both as a restaurant and a business. For its first year as a public company, Chipotle reported that its same-store sales increased 13.7% and overall restaurant sales increased 31.1% to $822.9 million.

Moreover, Chipotle opened 94 restaurants in 2006, and this increased the company's total restaurant tally to more than 570 restaurants. Even with this quick expansion, Chipotle produced $6.3 million in free cash flow. In other words, even after it expanded its restaurant base by roughly 20% in a single year, Chipotle still had cash left over to put in the bank. That is an impressive feat for a rapidly growing business, and I believe it is one of the primary reasons why we have not seen "the next Chipotle" yet. 

Where Potbelly is struggling today
In the second quarter of this year, Potbelly is expecting same-store sales to decrease 1.9%. Potbelly lowered its guidance for the year as well, and now projects 40-48 new shop openings and flat-to-negative same-store sales in 2014. This new shop growth represents approximately 14% shop growth with Potbelly's current base of more than 300 shops. 

One major differentiating factor between the financial performances of Potbelly and Chipotle is free cash flow. Chipotle is managing to increase its free cash flow production each year while maintaining extensive domestic expansion (the company now has well over 1,600 restaurants in the US). On the other hand, Potbelly barely inched out as free-cash-flow positive in 2013 and the company's overall cash flow production decreased 21.5% year over year in the first quarter of 2014. 

The economic climate is certainly different today than it was in 2006 when Chipotle arrived on the scene, so it makes sense to focus on comparing the performances of these businesses today. Chipotle's 2013 sales measured $3.2 billion compared to Potbelly's $300 million. Despite being a much larger business, in the first quarter of 2014 Chipotle actually grew sales 24.4%, same-store sales increased 13.4%, and the company expanded free cash flow by an astonishing 49.3%. In the same quarter, Potbelly's sales expanded 7.5%, same-store sales decreased 2.2%, and the company's cash flow also decreased by more than 20%. 

Foolish bottom line 
Potbelly's underwhelming performance has contributed to the stock's steady decline since its November 2013 IPO. The business itself is showing slow-to-negative growth and is not producing sufficient or consistent cash flow to finance expansion. 

Investors who are in a rush to find the next Chipotle shouldn't be so quick to write off Chipotle itself. Chipotle's results are unprecedented when it comes to restaurants, and the company still has room to expand in the US. Its fledgling Pizzeria Locale and ShopHouse concepts could also represent significant opportunities for growth over the long haul. While Chipotle shares are certainly trading at a premium with a P/E of 56, it is worth remembering Warren Buffett's adage: 

It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.... when buying companies or common stocks, we look for first-class businesses accompanied by first-class managements.

After its recent drop, Potbelly may come close to being a fair company trading at a wonderful price. I would much prefer to invest in the wonderful and proven business that is Chipotle at a fair price. 

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Apple recently recruited a secret-development "dream team" to guarantee its newest smart device was kept hidden from the public for as long as possible. But the secret is out, and some early viewers are claiming its everyday impact could trump the iPod, iPhone, and the iPad. In fact, ABI Research predicts 485 million of this type of device will be sold per year. But one small company makes Apple's gadget possible. And its stock price has nearly unlimited room to run for early-in-the-know investors. To be one of them, and see Apple's newest smart gizmo, just click here!

David Kretzmann owns shares of Chipotle Mexican Grill. You can follow David on his Foolish discussion board, Pencils Palace, on CAPS, or on Twitter @David_Kretzmann. Learn more about David's Pencils IRA Project at Fool.com. The Motley Fool recommends and owns shares of Chipotle Mexican Grill. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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