With Its Momentum Gone, Is Potbelly Finally a Good Bet?

Shareholders of restaurant chain Potbelly were not smiling after the company's latest financial update led to a sharp drop in the company's share price. After the big drop, though, is it time to buy in?

Jul 17, 2014 at 11:00AM


Source: Potbelly

Since its hard charge out of the IPO gate when its stock price more than doubled on its first trading day, it has been all downhill for fast-casual restaurant chain Potbelly (NASDAQ:PBPB), as its price has declined 60% since then. The company has anecdotally been hurt by unrealistic growth expectations, no doubt due in part to comparisons with segment leader Chipotle Mexican Grill (NYSE:CMG), a company that seems to be in a category of one.

A case in point was Potbelly's latest financial update, where it pre-announced worse-than-expected financial results for its fiscal second quarter; this revelation led to a bloodbath for its stock price, which subsequently dropped by a double-digit percentage. However, with management sticking to its new store growth plans despite the business challenges, could the company be a good bet at its current price?

What's the value?
Potbelly is a rising player in the fast-casual segment of the restaurant business, operating a network of more than 300 stores with a heavy concentration in its home market of metro Chicago. The company has ridden the increasing popularity of its trademark oven-baked sandwiches and homemade cookies to solid top-line growth of roughly 40% over the past four fiscal years. More importantly, the higher sales tallies have led to higher operating cash flow that has funded an expansion of Potbelly's store base into new markets, including recent moves into the Boston and New York City metro areas.

In its latest fiscal year, Potbelly continued to build upon its long-term growth trajectory. It reported a 9% increase in total revenue that was a function of an expansion of its store base and a modest pickup in its comparable-store sales, where it reported its fourth straight year of growth. On the downside, though, the company was hurt by its current focus on increasing its presence in higher-cost urban markets, which adversely affected its occupancy costs. The net result for Potbelly was a sizable drop in its operating profitability, highlighted by a double-digit decline in its adjusted operating income.

Looking into the crystal ball
The question for investors is: When will Potbelly start to deliver the consistent profit growth necessary to provide a solid foundation for a higher market valuation? Unfortunately, that seems unlikely to happen anytime soon, given that management just reduced its profitability outlook for the current fiscal year.

Of course, Potbelly isn't alone in its profit growth challenges, as competitor Noodles & Co. (NASDAQ:NDLS) has also been struggling to meet high expectations, which most certainly caused its roughly 15% stock price slide in 2014. While the company reported a slight gain in adjusted operating income in its latest fiscal quarter of 2.4%, its operating margin declined during the period, partially due to its first negative comparable-store sales performance since the third quarter of fiscal 2009. In addition, much like Potbelly, Noodles & Co.'s profitability was negatively affected by its strategic move into higher-cost markets, including San Francisco and Philadelphia.

Indeed, Chipotle is the only company that seems to have been able to sidestep the industry slowdown in 2014, evidenced by a 24.4% top-line gain in its latest fiscal quarter that benefited from higher customer traffic volumes. While the company was negatively affected by rising commodity prices, especially for avocados and beef, an increase in productivity at its stores allowed Chipotle to report a double-digit increase in operating income. More importantly, the company's popularity is providing cover for it to raise prices for the first time in three years, a move that should keep its profit growth trending in a positive direction.

The bottom line
Potbelly's latest financial update was clearly not what Mr. Market was looking for, judging by the subsequent decline in the company's stock price. That being said, Potbelly now looks like an emerging value story, with a current price to adjusted EBITDA of roughly 14 compared to roughly 19 for Noodles & Co, based on each companies' last fiscal year adjusted EBITDA. 

In addition, the company is a potential margin expansion story, given that its current corporate infrastructure can likely support much more than the 300 or so current stores.  The key for Potbelly, like with most retailers, is comparable store sales increases, one of the key ingredients for improved operating profitability and sustainable profit growth. 

While investors should keep the company on the back burner for the time being, once Potbelly's sales comps turn positive again, they should definitely be buyers.

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Robert Hanley has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill. The Motley Fool 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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