Why Potbelly Should Hurry Up and Franchise More Stores

Potbelly (NASDAQ: PBPB  ) is one of the worst-performing restaurant stocks so far in 2014. Shares of the sandwich chain have lost more than 50% of their value year to date, compared to a 6.7% gain for the S&P 500. The stock's fall from grace is a mix of profit-taking and worry over Potbelly's declining same-store sales in recent quarters. Up to this point, the company's strategy has been opening new company-owned restaurant locations and offering guests new lower-calorie flatbread options. However, Potbelly could learn a thing or two from McDonald's (NYSE: MCD  )  franchise business model.

Would you like a franchise with that?
Potbelly said recently that it would "vigorously test a number of new marketing, menu, and operational tactics during the second half of the year" in hopes of reigniting investor confidence. Perhaps a smarter approach would be to take a page from McDonald's playbook and franchise more locations.

Potbelly began offering franchises in 2010, but hasn't as of yet expanded further on this initiative. In the chain's S-1 financial filing the company says it plans to expand the number of franchised shops on a "disciplined basis" in the future. With the system already in place and Potbelly's market value losing steam these days now could be the perfect time to ramp up its franchise model.

The fast-casual sandwich shop currently operates around 300 stores in the United States, and management plans to have at least 1,000 stores down the road. If Potbelly were to successfully franchise a portion of those new locations, it could benefit both the company and its shareholders for years to come. McDonald's structure, after all, offers ample proof that the franchise model works

McFranchise me
McDonald's franchise network is one of its key competitive advantages today. That's because the company collects rent, royalties, and service fees from franchised restaurants on a regular basis. This translates into a steady stream of free cash flow for McDonald's. Franchisees account for about 90% of the Golden Arches' 14,200 U.S. restaurants today.

Historically, more franchised stores have been a good thing for Mickey D's shareholders because it creates reliable profits for the company. The chain has successfully raised the fees it charges franchisees an average of 8% over the past five years, according to Bloomberg . Sure, franchise owners weren't happy about the increased costs, but they agreed to pay them nonetheless. Moreover, franchised restaurants generated $9.2 billion of McDonald's total $28 billion in revenue in fiscal 2013as a result -- thus creating a steady stream of free cash flow for the Golden Arches and its shareholders.

Instead of spending capital on its restaurants, McDonald's typically buys the land the franchised restaurant sits on and collects rent payments and service fees from said franchisee . As a result, McDonald's owns some of the best commercial property in the world today, thereby giving its balance sheet some impressive real estate assets. Looking ahead, Potbelly could operate a similar structure, though it will take time. Potbelly is tiny by comparison and building out its franchised model will take time and resources. Unlike McDonald's, Potbelly must first earn the trust of its franchisees and prove that it can be a valuable business partner.

Source: The Motley Fool

Potbelly is well positioned to follow McDonald's lead
The vast majority of Potbelly's 300-plus stores today are company-owned and operated. However, the chain has franchisees operating 13 domestic stores and 12 locations in the Middle East. The company is therefore well positioned to grow its business further through franchising. Additionally, the company's unique "neighborhood marketing approach" helps it connect with local communities and drive word-of-mouth business to its stores.

Potbelly began offering franchises in 2010, yet franchise royalties and fees still represent less than 1% of Potbelly's total revenue. For comparison, more than 32% of McDonald's annual revenue last year came from franchised stores .This creates a clear opportunity for the company to grow its franchise business in the quarters ahead. As McDonald's has demonstrated, a more franchised business model could drive profitability for Potbelly over the long-term. Potbelly is in the early stages of its growth story. Yet patient investors could be rewarded as the company builds out its franchise business and enters more markets abroad in the years to come.

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