Potbelly Skeptics: The Pot Calling the Kettle Black?

Historically, across numerous industries, complete product differentiation is more of a theory than reality. Sure, it would be nice for every company to produce a unique idea, product, or business model that is completely revolutionary and has never been thought about or attempted before. In many cases, though, competitors model themselves around their industry peers and improve on existing products or ideas.

New kid on the block
With less than a month under its belt as a publicly traded company, Potbelly (PBPB 1.88%) already has many naysayer analysts doubting its long-term potential. Investors likewise are starting to question the valuation of the stock--it has declined over 13% since trading began on Oct. 4, 2013 with a 120% surge.

By Bobak Ha'Eri (Transferred from en.wikipedia) [CC-BY-SA-2.5 (http://creativecommons.org/licenses/by-sa/2.5)], via Wikimedia Commons

The biggest burden being placed on Potbelly by the bears is the company's lack of product differentiation. Potbelly's menu mostly consists of sandwiches, soups, salads, smoothies, and shakes, which echoes places like Subway, Jason's Deli, Quiznos, Jimmy Johns, and Panera Bread (PNRA). Outside of the food industry, product similarity exists everywhere from your cell phones, computers, cars, appliances, clothing, and everything in between. More importantly, within the food industry, product similarity is even more common.

Domino's, Papa John's, Pizza Hut, Pizza Inn, and thousands of other pizza establishments all co-exist despite the fact that all of their menus are nearly identical. Even a pizza connoisseur would have trouble telling whether a random slice of cheese pizza was from Domino's or Pizza Hut. The same goes for the numerous places that sell glazed doughnuts, coffee, or the ever popular and forever duplicated hamburger.

Taking market share with lower prices?
Expansion has been accelerating during the past few years for Potbelly. In fact, it took the chain two decades to open its second shop in 1997, but just five years to go from 200 (2008) to 300 (2013) locations. Since new shops are estimated to cost $600,000 each , it should be no surprise that Potbelly's profit margin will be low for awhile--it currently sits at 1.89%.

In the meantime, Potbelly's rapid growth should make Panera Bread's management and investors pay attention. With very similar menu selections, the competitive advantages of product differentiation disappear. Instead, low-price strategies could give the edge to Potbelly. Based on the prices below, Potbelly could actually improve its margin by slowly raising prices, thus narrowing the gap between it and Panera Bread.

Data based on Potbelly's Northern Virginia menu prices and Panera Bread's 2013  menu prices.

The flaw of being too different
Too much product differentiation may turn out to be a bigger burden for Noodles & Co (NDLS -5.60%). The chain currently has an even lower profit margin than Potbelly, which came in at 0.08% based on its second quarter earnings.  Despite already climbing over 27% since its July IPO, Noodles & Co may find the road ahead difficult.

Even though Noodles also serves soups, sandwiches, and salads, the chain is known for noodles and pasta. Because of the lack of direct menu competition, Noodles & Co will not be able to gauge future menu or location interest.

Changes to the menu will require more investment and market research. A McDonald's competitor can easily see what works and what doesn't before it attempts to make its own version of a popular McDonald's menu item. Burger King, for example, launched its own rib sandwich after seeing the success of the McDonald's McRib earlier this year.

Restaurant expansion for Noodles & Co will require more caution. Existing restaurants that specialize in noodles or pasta are less common than burger and fries joints.

Recently, Noodles & Co launched plans for a new limited-time-only menu offering. Its new fall and winter menu items include the Thai Hot Pot, Spaghetti Alfredo MontAmore, and Pork Adobo Flatbread. Menu changes are typically expensive and often take years of marketing research to get correct. If Noodles & Co has to go this route to improve its menu, its profit margin may continue to stay near zero for quite some time.

Bottom Line
Claiming Potbelly is doomed due to a lack of product differentiation is really the pot calling the kettle black. If product differentiation is a requirement to survive in the restaurant industry, then Domino's and McDonald's would be the only ones left selling pizza and hamburgers. The fact is that the industry historically has always been open to new companies no matter how similar their menus are with existing companies. This trend won't suddenly change for Potbelly.