On July 10, Potbelly (PBPB +0.00%) 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 (CMG +2.54%), 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.
