Investors expected to get high off the hog, and consumers expected to be healthfully fed; but is the growth story behind Potbelly (NASDAQ:PBPB) already dead?

When Potbelly announced its intention to become a publicly traded company more than a year ago, the buzz among investors, and even among customers, was loud enough that you could hear it walking down the street. It was hard not to fall in love with the rapidly growing sandwich maker, which offered its customers healthy food choices, prepared right in front of them, in a fast -- but not fast-food -- environment. The restaurants were inviting, unique, and they felt down to Earth, as if the company's founder and chairman, Bryant Keil, could walk through the door at any moment.

Source: Jaysin Trevino, Flickr.

Potbelly's growth was truly the stuff investors' dreams are made of. Between 2002 and 2005 Keil took Potbelly from just 10 locations to more than 100; and by 2008 that figure had jumped to more than 200!

In addition to offering a bevy of healthy food choices and growing like a weed, Potbelly also added a unique charm to its restaurants by having local musicians perform live while you eat. It might sound silly at first, but it's the little factors like this that create emotional attachments between consumers and the establishments they come back to over and over.

Things have changed
But that was then. Today's reality is more bleak, as evidenced by Potbelly's latest quarterly earnings results, released last night.

During the quarter, for which I should add Potbelly notably reduced expectations just a few weeks prior, Potbelly delivered revenue growth of 7% to $83.6 million and produced adjusted net income of $2 million. All things considered, that might appear pretty good on the surface, especially when you consider the high cost involved with expanding into new regions and the innovation that's constantly going into menu, music, and store design.

Yet the real shock comes when you remove the addition of its eight new shops opened in the quarter and compare the sales performance of stores that were opened last year to their sales performance this year. The result was a 1.6% decline in comparable-store sales, which is actually a slight improvement from the decline reported in the previous quarter. In other words, sales at shops open for at least 12 months are falling.

What's wrong with Potbelly?
There are arguably a number of factors which have influenced the company's recent sluggish performance.

Source: James Lee, Flickr.

To begin with, competition among fast-casual restaurants is becoming fiercer. Potbelly was able to fly under the radar for a while when it only had a few dozen shops, but larger chains with deeper pocketbooks have begun to take notice as Potbelly's growth rate has picked up. The company owns and operates more than 300 shops in the United States and franchisees operate more than 20 shops in the U.S. and the Middle East. The company plans 40-48 total new shops in fiscal 2014.

Chains like Panera Bread (NASDAQ:PNRA) and Chipotle Mexican Grill (NYSE:CMG) have been pioneering the push toward healthier eating habits for more than a decade. Chipotle's Food with Integrity campaign offers the company's commitment to utilize local growers to supply its vegetables and provide its customers with hormone- and antibiotic-free meat when possible. By a similar token, Panera recently announced that it would be removing all food additives from its menu by 2016. The point being that providing fresh and healthy food options is no longer the exception in the casual-dining space; it's the expectation! This makes it very difficult for Potbelly to stand out from its peers. 

Another complication in the Potbelly growth story is that it's expanding so rapidly that its stores are losing their homey, unique appeal.

Potbelly investor presentation. Source: Potbelly.

After stamping out its footprint in its home state of Illinois, Potbelly moved well beyond Illinois' borders into a number of different states and regions. Whereas most Illinois residents understand the story behind Potbelly (part of its appeal), citizens in other parts of the country may not. And as there are more Potbelly sandwich shops, the stores lose their individuality, part of what helped make the company so successful.  

A final concern is the company's focus on retaining store ownership as opposed to franchising in order to grow.

Restaurant chains have two paths they can take when expanding their business: store-owned restaurants or franchised restaurants. Franchising often allows a chain to grow the quickest, as it brings in franchisees which supply at least some of the start-up capital for a new restaurant, ultimately reducing the capital costs on the parent company when opening new shops. In addition, since franchisees' own money is on the line, it tends to create a very motivated management team. On the flip side, store-owned restaurants allow a business to maintain majority control over how its stores are operated, and, best of all, it allows the company to keep all of the profits rather than share them with franchisees.

If Potbelly's business were growing quickly enough and it were trying to retain its individuality, then the store-owned model would make sense. However, neither of these things is true. Potbelly would appear to be struggling to differentiate itself from the competition, as its falling same-store sales would seem to indicate. Yet Potbelly has made it clear that it prefers to only franchise a small number of stores, and would like to keep most of its stores under the management of the company.

"Why is this a problem?" you ask? Simply put, the costs associated with opening a Potbelly store, or even running a Potbelly store, are significantly higher than those of its peers.

Source: David Wilson, Flickr.

As Chicago Business noted in 2012 prior to Potbelly going public, Potbelly shops involve the use of costly wooden furniture, and its work shifts often employee 16 to 20 workers at a time since everything is done fresh and right in front of the customer. In contrast, other fast-growing chains such as Jimmy John's and Jersey Mike's only employ four to six workers at a time behind the counter. These expenses add up quickly, and make Potbelly's choice to stick with a store-owned model a potentially poor business move.

Is the Potbelly growth story dead?
I wouldn't exactly stick a fork in Potbelly, but the path management is currently taking doesn't make much sense -- and I believe yesterday's earnings results verify that thesis.

In order for Potbelly to become a growth stock once again, it needs to seriously consider franchising more of its stores, which will reduce upfront store opening costs and install motivated management teams across the country that understand their regional customer bases better than Potbelly's Chicago-based management team.

Potbelly also needs to consider ramping back on its expansion until it's figured out a better way to compete against its peers. Expanding while same-store sales are falling is not a recipe for long-term success. Whether that involves finding a way to reduce expenses through employee cuts and trimming store-opening costs, or through menu innovation, Potbelly is unwise to continue its expansion in the wake of falling sales.