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The Potbelly IPO Could Leave You with Indigestion

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I was tempted to go with a headline along the order of ‘Potbelly (NASDAQ:PBPB) Flop’, but that would not accurately reflect my skepticism regarding the sandwich maker’s initial public offering  scheduled for tomorrow.  I think the IPO will meet good demand and enjoy a nice first-day pop. But longer-term, this sandwich chain is likely to leave investors satisfied.  

Let’s break down the numbers, operations, and intangibles to see if this is next Chipotle (NYSE:CMG) -- up 960% in the past six years -- or the next Cosi (NASDAQ:COSI), which is down some 80% since its 2003 IPO.  

It’s Small…

The company plans to sell 7.5 million shares, and recently upped its offering price range from $9-$11 to $12-$13 range. With the increase, Potbelly will raise about $82 million, giving it a market capitalization of around $300 million. By offering just 25% of what borders on a micro-cap, I have no doubt that investors will be hungry for a piece of the action. People tend to gravitate towards tangible businesses they can relate to and it makes an easier sell for the brokers. 

The company is indeed growing, but at a less than impressive rate. It was founded in Chicago in 1977 and as of a full 20 years later in 1997, the company had just two stores when it sold to Bryant Keil. He quickly found private equity investors and has grown the chain to a current level of 286. All but 12 remain company-owned so there is plenty of room for franchising. Another bright spot is improving top-line revenue growth and healthy margins; From 2011 to 2012, total revenue increased 15.5% to $274.9 million, and profit margins have improved 500 basis points to 20% over the past five years. The plan is to grow the store count 10% annually, which seems reasonable and attainable.

…But It May Stall

Unfortunately, the fact of the matter is that growth plans are not only coming up short but going backwards. In 2011 it opened 31 new locations and in 2012 that number dropped to 17, not including the closure of 12 existing locations. And same-store-sales only grew by 1.5% in 2012. It's not quite the growth story some would have you believe, especially in the ultra competitive sandwich space which includes heavyweights such as Panera (NASDAQ:PNRA), Subway, and some lesser-known chains.
It should also be noted that $50 million of the $75 million it plans on raising will be used to pay off existing investors in the form of a dividend. The remaining $25 million is to be used to pay down debt, meaning zero is being allocated for growth and opening new stores. 

That’s where naive franchisees make come in. And what exactly will they be buying?

Given Potbelly’s branding of being “your local best food” and customizing each store to the particular region in terms of decoration and to some extent the menu, start-up costs are significantly higher than that of established brands. According to Technomic, a Potbelly franchisee's investments run as high as $767,700, excluding rent or mortgage payments. This compares to about $80,000 for Subway in a comparable location. Potbelly also costs more to run. Because all its sandwiches are custom-made and toasted, each restaurant requires 16 to 20 workers during peak hours. Jimmy John's gets by with as few as six.

Yet, it doesn’t command higher ticket prices. And with less than 300 locations, I don’t think the operational expertise and infrastructure are in place to attract franchisees in new locations and expect them to achieve immediate profitability.

A Questionable X Factor

People are citing the loyalty of Potbelly customers in an attempt to position it as the next Chipotle or Starbucks (NASDAQ:SBUX), posting pictures of lines as Ronald Thomas did in his brief take the other day. First, let me say that in Manhattan, at lunch time, almost anything that is quick, of decent quality and fairly priced will have a long line.  To his second point that Potbelly will win at due to its lower price point of around $6 versus $9 at Panera or Chipotle, I’d argue that the real direct competitors are Subway, Blimpie, Quiznos, as well as regional local chains.

Potbelly has no competitive advantage in terms of price, product or technology.  It doesn’t have the cache of being organic or healthy; it promotes sandwiches with names like 'The Wreck and allows you to supersize everything.  It does not break new ground in terms of type of food; the biggest hook seems to be that it can toast bread. I don’t believe that is much of an economic moat.

No White Knight

As mentioned, the bulk of the money from this IPO is going to pay out existing investors. This includes Maveron Equity Partners, the largest shareholder with a 28% stake. Much has been made that Maveron is headed by Starbucks CEO Howard Shultz, who was also was on Potbelly's board of directors. It would surely be positive to hitch your wagon to one of the greatest quick-serve food operators in history.

But let me be a spoiler. Schultz recently resigned from the board and as mentioned, his fund is likely cashing out on this IPO. Also note that the above-mentioned Cosi initially tried to ride Starbucks' coattails by opening adjacent locations. Starbucks has since offered the same flatbread fare and more and basically crushed them. Don’t expect Mr. Schultz to act as some leader or savior of Potbelly. He has much bigger coffee to grind.

I’ve lost a lot of money trying to short hot retail chains, especially in the food category. These includes Starbucks and the once high-flying Boston Chicken. I lived in Chicago during the mid-90s when Potbelly was a local phenomenon. On a trip back a few years ago, when I saw them spawning and prospering, I swore that if it ever went public I was going to be buyer. Maybe my taste has changed, but I’m no longer biting. Instead, I’m now waiting for Pollo Tropical.

That place is the best.

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POSITION:  No positions in stocks mentioned.