Potbelly's Shares Popped, But Risk Remains

Shares of Potbelly (NASDAQ: PBPB) popped as much as 20% on Wednesday following the release of the company's third quarter results. Revenue of $78 million and adjusted diluted earnings per share of $0.15 were both ahead of analyst expectations, which refueled investor excitement that Potbelly could be the next Chipotle Mexican Grill (NYSE: CMG) or Panera Bread (NASDAQ: PNRA). Solid results and the Streets' reaction begs the question: Should investors be that excited?

Top line growth was solid, but not exceptional
Potbelly's earnings release featured an 11.7% increase in revenue and 2.5% increase in same store sales ("SSS"). These are solid numbers, but nothing extraordinary; here's a comparison of Potbelly's growth to that of Chipotle and Panera:

Panera's results were labeled by many in the investing community as a "surprise" and "failure," and shares were punished with a 6% decline to a 52-week low. This negative sentiment for Panera was driven largely by the steady deceleration of year over year SSS growth in recent quarters from 5.9% in Q1, 3.7% in Q2, and 1.7% in Q3.

It is easy to argue that Potbelly's results this quarter look more like Panera's than they do Chipotle's. Potbelly's SSS growth of 2.5% follows anemic growth of 1.5% in the first half of the year.

Significant risk to investment thesis
With lackluster SSS results, investors are relying on store expansion as the basis for driving shares higher. As discussed just a month ago as Potbelly's shares were falling, there is certainly room for Potbelly to increase its store count; with just 307 stores at the end of the third quarter, Potbelly is still significantly smaller than Chipotle and Panera. However, there is significant risk to investors that are willing to pay for Potbelly at a price to earnings ratio above 30 despite the fact that the company has reported revenue growth of 10% in just one of the past four years (15.5% revenue growth in 2012). While 2013 will likely be the second such year in the past five years, there are a lot of aggressive assumptions priced into the current market valuation. Without a consistent track record of achieving strong growth, this risk/reward profile should be considered very carefully by investors before purchasing shares of Potbelly.

Expect continued volatility
In addition to the elevated risk created by the current valuation and lack of a proven track record of growth, Potbelly will continue to be volatile based on both the size of the company and the proximity to its IPO in October. Below is a brief illustration of how shares declined sharply between the IPO and the first earnings release:

PBPB Total Return Price data by YCharts

For Potbelly, 20% swings in share price without any material new information are to be expected as the market familiarizes itself with the company and calibrates the growth models used to value the stock.

Caution is urged
The combination of high valuation, lack of proven growth record, and post-IPO volatility create a significant need for caution on the part of investors. For investors that are convinced that the potential to increase store count is enough reason to purchase shares of Potbelly, purchasing shares in smaller increments rather than in one lump purchase will help ease the anxiety of attempting to time the purchase perfectly amid major swings in price.

For investors that believe in the Potbelly story but are concerned by these risks, a solid strategy would be to follow the company for a while before purchasing shares. By waiting until the IPO volatility has declined, investors will also have a few extra quarterly results to help evaluate Potbelly's growth potential; if it is determined that Potbelly can grow to reach 3,000 locations or more, waiting to purchase Potbelly until it reaches 400 locations still provides plenty of runway for grow (and market beating returns) without nearly as much risk as is present today.

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The article Potbelly's Shares Popped, But Risk Remains originally appeared on Fool.com.

Brian Shaw owns shares of Chipotle Mexican Grill and Panera Bread. The Motley Fool recommends Chipotle Mexican Grill and Panera Bread. The Motley Fool owns shares of Chipotle Mexican Grill and Panera Bread. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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