Why I Bit into Potbelly's IPO Anyway
When Potbelly first announced plans to go public, I immediately began researching to see if this was a company I wanted to add to my portfolio. I came across many articles while researching, but one was particularly good in presenting a bear argument: Five Reasons Not To Bite Into Potbelly's IPO. While I recommend reading it, I did in fact invest on the company's first day of trading. Allow me to share with you -- despite a good bear argument -- why I decided to bite anyway.
Addressing the elephant in the room
One of the most disturbing issues with Potbelly was its plan for using the IPO proceeds. The capital injection gained from an IPO is a once-in-a-lifetime opportunity, and nobody wants the company to blow it. Potbelly's plan? Issue a $49.9 million special dividend to pre-IPO shareholders. While it surely made pre-IPO shareholders happy, post-IPO shareholders would rather that money went toward, you know, growing the business.
With the leftover cash Potbelly plans to pay off $14 million in outstanding debt. I'm a huge fan of paying off debt, and this was one reason I came to believe in Noodles & Company . By paying off its debt early, Noodles saves $3 million a year. This move hasn't slowed Noodles' growth plans at all -- last quarter alone it opened 13 new locations and looks to deliver on the high-end of its guidance for 38-42 new locations this year. A company can grow using free cash flow instead of debt. With a long-term outlook, it's a smarter move.
When evaluating Potbelly's planned use of the IPO proceeds, I found the silver lining: the plan was based on pricing between $9-$11. At the mid-point of that range the company expected to receive $67 million, which would leave a measly $3.1 million cash boost after the dividend and debt repayment. However, instead of pricing at $10, the IPO priced at $14, which should net the company $94.1 million. After the dividend and debt repayment, the company should now have $30.2 million. While I still wish the dividend wasn't happening, at least in the end Potbelly is left with significant seed money.
Great or not-so-great growth?
Let's talk about growth on two fronts: new locations and comp-sales. Many analysts aren't crazy about Potbelly's growth in either of these categories.
In fact, let's be honest: comp-sales look awful, especially when compared to Starbucks ,
|3 year average||2.3%||7.3%|
|5 year average||0.2%||2.6%|
Potbelly has been improving in this area lately -- comp-sales were up 3.4% in 2012 -- but the company attributes much of this to an increase in average checks, not increased traffic. Last year when Starbucks' comp-sales increased 7%, 6% was attributed to increased transactions, not price increases. This shows that Starbucks not only has better comp-sales, but better quality comp-sales. Without a doubt, Potbelly will need to address this issue going forward.
While comp-sales growth is relevant, perhaps it's not the most relevant growth metric that should be considered. More important than comp-sales in the near term for Potbelly is new unit growth. Many analysts aren't digging the company's forecast of 10% annual unit growth, especially considering that companies like Buffalo Wild Wings are growing faster. And that's true, Buffalo could grow its total locations 18% next year.
But not all growth is the same. Buffalo has taken a combined franchised and company-owned approach to growth, while Potbelly has decided to grow almost exclusively through company-owned stores. Franchising often allows for faster growth, but Buffalo's profits will be somewhat capped at these locations -- franchisees have to make their money too. In contrast, 100% of the profits from new Potbelly locations will go directly to the company.
I also have a hunch that Potbelly might be guiding conservatively. The company should have relatively little difficulty achieving 10% annual unit growth, especially considering its better than expected cash position. The company could wind up surprising investors in coming quarters.
What's next for the newbie?
I see a lot of growth for Potbelly. With only around 300 locations, I wouldn't be surprised if the company could grow locations over 400% to rival privately-held competitors Jimmy John's and Firehouse Subs. I think the quality of this growth is also superior given that this will be debt-free, company-owned growth.
This stock is not without risk and has some issues to address going forward. But I do like a lot about this story, and I'm happy to be a part of it from the beginning.
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The article Why I Bit into Potbelly's IPO Anyway originally appeared on Fool.com.Jon Quast owns shares of Potbelly. The Motley Fool recommends Buffalo Wild Wings and Starbucks. The Motley Fool owns shares of Buffalo Wild Wings and Starbucks. 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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