Should You Wait for the Euphoria to Subside at Potbelly?

According to the National Restaurant Association, the restaurant industry is on pace for $661 billion in sales in 2013, up 3.8% from the prior year.  With Americans continuing to hit the dining-out scene en masse, investors are on the lookout for the next Chipotle Mexican Grill or Panera Bread

Some investors have christened newly public Potbelly as the heir apparent, driving its stock up sharply from the initial public offering price. So, should investors dive in or wait for a post-IPO cool down?

What's the value?
Potbelly is a quirky chain of sandwich shops, 280 at last count, that have an antique look and feel -- no doubt due to its inception as a Chicago antique shop. The company creates efficiency in its food purchases by offering a limited menu, mainly consisting of an assortment of oven-baked sandwiches, complemented by hand-dipped shakes and homemade cookies. With health consciousness on its customers' minds, Potbelly has also tweaked its menu in recent years, introducing smaller Skinnies sandwich sizes in 2008 and salads in 2010.

In FY 2013, Potbelly has continued its solid growth pattern, with revenue up 11.7%, aided by positive comparable-store sales and a double-digit increase in its store count. The company's adjusted profitability, however, dipped slightly due to rising occupancy costs from its push into urban markets, notably New York and Boston. 

Nevertheless, Potbelly's geographic expansion will reduce its exposure to its home-Illinois market, accounting for roughly 30% of its store base, and should ultimately help it to generate better profitability through scale efficiencies.

Looking for an edge
While Potbelly has substantial growth opportunities, with operations in only 18 states and Washington, D.C., investors may have gotten ahead of themselves, pushing the company's market valuation to almost 25 times 2012 adjusted earnings before interest, taxes, depreciation, and amortization. As such, investors might want to look to its aforementioned competitors for a more favorable investment risk-reward ratio. 

Both Chipotle and Panera have better overhead efficiency, due to their much larger operating bases, and they each generate excess cash flow that they are returning to shareholders, primarily through stock repurchases.

The larger of the two, Chipotle, was the likely operating blueprint for Potbelly, with a similarly simple menu, which in its case consists mainly of burritos, tacos, and salads. The company, however, also leverages its mission of "Food With Integrity" and responsible business practices to create word-of-mouth advertising that lowers its required marketing expenditures. In addition, Chipotle's efficient store format and multi-tasking employees allow it to generate a high store margin, roughly 27% in its latest fiscal year.

In FY 2013, Chipotle's business has been humming along, with a 16.7% top-line gain that was driven by higher comparable-store sales and the addition of nearly 190 new stores. Its operating profitability did decline slightly, mainly due to higher commodity costs, but the company was able to partially offset the negative impact with greater efficiency in its administrative support operations. 

More importantly, Chipotle's strong operating cash flow, $389 million for the period, is allowing the company to continue its growth trajectory, with plans for at least another 180 new stores in FY 2014.

Meanwhile, Panera has also been growing, albeit at a slower rate than Chipotle, adding roughly 80 locations to its base of more than 1,700 total stores in FY 2013. While the company's overall profitability has held up well year-to-date, its store operating margin has declined as a result of a deceleration in its comparable-store sales, which came in at just 1.7% in the most recent quarter. 

On the upside, management has acknowledged its operational execution issues and is working on remedies to increase customer visits to its stores, including adding store personnel to speed up the ordering process and making better use of its advertising dollars.

The bottom line
Potbelly has delivered pretty consistent top-line growth over the past few years, but investors have raised the expectation bar dramatically via a substantial increase in the company's valuation since its initial public offering. With plans to increase its store base by 10% per year going forward, Potbelly will need to keep improving its store productivity and efficiency, if it hopes to meet those lofty expectations. 

While the company isn't a flash in the pan, prudent investors might want to see some margin improvement and geographic maturation in its business before going long. 

One stock to buy now
While Potbelly stormed out to a huge gain, investors might be better off waiting on the sidelines for the stock to cool. But if you're looking for growth, the Motley Fool's chief investment officer has hand-picked one such opportunity in our new report: "The Motley Fool's Top Stock for 2013." To find out which stock it is and read our in-depth report, simply click here. It's free!

The article Should You Wait for the Euphoria to Subside at Potbelly? originally appeared on

Robert Hanley owns shares of 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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