2 Red Flags in Potbelly's Growth Story

Potbelly hit the public markets for the first time just ten months ago. The Chicago-based sandwich chain had a stellar IPO, with shares surging over 120% on its first day of trading, as investors believed it would be the "next" Chipotle . The shares have pulled back since that time and trade near 52-week lows today. 

If Potbelly can ever live up to its IPO promise, today's share prices may prove to be a bargain. But two lingering red flags stand in the way of Potbelly reaching its full potential. 

Image courtesy of Potbelly

Follow the leader?
Potbelly may not have the leadership required to reach Chipotle or Starbucks'success. Chipotle and Starbucks' leaders both have a unique connection to what makes their businesses special in the first place. Steve Ells is the founder of Chipotle, and Starbucks CEO Howard Schultz is the visionary behind the coffee shops that we all know today. 

Upon his return to Starbucks in 2008, Schultz first order of business was to help Starbucks "find its soul" again. To get started, Schultz ordered a worldwide, three hour shutdown of all Starbucks stores for training. Shutting down during peak hours to "perfect the art of espresso" reminded customers of what makes Starbucks different. Starbucks lost some revenue that day, but it sent a meaningful message to the market. Starbucks was expanding too fast; Schultz slowed things down and reconnected with the customer. Starbucks has been on fire since his return. 

Steve Ells has been similarly protective of Chipotle's identity. In 2012 Taco Bell unveiled its upscale "Cantina Bell" menu, and some analysts pressured Chipotle to cut costs to compete. Rather than aim low, Ells publicly blasted competitors who sold grilled chicken despite not having "grills, knives, or cutting boards." By educating customers about what they're actually eating, Ells didn't have to defend higher costs for long. Today Chipotle is still educating us about what's in our food, and it's a key reason they're doing so well. 

Would Potbelly CEO Aylwin Lewis take similar bold steps if necessary? I'm not so sure. Mr. Lewis is a fine executive, but he may not understand what makes Potbelly truly special. In this interview following Potbelly's IPO, Mr. Lewis had difficulty recalling basic menu items (i.e. the ingredients in a "wreck" sandwich), and couldn't seem to define what makes Potbelly unique. He's just not connected to Potbelly's roots in any way, and in countless interviews, he seems to be indifferent about the product. He was selected by Potbelly's venture capital backers before its IPO, taking over for Bryant Keil. Mr. Keil was not the founder of Potbelly either but, like Howard Schultz at Starbucks, he purchased the chain early on and grew it into the recognized brand it is today. 

Mr. Lewis needs to connect with customers to help improve their experience. Here's hoping he has more "soul" than he's shown so far. 

Image courtesy of Potbelly

Where's the demand?
Potbelly has been sold to investors as a growth story. One red flag with this plan is management's low same-store sales target. The sandwich maker is only targeting same-store sales in the "low-single digits," which is unusual for a growth stock. 

Otherwise, Potbelly's stated financial goals are pretty lofty: new unit growth of 10%, net income growth of 20%, and returns on capital of 25%. How does it expect to achieve this growth on relatively mild demand in new shops? While the existing shops may generate enough cash to open new shops, we have to wonder if the demand for so many new locations really exists.

It's not all bad news for Potbelly
Potbelly has a huge market opportunity. The limited-service sandwich segment holds 18% of the store count for all restaurants. We've all seen how Subway, a sandwich chain that literally offers nothing unique or special, can grow to over 40,000 locations. It's a big pond, and Potbelly has less than 400 shops; the opportunity is there.

Still, these two red flags may hold Potbelly back from reaching its full potential. My hope is that management is spending its time reconnecting with what customers want, so it may spur demand and live up to its pre-IPO growth billing. 

Free 30-day trial: The Motley Fool's flagship service
Tom and David Gardner founded The Motley Fool over 20 years ago with the goal of helping the world invest...better. Their flagship service, Stock Advisor, has helped thousands of investors take control of their financial lives and beat the market. Click here to sign up today.

The article 2 Red Flags in Potbelly's Growth Story originally appeared on Fool.com.

Adem Tahiri owns shares of Starbucks. The Motley Fool recommends Chipotle Mexican Grill and Starbucks. The Motley Fool owns shares of Chipotle Mexican Grill 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.

Copyright © 1995 - 2014 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

Read Full Story