From Toasted Sandwiches to Smokin’ Margins

Potbelly Sandwich Works 

The bad boys over at Azar Capital love Potbelly’s and recommend you try their wreck sandwich. Potbelly Corporation was founded in 1977 in Chicago, starting as a simple sandwich shop, and eventually grew into an iconic fast-casual restaurant chain specializing in sandwiches, soups, salads, and desserts. Potbelly prides itself on creating good vibes for its customers through its warm atmosphere and handcrafted menu.

Potbelly operates in a highly competitive sandwich dining industry, over the years they have been able to differentiate themselves through a unique store experience, menu innovations, digital strategies continuing a successful loyalty program. We believe that Potbelly represents a compelling growth opportunity with its franchise growth acceleration initiative. The company's goal is to unlock long-term scalability by shifting its business model to a franchise-owned strategy, with a goal of 2,000 shops with 85% franchised. 

We believe that Potbelly is well positioned to capture a significant amount of the $70 billion fast casual dining market. Its recently improved profitability metrics and pivot to a franchise-led model show that its management strategic shifts are beginning to pay off. With customers increasingly favoring fast casual dining over traditional quick service restaurants, the Belly has the opportunity to ride the wave to long-term success. 

Potbelly’s recent earnings have been a mixed bag of results, showing some progress as well as challenges with weekly sales. The company reported revenues of $115 million, showing a small decrease of 4.7% due to the short-term impact of franchising efforts. They also reported a decline in average weekly sales of $24,870, showing slight headwinds in demand. Despite these decreases, Potbelly was able to report an increase in net income of $3.7 million with an improving shop margin of 14%. Potbelly reported strong operational cash flow driven by its improved shop profitability and better cost controls.

The company has been showing profitability, but its PE ratio is slightly above the industry averages due to its turnaround strategy. The company reported an adjusted EBITDA of $34 million representing an EV/EBITDA ratio of 10x which is slightly below the sector average of 12x, showing a small room for appreciation. Potbelly trades at a slight discount compared to peers like Wingstop or Chipotle, reflecting its long-term franchising model is promising. 

Potbelly operates in the fast casual dining industry, a food industry segment bridging the gap between quick-service restaurants and full-service dining establishments. Over the past decade, the segment has seen tremendous growth from offering appealing meals to customers who are seeking quality, customizable, and quick meals. Potbelly has been able to differentiate itself as a neighborhood sandwich shop with personalized service and a welcoming atmosphere. Its core audience is middle-income urban professionals and families who value high-quality offerings at an accessible price. 

The fast-casual dining market is highly competitive with several dominant players and a mix of regional and niche competitors. Some of Potbelly’s major competitors include Subway, Jersey Mikes, Panera, and Chipotle. While Chipotle is not a direct competitor within the sandwich market, it represents a large share of the fast-casual market segment from its operations, branding, and customer loyalty.  Potbelly is a smaller relative to these companies, but they hope its franchise-led strategy aims to close the gap by expanding the company's footprint. 

Potbelly brands itself as a community-first sandwich shop, with a history of playing live music in its restaurants helping them create customer loyalty.  Potbelly has created a strong loyalty program and digital marketing campaigns that have driven repeat traffic and higher average checks. With limited time and seasonal offerings, Potbelly has been able to its menu fresh and engaging for its customers. 

With its toasted sandwiches, soups, and desserts, Potbelly has carved out a niche for quality food that appeals to discerning diners. As well as its brand identity, digital ecosystem, product quality, and franchise scalability Potbelly, has been able to create and maintain a competitive edge over the long term.  Recently, Potbelly has begun to focus on franchising its restaurants which will dude capital-intensive operational risk to its franchise partners. The shift to franchise ownership has shown to be successful for chains like Dunkin and Domino’s. 

Potbelly has been able to create several organic revenue drivers, including franchise growth, market expansion, menu innovation, and a loyalty program. Potbelly has recently pivoted its strategy to focus on a franchise model, with goals to grow its shop count to 2,000 locations with 85% of them franchised. Potbelly has also recently announced an agreement to open 47 new shops across several states including Texas, Illinois, North Carolina, and Georgia providing opportunities for new growth. 

Potbelly has no history of acquisitions. However, if they were to acquire regional sandwich chains or fast casual players that align with Potbelly’s values the company could see similar growth to Cava. Collaborations with third-party platforms like DoorDash or Uber Eats could enhance the company's reach and profitability. If Potbelly could secure alliances with real estate firms they could secure premium locations in urban and suburban areas. 

Several potential growth catalysts could propel potbelly growth in the near term including an expansion into untapped markets, digital transformation, consumer trends, and improved cost efficiency. With the shift in consumer demand for healthier and high-quality options, Potbelly should be able to capture market share. Potbelly’s ability to onboard strong franchise partnerships like Royalty Restaurant Group should enable the company to bring high-quality operations that align with the brand's values. 

Potbelly faces several risks in its day-to-day operations including its logistics, franchise model execution, and workforce challenges. Transitioning from a company-operated to a franchise-led model includes risks that include operational control, franchise recruitment, and franchisee performance that could dilute the brand's image and customer loyalty. Like many restaurants, Potbelly faces risk from rising wages and labor shortages could increase costs and strain shop operations. 

Operating in a highly competitive market, Potbelly faces several risks that include regulatory changes, competitive pressures, and shifts in consumer behavior. Increases in minimum wages or healthcare mandates could significantly increase costs. Potbelly is significantly smaller than some of its competitors limiting its ability to have high marketing budgets, pricing power, and ability to access prime real estate locations. 

Since Potbelly is a publicly traded company it faces several valuation risks like aggressive growth expectations, institutional coverage, and sensitivity to macroeconomic factors. Since Potbelly is a smaller-cap stock they are more vulnerable to volatility and sentiment shifts due to limited analyst cover and institutional ownership. If Potbelly underperforms in terms of opening new shops or franchise partner recruitment the stock could face significant downside pressure. 

Transitioning into an asset-light, franchise-driven model positions Potbelly favorably for scalability with growth and reduced capital expenditures. The company currently has a strong pipeline of new shops in untapped markets Potbelly is poised for continued profitability. Although the franchise-led model risk could lead to risks when searching for high-quality franchisees to ensure product and custom experience consistency. Rivals like Jersey Mike and Panera Bread have been able to show significant growth due to the company's scale and resources. 

There are several catalysts for potential investors and fans of Potbelly should watch in the near and long term. Its continued improvement in adjusted EBITDA and shop margins should validate the company's long-term scalability. Potbelly’s digital and menu innovations have shown success with initiatives like its perk programs creating increasing same-store sales. 

As previously stated, the bad boys over at Azar Capital Group are fans of Potbelly’s food however we are unsure about their long-term growth potential due to the company's cash pile compared to its competitors. For this reason, we will be giving Potbelly a ‘HOLD’ rating because we believe in the short term it will have some troubles with its in-store sales and the growth of its franchises. However in the long term if they can sustain its growth and open its goal of 2,000 shops we believe that Potbelly will defeat its competitors like Jersey Mike’s and Subway. 

Disclosure

This analysis is for informational purposes only and should not be considered financial advice. Investors are encouraged to perform their own due diligence or consult with a financial advisor before making investment decisions.