Potbelly Still Way Too Expensive

Aug.27.14 | About: Potbelly Corporation (PBPB)

Summary

Shares of Potbelly have fallen by about two-thirds since going public.

Terrible execution has led to missed earnings estimates and disappointing guidance.

Estimates are still far too high for this struggling chain, and there is a lot of downside risk from here.

Since a much-hyped IPO about a year ago, shares of restaurateur Potbelly (NASDAQ:PBPB) have done pretty much nothing but go straight down. Of course, anyone paying attention could tell in about five seconds that Potbelly's initial valuation of ~$1 billion was absurdly high. Nonetheless, investors bought it like it was going out of style on the IPO, and unfortunately for them, holders of the stock have lost a lot of money since. After the enormous decline in shares, are they finally a bargain? In this article, we'll take a look at Potbelly's earnings forecasts in light of its current valuation to see if it has fallen far enough to warrant a long position at around $12.

Click to enlarge

To do this, we'll take a look at a DCF model that you can read more about here. It uses inputs such as earnings estimates, which I've taken from Yahoo, dividends, which I've set at zero forever, and a discount rate, which I've set at the 10-year Treasury yield plus a risk premium of 7.5%. I've chosen a relatively high risk premium due to Potbelly's past performance and volatility in its business; investors should be compensated for such risks.

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

Prior-year earnings per share

$0.34

$0.19

$0.25

$0.31

$0.38

$0.48

x(1+Forecasted earnings growth)

-44.10%

31.60%

24.00%

24.00%

24.00%

24.00%

=Forecasted earnings per share

$0.19

$0.25

$0.31

$0.38

$0.48

$0.59

Equity Book Value Forecasts

Equity book value at beginning of year

$5.39

$5.58

$5.83

$6.14

$6.52

$7.00

Earnings per share

$0.19

$0.25

$0.31

$0.38

$0.48

$0.59

-Dividends per share

$0.00

$0.00

$0.00

$0.00

$0.00

$0.00

=Equity book value at EOY

$5.39

$5.58

$5.83

$6.14

$6.52

$7.00

$7.59

Abnormal earnings

Equity book value at beginning of year

$5.39

$5.58

$5.83

$6.14

$6.52

$7.00

x Equity cost of capital

9.90%

9.90%

9.90%

9.90%

9.90%

9.90%

9.90%

=Normal earnings

$0.53

$0.55

$0.58

$0.61

$0.65

$0.69

Forecasted EPS

$0.19

$0.25

$0.31

$0.38

$0.48

$0.59

-Normal earnings

$0.53

$0.55

$0.58

$0.61

$0.65

$0.69

=Abnormal earnings

-$0.34

-$0.30

-$0.27

-$0.22

-$0.17

-$0.10

Valuation

Future abnormal earnings

-$0.34

-$0.30

-$0.27

-$0.22

-$0.17

-$0.10

x discount factor(0.099)

0.910

0.828

0.753

0.686

0.624

0.568

=Abnormal earnings disc. to present

-$0.31

-$0.25

-$0.20

-$0.15

-$0.11

-$0.06

Abnormal earnings in year +6

-$0.10

Assumed long-term growth rate

3.00%

Value of terminal year

-$1.48

Estimated share price

Sum of discounted AE over horizon

-$1.02

+PV of terminal-year AE

-$0.84

=PV of all AE

-$1.86

+Current equity book value

$5.39

=Estimated current share price

$3.53

Click to enlarge

What we see here isn't pretty; the model suggests Potbelly's fair value is somewhat less than $4. Now, before you write me off as a crackpot, let's take a look at the reasons for the large deficit between the fair value and the current share price to see if it's warranted.

First, stocks like Potbelly are originally valued on something other than earnings. We saw it happen again with Potbelly; on the IPO, investors just bought and bought and bought some more, regardless of the valuation they were paying for. Whether it's a takeover premium for some stocks, the "story" of the stock or just momentum, many stocks like Potbelly, Noodles (NASDAQ:NDLS) and the like are bid up for no fundamental reason, and when that alternative reason disappears, it gets ugly. That is what has happened here; whatever investors were buying before isn't there now, and shares have been absolutely decimated.

In light of that, the fundamentals have been terrible since the company went public. A warning for the first quarter of this year saw 70 basis points of comp sales, resulting in missing top line estimates. Management was quick to blame the weather, the most popular excuse I've seen for poor execution, and shares were punished on the news.

A poorly timed upgrade from a clueless analyst provided yet another selling opportunity in front of the company's actual first-quarter report that saw the company beat watered-down expectations. However, a beat is a beat, and perhaps shareholders were beginning to see the light at the end of the tunnel.

That is, until the company warned on Q2 earnings. Potbelly had a "kitchen sink" quarter, reporting terrible comp sales (again) and forecasting flat-to-negative comp sales for the entire year. Shares were duly punished on the news, as Potbelly's valuation is not set up for negative comp sales. And just a few weeks ago, more of the same; negative comp sales for a chain that is supposed to be rapidly expanding.

The point of all of this is to show that Potbelly's fundamental performance has been the reason shares have been cut down by two-thirds since going public; the company isn't executing, and its shares should reflect that. If we take a look at the earnings estimates above, analysts are expecting ~25% annual growth in earnings for the foreseeable future, and this for a company that can't even maintain its revenue on a comp basis. Yes, it is opening new stores, but that party can only go on for so long; eventually, it will need to actually improve its fundamentals and quit hiding behind a growing store base. The company will not be expanding its store base by 25% every year, and even if it did, the loss of operating leverage from falling comp revenue would likely preclude that kind of growth anyway.

Needless to say, I'm very skeptical of these earnings estimates. And besides that, even if I weren't, the idea that a stock is already overvalued after factoring torrid earnings growth is not a great setup for a long investment. Potbelly has big problems, and it has nothing to do with the weather. This company has lost its way, but to its credit, it went public at the perfect time, selling overpriced shares to uninformed investors. Unfortunately for those investors, fundamentals have continued to deteriorate, and I think we'll see shares even lower next year. Unless things turn around in a big way for Potbelly, my $4 fair value will be in play in the not-too-distant future on poor fundamentals and a lack of execution, regardless of what the weather is like.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.