Potbelly Has Real Upside

About: Potbelly Corporation (PBPB)
by: Detroit Bear

New CEO Alan Johnson is demonstrating competency, and Potbelly's business is not declining as much.

Traffic trends have improved materially.

Shares look cheap for a business that could generate nearly $20M in FCF in FY19.

Shares of Potbelly (PBPB) have fallen sharply over the past two months, dropping from $11.61 when the company posted Q3 earnings to $8.44 at the time of writing, a decline of 27%. I noted in my last review that I would take a look at the company under $10 per share. With the benefit of another quarter, appointment of a new CFO, and another quarter of flattening comps, I believe CEO Alan Johnson is the right man to turn the company around. Shares currently trade at a TTM EV/FCF multiple of 21x, but I believe the company is easily capable of $20 million in free cash flow with low single digits growth given historical operating cash flow generation, meaning shares could trade at a multiple closer to 8.7x free cash flow. The situation is improving, and though I have some broader concerns related to recessionary pressures and Potbelly’s reliance on lunch traffic, I believe the stock could get to $12. Let’s take a look at why now may be the time to consider a position.

Q3: Numbers Still Weak but Improving

It’s tough to spin Q3 as a “good quarter.” Sales increased just 0.8% y/y to $107 million, and same-store sales declined 0.2% y/y on top of a 4.8% decline in Q3’17, driving a 2-year stack of -5%. This is a very slight improvement from the 5.1% 2-year trend in Q2, but an improvement nonetheless. Normally, I would find this fairly immaterial, but management provided some additional insight on traffic that I found exciting. Traffic was up 850 basis points y/y to -0.3%, meaning traffic was down a whopping 8.8% in Q3’17. Potbelly had lost relevancy, but it appears the new management team has been able to control the bleeding. Even more encouraging, traffic outperformed the industry by 190 basis points. In Q1, Potbelly underperformed by 180 basis points. Without question, new marketing initiatives and operational improvement are helping the company maintain customer traffic, which I find highly positive for the turnaround story.

One qualitative aspect of the story I like is that Johnson clearly has deep industry knowledge, and he is able to improve Potbelly just by doing some basic tweaks. If you have worked at a big corporation before, then you are well aware of how often someone with expertise can institute a few simple changes to drive big results. Johnson simply introduced a bundle option and a meal option to the Potbelly menu, and customers thus far like it. I thought Johnson’s response to a question on the conference call about the bundle aptly summarized the situation. He responded to a question regarding how big of a sales driver it might be, by saying:

“What I can -- what I do know is the customer likes it. The P&L likes it and therefore I like it. I mean, it's early days, but the results are encouraging. And the first is, our customer when they shop elsewhere with the competition already show a preference on 60% of occasions buying on combo and bundles. So why are we not taking advantage of that? And, if I can sell a larger transaction simply by offering something the customer already wants, it's a win-win.”

Again, this is not rocket science, but it sounds like a great way to drive incremental revenue and loyalty.

Of course, the improvement in traffic trends is excellent, but in the near-term, negative traffic and comps continue to weigh on profitability. Restaurant-level operating margin declined 200 basis points y/y to 16%. Johnson noted that operating margin might be choppy in the near-term, but I expect a focus on execution to drive improvement on this front over time. We will see what Potbelly is able to do to increase throughput, which management says could generate an additional $1 million in pretax margin.

Labor and occupancy deleverage were the primary drivers of lower margin in Q3, contributing 150 basis points to the decline in operating margin. Labor will continue to be a persistent industry headwind going forward, but some comp leverage would help mitigate this issue. Ditto for occupancy.

Also on the qualitative side, Potbelly has improved its social media –something Johnson is very excited about. I don’t know if it will necessarily translate into improved sales growth, but the Potbelly Twitter (TWTR) account is much more Wendy’s (WEN) in nature now.

Capital Allocation – Untapped Upside Could Send Shares to $12

Potbelly continues to possess a strong balance sheet, with $26.7 million in cash versus no long-term debt aside from deferred rent and landlord allowances. As a result, management has been able to get aggressive on repurchases, buying back 700,000 shares for $9 million. Unfortunately, Potbelly has seen approximately $8.2 million in options exercised in FY18, so the $12.4 million used to repurchase shares has only resulted in a net expenditure of $4.2 million, so the total share count YTD is down by only 600,000 shares.

Nevertheless, Potbelly’s management team has $52.6 million in authorizations to put to work, and thus I would expect the company to more aggressively repurchase stock in FY19 at the lower price.

In addition, Potbelly still has untapped upside from refranchising. Over the next few years, Potbelly could reduce capital intensity, raise cash from refranchising, and potentially repurchase significant amounts of stock. This would all drive a higher share price.

Importantly, I believe Potbelly has been able to significantly reduce capex as they have pumped the brakes on growth. With operating cash flow of $40-50 million and capex of $22-24 million in FY19, Potbelly could easily see free cash flow over $20 million, which would make shares a decent bargain at 8.7x free cash flow.

This, of course, assumes some low single digit comp growth as well as no major macroeconomic shock. I believe casual lunches out are quite economically sensitive, so any recession could disproportionately impact Potbelly. In addition, many of the Potbelly issues are simply part of doing business in the casual dining industry. At the end of the day, Potbelly is a sandwich shop with little differentiation. This is not a wide moat business; however, it is a potential cash cow with the ingredients of a turnaround. I think shares could have upside to $12, but it is more of a bet on what appears to be a solid new management team rather than any other thesis driver.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in PBPB over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.