Description

Potbelly (PBPB) presents an attractive risk / reward as a long with likely near term catalysts to generate value for shareholders.  We believe that a sale of the Company by year end is probable, and if a transaction does not occur, shareholders can also win in the medium term, driven by improved capital allocation as the company transitions to a franchise from an owned model, drives its per unit build cost down, and benefits from leadership transitions at both the management and board levels (if it remains public).  We believe that the upside in an LBO is $14-$15, approximately a 25%-30% premium, or independently PBPB could double over the next 18-24 months if a franchise transition is executed in a public setting under new leadership.

Company overview

Potbelly defines itself as a “fast-growing neighborhood sandwich concept offering toasty warm sandwiches, signature salads and other fresh menu items served by engaging people in an environment that reflects the Potbelly brand.”  At 6/30/17, the company operated 424 owned shops and 54 franchised locations (38 domestic) predominantly in the Midwest, Texas, and the Mid-Atlantic.  ~60% of Potbelly’s business is lunch, and the target model for shops is 1,800-2,200 sq ft with build costs ~$600k, ~20% restaurant margins, with ~25% cash on cash returns after 2 years.  In 2017, PBPB will likely report AUV’s close to $1m with restaurant margins ~18%.  For more background on the company, here is the latest investor pres: http://files.shareholder.com/downloads/AMDA-24CMIO/4421032983x0x954036/297EB1C0-A955-4899-AA62-CBDF979CE623/PBPB_-_Investor_Presentation_-_August_2017_-_FINAL_-_Full.pdf

PBPB IPO’d in October 2013, briefly trading ~$30 following the offering before settling in the $11-$15 range it has traded in from mid-2014 until now.  Operating performance has been poor recently (2 consecutive quarters of negative comps), leading the company to fire its CEO Aylwin Lewis in May.  The CFO Mike Coyne has been named interim CEO, and the company announced that it is pursuing strategic alternatives and hired JPMorgan to assist in its review.

Activist involvement

In June, activist Ancora Advisors sent a letter to the company, outlining ways the company could improve returns on invested capital, including dramatically increasing the franchise mix and driving down the build cost per box, and noted that if the company disagreed, they should sell the business.  (Letter here: http://www.ancora.ws/private/Ancora%20Letter%20to%20PBPB%20BOD%206.22.17vF.pdf)

We believe the activists are in a strong position here given the company bylaws require PBPB’s board to de-stagger in 2018.  Because of this, all board members will be up for re-election in 2018, providing the activists the ability to run for control of the company should the board not choose to work with them.  We believe the hiring of JPMorgan indicates that the current board recognizes its situation, and despite the broad mandate of the strategic review, we think the board likely views a sale of the company as a better outcome than one where they potentially lose control in 2018.  

Valuation   

Based on consensus estimates, PBPB trades at ~6.8x ’17 EBITDA ($39m of EBITDA on a $264m EV) and 6.6x ’18.  The company generated $46m in cash from operations in 2016 and is expected to generate in the $40m range in ’17, but has spent the bulk of the cash generated on opening new company owned stores ($37m of capex in ’16 and ~$34m expected in ’17).

Due to our view that the company will be sold with private equity as the likely buyer (any strategic interest would be upside to our numbers), we think an LBO is the most appropriate approach to valuing the company.  We run 2 cases below – one in which the forecast is based on a status quo view of running the business, and then a second case in which the company refranchises a substantial portion of the store base and grows the footprint predominantly through franchising rather than company owned stores.  In the franchising case, most of the proceeds from the refranchising transactions (franchise deals assume 5x EBITDA and proceeds are fully taxed) are dividended out.  As you can see, while the status quo case is relatively uninspiring from an IRR perspective, there is a lot of value that can be generated in the franchise case.  Given that we believe PBPB has been dramatically undermanaged, and based on our conversations with industry experts and banking/PE contacts, we think a PE firm with restaurant experience that could bring operating and franchising expertise to the table would have strong interest here.  

We show two turns of multiple appreciation in the franchise case, as predominantly franchise businesses typically warrant higher multiples than owned concepts (see JACK as an example – 7.0x multiple as an owned concept and ~12x after its franchise conversion).  The table below shows a sensitivity analysis based on various entry/exit multiples, with many alternatives showing strong returns in an LBO:

If the outcome of the process is not a sale of the company, we believe the company can still generate significant value for shareholders by running the franchise case in a public setting.  While the company likely won’t enjoy much benefit from leverage as a pubco given its relatively small size, we believe it can repurchase over 50% of the shares outstanding and generate more than $1.50 in FCF / share by 2020 if it executes an accelerated franchise conversion and uses the proceeds from refranchising transactions and FCF to repurchase stock.  We also believe there is a significant cost cutting opportunity at PBPB, particularly at the corporate level.  PBPB is expected to spend $43m on corporate level G&A (~10% of sales) in 2017.  A substantial portion of this G&A is a robust real estate / site development team, which can be pared back significantly should the company transition to growing primarily via franchises.  We believe there is a $5-$10m cost cutting opportunity if PBPB remains public and potentially up to another $5m should the company go private.  Below are franchise case price targets based on 6% FCF yield or more conservative 7.5x EBITDA:  

If there is no sale of the company, there is likely to be more volatility in the stock in the near term – we believe downside of ~15% to the mid to high $9’s, implying another turn of multiple compression to the mid 5.0x EBITDA range, is a reasonable downside target.  However, if the current board does not sell the company, we believe that the activists are in a strong position to take control of the company in 2018, which increases the likelihood of the franchise case being implemented along with significant upside in the medium term.

Conclusion

We believe the set up here strongly incentivizes the board to sell the company, which we believe will result in 25%-30% appreciation in the stock by year end based on our LBO analysis.  Given the event path is likely a sale or the activists taking control of the company and executing the franchise plan, we find this to be a very compelling risk/reward at the current valuation.     

Risks

• The company does not find a buyer at an attractive price.  Other restaurant companies have run processes recently, such as FRGI, which have resulted in the board walking away with no deal.  In PBPB's case, we believe the incentives to sell are strong as outlined above and that if no sale occurs, there is a solid plan to fall back onto that can create significant shareholder value

• Continued deterioration of restaurant fundamentals.  The restaurant industry has faced significant headwinds to say the least over the last year, and the blackbox data shows continued macro weakness with traffic down 4.7% and comps down 2.8% in July.  While there is likely somewhat limited ability for PBPB to address certain macro conditions such as over-supply of options in the lunch category and cost of eating at home vs. eating out, it can certainly do a better job of addressing changing consumer behavior towards more take-out / delivery and online ordering.  The sq footage of the boxes should be smaller at PBPB (particularly in suburban areas) which would improve returns, and they need to improve the app (which it was late developing in the first place) and digital marketing strategy, as well as its appeal to women.  We believe all these will be seen as opportunities for a PE firm to improve PBPB’s value proposition and drive traffic at the company relative to industry trends / take share in the lunch category

• The company does not sell and the activists lose a proxy contest

Catalyst

·         Company potentially agrees to give the activists board representation

·         Sale of company

·         New CEO announced

·         Refranchising transaction announced

·         Proxy fight if no sale of the company