Description

Here is very quickly a random, fun, little guy. Granted, it was initially assembled a little over a week ago, just prior to the coronavirus taking it and just about every other restaurant stock to the woodshed, so excuse comments that may seem asinine amidst this new, or least temporary, world order. But with that context, and looking beyond the next several months, I find  it all-the-more compelling:

This Potbelly seems like a massive long. There are incipient signs that the business is turning, and, global pandemics notwithstanding, if the trends even remotely continue over time, one could very foreseeably envision a scenario where the public markets value the enterprise at 5x or more its current $2.97 stock price ($14-15 p/ share) looking forward just 1-2 years. And as the inflection taking place becomes readily apparent, it wouldn’t be surprising to see any one of a number of likely interested parties competitively bid up the company to purchase it at a substantial take-out premium ($9-10 range, or over 200% higher) somewhat imminently.

So, three straight-forward items, really:

a.                 Just as a baseline, the stock is extremely cheap any way you slice it

b.                The fundamentals are inflecting positively, which is not priced-in in the slightest

c.                While it’s always hard to read the tea leaves on take-out potential, we wouldn’t be surprised at all if the business got bought tomorrow at a huge premium to current market value by any one of a myriad of potential suitors.

It’s way too cheap

PBPB trades at 2.3x 2020 consensus EBITDA right now, which is cheaper than virtually any other publicly traded restaurant. Feel free to doctor your company-operated restaurant comp table any way you want, but it’s hard to come up with a true peer group that doesn’t trade 3-4 turns more expensive than Potbelly. Add to the absurdity that it has no debt and that ~27% of its market cap ($18.8mm coming out of 4Q) is cash on the balance sheet. It’s also generating healthy FCF, which, if the most recently reported quarter is any indicator, just got all-the-healthier. On just baseline assumptions, for example, the business generates a double-digit maintenance FCF yield on 2020 guided-to numbers. What’s more is that we spoke to the CEO early last week to review the quarter, and while the discussion was purely innocuous, we walked away sensing management has sandbagged the shit out of guidance to (finally) set themselves up for a beat-and-raise story fundamentally and (perhaps more subtly) ensure earnings report-based volatility doesn’t hamper a sale process strategically. More on 2020 set up and assumptions in a minute, but the point being my own projections are higher, making the stock even cheaper. For the moment, just using the conservative case establishes the point: shares are priced as though the company is experiencing a continued secular decline, and that the rate of that decline is accelerating. 

I think just the opposite is happening right now.

Fundamental Inflection

The background in a nutshell is that this thing had comped well into the negative single digits for nearly three straight years until last week when they announced 4Q comps at essentially flat (down 0.1%). Four-wall margins also increased sequentially for the first time in forever, and EBITDA (adjusting out costs associated with third-party consulting that I’ll come back to shortly) grew slightly yoy for the first time since 2016. If they were not to have announced all this as a microcap restaurant amidst current coronavirus-driven market lambasting, I’d think the magnitude of change in operating performance would have led to the stock trading into at least the $6.50-$7 range already, so broad strokes, you’ve probably got 120% - 135% latent P&L in the stock right now.

A few compelling items as we look at the back half of 2019 and into 2020 more closely:

-          In 3Q ’19 the company hired a specific management consulting group that we’ve done our best to follow very closely over the past decade. They were influential in the DPZ turnaround in 2010, which in-part took the stock from ~$8-9 to ~$35-36 over the following couple years. DPZ has of course been a 10-bagger even since then in its own right. But at the time, I vividly recall a conference/investor meeting with Patrick Doyle (then CEO) where he went out of his way to give the consulting group its due credit (I jotted a note down as he said this just given how rare it is for C-suites to share in the limelight). More recently, and as a more apt corollary, the same group was instrumental in taking NDLS from $2 to $10 (even if the stock has come in a bit since on Catterton selling some of its control stake). In private, then Exec Chairman Paul Murphy has spoken glowingly about the group. Its impressive track record and associated playbook largely focus around a less-is-more approach of identifying, clearly communicating, and delivering upon what consumers perceive as a given brand’s core strength. We believe the group’s recommended initiatives, collectively referred to by PBPB management as Project Aurora (albeit they’ve been extremely tight-lipped on details), are launching this week in 52 initial Potbelly stores after testing in several locations meaningfully exceeded expectations. In fact, we spoke to one of these test location’s store managers who wouldn’t provide detail other than that they “crushed it” and a description of the look and feel of the store (a pared-back menu that further encourages various combinations, bundling, and add-ons, improved sightlines to the kitchen, cleaner menu boards and a few other subtle, millennial-capture-focused design elements in-store). While this Project Aurora is at its outset, if history is any guide, it may be a huge catalyst to Potbelly’s ability to strengthen and grow its brand and lead to a multi-bagger over the long-term.

-          But a lot more has already happened than just what’s on the come. For starters, Potbelly launched its third-party delivery partnership with GrubHub in November, and it’s just now in 2020 that we’re beginning to see the benefits of its full integration. To be sure, I’d generally call BS to the often overstated benefits of third party delivery to the P&L of most QSR/fast casual restaurants, believing that in the majority of instances restaurants underappreciate the degree to which they trade quarters for nickels by shifting orders that would have been direct onto platforms where they’re paying a ~20%+ fee to DoorDash/Uber Eat/GrubHub/whoever. Given my skepticism, in the last two months through as recently as this week, we’ve tracked this particularly closely at Potbelly, talking to managers at the store-level, several franchisees, the former COO, and the former CMO. The difference for Potbelly is that the current day-part mix is vastly during lunch and less-so at dinner, whereas third-party delivery is primarily levered to the dinner day part and less-so for lunch, making third-party delivery particularly synergistic for Potbelly. Simple as it sounds, so far this is giving Potbelly the somewhat unique benefit of actually driving incremental use occasions at dinner time with little if any cannibalization, allowing them to lever labor and other fixed costs, such that third-party delivery is actually accretive (as opposed to what we’re so often seeing at many of its peers) to profitability.  This has been corroborated via bottom-up and top-down kick-the-tires research: in a conversation with the company’s largest franchisee, whose demeanor we’d have otherwise expected to be starkly negative given the company’s woes (especially outside of core markets, where he operates) in recent years, we were surprised to hear him sing the praises of third-party delivery roll-out and confirm the general outline of the unit-economic equation outlined above. The former CMO said as much, suggesting off-premise can transform PBPB’s profitability in the back-half of the operating day. Moreover, signposts this is happening have already shown up in the numbers: 4Q 4-wall margins were up 10 bps sequentially from 3Q to 4Q even as 4Q had the full-impact of third-party delivery expenses.

-          The other thing Potbelly did in the back half of 2019 was re-launch its app and associated loyalty program. It now has new features such as remembering favorite products to be easily re-ordered and improved accuracy for catering locations, which in part has led the app rating to jump from 2.3 stars to 4.8 stars. According to several app and data tracking sources we use (the same sources expressed in our recent FTCH and SDC write-ups), the updated tech drove an explosion in usage starting in the middle of 4Q 2019 after two years of stagnant activity.

-          Finally, and perhaps most notably, PBPB stopped discounting in the 4Q, and despite that, traffic trends (while still negative) accelerated by 190 bps year-over year, driven in part by the two initiatives above and also, we think, by launching some bundling/combination offerings, which are just a couple of the initial nuggets of what’s about to further roll out with Aurora. Right now, even prior to Aurora’s imminent integration, our primary research and data analytics suggest trends have improved further in 2020. Add to this easy compares (on a 1, 2, or 3 year stack basis) for the next few quarters, the fact that they spent $3mm on the aforementioned consultancy in 3Q (and haven’t backed it out as a one-timer as it relates to the 2020 EBITDA guide, providing effectively a 15% of EBITDA cushion), the cycling of all these aforementioned initiatives throughout 2020, the precipitous, capitulation-led stock price decline over the past 18 months….and you get maybe the most asymmetric set up we’ve seen in small cap restos in the past ten or so years.

-          Putting all this together, we’ve found that we tend to extract the most value from monetizing the fat end of the curve, or said another way, we find that stock’s rerate a lot more when an underlying business’s fundamentals go from an “F” to a “D” than when they go from a “B” to an “A.” While PBPB is in a position to improve multiple letter grades over time, we think you just gotta be there now. Consensus expects EBITDA to decline by 5% in 2020. Which gave management the opportunity to guide conservatively and still position themselves above that at the midpoint. Perfect. If the rate of EBITDA decline just moderates, there is a ton of upside in fundamental value:  in this more conservative case, at just 6x EV/EBITDA on our base case 25mm 2020 EBITDA, you’re at $7.15 p/share, or 140% higher; at 8x you’re at $9.26, just over 210% from here.  But if comps turn positive and EBITDA stabilizes, which is where we believe they’re headed, the stock is spring-loaded. In a more reasonable thesis case, where we bridge to 30mm in EBITDA and apply 10-12x, the low end of the EBITDA multiple range NDLS began to trade as it turned, we get $13.50-$16 in upside, or a 350% to a 440% percent return (note: we think Noodles is the most apropos comp based on size of company, similar prior struggles in growing outside of core markets, and most importantly that the aforementioned consultancy is using an iteration of that playbook here; but feel free to throw stones at the comparison, we were shareholders in NDLS for the period in question and follow it closely. i.e., we’re ready for them).

Brand Value and Strategic Alternatives

Last thing. Potbelly is one in a multitude of QSR examples (like previously mentioned Noodles) to show tremendous brand strength in core markets, attempt to grow too quickly outside of them, and then get their clock cleaned. But that’s why the stock went from $33 to $13. Buying these little guys when they overreact to the downside (current price ~$2.97), as they begin to retrench in their backyards, has been a profitable rinse-and-repeat to timely public markets investors. But it’s also lured private equity to do the same, especially given the stability of regional brand value inherent in some of these restaurants. Bojangles, for instance, is a force of nature in the Carolinas but, at least as a public company, had yet to fully prove itself outside of them. It nearly touched $30 a share at IPO, got crushed to an intraday low of close to $10, and then recently got bought at $16. Habit Burger, which folks from the SoCal and especially the Santa Barbara area will tell you is better than In-N-Out (which, I, for one, incidentally think is batshit crazy but nonetheless), touched $40 on its IPO, got blasted to $8 on the downside, and was taken out by YUM at a 60% premium($14) just in the last few months. The buy-out rationale for strategic bidders like YUM is all-the-more overt than for the financial buyers: the dramatic valuation gap between large and small cap restaurants has maybe never been greater, making the brute-force multiple accretion math as eye-popping as ever; with the G&A cost synergies to boot.

Back to Potbelly. If you look at PBPB’s brand value, loyalty, and net promoter scores in their core markets of Chicago and DC, they stack up at least as good if not better than BOJA or HABT (and anecdotally, ask someone who grew up in the Chicago area about Potbelly and they’re bound to spit folklore about how worthwhile it was to stand in the -10 degree weather in a line out the door at lunchtime, all well-worth it for their chicken cheddar toasted sandwich and soft chocolate chip cookie). BOJA and HABT traded away at 8.6x and 10.3x EBITDA, which, if applied to PBPB, would imply $9.09 and $10.73, or roughly 206% to 260% upside, respectively. These are timely comparisons in that within the last two weeks, The Deal published an article suggesting someone like Restaurant Brands or Roark Capital Group or both are “in talks to buy Potbelly at a large premium.” Maybe, maybe not. But I could see how someone might dismiss this as an unfounded rumor, solely based on Potbelly’s small size. We think that would be unwise. Unlike BOJA, which, for example, wouldn’t fit into RBI’s platform given the similarity in offering to Popeye’s, as with HABT given the burger overlap with BK, we think Potbelly represents a tremendous opportunity to these platforms, allowing them to integrate an undermanaged brand in an adjacent, incremental category (on that note, PBPB has just 46 franchisees now, but franchise development agreements just ballooned to another 42, which would nearly double their footprint. Given the magnitude of this recent trajectory change, we’re digging in to further understand what’s driving the hockey-stick in franchisee interest; we sense this is a function of cost-to-build improvements making ROI more attractive, but admittedly still a bunch more for us to learn here).

If timing appears ideal on the demand / buy side, I would think it’s even better on the supply / sell side. There are two activists on the board, both of whom are a couple of years into this, with cost bases much higher (reference Dman976’s write up in in this timeframe, Aug 2017) and at least in one case, for whom, Potbelly appears not to be much of a needle mover given they’re a fairly large fund. We’ve heard rumors from various corners of the restaurant industry suggesting PBPB’s board turned down a low-teens offer to buy the company a year and change ago. Believable enough. But shareholder board members may be a little more eager to vote on hitting the sell button these days given a perhaps more pressing return-on-time equation.  Over the past month things have accelerated to a fervor pitch: at around January month-end, a new activist filed a 13D advocating for changes in the company’s operations, ownership, dividend policy, and a potential sale of the company or assets. Then, just days ago, the founder of the company filed a 13D in concert with what appears to be an investment firm backing him and nominating a slate of four new board members. Like I said, we don’t bet on take-outs, but we’ll take the optionality, and right now Potbelly is pretty much the most likely imaginable restaurant acquisition candidate one could think of from just about every possible angle.

Catalyst

See Brand Value and Strategic Alternatives above