Description

Thesis: A high quality but a Covid recovery laggard with 400+ OWNED iconic Potbelly Sandwich Shop brand locations led by the core Wendy's operating team responsible for a 6000+ FRANCHISED locations is undergoing a business transformation to a more FRANCHISED business model while substantially improving core operations has an opportunity to be a multi bagger (300%+) in the intermidate future.

Profile: Potbelly Corporation, through its subsidiaries, owns, operates, and franchises Potbelly sandwich shops. As of December 26, 2021, it had 443 shops in 33 states and the District of Columbia, which included 397 shops and 46 franchisees operated shops. The company was formerly known as Potbelly Sandwich Works, Inc. and changed its name to Potbelly Corporation in 2002. Potbelly Corporation was founded in 1977 and is headquartered in Chicago, Illinois.

Background: Any self respecting value investor has heard of the thrift conversion play over the last 20 years. Its a one time deal that in theory creates long term value for the depositors/shareholders. Much in the same vein, I consider the OWNED to FRANCHISED play on the same level. No matter what field you're in, converting from a capital intensive low ROC owned location models to a capital light, franchisee fee/high ROIC oriented business model has consistently worked in the markets. A few off the top of my head have been Popeyes, Joint Chiropractic (ignoring the pull back, the stock is still substantially up from $4.00 when it began the conversion), and Hire Quest.  Popeyes is probably the most comparable historically as it was a post financial crisis laggard that had a number of underperforming owned locations masking the high quality performance of its franchise locations and selling/closing those 10ish locations and improving the menu/operations considerably improved the company on all metrics with the stock going from $7ish in 2010 to finally a $79 buyout in 2017. While I don't expect the same level of success with Potbelly, I believe the levers are currently in place to at least attempt to replicate this success which should result in a price a few multiples from today.

Potbelly was certaintly a Covid victim, with revenues dropping almost 30% in 2020 and resulting in a negative $21mm FCF in 2020, and another negative $12mm in 2021 as well as a dilutive $15mm equity offering at rock bottom prices last year. Being a primarily lunch oriented company with a heavy presence in the Chicago Business District (CBD) left it as quiet the underperformer among its QSR peers. I will not beat around the bush, I believe this one has some hair on it, and this is a high risk reward opportunity but one that has crested its distressed period and I believe on its way to greatness. 

How great? I'll place my financial projections first and then explain how I think we can get there:

Price Target (2-3 years): $20.00 at at $600mm EV at 15.0x FCF/11.0x EBITDA of $40mm/$55mm by year end 2024 on 2025 estimates. I AM EXCLUDING $20mm to $100mm in cash flow that the company could receive from the Franchise Conversion/sales which could add a few more dollars to the PT.  For now I am assuming that the company will be debt free at end of 2024 and I do not consider operating leases as EV inclusive liabilities. 

In order for the company to get to these numbers it needs to execute on its 3 year goal strategic pillars. For the purposes of conservatism I am saying it will take 4 years.

- The company has 400 owned locations with an average of $1mm Annual Unit Volume. (AUV). The 3 year stragetic goal is $1.3mm. How to get there? One easy one is recovery of CBD which has consistently lagged as Chicago was one of the more stringent Covid lockdown and work from home places. With 64% SSS in 1Q22 I believe this is an easy lever. Improvement in the menu, adding dinner options and continued to improve its share of digital/drive through from almost non existent pre Covid to close to 50% today (39% for digital) and smart investment in advertising should get us there. Overall I consider this goal to be one of the easier ones.

- Shop level margins from 5% in Q1 to guidance of 9-11% in 2Q22 and low double digits in 2022 (inclusive of 5% in 1Q22) to 16%+ by 2024. This one is a toss up. The margins were 15% in 2021 so probably not that hard but current inflation/labor shortage environment does not bode well in the near term. It may abate by 2024 and hopefully by 2025. I am comfortable with 15% or about $200,000 per location.

This brings us to about $60mm of shop level margin for about 300 locations. Why 300 when the company has 400 owned locations? 

- Bob Wright, CEO of Potbelly, the former COO at Wendy's, with 30 years QSR experience and responsible for running 6,000 franchised locations, joined the company in 2020 and over the last few years brought a few of his leutenants with him to beef up his team. One didn't need to be Sherlock Holmes to figure out what was going to happen eventually. And of course late last year, the company announced its 5 pillar strategic plan ($1.3mm AUV/16% margins among them), which included at least 25% units to be refranchised in 3 years with a longer term goal of refranchising most of them, while growing units at 10% a year to a potential unit TAM of 2,000.

   * so refranchsing a 100 units ... what does that mean? In a conversation with IR last year they dropped a $600k per unit price tag because of a BCG study placing Potbelly as one of the higher quality sandwich shops substantially above Jimmy Johns and Subway. At 3x cash flow this doesn't seem to be too high of a hurdle but I still think that the price/financing to be conservative in the $300k -$400k range implying one time cash inflow of $30-40mm (which I believe also takes another dilutive secondary offering risk off the table). Not a small number considering the market cap is at $160mm so 25%. For context it costs between $350k and $550k to greenfield a Jimmy Johns franchise.

  * 100 units at $1.3mm AUV ... whats the gross rake? Hard to say with what the franchise fee (4-7% ... 5.3% average) and advertising fee (2-5% ... 2.3% average) will be? Jimmy Johns takes 6% and 4.5% for 10.5% total. I am comfortable with a $100k per franchisee take or $13mm of FCF to the operating margin line. Last year with substantially low AUVs the company collected $2.8mm from 45 franchise locations at $65k (vs $3mm and $75k in 2019), however I believe with Bob in charge those numbers should rise substantially.

* opening 40-50 units a year (10% growth) with a $50k per unit up front could result in another $2-3mm a year. 

* hard to say what the profitability/rake will be of the 120 to 200 new units in place by 2025 which could be another $12mm to $20mm but for conservatism sakes I am saying this will be $5mm.

= $60mm of owned units + $13mm of converted/existing franchise unit rake + $2mm of new unit fees + $5mm of new unit rake = $80mm pre- SG&A expenses cash flows. If management continues to execute this should be a fairly realistic goal. I am, again, saying this will be achieved by 2025, to give myself some cover for unforseen circumstances. 

- SG&A ... this number has been fairly consistent at low to mid $30s millions. Inflation is not going away, employees are going to want COLA so I think $40mm is a fairly decent estimate.

This brings us to my base case scenario of $40mm in FCF and $55mm in EBITDA by 2025. The margins and revenues would be substantially different from today as replacing a $130mm of owned revenues with $20mm franchise fee revenues would keep the revenues at the $400-$420mm while increasing FCF/EBIT/EBITDA to $40/$40mm/$55mm from $0/$0/$17mm today will substantially increase operating/cash flow margins to low double digits. The company has $20 to $35mm in NOLs and during my time horizon I do not anticipate PBPB to be a tax payer. 

So thats the base case that rests on management doing what they've committed to doing and coming up with some conservative haircuted estimates. Most high % franchised profitable QSR operators trade at high teens EBITDA multiples. By 2025 the company should have close to 600 units of which roughly half will be franchised. This would continue to leave a long run way to 2,000 of continuing to convert existing (though there will be some that they will never part with like CBD or some key airport locations) and grow new franchise units. 15x FCF and 11x EBITDA forward 2025 multiples do not seem heroic. 

Bear/Best Cases.

In March 2020 the company dropped to about $50mm market cap or $2.00 per share. This is probably extreme panic case. I think in the worst case scenario the company continues to tread water at $1mm AUVs or below, single digit shop level margins, burning single digit millions a year and possibly another dilutive secondary. I doubt that it would go to $2.00 again, but while $3.00 or $90mm market cap is not realistic, I believe there does exist an execution/macro risk that could result in a 50% draw down probability. At those levels it would probably be worth the value of its brand.

Best case while idealistic also has a chance of happening. 300 units at $250k per shop profitability on a combo of higher than $1.3mm AUVs/16%+ margins as well as getting $600k per unit sale for a $60mm cash inflow and $40mm+ franchise fees could easily take the company company's FCF to $80mm+ and EBITDA close to a $100mm. Applying 20x multiples could take this puppy to $70.00

Overall I think this is still a speculative situation (as I consider most things with 50% drawdowns and sub par balance sheets) but one with a realistic chance of getting a 300%+ in 2.5 years.

Risks

- Pretty standard QSR risks especially in today's unprecedented environment of labor shortages and substantial food inflation (those wheat prices boy oh boy) can hoble even the best laid plans. This (or probability of this) happening will likely keep this stock on the sidelines for years.

- Bob Wright is top notch. We did some DD on him and he comes as advertised. I believe losing him would probably hurt this story substantially. 

- Re franchising strategy failing would also kill the story.

- continuing need to tap markets for dilutive or expensive financing

Catalyst

- CBD district continuing to recover and drive AUVs to $1.3mm goal

- getting substantial momentum on re-franchsing and getting some much needed cash inflows from sales of franchises

- eventual sale of company