Fast casual dining stocks have been one of the hottest sectors of the market throughout the past couple of years. With stocks like Chipotle Mexican Grill (NYSE: CMG) up 78% in 2013, and Noodles (NASDAQ: NDLS) soaring 139% following its IPO, it’s clear that investors have an appetite for fast food stocks.
Recently, a small sandwich shop named Potbelly (NASDAQ: PBPB) went public in a well-received IPO. Not surprisingly, the stock soared 120% during the first day of trading.
Potbelly restaurants standout because of a cozy ambiance, local musician performances and most importantly, high quality toasted gourmet subs. The attraction for investors is the big growth opportunity. With just 300 locations today, the potential for expansion is considerable.
Just consider Subway, with over 23,000 locations in the U.S. If Potbelly can convince just a small portion of customers to embrace its higher quality subs, it could eat a big chunk of Subway’s lunch. After all, a small Potbelly sandwich costs just $4.70, a bit less than Subway’s famed $5 foot long promotion. This also shows just how much room Potbelly has to raise prices and position itself as a premium alternative.
In a recent SEC filing, Potbelly called for 10% annual store growth for the foreseeable future. That expansion of new restaurants should keep Potbelly’s revenues growing in the double digits for at least the next three years.
Now trading at $30 per share, Potbelly is valued at $840 million. That values the company at roughly 3-times last year’s sales. For a business with as much room to grow, this seems cheap. For comparison, fast-casual leader Chipotle trades at 6-times last year’s sales.
I believe Chipotle is a great comparable for Potbelly’s for two reasons. First, Potbelly is reinventing a fast-food concept into something more modern and doing it with healthier and higher-quality food. Second, Potbelly already has excellent gross margins, and has lots of room to raise them going forward.
So, why does Potbelly trade at a deep discount to Chipotle? The answer is most likely Potbelly’s smaller margins. Although its operating margins are significantly lower than Chipotle’s, they are not an accurate reflection of where the company could be in a few years. During this phase of rapid expansion, Potbelly’s operating margins are pressured by new store openings.
Because Potbelly is rapidly expanding and opening tons of new stores, its P/E multiple is inflated. This is misleading because Potbelly’s earnings are bogged down by temporary costs to spur growth, and thus don’t accurately display the company’s true earning potential.
This anticipated operating margin expansion is actually already unfolding. In the first half of 2013, Potbelly increased its net income by 26% to $4.9 million. That increase was considerably higher than revenue growth of 15%.
If Potbelly grew to just 10% the size of Subway, it would have 2,300 restaurants. Armed with $105 million in cash from its recent IPO, Potbelly’s will be accelerating store openings.
It’s just a matter of time before investors wake up to this opportunity. Given Potbelly’s cheap valuation, it appears the rapid growth has yet to be priced in.
Potbelly is a long-term growth story in its early stages. The sandwich market in the U.S. is big enough to accommodate the growth of Potbelly’s to more than 2,000 stores – or a 10x increase. This long runway for growth gives Potbelly the potential to grow very quickly in the years ahead.
Disclosure: Galileo Russell owns shares of Potbelly (NASDAQ: PBPB).