Potbelly (PBPB): Significant changes after the appointment of new CEO; new CEO is a former Wendy's COO; Shift from company-owned store to franchisee store; 13D by Nierenberg Investment

M.Cap: $237 million  |  Debt: $200 million  |  Cash: $34 million  |  EV: $402 million  |  Revenue: $483 million  |  EV/Revenue: 0.8X 

Volume: 230,730

Major shareholders: Nierenberg Investment - 9.2%  |  Renaissance - 5.6%  |  Blackrock - 5.4%  |  Soviero Asset Mgt - 5.3%  |  Punch & Assoc. - 4.5%  |  Archon Capital - 4.3%  |  Vanguard - 4%

Screen: 13D

RESEARCH

I. BASICS

Potbelly owns and operates Potbelly Sandwich Shop concepts in the United States. 

 Number of stores

 Free cash flow

 II. Significant changes after the appointment of new CEO

In June 2020, the company appointed

1. Management shakeup

Management team

• April 2020: CFO
• July 2020: CEO
• Dec 2020: Chief Legal Officer
• Aug 2021: Chief Marketing Officer
• Jan 2023: Chief Operating Officer
• April 2023: Chief People Officer
• June 2023: SVP
• Franchising

New directors

• Five new directors were added to the board since 2020.

2. Improved financial profitability

• Despite significant wage and inflationary pressures, the company's profitability improved sequentially. The improvement in profitability is driven by robust demand levels, successful implementation of cost-cutting strategies, and strategic price increases.
• Cost-cutting strategies included the permanent shutdown of shops, reduction in G&A, and renegotiation of hundreds of leases.
• Quarterly Adjusted EBITDA ($, mm)

 Annual Adjusted EBITDA ($, mm)

 3. Shift to a franchise-focused business

• In March 2022, the company's CEO launched a plan to accelerate franchise growth through multi-unit area agreements, including the refranchising of some company-run shops.
• Two goals:
• Refranchise approximately 25% of the company-operated shops by the end of 2024.
• Over the next 8 to 10 years, the company aims to have 2,000 total shops, with at least 85% of those owned by franchisees.
• Current status: Roughly 8% of company-operated stores refranchised
• In 2022, the company announced a plan to refranchise 25% of its total operated shops but made no progress that year. However, between March and July 2023, the company successfully refranchised 8% of its shops, making headway toward its goal.
• Details:
• In March 2023, the company sealed a deal in NYC to open 13 new shops in eight years and refranchised eight existing shops.
• In July 2023, the company finalized a multi-unit development agreement to develop 15 new Potbelly shops over the next eight years. The transaction included refranchising 12 existing shops.
• In July 2023, the company announced that it had finalized a 27-shop agreement in Maryland with the company's founder, Bryant Keil, and his son Hampden. The agreement grants the founder and his son the right to develop 15 new Potbelly shops in the next eight years. Additionally, Potbelly will refranchise 12 existing restaurant locations as part of the transaction.

4. Other significant changes

• Liquidity:
• In 2020, amid a chaotic situation, the company raised $16 million through private placement and amended credit facilities.
• Simplified the menu
• Consolidated menu boards and fixed value with a wider price ladder.
• Introduced product enhancements, such as offering smaller sandwiches and half salads outside the Pick Your Pair promotion.
• The company started testing larger-sized options featuring more meat, cheese, and toppings.
• Added new variety to the menu: Avo Turkey Sandwich and Steakhouse Beef Sandwich.
• Additionally, the company reduced SKUs, resulting in a more efficient system and faster customer experiences.
• After testing the simplified menu, the company launched it nationwide in August 2021.

"We're getting a whole lot of love on social media for the various flavors we've introduced and how much people are creating videos about how much they like our cookies and the LTO cookies are no exception." – Q2 2022

• Digital marketing
• In mid-2021, the company revamped its Tech Stack, which includes a new mobile app, website, online ordering portal, digital ordering integration and Perks loyalty program integration. Moreover, the company improved its engagement with its customers through targeted digital advertising.
• Outcome? The company experienced increased enrollment and engagement in its Perks loyalty program and increased its topline.

 Interesting articles

https://www.nrn.com/fast-casual/how-potbelly-started-gaining-market-share-and-traffic

https://www.qsrmagazine.com/finance/potbellys-profitability-strategy-hits-new-stride

III. WHY ARE WE FLAGGING THIS?

Nierenberg Investment Management Company highlights the changes and suggests the board to use its free cash flow to repay debt and buyback shares

• On July 21, 2022, Nierenberg Investment Management Company (9.4%) stated its belief that the market is far from recognizing the Company's rapidly improving unit and corporate economics, its substantial potential profitability increase from franchising, the quality and experience of the Company's management and board, its brand, and unique positioning.
• On August 7, 2023, Nierenberg Investment Management expressed its opinion that the Company's strong performance post their July SC 3D filing justifies an update to reflect increased company value and a request for opportunistic repurchase of 8M shares over 9 years. It anticipates a 7-9 times share price increase to $69-86 by 2032, indicating enhanced confidence in leadership, governance, strategy, and execution compared to last year. Nierenberg Investment Management's suggested actions for the company include:
• Clear existing borrowings while maintaining a prudent line of credit.
• Thoroughly review all corporate level costs for potential savings.
• Utilize free cash flow to decrease the share count from 29.3 million to 23 million.
• Encourage insiders to invest in shares.

We strongly urge you to read the below section extracted from the 13D filing of Nierenberg Investment Management.

The Issuer's excellent execution since the Reporting Persons filed the Schedule 13D last July justifies updating that filing to reflect the company's increased value and to ask the Issuer to repurchase over 8M shares opportunistically over the next nine years, beginning as soon as possible. The Reporting Persons now model that the Issuer's share price could multiply 7-9 times, to $69-86, by 2032. That is 70-115% more than the Reporting Persons estimated last year. This reflects the Reporting Persons' increased confidence in the Issuer's leadership, governance, strategy, and execution:

• In the Issuer's second quarter same shop sales jumped 12.9%, driving average weekly sales (AWS) up 13.3% to $25,950, versus the same quarter last year, and shop margin climbed 300 basis points to 14.4%. The Issuer already is ahead of its 2024 annual shop revenue goal of $1.3M. Shop margin already has climbed to 90% of its 2024 goal. Cash climbed $8.7M in Q2 after rising $10M in Q1. Unrestricted cash of $34.6M now exceeds debt by $11.9M.
• As a result, through August 3, the Issuer's share price climbed 89% after the Reporting Persons filed the Schedule 13D. This enabled the Issuer to rejoin the Russell 2000 index (the "R2K"). The combination of improved operating and financial performance, the share price rebound, and readmission to the R2K increased the Issuer's average daily share trading volume ("ADTV") over 10X and its average daily dollar value traded 17X since the Schedule 13D. Last July, ADTV was only 25,000 shares, worth $125,000; now ADTV has jumped to 239,000 shares, worth $2.17M. The Reporting Persons hope this substantial improvement in liquidity might generate additional Wall Street sponsorship.
• The Reporting Persons expect that most of the Issuer's projected growth through 2032 will come from refranchising 100 company-owned shops and franchisees opening 1600 shops. Since the Reporting Persons filed the Schedule 13D, the Reporting Persons' confidence in the Issuer's growth strategy has grown substantially because of the consistently positive operating results just mentioned and because Lynette McKee joined the Issuer to drive its franchising growth. At its current run rate, AWS annualized is more than double the investment a franchisee would make to open a new shop, which is an attractive ratio. More importantly, Lynette McKee is viewed as a franchising "rock star" by virtue of her 25 years in franchising, including success at Burger King, Dunkin Brands, and other restaurant companies. For example, in her final year at Dunkin, Dunkin sold 2,300 franchised units and 800 stores were opened. Hence the Reporting Persons' higher confidence that the Issuer could successfully execute its franchise growth strategy.

Let's illustrate how high franchising success might drive the Issuer's share price over the next nine years. The Issuer will retain about 300 company-owned shops after refranchising 80 more shops. Over the next nine years the Reporting Persons model that inflation could compel the Issuer to increase prices 3% annually and that shop traffic could grow 2% more annually, for total annual shop revenue growth of 5% compounded. This would propel annual shop revenue to almost $2.1M. Assuming 16% shop margins and corporate costs of 8%, the 300 shops could generate 2032 revenue of $628M, $100M of shop margin, and about $50M of pre-tax profit at the corporate level. The 1700 franchised shops, also with sales of $2.1M each, could generate $3.57B of system-wide franchise revenue and $214M of franchise fees paid to the Issuer. Assuming a 42.5% pre-tax margin on the franchise fees, pre-tax franchising profit at the Issuer could be $91M. Thus, at the Issuer's corporate level, total revenue could grow to $842M, pre-tax profit to $141M, and profit after 30% taxes to about $99M.

To project earnings per share, and the share price, one must address what the Issuer's share count could be. Today it is 29.3M shares. As noted earlier, the Issuer's unrestricted cash now exceeds its debt by $11.9M. The company now generates free operating cash flow, which the Reporting Persons expect could grow substantially with time. Finally, the Reporting Persons estimate that refranchising 80 shops could generate approximately $300,000 each for the Issuer, which could be $24M more cash. Although the Reporting Persons certainly do appreciate why the Issuer worked hard last and this year to obtain a line of credit, during COVID and when the turnaround was less proven than it is today, the Reporting Persons believe that the Issuer's current circumstances no longer justify borrowing $22M, on which it pays 15% interest. In Q2, for example, the Issuer reduced its hard-won earnings by paying $1M of interest on $22M of no-longer necessary debt. Without that drag, the Issuer could have earned $0.10 per share rather than $0.07.

The Reporting Persons therefore urge the Issuer to pay off the debt as soon as possible, while retaining the safety net of a line of credit somewhere.

Considering how much pressure the Issuer puts on its shops and staff to reduce costs and prudently expand margins, the Reporting Persons believe that corporate level costs should not have any "immunity" from cost reduction. While eliminating interest on unnecessary debt is the largest opportunity the Reporting Persons see for corporate-level profit improvement, the Reporting Persons do not believe it is the only one. The Reporting Persons urge the Issuer to commit to a $5M corporate-level cost reduction program, about 80% of which could be met by debt elimination, with most of the rest potentially coming from reducing audit fees and reducing its board size from nine to seven directors. The Reporting Persons estimate that this could produce a significant and unexpected $0.13 jump in annual EPS.

Returning to the share count, the Reporting Persons ask the Issuer to deploy its excess cash, free cash flow, and the proceeds from refranchising opportunistically to repurchase 2M shares through the end of 2024. After that, as free cash flow from operations and franchising grows, the Reporting Persons ask the Issuer to repurchase opportunistically about 2% of its shares each year in 2025 and 2026 and 3% per year thereafter. After nine years, the Reporting Persons model that Issuer could reduce its share count 21%, from 29.3M shares to 23M.

$99M of 2032 after tax profit divided by 23M shares would generate EPS of approximately $4.30. At a 16X P-E ratio, the Issuer's share price could rise to $68.80; at 18X to $77.40; and at 20X to $86.00.

Recall from the original Schedule 13D that the Reporting Persons urged insiders of the Issuer to take advantage of this substantial upside opportunity by investing their own cash to buy open market shares. The Reporting Persons are delighted that senior management did exactly this multiple times. While the Reporting Persons are pleased that most directors are taking their board fees in shares, rather than cash, the Reporting Persons encourage them to buy shares too—because life does not present many 7-9X investment opportunities, particularly in companies they know well and where they have strong faith in management, governance, strategy, and execution.

In conclusion, the Reporting Persons ask the Issuer to:

• pay off its borrowings while prudently maintaining a line of credit
• scrutinize all corporate level costs for more savings opportunities
• use free cash flow to reduce the share count from 29.3 to 23M
• encourage insiders to buy shares