Hearty Appetite for Fast Casual

November 7, 2013

The Potbelly restaurant on State Street still hummed with customers, long after a recent lunch hour had ended.

Tyler Andersen, a 20-year-old accounting student at nearby Harold Washington College, paid $10 for chips, a drink and a Wreckingball, a fusion of the restaurant’s popular Wreck sandwich — made with roast beef, turkey, ham and salami — and a meatball sandwich. He said he prefers dining at Potbelly over other sandwich shops like Subway and McDonald’s.

“I’d rather spend one-fifty or two dollars more because I like the product better,” Andersen said. As for fast food, “I can’t justify paying six or seven bucks. I’d rather spend 10 bucks here than four bucks at McDonald’s.”

Whether investors will retain their appetite for Chicago-based Potbelly remains to be seen.

Shares more than doubled in value in their debut Oct. 4, rising from $14 apiece to close at $30.77. Not bad for a company that started out in 1977 as an antique shop on Lincoln Avenue and began offering sandwiches to increase sales. It now counts 280 company-owned shops in the United States.

But shares have slipped since then; they closed Monday at $26.21, down nearly 6 percent, or $1.60 a share. Analysts point to a report over the weekend by Barron’s that questioned the shares’ lofty valuation.

Potbelly competes in the fast-growing restaurant segment known as fast casual, where made-to-order offerings like a Subway sandwich, Panera salad or Chipotle burrito are drawing busy, money-strapped consumers from more expensive casual dining restaurants like Chili’s and Olive Garden as well as less expensive restaurants like McDonald’s and Burger King.

“The millennial generation really likes fast-casual restaurants and are willing to spend a few more dollars,” said Darren Tristano, executive vice president at food industry research and consulting firm Technomic. “They are not as frugal as Gen X or boomers.”

Tristano said the fast-casual sector represents $35 billion in annual sales and has quickly grown, even through the recession. Tristano expects a 10 percent annual growth rate for the sector to continue for at least the next five years. The typical Potbelly check averages between $8.50 and $12, compared with $3 to $8.50 at a fast-food restaurant, according to company documents.

Company officials declined to comment.

Analysts had been comparing demand for Potbelly’s initial public offering to that of Colorado-based Noodles & Co., also in the fast-casual sector. Shares of Noodles & Co., the first U.S. restaurant IPO this year, also more than doubled in value in their trading debut in June. The stock was priced at $18 and closed Monday at $48.30. Noodles serves globally inspired noodle dishes ordered at the cash register.

Francis Gaskins, director of research at Santa Monica, Calif.-based Equities.com and founder of IPOdesktop.com, said he expects Potbelly to use the net proceeds from its offering to grow into a national brand. Potbelly operates in 18 states and the District of Columbia.

“I personally think it’s got to grow into its valuation,” Gaskins said. “If they can’t open profitable stores on a consistent basis, that’ll be a problem for the stock.”

Gaskins said the challenge for Potbelly will be to distinguish itself from the myriad sandwich chains with which it will compete as it expands.

R.J. Hottovy, senior restaurant analyst for Morningstar, notes that Potbelly is in a market saturated with sandwich competition “and that is something investors have to be mindful of.” Aside from well-known brands Subway and Quizno’s, there’s Jimmy John’s, Jersey Mike’s, Schlotzky’s, Jason’s Deli, Firehouse Subs and smaller chains.

This year Potbelly plans to open 32 to 35 shops, the company said in a regulatory filing. That compares with 31 stores in 2012 and 21 in 2011.

Revenue in 2012 rose 15 percent to $274.9 million, up from $238 million in 2011. Aided by a tax benefit of $16.9 million in 2012, net income was $24 million. That compares with earnings of $7.2 million in 2011.

Potbelly prides itself on its ambience. A potbelly stove usually is prominently displayed, and live music is provided at most stores during lunch. Its rustic decor is reminiscent of its roots as an antique shop.

Customers in the Potbelly on State Street listed ambience as a factor that draws them back.

“It’s open, and they play music, and it’s really relaxed and has cool stuff on the wall,” said Karen Chavez, a vegetarian who usually stops at Potbelly’s once a week. She says she picks up a Potbelly meatless sub and a canned drink for $5. Cookies and shakes also are a draw, she said.

“I feel like the ingredients are better and the options are better,” she added.