Potbelly Corporation set the terms for its IPO September 23. If you include the underwriters over-allotment, the Chicago-based sandwich shop is selling 8.49 million shares to the public at between $9 and $11. While it's tempting to take a bite out of this IPO, there are five reasons why you shouldn't. 

Pre-IPO Dividend

As of June 30, Potbelly had $21.7 million in cash and $15.1 million in long-term debt. It plans to pay out $50 million in dividends to existing shareholders from its net IPO proceeds of $77.5 million, which will leave it with $49.2 million in cash. It then plans to pay down $14 million in long-term debt as well as injecting $10.3 million towards working capital. On a pro forma basis it will end up with $24.9 million in cash on its balance sheet. The net result—it will raise just $24.3 million to improve its business. IPOs that don't use 100% of the net proceeds for the betterment of the business aren't worth considering. Especially when you realize that Potbelly's dividend payment to existing shareholders is an instant 33% boost on its $154 million investment. IPO investors are taking money from their own pockets and putting it into the pockets of pre-IPO shareholders with little or no return. It's a losing proposition. 

Limited Profitability

Over the past five years Potbelly's achieved a compound annual revenue growth rate of 7.6%. Its first operating profit came in 2010, when it earned $771,000 before interest and taxes. The next year its operating profit jumped significantly to $8.2 million on $238 million in revenue. On an annualized basis is fiscal 2013 operating profit should be $9.8 million with an operating profit margin of just 3.3% of its $294 million in revenue. In terms of comparable store sales growth, it's averaged 2.3% over the last three years. That's not great when you consider that Starbucks (Nasdaq:SBUX) averaged comparable store sales growth of 7.3% over the last three fiscal years. With something like 35 times as much revenue, Starbucks shouldn't be outgrowing Potbelly—but it is. For those who are unfamiliar with the company, Potbelly Sandwich Shop's goal is to create toasty sandwiches to order using high quality meats, cheeses and veggies and get the patron through the line really fast. 

Chicago Centric

Eighty-five of Potbelly's 280 company-owned shops are located in Illinois where its headquarters are based. Another 41 are in Texas with 22 in the District of Columbia. Over half its shops are operating in just three states with another 132 spread out over 16 more. I suppose you can view the glass full seeing this as an opportunity to put more shops in each of the 16 states. But  what happens if in the 10 states where it only has a single-digit number of stores, restaurant goers don't buy into the brand? The company says it's opened approximately 29 shops in each of the last three years and projects growing the number of openings by 10% annually. Given its revenue per shop is approximately $1 million, it will add $29 million per year in revenue and $5.8 million in profits, which means it will take 2-3 years to pay off its $600,000 investment per shop. I really have to wonder if it can get beyond its Illinois roots. An IPO investment makes an assumption it will be successful in doing so. That's not guaranteed. 

Better Alternatives

It may prove worthwhile looking into Potbelly's peers like Chipotle Mexican Grill (NYSE:CMG) and Panera Bread (Nasdaq:PNRA). Both are still growing annual revenues by double digits while Potbelly has averaged 7.6% over the past five years with double-digit growth possible in fiscal 2013—the first time in its history. For this the underwriters give Potbelly an enterprise value, at the high range of $11 per share, or $314 million. The company is being valued at 9.7 times adjusted EBITDA. While that's considerably less than the multiple for both Panera and Chipotle—11.4 and 21.2 times respectively—Potbelly is priced based on its potential while both of its peers are based on proven results. 

Franchising 

Lastly, Potbelly appears to be copying Starbucks' business model. It is developing company-owned stores except in places like the Middle East where it makes more sense to partner with companies that have experience growing brands in the region. While Alshaya Group, Potbelly's partner in the region, is one of the largest brand developers in the Middle East, it's very possible that Potbelly will get lost in the crowd. For example, Alshaya operates 63 Starbucks stores in Saudi Arabia, 186 in Turkey and 52 in Russia. And that's just one of many brands it represents. Twelve Potbelly stores is hardly a priority. Starbucks developed its hub-and-spoke expansion model before heading overseas. It's a real possibility that Potbelly will lose its focus. 

Bottom Line

While Potbelly might make a tasty sandwich, that doesn't mean you should buy its stock. If you want to invest in a restaurant stock I'd buy Starbucks instead. After all, you can always buy a lifetime supply of Potbelly sandwiches with the future profits.   

Disclosure - At the time of writing, the author did not own shares of any company mentioned in this article.

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