Now that Potbelly has hired J.P. Morgan Securities to develop “strategic alternatives” to business as usual in the tough restaurant marketplace, it’s easy to assume the 40-year-old Chicago sandwich brand is putting itself on the auction block. While a sale is a likely outcome, experts say Potbelly has other options despite a lackluster performance since its 2013 IPO.
“Everything is up for grabs at this point,” says Stephen Anderson, an analyst at Maxim Group, a New York-based investment bank. “The most likely event that will occur is a refranchising,” or selling company-owned restaurants to franchisees. The advantage: It’s more profitable to sell the right to operate Potbelly stores, and then collect annual fees, than it is to sell Wreck sandwiches and oatmeal chocolate-chip cookies (no matter how delicious they may be).
At the end of last year, Potbelly owned 411 of its restaurants and franchised just 43.
Selling franchising rights is also an easy way to pull in cash that can then be handed over to shareholders via dividends or stock buybacks, thus mollifying activist shareholders. Potbelly’s own activist, Cleveland-based Ancora Advisors, is clamoring for the move. In a June letter to Potbelly, Ancora CEO Fred DiSanto blasted the chain for delivering “nothing but losses” to investors over the last four years and recommended “dramatically increasing the franchise mix of its store base.”
DiSanto wrote that franchisees would be interested in buying because of Potbelly’s strong store-level sales, high-quality product and strong brand. The company, which reported $407.1 million in 2016 revenue, averages about $900,000 in sales per store—more than twice as much as the $424,300 that QSR Magazine estimates an average Subway location pulls in.
Restaurant industry experts aren’t so sure, however, that refranchising would work at Potbelly. “The problem is that when Potbelly began franchising, they went after small, one-person owners,” says John Gordon, principal of Pacific Management Consulting Group, a San Diego-based firm that focuses on chain restaurants. “It’s always easier for a chain to grow with existing franchisees because they already understand the business. But Potbelly’s small franchisees don’t have the wherewithal to buy stores quickly.”
“I think we certainly need to be open to larger deals,” Potbelly interim CEO Michael Coyne acknowledged on an Aug. 4 conference call with investors. That could include sales to “master” franchisees who would control an entire territory instead of a location or two. But finding big partners may take longer than executives or investors would like.
That brings the conversation back to a sale. J.P. Morgan will spend a few months assembling a pitch book and another few months shopping it around to the usual suspects—a wide range of private-equity firms.
“I think there are a lot of people interested in the brand,” says Howard Penney, managing director at Hedgeye Risk Management, an investment research firm in Stamford, Conn. “It’s a good brand that doesn’t have too many units. It’s not Applebees with 2,000 stores. The food travels well, which is important as people increasingly want food delivered.”
Penney points out another reason that Potbelly makes an attractive acquisition: It can use “dark kitchens.” The term refers to a restaurant that serves only delivery and catering customers and has no seats. Chains love the idea because they don’t have to pay for prime real estate or build out an attractive restaurant, and on-demand food delivery is continuing to explode.
Potbelly already is nodding to these forces by exploring smaller store formats under a project called “Shop 2020.” The effort, still in its planning phases, was presented at investor conferences in June. While discussing the idea at one conference in New York, Coyne pointed to a 600-square-foot Potbelly inside Lurie Children’s Hospital in Streeterville.
“It is doing phenomenally well, better than even our average revenue” at a 2,000-square-foot store, said Coyne, who took over from Aylwin Lewis earlier this summer. “We actually have the ability, we think, to go even smaller as long as we have some nearby space for commissary to store some things.” Potbelly executives think the model could work in high-traffic areas including hospitals, office tower lobbies, airports and universities.
(The company did not respond to requests for comment.)
Despite the harder time even some of the biggest chains have had lately at maintaining traffic and sales, private-equity investors have been increasingly interested in restaurants. Earlier this year, former McDonald’s CEO Don Thompson, through his new Chicago private-equity firm, Cleveland Avenue, bought a majority stake in PizzaRev, a 40-site chain that started in Los Angeles. And Portillo’s Hot Dogs sold itself to Berkshire Partners in mid-2014 (less than three months after the Oak Brook company hired an investment firm to explore its options).
Maxim’s Anderson says its impossible to say which private-equity firms would make a Potbelly bid, but he namechecks Sun Capital Partners of Boca Raton, Fla., which owns Boston Market, Friendly’s and Johnny Rockets; San Francisco’s Golden Gate Capital, which bought Red Lobster; and JAB Holdings of Luxembourg, which, with minority investor BDT Capital Partners of Chicago, has been rolling up premium coffee chains including Chicago-based Intelligentsia and recently snapped up Panera Bread, too.
Others say Potbelly’s small size puts it below those firms’ strike zones. But macroeconomic forces may push would-be buyers to act fast. “I would say with interest rates rising and access to capital starting to be a concern, the clock is running,” Anderson says.