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Best Idea: Short Potbelly $PBPB

Takeaway: PBPB's a single daypart, low margin, low return restaurant company w/ declining traffic & little competitive advantage over its competition.

Editor's note: This piece was originally published November 19, 2013 at 09:31 by Hedgeye Managing Director Howard Penney. For more information on how you can subscribe to our research click here.

 

We are adding PBPB to the Hedgeye Best Ideas list as a SHORT.


Best Idea: Short Potbelly $PBPB - sandwich

 

Chipotle redefined the quick-service industry with its innovative operating model, Panera created the bakery café segment and Noodles catapulted into the fragmented Asian fast casual category.  All three are unique concepts that have, in a sense, redefined their respective categories. 

 

At the heart of it, Potbelly is a single daypart, low margin, low return sub shop with declining traffic and little competitive advantage over its most basic competitors.  Admittedly, these are not quite the qualities we’d expect to find in a company that is trading at a P/E of 84.3x and 21.7x EV/EBITDA on a NTM basis.  But, this is precisely what we have here.  

 

To be clear, we believe Potbelly is a solid company with a strong management team, but it should not be trading at a premium multiple to its aforementioned peers.

 

With that being said, we would not be surprised to see PBPB decline by 30-40% over the next twelve months.


As we wrote last week, in aggregate, the current valuations seen across the casual dining sector are shockingly high.  In fact, we have no problem referring to them as bubble-like and we’ve found this extends beyond the depths of casual dining stocks to several newly minted “growth” restaurant stocks.  Our CEO, Keith McCullough, did a nice job contextualizing these bubbles in this brief excerpt from yesterday’s Early Look titled “Weird Bubbles”:

 

 

From a US stock market “Style Factor” perspective, check out the score:

  • LOW YIELD (i.e. GROWTH) stocks = +40.4% YTD
  • Top 25% EPS GROWERS (by SP500 quartile) = +37.2% YTD
  • HIGH BETA stocks = +35.8% YTD

 

From a pure “Style Factor” perspective, PBPB fits the bill of a “growth” restaurant stock.  Let’s consider management’s aggressive guidance:

  • New unit growth of 10%+ for a “long period of time”
  • Low-single digit same-store sales growth
  • At least 20% annual adjusted EBITDA growth
  • At least 20% annual net income growth
  • At least a 25% return on invested capital, as measured by the second full-year profit of new shops
  • Shop margins above 20%

At its core, Potbelly is a local sandwich chain competing in the most competitive segment of the restaurant industry – the sandwich segment.  Although many people like to refer to it as the newest fast casual concept, the reality is it’s only at the “intersection between the fast casual and sandwich categories.”  Needless to say, Potbelly’s operating model, while solid, is nothing close to jaw-dropping.

 

 

Peer Group Operating Model Comparison

  • Potbelly’s average unit volumes are low.
  • Food costs are in-line with Panera’s.  There is very little room to move lower without downgrading to lower quality food.
  • The company appears to be very efficient, with labor costs running at 27.96%.
  • Other operating expenses are also very low, which could be the difference-maker in maintaining 20% store-level margins over the long haul.
  • Excluding IPO expenses, Potbelly’s G&A costs are running closer to 8%, which puts it fairly in-line with its competitive set.
  • Even after adjusting for lower G&A costs, operating margins remain low and will require sales leverage for any further upside.

Best Idea: Short Potbelly $PBPB - hwp1

 

 

Same-Store Sales

Management’s long-term guidance of “low-single digit same-store sales” implies that they believe, or want us to believe, they have the ability to take price in order to consistently drive average check higher.  In fiscal 2012, Potbelly’s average check was $7, which, on the surface, appears to be in-line with other fast casual operators.  With average check already at this level, relying on price as the primary driver of future profitability is a risky proposition.  Needless to say, we haven’t seen anything recently that would suggest this rate of same-store sales growth will come from traffic gains.  Potbelly has seen traffic decline for at least the past 3 quarters and expectations are for this trend to continue into the first half of 2014.

 

Best Idea: Short Potbelly $PBPB - chart2

 

 

Average Unit Volumes

The Potbelly mission is to be “the best place for lunch.”  While a strong focus on lunch is important, restaurant companies that generate the best returns operate across multiple dayparts and, in turn, generate higher average unit volumes.  Depicted in the chart below, at $1.1 million, Potbelly’s average unit volumes are below all of its primary public peer competitors.  Given the inherent unit economics of a Potbelly shop, we find the company’s premium multiple very difficult to justify even with the “growth” story as a backdrop.

 

Best Idea: Short Potbelly $PBPB - chart3    

 

 

Restaurant Level Margins

Given the rapid projected growth rate of the company, PBPB will be facing downward pressure on restaurant level margins for the foreseeable future.  On average, new Potbelly shops will open up with shop level profit margins in the high-single digit or low-double digit range.  It will require nearly flawless execution on store openings to avoid being stymied by incremental margin pressure.

 

Best Idea: Short Potbelly $PBPB - Chart4

 

 

Low Returns

Relative to its competitive peer set, PBPB generates a very low return on assets.

 

Best Idea: Short Potbelly $PBPB - chart5

 

 

Strong Balance Sheet and Cash Flow

PBPB is expected to have $48.87 million of cash and short-term equivalents on its balance sheet at the end of 2013 and is expected to generate approximately $7.8 million in free cash flow after allocating $31.16 million to capital expenditures in 2014.  The company has not formally announced what it will do with its excess cash, but we can safely presume they will use it to fuel their self-funding model and accelerate new unit growth in the second half of 2014 and 2015.

 

 

Valuation

Per our comments earlier and the visuals from the charts below, PBPB is a very expensive stock that we, at the very minimum, find quite unattractive from a valuation standpoint.

 

Best Idea: Short Potbelly $PBPB - second to last

 

Best Idea: Short Potbelly $PBPB - last

 

 

Conclusion

As it stands, PBPB’s operating model has little room for error.  To justify the current multiple, it needs to be clear that there is significant upside from current consensus EPS estimates.  We don’t anticipate this coming to fruition and, with short interest comprising 15% of the float, it appears as though we are not the only ones.

 

 

 

Howard Penney

Managing Director

HPenney@hedgeye.com

 

 

 


What's New Today in Retail (12/4)

Takeaway: WMT.com and JCP stand alone w/ POS sales updates. H&M attacking LULU? Shareholder looks to oust Jeffries from ANF. Un-American Eagle.

EVENTS TO WATCH OVER THE NEXT 24 HOURS

 

Hedgeye Black Friday Consumer Survey: Focus on JCP.  We'll be conducting a follow-up to our prior consumer survey (which helped us call a JCP beat and KSS miss) following Black Friday weekend and Cyber Monday. We'll have results next week, and will have an updated presentation accordingly. If you are interested in our results, please email sales@hedgeye.com, or .

 

ARO - Earnings Call: Wednesday (12/4) 4:15 pm

GES - Earnings Call: Wednesday (12/4) 4:30 pm

WTSL - Earnings Call: Wednesday (12/4) 5:00 pm

FRAN - Earnings Call: Thursday (12/5) 8:30 am

SKX - Analyst and Investor Meeting: Thursday (12/5) 9:30 am

HBI - ISI Group Consumer Holiday Conference: Thursday (12/5) 9:30 am

DG - Earnings Call: Thursday (12/5) 10:00 am

 

ECONOMIC DATA

 

Weekly Athletic Footwear Data

 

What's New Today in Retail (12/4) - chart1 12 4

What's New Today in Retail (12/4) - chart2 12 4

What's New Today in Retail (12/4) - chart3 12 4

 

COMPANY NEWS

 

JCP - J. C. PENNEY COMPANY, INC. PROVIDES HOLIDAY UPDATE

(http://ir.jcpenney.com/phoenix.zhtml?c=70528&p=irol-newsCompanyArticle&ID=1881648&highlight=)

 

  • "J. C. Penney Company, Inc. today provided a preliminary update on the Company's performance for the fiscal month ending November 30, 2013. During that period, which includes the important Thanksgiving weekend, the Company's comparable store sales grew 10.1 percent over last year. The Company also noted that its e-commerce sales through jcp.com continued to be strong, running well ahead of last year, consistent with last month's trend."

 

Takeaway: See our note "JCP The Bear Case Lacks Intellectual Honesty"

 

WMT - Walmart.com Has its Best Sales Day Ever on Cyber Monday 2013

(http://news.walmart.com/news-archive/2013/12/03/walmartcom-has-its-best-sales-day-ever-on-cyber-monday-2013)

 

  • "Walmart today announced that Cyber Monday 2013 was the biggest online sales day in its history. The five-day period from Thanksgiving to Cyber Monday is the highest five-day stretch in online sales for the retailer to date, and Walmart.com processed more than 1 billion page views during that period."

 

Takeaway: It's kind of funny…every retailer will cherry pick the highlights and report them to the world. The bad news gets stifled. At least Wal-Mart had SOMETHING good to say -- even though it had nothing to do with store sales over Black Friday weekend. JCP had good news. So far, crickets from the rest of US retail.

 

ANF - Engaged Capital Tells Abercrombie: Replace CEO

(http://online.wsj.com/news/articles/SB10001424052702304355104579235882032904384)

 

  • "Engaged Capital said in a letter to the Abercrombie board that it should start looking for a replacement for chairman and chief executive Michael Jeffries, whose employment contract expires Feb. 1."
  • "The hedge-fund firm, which said it owns about 0.5% of Abercrombie's stock, also said the sale of Abercrombie to a private-equity buyer 'may represent the best option for shareholders.'"
  • "Abercrombie on Tuesday said it welcomed 'input from all shareholders' and that it had held 'extensive discussions' with many shareholders, including Engaged Capital, over the past several months."

 

Takeaway: We hope they succeed. We've been tempted to get involved with ANF over the years, but the fact that Jeffries is still CEO has repeatedly held us back. It's rare to see one person destroy significant equity value at a company, but that's the one area where Jeffries has succeeded.

 

HMB - H&M Sport to Compete in Activewear

(http://www.wwd.com/retail-news/mass-off-price/hm-sport-to-compete-in-activewear-7298244?module=hp-topstories)

 

  • "The Swedish high-street retailer will reveal today that it is launching H&M Sport, an expanded concept with a new visual identity, on Jan. 2 in all its markets worldwide."
  • "Dedicated areas in selected stores will feature activewear and accessories including windproof and water-repellent running jackets; warm-up tops and trousers for working out; comfortable garments for yoga; tennis shorts, and protective fleece jackets for outdoor activities."
  • "H&M signaled its intention to deepen its sportswear offering earlier this year when it said it would dress Sweden’s athletes for the Winter Olympics and Paralympics in Sochi, Russia, next year and the Summer Olympics and Paralympics in Rio de Janeiro in 2016."

 

What's New Today in Retail (12/4) - chart5 12 4

 

Takeaway: So many retailers are hopping on the Athletic bandwagon. Heck, you can buy yoga apparel at Whole Foods now. Nike and UnderArmour have been dealing with this for a long time. But Lululemon better keep an eye on the price gap between its Down Dawgs and what the H&M's of the world are offering.

 

SHLD - Filing Reveals Edward Lampert's Stake in Sears

(http://www.wwd.com/fashion-news/fashion-scoops/still-number-one-7298342)

 

  • "Edward Lampert, Sears Holdings Corp.’s chairman and chief executive officer, pared his stake in the company over the last few months and no longer controls the majority of its shares, but the pruning job was relatively modest."
  • "In a regulatory filing Tuesday, Lampert and his various investment vehicles, including ESL Partners LP, were listed as owning 51.6 million shares of Sears stock, 48.4 percent outstanding. That’s down from the 58.9 million shares, or 55.4 percent, listed in March. The reduction was caused by distributions to ESL investors."

 

Takeaway: Perhaps this is a complete non-event if it was simply a distribution to ESL Investors. But if there was any part that was driven by his desire to downside his stake, then it would be catastrophic to SHLD. In fairness, Lampert is savvy enough to not let that happen.

 

AEO - American Eagle Inks Overseas Deals

(http://www.wwd.com/retail-news/specialty-stores/american-eagle-inks-overseas-deals-7298239)

 

  • "American Eagle Outfitters Inc. is expanding its presence in the Americas and in Asia-Pacific. The teen retailer has signed three new licensing agreements for stores that are set to begin opening in time for back-to-school in 2014."
  • "According to Simon Nankervis, senior vice president for the Americas and global licensing, one agreement is with Grupo David Enterprises. That contract covers Venezuela, the Caribbean Islands and, in Central America, the countries of Panama, Costa Rica, Honduras, Guatemala, El Salvador, Nicaragua and Belize."
  • "A separate agreement was signed with Grupo Comercializadoras for Colombia. In Asia-Pacific, the retailer signed an agreement with Pacifica Lifestyle Co. for stores in Thailand."
  • "All agreements are for two, five-year tranches. Each agreement also allows the licensing partner to open aerie concept shops-in-shop or side-by-side stores...While many of the stores in the U.S. are about 7,000 square feet, Nankervis said those overseas range on average from 4,000 square feet to over 7,000 square feet, depending on location and availability of real estate."

 

Takeaway: American Eagle is doing the unthinkable -- taking the 'American' Eagle brand outside of America. Let's face it, the US isn't too popular on the world stage. If AEO can make this work, they definitely tack on another leg of growth to the story.

 

Burton - Burton Unveils U.S. Olympic Snowboard Look

(http://www.wwd.com/markets-news/intimates-activewear/burton-unveils-us-olympic-snowboard-look-7298188?module=hp-markets)

 

  • "When the 2014 Winter Olympics take place in Sochi, Russia, Feb. 7 to 23, the U.S. snowboarding team will be sporting Burton. The Vermont-based brand unveiled the original men’s and women’s designs at its flagship here Tuesday night."

 

What's New Today in Retail (12/4) - chart4 12 4

 

Takeaway: Out of any sport in the games, the apparel that gets the greatest focus is arguably snowboarding. Burton was the first and remains the premier snowboarding brand. Though it's surprising that one of the bigger brands with deeper pockets has not stepped up and bid away the deal.

 

NKE - Nike starts waterfree fabric dyeing facility in Taiwan

(http://www.fibre2fashion.com/news/textiles-company-news/newsdetails.aspx?news_id=156717)

 

  • "NIKE, Inc. celebrated the opening of a waterfree dyeing facility featuring high-tech equipment to eliminate the use of water and process chemicals from fabric dyeing at its Taiwanese contract manufacturer Far Eastern New Century Corp."
  • "NIKE, Inc. has named this sustainable innovation 'ColorDry' to highlight the environmental benefits and unprecedented coloring achieved with the technology."

 

INDUSTRY NEWS

 

Visa’s Black Friday weekend online sales up 30%

(http://www.chainstoreage.com/article/visa%E2%80%99s-black-friday-weekend-online-sales-30)

 

What's New Today in Retail (12/4) - chart6 12 4

 

New Rules to Dictate Spending Habits of China Officials

(http://www.wwd.com/business-news/government-trade/new-rules-to-dictate-spending-habits-of-china-officials-7297901?module=hp-topstories)

 

  • "In what could be a further blow to luxury consumption in China, the nation’s leadership is deepening its pledge to crack down on corruption and ostentation with the release of new rules outlining how officials should avoid extravagant spending on activities ranging from overseas travel to the purchase of new vehicles."
  • "With 12 chapters outlining 65 rules on how to manage funds and employ more transparent spending, the document, released last week, is extensive and is causing analysts to question whether the antigraft campaign that began nearly a year ago under the new administration of President Xi Jinping will continue to have a far-reaching impact on China’s luxury sector. Spending on luxury products has historically been bolstered by the purchase of expensive gifts between officials and business associates as bribes."

 


#EOW (End of World)?

Client Talking Points

VIX

Volatility made another higher-low last week (signaling a short-term SPY stop), but then it failed at Hedgeye TREND resistance of 14.92 yesterday. This is what we call a very manageable risk range for US Equities. The VIX is now overbought .

S&P 500

Witness the 3-day correction of -0.7%. That's called bear scraps.So keep moving out there or get mauled. Fund flows have been epic (and they haven’t been put to work). Bottom line is you want to be buying red and selling green… and looking mean. 

DAX

We still like European growth equities more than U.S. equities right now. Germany (DAX) held our Hedgeye TRADE support of 9138 after another #GrowthAccelerating data point in the November Services PMI of 55.7 (versus 54.5 last month). #EuroBulls 

Asset Allocation

CASH 58% US EQUITIES 4%
INTL EQUITIES 4% COMMODITIES 4%
FIXED INCOME 4% INTL CURRENCIES 26%

Top Long Ideas

Company Ticker Sector Duration
FXB

Our bullish call on the British Pound was borne out of our Q4 Macro themes call. We believe the health of a nation’s economy is reflected in its currency. We remain bullish on the regime change at the BOE, replacing Governor Mervyn King with Mark Carney. In its October meeting, the Bank of England voted unanimously (9-0) to keep rates on hold and the asset purchase program unchanged.  If we look at the GBP/USD cross, we believe the UK’s hawkish monetary and fiscal policy should appreciate the GBP, as Bernanke/Yellen continue to burn the USD via delaying the call to taper.

WWW

WWW is one of the best managed and most consistent companies in retail. We’re rarely fans of acquisitions, but the recent addition of Sperry, Saucony, Keds and Stride Rite (known as PLG) gives WWW a multi-year platform from which to grow. We think that the prevailing bearish view is very backward looking and leaves out a big piece of the WWW story, which is that integration of these brands into the WWW portfolio will allow the former PLG group to achieve what it could not under its former owner (most notably – international growth, and leverage a more diverse selling infrastructure in the US). Furthermore it will grow without needing to add the capital we’d otherwise expect as a stand-alone company – especially given WWW’s consolidation from four divisions into three -- which improves asset turns and financial returns.

TROW

Financials sector senior analyst Jonathan Casteleyn continues to carry T. Rowe Price as his highest-conviction long call, based on the long-range reallocation out of bonds with investors continuing to move into stocks.  T Rowe is one of the fastest growing equity asset managers and has consistently had the best performing stock funds over the past ten years.

Three for the Road

TWEET OF THE DAY

Remember the fear mongering in OCT about a US "Debt Default"? a consensus gift @KeithMcCullough

QUOTE OF THE DAY

"We don't see things as they are, we see them as we are." - Anais Nin

STAT OF THE DAY

U.S. private employers added 215,000 jobs in November, topping expectations, according to ADP, reinforcing expectations the Fed may soon begin to taper. Economists surveyed by Reuters had forecast the ADP Report would show a gain of 173,000 jobs. The high end of the estimates was 205,000. October's number was revised to 184,000 from the initially reported 130,000. (Reuters)


Daily Trading Ranges

20 Proprietary Risk Ranges

Daily Trading Ranges is designed to help you understand where you’re buying and selling within the risk range and help you make better sales at the top end of the range and purchases at the low end.


Spiking Skew

“My reading of history convinces me that most bad government results from too much government.” -Thomas Jefferson

 

Over the Thanksgiving break, I started reading “Thomas Jefferson: The Art of Power” by Jon Meacham.   For many of you Americans (like Keith I’m Canadian), undoubtedly studying the founding fathers is old hat, but for me the book has a number of revealing insights.

 

The key insight relates to the quote at the outset.  Specifically, this idea that too much government may, in fact, be too much government.  No doubt there are some pensioners in Detroit who are thinking just that as they are beginning to realize that the “government guarantee” of their pension is not as solid as they believed it to be.

 

Like most great men, Jefferson had his faults.  Regardless, the author of the Declaration of Independence was a stalwart protector of individual liberty, especially in the face of the threat of government.  Compared to the Jeffersonian era, the individual American certainly has much broader freedoms than he, and especially she, would have had in the early 1800s.

 

The one caveat to this of course is in the area of economic freedom, specifically taxation.  From the Jeffersonian period to the early 20th century, the government was both a small percentage of the economy and direct taxation was originally very limited.  On the last point, as recently as 1895 the Supreme Court of the United States actually ruled that federal income tax was unconstitutional.

 

Today as we “gladly” hand over 1/3+ of our incomes to the federal government and the government comprises 20%+ of the economy, it certainly begs the question of whether we have the personal economic freedoms that our Founding Fathers envisioned.

 

Back to the global macro grind . . .

 

Related to the topic above, one sneaky macro positive that has been emerging domestically is a shrinking of the federal budget deficit.  Over the past four years, the federal budget deficit has been cut in half from the peak level of $1.4 trillion.  Certainly, a $700-ish billion budget deficit is still too large, but in this regard the trend is definitely our friend, especially as it relates to U.S. dollar tailwinds.

 

Sadly, none of today’s current politicians have the political acumen of Thomas Jefferson, so the primary method to halt federal government spending growth has been for the Tea Party to effectively hijack the government, which most recently led to a government shutdown.

 

In 2014, we may have déjà vu all over again.  Consider the federal government catalysts we have in front of us in the next three months:

  • December 13th – The bipartisan budget committee is supposed to report back on budget / compromise progress;
  • January 15th – The Current Continuing Resolution runs out;  and
  • February 7th – The next debt ceiling deadline. . .

The threat of more negative government catalysts is actually coming at a really complacent and inopportune time for the U.S. equity markets. Specifically, the VIX’s monthly average price was just under 13 in November and at the lowest level we’ve seen in over two years.  As many of you well know, there is an inverse correlation between the VIX, a measure of volatility, and the price of the SP500.  Suffice it to say, the equity volatility ball is sufficiently under water . . .

 

In the Chart of the Day, we highlight the SKEW Index compared to the VIX index.  As the chart shows, SKEW is spiking and historically SKEW has been a decent leading indicator of volatility.  Intuitively this makes sense as investors are becoming more compelled to hedge exposure given the highs in the market and the fact that year-end is fast approaching. 

A potential spike in volatility and decline in equities also makes sense given a number of other signs of a near term top.

 

Consider a couple of headlines from the Wall Street Journal and Reuters from yesterday:

  • “More Hedge Funds Turn to Long-only Strategies”
  • “Short Sellers Trying to Cope”

No doubt, this has been a challenging year for short sellers as stocks with high short interest have outperformed meaningfully, but when more than half of hedge funds launch or plan to launch long only strategies it does reek of capitulation.  (And no, the Hedgeye Long Only ETF won’t be launching anytime soon!)

 

Before signing off, I also wanted to remind you of Hedgeye’s Energy Best Idea call on Boardwalk Partners (BWP) this Thursday at 11am.  BWP is a $6.4 billion market cap MLP primarily engaged in the transportation and storage of natural gas in the south/central US.  The diversified holding company Loews Corp. (L) owns the 2% GP interest in BWP, all IDRs (currently in the 50/50 split), and 52% of the BWP’s outstanding common units.

 

BWP is a high-conviction short idea given the Company’s deteriorating base business, aggressive accounting, high leverage, unsustainable distribution, valuation.  If this thesis sounds a little like our calls on Kinder Morgan (KMP) and Linn Energy (LINE), it should.  We think the valuation of the MLP sector is grossly overstating the intrinsic value of the underlying businesses held in these structures.  If you’d like to get access to the call, email sales@hedgeye.com.

 

Keep your head up and stick on the ice,

 

Daryl G. Jones

Director of Research

 

Spiking Skew - SKEW

 

Spiking Skew - 12 4 2013 8 07 41 AM


December 4, 2013

December 4, 2013  - Slide1

 

BULLISH TRENDS

December 4, 2013  - 2a

December 4, 2013  - 3A

December 4, 2013  - 4A

December 4, 2013  - 5A

December 4, 2013  - 6A

December 4, 2013  - 7A

December 4, 2013  - 8A

December 4, 2013  - 9A

 

BEARISH TRENDS

December 4, 2013  - 10A

December 4, 2013  - 11A
December 4, 2013  - 12A

December 4, 2013  - 13A


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