Is Potbelly the Next Big Thing?

A bulging war chest and some top-ranked talent puts Potbelly Sandwich Works on the map.

By David Farkas, Senior Editor -- Chain Leader, 8/1/2006

You’ve probably never heard of Bryant Keil, but one day he might deserve a place alongside Ray Kroc, Dave Thomas, Fred DeLuca and Howard Schultz. The 42-year-old Chicagoan has raised $86 million since 2000, attracted a high-falutin’ board of directors and hired the executives responsible for Starbucks explosive growth in the 1990s. His vehicle to fame: Potbelly Sandwich Works.

“We are focused on building a world-class company,” insists Keil, chief executive, seated in Potbelly’s board room on the 23rd floor of Chicago’s Merchandise Mart. “I want people to look back and say, ‘That was the best company I ever worked for.’ That would be a great honor.”

To be sure, the virtually unknown but fast-growing concept has a ways to go before it’s added to the list of marquee chains. The company is in the midst of reorganizing senior management and working out how to double in size by 2008.

Today, there are about 125 Potbellys. Most have opened since 2002—a year after Starbucks Chairman Schultz bestowed nearly $11 million on the then eight-unit chain through Maveron, his Seattle-based venture-capital fund. Keil had bought the business—a busy 20-year-old sandwich shop on Lincoln Avenue in Chicago—for $1.7 million just four years earlier using his own money. Meanwhile, he was entertaining thoughts of an empire as he “changed everything,” he says. At the time, Keil owned Room Service, an outfit that delivered meals from restaurants to homes—his only foodservice experience.

Says Keil: “I wanted to figure out what made Potbelly tick. I wanted to build a scalable business.”

Starbucks Clone?
Maveron partner Dan Levitan described its investment in a Business 2.0 interview in 2004: “[Potbelly] has many of the same characteristics that Starbucks had in the early days. There is this intensity and passion among people that it is their Potbelly.” Both Schultz and Levitan are Potbelly board members.

Comments like that help to explain why Keil has been able to amass a sizeable war chest over four more rounds of financing. The commitments have been notable. Venture capitalist firms Oak Investment Partners and Benchmark Capital have a stake. Chairman Ned Jannotta of William Blair & Co. and Whole Foods Market Co-President Walter Robb have seats on the board.

The most recent round, in February, brought on former El Pollo Loco owner American Securities Capital Partners, which ponied up $30 million for a 10 percent stake and board seat.

Thirty million? “On the surface, that’s a healthy price,” offers financial adviser Mark Saltzgaber, a former investment banker who unsuccessfully attempted to invest in Potbelly several years ago. But he estimates the company is worth about $300 million. Based on a revenue run-rate of $146 million, investors are currently paying from 1.5 to 2.0 times annual revenue—a rich valuation for a relatively small company, he says.

Well-Traveled
Small, yes, but not untested. The chain is now in eight states, and performance is consistent. “It’s how consistent Potbelly is market by market that impresses me,” says Oak General Partner Jerry Gallagher. Sales and unit growth, compounded annually, have shot up 60 percent or more over five years—rates comparable to hot-shot players like Chipotle and Panera Bread Co. Systemwide sales in 2007 are expected to exceed $200 million.

Same-store sales remain “very positive,” says CFO Bill Moreton, though he concedes trends have softened “slightly” due to high energy prices and climbing interest rates. He won’t say how much or disclose which markets have experienced the steepest declines. In fact, the privately held company says little about how Potbelly units perform.

Declares Keil, “The business model and our execution of the business warranted [the $30 million].”

Managing Director Glenn B. Kaufman of American Securities Capital Partners agrees. “It is clearly a valuation reflective of a business performing exceptionally well. It’s been growing 30 to 40 percent year over year with a distinguishing set of characteristics that make [Potbelly] special,” he explains.

What’s so special about a sub chain that toasts sandwiches? For one thing, the sandwiches are priced at a competitive $3.89 each (check average: $6.50). For another, they arrive quickly, roughly two minutes from order to pickup. Long lunch lines don’t seem to matter, either. Customer throughput averages six minutes. And there’s live music—usually a guitar or piano player—in each unit, a refreshing change from rivals’ piped-in pop. The unique amenity costs the company about $1 million a year.

The payoff has been music to investors’ ears. It doesn’t take a genius, for example, to surmise that on a $575,000 per-store investment and $1.2 million in average unit sales, there’s strong cash flow, perhaps 20 percent or more, according to observers. Declares Gallagher, an early investor: “We didn’t have to retool the profit formula.”

Gallagher, who has also backed Jamba Juice and P.F. Chang’s, foresees an IPO in Potbelly’s future. “If you don’t aim for that, then you depend on a strategic buyer,” he says. Strategic buyers have been all but absent from recent restaurant transactions given the sometimes towering valuations financial buyers have been willing to pay.

To prepare for fast growth and, perhaps, the eventual scrutiny of the Street, Keil has been retooling management. John Bettin, the former Morton’s The Steakhouse president who joined Potbelly a year ago as senior vice president and COO, resigned in June. Keil will only say that Bettin, who oversaw all store operations, is “very bright.” Bettin, who is not being replaced, declines to comment.

Chief Development Officer Tom Jednorowicz and Chief Marketing Officer David Selby have also left. Dan Fogerty, who oversaw brand development for Chipotle, replaced Selby late last year. Jednorowicz, according to Keil, wanted to buy a restaurant chain. “Who knows? I might invest with him,” says Keil, who dropped out of American University to start a flower-delivery business.

Still, he concedes, “Different stages in a company require different things. I tried to get Arthur from Day One.”

“Arthur” is Arthur Rubinfeld, the former Starbucks executive who’s credited with swelling the coffee chain from 100 to 3,800 units. Schultz introduced Keil to Rubinfeld in 2000, and Keil immediately hired him as a consultant after he left Starbucks in 2002. Rubinfeld, a real-estate expert and co-author of a brand-building manual called Built for Growth (Wharton School Publishing, 2005), says he convinced Keil to put real estate, construction and property management in one department to facilitate rapid expansion.

Mastering the Brand
He also helped Potbelly develop a “kit of parts,” or key brand elements that can be shaped and reshaped to fit a particular store site. They include wood paneling, wooden floors, pew-like booths, bookcases and old­fashioned light fixtures. The first Potbelly, which opened in 1977, was originally an antique store.

“It is a family of materials, colors and equipment,” explains Chief Development Officer Rubinfeld, who brought former Starbucks development executives Jayson Tipp, vice president of store development and analytics, and Bill Sleeth, vice president of store design, on board. The three were also partners in Airvision, the San Mateo, Calif.-based retail consultancy Rubinfeld formed after leaving the coffee chain in ’02.

Today, Rubinfeld’s job is to grow Potbelly “at a highly doable pace,” declining to offer specifics other than to predict there will be “thousands” of units. “That was the idea of bringing aboard our team,” he says.

The trio is currently studying the results of a site-analysis model that Tipp, a statistician, developed, and recruiting staff. Says Rubinfeld: “We are looking to hire designers and construction managers. Those who love the thrill of growth.”

Potbelly grew by 50 percent, to 102 restaurants, in ’05, making it the fastest-growing sandwich concept among the 40 on Technomic Inc.’s “Top 500 Chain Restaurant Report.” With $38 million in cash to help fund growth, the debt-free company is adding 37 units this year (a dozen have opened so far) and 40 to 50 in ’07. Most will open in existing markets, though the chain will likely enter a new, as-yet-undisclosed market next year. All Potbelly restaurants are company owned.

Downtown Legacy
The strategy has been to open the first outpost in an urban center with plenty of foot traffic and nearby office buildings. Keil proved in Chicago that downtown workers flock to the concept after opening his second Potbelly in the late ’90s. Later, the company looks for high-traffic suburban sites, usually in strip malls. It counts on buzz from the downtown locations to attract customers.

Keil has so far opened 54 units in and around Chicago, the largest market, and he thinks there is room for more. The second largest is Washington, D.C., with 22 units. The remainder is spread among Minneapolis; Milwaukee; Detroit; Ann Arbor, Mich.; Columbus, Ohio; Cincinnati; Houston; and Dallas/Fort Worth.

Exactly how well this strategy is working is anyone’s guess. Neither management nor the investors interviewed for this article will disclose the range of volumes, crucial to gaining an accurate picture of where the Potbelly model works best. Despite the range in the size of units—from 675 square feet to 4,000 square feet—the company maintains the stores average $1.2 million; that’s roughly three times the volume of most rival sandwich shops.

Keil says remaining site-flexible is key to maintaining volumes. “Yesterday we were talking about doing a 3,000-square-foot store,” he recalls. “The question was raised, ‘Do we really need it?’ I said, ‘The extra square footage will really help our operators and customers. Over time, maybe not today, we will earn a return worthy of our effort.’ That’s not a blindly naïve approach.” Keil, whose wife is pregnant with their fourth child, says parents with strollers need more room.

Rubinfeld shares a similar philosophy, as long as the 3,000-square-foot unit is an A location. “I’m a believer that if a Main Street and Main location is available, you have got to find a way to take it,” he says. “You then figure out how to make it work, perhaps leasing a portion or making it a regional office.”

The tack worked for Starbucks, which rushed to lease stores in highly visible sites as it stampeded across the country gobbling up market share.

Will the same approach work for a more complicated and less retail-oriented system? Keil seems willing to find out. “One thing we’ve been talking about lately is that it’s OK not to know everything,” he says. “Someone can come in with a different background and teach us something new.”

Something, perhaps, that could make him famous.