Potbelly Corp (PBPB) 2017 Q2 法說會逐字稿

Greetings, and welcome to the Potbelly Corporation Second Quarter 2017 Earnings Call. (Operator Instructions) As a reminder, this conference is being recorded.

I'd now like to turn the conference over to your host, Matt Revord, Chief Legal Officer.

Good morning, everyone, and welcome to our second quarter earnings call. Before we get started, I'd like to note that certain comments made on this call will contain forward-looking statements regarding future events or future financial performance of the company. Any such statements, including our outlook for 2017 or any other future periods, should be considered forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are not guarantees of future performance nor should they be relied upon as representing management's views as of any subsequent date.

Forward-looking statements involve significant risks and uncertainties, and events or results could differ materially from those presented due to a number of risks and uncertainties. Additional detailed information concerning these risks regarding our business and the factors that could cause actual results to differ materially from the forward-looking statements and other information we'll be giving today can be found in our most recent annual report on Form 10-K under the headings Risk Factors and MD&A and in our subsequent filings with the Securities and Exchange Commission, which are available at sec.gov.

I'll now turn the call over to Mike Coyne, our Chief Financial Officer and Interim Chief Executive Officer, who'll begin with his perspective on the second quarter performance, provide a discussion of our ongoing strategic initiatives, will then review our financial results and future outlook in more detail before we open up the call for your questions. Mike?

Thanks, Matt. Good morning, everyone, and thank you for joining the call. First, I'd like to give you a quick recap of what we highlighted in our press release that we issued this morning.

During the second quarter, we generated revenue of $108 million, an increase of 3%, driven by new unit growth offset by the impact of our comparable store sales, which decreased 4.9%. While disappointed with our top line performance, we are encouraged by our ability to manage costs, drive solid flow-through delivering shop margin of 19.2%.

During the second quarter, we generated adjusted EBITDA of $11.8 million and adjusted net income of $2.7 million or $0.11 per diluted share.

As you know the overall industry operating environment remains challenging as weakened consumer demand, food inflation gap and the proliferation of concepts and units continue to negatively impact traffic trends.

As we discussed last quarter, while we expect 2017 to be a tough year due to the macro operating environment, we are very focused on strategies to mitigate the headwinds and improve traffic trends. To build a stronger Potbelly for the long term, we are undertaking a comprehensive review of our business strategy. Over the next few months, we will analyze every aspect of our business, including but not limited to: our capital structure and allocation; returns on invested capital; operational productivity; our marketing strategy; company-owned unit growth; CapEx; and potential ways to accelerate franchising.

In addition, we have engaged J.P. Morgan as our financial adviser to assist us with this review and the development of strategic business alternatives, with the objective of maximizing shareholder value.

In the near term, we continue to drive various initiatives designed to improve traffic and grow sales. So let me spend a few minutes updating you on a few of these initiatives.

First, we are very focused on increasing convenience and customer engagement through investments in technology to drive sales growth. During the first quarter, we launched our new mobile app and redesigned website, so our customers can more conveniently access Potbelly. Order customization is a big part of the Potbelly experience and our convenient ordering systems easily allow customers to do that on their terms, whether in person, online, drive-through or via our app.

We continue to see growth and adoption of both our website and our app to drive digital orders. In particular, on our website, we've seen not only an increase in online ordering but also growth of add-ons based on the updated user interface experience. We will continue to test and adjust both the website and the app to ensure that they are both optimized to further grow sales.

We also introduced our Potbelly Perks Customer Engagement program as part of the app and website rollout. We're seeing strong customer adoption of Potbelly Perks and currently, have a growing database of over 300,000 registered perks members that we can micro-target with personalized communication and offers to drive frequency in sales.

We are ramping up our acquisition strategy, with the use of digital advertising to drive the app downloads and online order conversions. We're also exploring additional ways to enhance Potbelly Perks membership value through potential external partnerships.

And separately, to provide messaging flexibility to drive sales and enhance the customer experience, we've also expanded the testing of our digital menu boards to additional -- several additional shops. We're encouraged by the early indications of their ability to enhance our in-shop messaging and will allow us to drive daypart sales, menu innovation and segmentation and add-on messaging to drive sales growth.

In addition to technology, we continue to focus on menu innovation and backline as sales growth drivers. Our recently introduced Turkey Club Sandwich builds on the success of our Turkey Fresco sandwich and features all-natural, slow-roasted premium Turkey, with new Squeez Bacon and melted cheddar cheese. While it's early, the Turkey Club has been very well received and is showing potential to help positively impact sales. As a result, we are considering adding this premium sandwich to our permanent menu.

Our menu innovation pipeline remains robust, and we continue to look for ways to evolve our menu to address relevant trends, customer expectations and to drive same-store sales.

Now turning to backline. Backline is an important sales driver, with great flow-through and minimal capital requirements. Our backline is about 15% of sales and is a tremendous opportunity to grow this business, through investments in catering sales managers, optimized delivery models and catering kitchens.

Our catering kitchens focus only on catering orders. There is no front-line operation, which allows for both great execution and efficient deployment of labor. We currently have catering kitchens in Chicago and New York. We plan to add 2 more catering kitchens this year, and we'll continue to be opportunistic with investments in additional catering kitchens over time.

One of the areas that we'll be focusing on, on our strategic review is our brand and advertising strategy. Potbelly is a special brand from our culture, to the distinctive in-shop Potbelly experience, to our commitment to quality ingredients and warm and toasty sandwiches. We believe there are opportunities to better convey our brand messaging to our customers through improved storytelling.

In addition, we are teaming with a new partner to be more strategic about and effective in our digital advertising going forward, which will provide greater clarity on attribution, conversion and return on ad spend.

In the third quarter, we began testing television advertising for the first time, with a commercial in Chicago, which we believe, will help drive greater top-of-mind awareness and traffic. In the past, we focused primarily on neighborhood marketing at the shop level. But television provides a broad opportunity to reach many more people, and we're excited about the possibilities with this campaign.

The objective of the TV spot is twofold. First, to better enable the launch of our new Feed Your Smile tagline and a simple, engaging cost-effective ad, that also reinforces key brand elements and ends with a call to action to come try the new Turkey Club. We are committed to these strategic brand growth investments to help drive both sales growth and profitability over the long term.

Now I'll turn to a brief walk through of our P&L and then an outlook for the year.

As I mentioned earlier, our total revenue was $108 million in the quarter, with company-operated same-store sales decrease of 4.9%. Breaking down same-store sales, our average check grew approximately 3.1%, driven by price.

Our shop-level margin for the quarter was 19.2% of company-operated sales as compared to 21.2% in the prior period. Cost of goods sold was 26.7% in the second quarter, an improvement of 60 basis points for the prior year driven by pricing.

Labor was 29.4%, which is an increase of about 70 basis points from the prior year, driven primarily by wage inflation, partially offset by our price increases. Occupancy expense was 13.3% in the quarter, an increase of 70 basis points compared to the prior year due to sales deleverage and certain occupancy-related costs including lease renewals, higher real estate taxes and higher common area maintenance.

Operating expenses were 11.4% in the quarter, an increase of 120 basis points compared to the prior year, due largely to sales deleverage and operating expense items such as repairs, maintenance, utilities and other expenses not directly variable with sales.

Our G&A expenses were approximately $10.9 million in the second quarter or 10.1% of total revenue, which is an increase of about $600,000 or 30 basis points as compared to the prior period, driven primarily from severance and equity compensation charges related to the departure of our previous CEO. Excluding these expenses, we achieved leverage of 60 basis points, driven primarily by our cost control initiatives and the reduction of our performance-based incentive accruals, given the company's performance to date.

Our adjusted EBITDA was $11.8 million for the quarter, which was a decrease of 9% from the prior year period, mostly driven from our drip line in same-store sales and labor and occupancy inflation.

With income tax expense of $186,000, which is primarily driven by the negative impact of the adoption of accounting standard update 2016-09, which pertains to the recognition of excess tax benefits and deficiencies related to share-based compensation. The adoption of the standard resulted in approximately $158,000 of additional income tax expense during the second quarter or about $0.01 per diluted share.

Excluding the new accounting standard and other immaterial onetime impacts, the effective tax rate would have been approximately 34%.

Our adjusted net income for the second quarter was $2.7 million or $0.11 per diluted share as compared to adjusted net income of $4 million or $0.15 per diluted share in the prior year period.

Regarding our share repurchase program, in the second quarter, we repurchased approximately 260,000 shares of Potbelly common stock in the open market for a total of approximately $3 million. At the end of the second quarter, we had $22.7 million available from our board authorized program for repurchases, which will continue as we move forward.

Our capital expenditures came in at approximately $8 million. Our balance sheet remains very strong, with a cash balance at the end of the second quarter of $21.2 million and we had 0 debt.

Turning now to our outlook for the full year fiscal 2017. We have continued to experience negative traffic trends from the end of the first quarter through the end of the second quarter of 2017. As we look out to the balance of 2017, while we expect to see some benefits from our sales growth initiatives, we currently do not contemplate an improvement in the challenged macro environment. Therefore, we have revised our comparable store sales guidance from the decline in the low single digits to a decline in the mid-single-digit range in 2017.

We continue to expect relatively modest levels of goods inflation for the full year and our food cost basket is over 90% locked for the year. Therefore, we now expect cost of goods sold to improve to the range of 26.5% to 27% versus the previous guidance of 26.5% to 27.5%.

We continue to expect labor as a percentage of sales to trend around 30%. Our guidance assumes continued wage pressures from minimum wage increases implemented last year as well as expected statutory and inflationary pressures in part, offset by the price we have taken.

Due to the challenging top line environment, we are tightly managing our expenses and reducing our pay-for-performance incentives in an effort to improve our bottom line performance.

For the year, we expect our adjusted G&A expense to be in the range of $41.5 million to $42.5 million, excluding the full year onetime cost of approximately $2.5 million related to our CEO transition costs. This G&A range is down from the original guidance of $44.5 million to $45.5 million. Given the top line challenges, we now expect adjusted net income per diluted share to be in the range of $0.30 to $0.33 for 2017. In addition, we continue to expect an effective tax rate in the range of 36% to 38%, excluding the impact of the new accounting standard.

Turning now to our new unit development. During the second quarter, we opened 16 new shops, including 3 franchise shops and 13 company-operated shops. As part of our ongoing strategic review, we expect to continue to moderate the pace of our company-operated shop growth going forward, and we now expect to achieve 30 to 35 new company-operated shops, down from our original outlook of 30 to 40 new shops.

In regard to franchising, we expect to achieve the low end of our outlook of 15 to 20 new shops. With our expected moderation in company-operated shop growth, we now expect to spend between $33 million and $35 million on CapEx in 2017.

In closing, Potbelly offers a welcoming environment, with the best-tasting sandwiches, hand-dipped shakes, daily baked cookies, all served quickly by really friendly people. It's our goal to have every customer leave our shop with a smile.

We've got a strong pipeline of menu innovation, which will further strengthen our connection with our customers. We've made and we'll continue to make investments in technology and convenience to drive a superior experience and there's enormous opportunity to reach more customers using delivery, catering and enhancing our marketing engagement tactics.

As I mentioned, we are undertaking a comprehensive review of our business and have engaged a financial adviser to help us evaluate our strategic business options. We believe that with our ongoing strategic review and the initiatives that we are implementing, we can navigate this challenging environment, drive our brand forward and create long-term sustainable value for our shareholders.

Thank you all for your time today. We appreciate you being on the call and the support of our business. Now I'll turn it over to the operator and open it up for questions.

(Operator Instructions) Our first question is from the line of Steve Anderson with Maxim Group.

What we've been hearing from some competitors in the industry is that we've seen a lot more promotional activity from the quick service burger giants. McDonalds, Burger King, have been doing a lot more in the premium sandwich category. So I just wanted to ask about your comments on that and see if you may be seeing some loss of customers to some of the burger giants? And do have a follow-up.

Sure. Thanks, Steve for joining the call and thanks for the question. Yes, sure, we see the same thing that you see and others in the industry see. It's a highly promotional environment. It does make things a bit more challenging. It's hard for us to individually tease out the impact on our traffic to any one competitor or even sub-sector. But clearly, that said, that is one of the impacts, Steve.

Okay. And with regard to your Potbelly Perks program and some of the sandwich giveaways we saw during June, what kind of impact do you think you're seeing in terms of increased additional food costs from those people who signed for the Potbelly Perks program?

Yes, sure. Thanks for bringing that up. We're actually proud of where we're at so far in the evolution of Potbelly Perks, with over 300,000 members so far, which is terrific. As for the cost. It's actually very much in line with what we anticipated when we set this program out, which means it's very profitable for us. In the end it's factored in, of course, into our COGS number, which is really good. We've obviously revised our guidance downwards on that in a favorable way. So it's maybe measured in 1/10 or so in the COGS, but not too much more than that, Steve.

Our next question is from the line of Sharon Zackfia with William Blair.

Just a few questions. This may have been implicit in your review, your strategic review, but are you open? Are you contemplating the potential to refranchise some company? And then, secondarily, I mean, you don't need me to tell you that lunch has been pretty challenged, industry wide for a while. So as you think about the going-forward strategy, is there any kind of efforts to diversify the business away from what is historically been a heavy lunch business?

Great. Great. Sharon, thanks for joining. Thanks for the questions. So yes, what I would say is the words that we included in the press release and that I noted in the script are very broad, right. This would be a very comprehensive review and really looking at every part of the business. So the words around potential ways to accelerate franchising, we're really open to anything. We're looking to getting ourselves a lot smarter about the ways in which we can do that, the resource that we'd need to be doing it. And the role, if any, that refranchising would play. So that is certainly on the table for evaluation and exploration. For the second part of your question, certainly with the concentration that's nearly about 60% lunch, looking at ways in which we can leverage other dayparts would also be part of the overall strategic evaluation. Challenging, it's not easy to do when you become so well known for lunch, and we don't want to lose that. But we think there's opportunities for us to build business in other parts of the day.

Our next question is from the line of Nicole Miller with Piper Jaffray.

Just 2 questions. On the franchising topic, do you envision as you embrace that more, so going forward being smaller groups of restaurant entrepreneurs? Or would you even consider master franchising? What do you favor and why? And then what might be the right mix, when you look really further down the road? Is it a 50-50 kind of model? Or would you go to 90% franchise? What makes sense in your mind?

Thanks, Nicole, for the question. Yes. What I would say is we're really early on in the strategic review process. And we need to learn a lot more about what makes most sense for us. What I can safely say is that with our historical pattern of really going to kind of more one off mom-and-pop kind of operations, and we kind of we're slowly evolving into 3 to 4 shop deals. I think we are certainly need to be open to larger deals, whether that evolves all the way to kind of master arrangements or not, premature for me to say at this point in our evaluation. Okay. And then, as to the percent, again, where I start there very safely is we've set forth quite some time that we want to move to 25% of franchise, and we sit here at 10%. So we've got a long way to go just to get to that 25%. So again, part of this evaluation will be that you look at all of the economics, all the implications on cash flows, the P&L and ultimately, balance sheet. We, amongst these different alternatives, we'll look at. In the end, it's all about what do we think will create the most shareholder value. So sorry to say, it's a little bit premature for me to give a percent out there yet, in terms of mix.

Well, that's fair and helpful. Just a second and last question. Earnings have been relatively flattish just going back sometime. Just big picture, so if you think about the drivers going forward, how would you prioritize things like growing faster or cutting costs or levering up and buying back shares and earnings in order to generate more earnings power?

Yes. Great question. I think one of the key outcomes of the work not to defer everything to this review that we're doing, will help us prioritize what makes the most sense. And everything you just named is on the table. I think that for the first part of what you said as to growing, I think that as we've implied on the call, we actually would look to be moderating to a degree anyway our own unit growth for a bit during kind of where we're at in the cycle and our own performance. We'll see how quickly, we can get about the business of improving and growing the franchise side of the business. I think that we would continue to be buying back shares, not in a position yet to say whether we would be accelerating that or at any point, but it does make sense for us right now. So we have all those opportunities and all of those will be with an eye toward improving our cash flows. Yes, improving earnings but importantly, improving our returns on invested capital.

Our next question is from the line of Gregory Francfort with Bank of America.

Mike, just had a few questions. The first, I think you mentioned when you're talking about perks, the potential to do external partnerships, or that you were doing external partnerships. Can you help frame up kind of what that opportunity is? Or what you guys are doing right now, on the perks external partnership side?

Yes. Sure. Maybe with a couple of examples, right. So this is meant to be value add for the members, right? So we're working with, for example, Yelp, for folks who go there and place an order on the Yelp website and this will go through to our system. We're working with one of the banks -- or credit card -- actually one of the banks and one of the credit card companies that would -- for our internal purposes of targeting acquisition. We're working with a couple of our own vendors. So one of our beverage vendors that for example, we could give away a free soda, right? To the members, whether it's a surprise and delight or having earned it, et cetera. So those are the kind of partnerships we're working on so far. And I think there's lot of creative things that our marketing folks are working on to add value for the perks members.

Great. And just switching back to the flowing unit growth and I guess, maybe can you help me understand how much new stores right now are the drag on restaurant margins? And then, I guess, also in terms of the G&A side, I think, you guys have G&A, as a percent of revenue, about -- I think about 10%. A lot of these sort of nongrowth casual diners are more like 5%. Is that an opportunity, where if you weren't opening up stores, you would have G&A, as a percent of revenue, at more like 5%? I guess, maybe, is there something structural in the Potbelly business, where G&A should be higher than sort of other nongrowth name? I guess, I'm just trying to think about it. If you guys were to cut off store growth, where would G&A go as a percent of revenue and kind of roughly, how you think about that?

Yes, sure. Thanks, Greg. Let me try to get at the -- maybe the second one first. So I may be a little less familiar with kind of industry average and maybe in that it was casual dining. I don't know at 5%. Certainly at 10%, we've always said we were looking to improve upon that over time. And yes, in the past we've said incremental ways of 20, 30 basis points a year, and ultimately getting kind of into the 8% plus kind of range. So I'm less familiar and so I can't really speak to the 5%. And so what we have to do and this is part of putting the whole picture together, and that's why this strategic review is we use very broad language here, because there's a lot that goes on as you make this -- as you moderate own growth and maybe perhaps looking to -- for avenues of franchising more. There's a lot of implications for the balance sheet and the P&L and the cash flows. And so you've to be very mindful as your -- the nature of your top line, if it's too change, and I'm not presupposing anything here, but you have to be very mindful and how you lever the G&A and how that evolves over time. So I know that maybe a bit of a vague answer, but I guess, the first part is, less familiar with the 5% but certainly know that we've been trying to make a progress on getting below 10% and to the high single digits. And then secondly, as we work through our analysis here, we will certainly be mindful of what G&A -- how G&A can lever over the future. And I'm sorry, Greg, the first question?

The other question was just on restaurant margins, and I guess, maybe what has been the performance of the new stores on the margin side? And how much of a drag do you think that is on your annual restaurant level margin, just the pace of openings right now?

Yes, sure. Maybe I can give you a qualitative answer to that. Certainly, are kind of static comp group is in excess of -- to well in excess of the overall margin that you would see on our P&L. And then as you look at those shops that are 1-month old or 3-months old or 6-months old, those certainly are well below that average. In some cases, they start off at a single-digit margin so that's a very significant drag. But they fairly quickly get themselves into low double digits, low teens and then, make their way up as we expect them to normalize. We always talk about how we get to year 2, and when we do our assessment of return on invested capital, we expect those to be kind of fully functioning, up to speed, scale, operational productivity, et cetera. So there is a drag. And that's why when you do a little bit less new shops, at least, in the short term, you get a benefit to a shop margin, which helps the bottom line in that short term.

Got it. And maybe, I may sneak one last one here. How many stores in your portfolio right now, are beyond 1 year or 2? So I guess, excluding the new stores, how many of your more mature stores are cash flow negative right now? And I guess, I don't know if you do think about that on an EBITDAR basis? And how many in the portfolio are negative as we stand today?

Yes. Sure. So as part of that, well I might not have a specific number for you. We look at it both on a shop margin or near to your EBITDA kind of number. But yes, we also look at it on an EBITDAR level, so looking at it before rent as well. And we are focused on those shops that are the least profitable. In fact, one element of our Strat review is looking at those shops that are least profitable, and trying to figure out all the things that we can creatively with those, whether they are negotiating lease terms or getting up from under the shops and closing them. So that's -- so we are focused on them. And that will be, again, one of those outcomes of our Strat review.

The next question is from the line of Mary McNellis with Robert W. Baird.

First, just a couple of clarifications. Mike, within the average check of 31 for Q2, can you just break out specifically how much of that was price versus mix? And then, also, what was the drag from Easter during the quarter?

Okay. So the drag from Easter, I've got Andy here to help me out. You get a few tenths drag from the quarter?

Yes.

Yes. And then, the breakdown that actually, that was all price, that check. It was essentially all price. It was a very modest impact from mix.

Okay. That's helpful. And then we've heard from several companies the trends exiting Q2 and early Q2 have gotten softer for the industry overall, so I was wondering if you'd be willing to comment on whether you're seeing a similar trend in your business. And then maybe related to that, if you're willing to provide any perspective on how you're thinking about the progression of comps for the second half of the year, given the easier comparisons?

Yes, certainly, so what I would say about the progression within the quarter, it was kind of up and down throughout the second quarter, and that May was a bit better than April and June. As we entered the quarter, I would say, by a matter of a couple of tenths, June was a little bit softer than the Q2 average. And then as we enter July, and this is what you've heard from many others. We've read it from many others. There was a softness as the quarter ended and a softness that continued in July. Not dramatically so, but again, measured in a few tenths. And so back to your question about outlook and what I said during the prepared remarks. The part of the reason why we revised our outlook for the second half is that we expected that as we came upon easier comparisons which we had to some degree in June and to a little bit greater degree in July, we didn't see that improvement that we expected to see. What the industry saw which is a little bit of softening, overall. So that, in part, is what caused us to refine our overall guidance for the full year-end and thus the second half.

(Operator Instructions) The next question is from the line of Steve Anderson with Maxim Group.

This is a follow-up question. Certainly, with the -- we've heard from few operators talking about some of the weather impacts during the quarter, particularly in the eastern, central U.S. So I just wanted to see if some of the heavier rainfalls had any impact on your foot traffic and if you may be able to quantify that?

Yes, sure. What I would say is we -- I wouldn't attribute much, we did have some modest negative impact if you look at the quarter as a whole. What I would say geographically, we don't -- we didn't see much in way of differences across our geographies in terms of performance. As I said yes, there were some what impact in some parts versus others. But part of some of what we've read in -- from industry players and the various indices out there is that when they look at geographic differences, I think there are some favorability on a relative basis in the West, where we are not. Perhaps there was some favorable in the Southeast where we're not. So those parts of the country, where there is that continued softness and maybe a little bit more so at the end of June and in July, in the Midwest, in Texas, et cetera. Those are places where we're pretty heavily concentrated. So as to weather, not significant. I would call it a modest impact. And then geographically, that's -- those are the comments I've just made.

Thank you. At this time I would turn the floor back to Mike Coyne for closing remarks.

Terrific. Thanks, operator. Thank you all for attending. Let me just reiterate that while we're in a tough part of the cycle and disappointed with our top line, we're working hard to maintain margins, get our flow-through. We've got a great brand, great opportunities ahead. We believe in the strength of our people, the fundamentals of the business. As I said, on the one hand, we're focused on our near-term initiatives to drive sales. And very focused on what I mentioned in terms of our -- a comprehensive strategic review. So thank you, and thank the many people of the Potbelly Nation, who work very hard every day on our behalf. Thank you.

Thank you. This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.