Potbelly Corporation
Q1 2017 Earnings Call Transcript

Published: 3 May 2017

[Operator:]

Greetings, and welcome to the Potbelly First Quarter 2017 Earnings Call and Webcast. At this time, all participants are in a listen-only mode. An interactive question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Mr. Matt Revord, Potbelly's Chief Legal Officer. Thank you. You may begin.

[Matthew J. Revord:]

Good afternoon, everyone, and welcome to our first 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 the 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 Securities and Exchange Commission, which are available at sec.gov. Our presenters today are Aylwin Lewis, our Chairman and Chief Executive Officer, and Mike Coyne, our Chief Financial Officer. Aylwin will begin with his perspective on the first quarter performance and provide a discussion of our ongoing strategic initiatives. Mike will then review our financial results and future outlook in more detail before we open up the call for your questions. Aylwin?

[Aylwin B. Lewis:]

Thanks, Matt. Good afternoon, everyone. Thanks for joining the call. During the first quarter, we generated revenue of $102 million, an increase of 6% driven by our new unit growth. We opened 11 new shops including 8 new franchise shops and 3 company-operated shops. We still delivered adjusted EBITDA growth of 12% to $9.2 million, adjusted net income growth of approximately 17% to $1.3 million, and adjusted EPS growth of 25% to $0.05 per diluted share. The operating environment remains highly challenging for restaurants and our business performance in the first quarter was reflective of the negative traffic trends experienced throughout most of the industry. The comparable same-store sales declined 3.1% during the quarter. This fell short of our expectations as the negative traffic trends that we saw at the end of 2016 declined through the first quarter and continues to persist. As we view our outlook, it is clear that the industry headwinds continue unabated and traffic-building remains challenging. While we expect comparisons to ease in the second half of the year as we began to lap the industry headwinds, we assume a continuation of concurrent macro trend and our outlook is for low single digit decrease in comparable same-store sales for 2017. We're not satisfied with these outcomes and we are evaluating new strategies to drive sales growth and profitability. We're dedicating teams to uncover cost-saving opportunities in operating expenses, to manage profitability and optimizing our capital spend to align with market conditions. While the current restaurant environment remains challenging, we are reassured by the fact that we have a proven brand and remain committed to enhancing our value equation and delivering on our promise of providing great fresh food served quickly by friendly associates in a warm and inviting atmosphere at a good price. Let's discuss several key strategic areas that we are focused on to drive operational excellence, improve our performance and increase shareholder value. A major focus in 2017 is to clearly communicate our differentiation from other fast casual concepts, as well as to enhance convenience and loyalty. As an organization, we can vastly improve on our storytelling of our special brand, its long history of great people and exceptional food, and this can be a sales driver for us when communicated the right way. As a result, we will soon be refreshing our brand message, creating a new tagline, updating the content of our digital advertising. In addition, Potbelly is turning 40 years this year and, to that end, we're having a month-long celebration in June. All elements of the brand will be featured during this 30-day period

[Michael W. Coyne:]

Thanks, Aylwin, and good afternoon, everyone. As Aylwin mentioned, I will review the P&L and give you some of the highlights associated with our first quarter results. I will also provide a summary of our outlook for the remainder of 2017. Starting with the top line, total revenue increased 6% to $102 million in the first quarter driven predominantly by our new unit growth. During the first quarter, our company-operated same-store sales decreased 3.1%. Breaking down same-store sales, our average check grew 3.1% driven by price. Moving down to shop P&L, shop level margin for the quarter was 17.8% of company-operated sales as compared to 18.6% in the prior-year period. Our cost of goods sold as a percent of company-operated sales was 26.4% in the first quarter, an improvement of 110 basis points to the prior year driven by the combined impact of pricing and favorable commodity trends. Labor was 30.2%, which was an increase of about 70 basis points versus the prior year driven primarily by wage inflation and sales deleverage partially offset by our price increases. Occupancy expense was 14% in the first quarter, an increase of 60 basis points as compared to the prior year due to sales deleverage and increases in certain occupancy-related costs including lease renewals, higher real estate taxes and higher common area maintenance. Operating expenses as a percent of sales were 11.5% in the first quarter, an increase of 40 basis points compared to the prior-year period. Our operating expenses include items like repairs and maintenance, credit card fees, insurance, utilities and supplies and therefore have variability from quarter to quarter. We remain focused on finding opportunities to drive productivity across our shop level expenses to offset these cost pressures. Our general and administrative expenses were approximately $10.4 million in the first quarter or 10.2% of total revenue, which is a reduction of about $200,000 or 80 basis points as compared to the prior-year period driven primarily from advertising and performance-based incentive expenses. The timing of our advertising expense in 2017 is aligned to sequence with our mobile app launch and our brand and storytelling initiatives later this year. Our adjusted EBITDA was $9.2 million in the quarter, which was an increase of 12% from the prior-year period. Note that beginning in the first quarter of 2017, we modified our definition of adjusted EBITDA to eliminate the adjustment of preopening and public company costs in order to improve the usefulness and comparability of this measure. Prior period adjusted EBITDA financial measures have been restated to reflect this change. We had an effective tax rate of 45% in the first quarter, which was negatively impacted by the adoption of a new accounting standard which relates to the recognition of excess tax benefit and deficiencies related to stock option exercises. The adoption of this standard resulted in approximately $100,000 of additional income tax expense during the first quarter, which increased our tax rate by approximately 7 percentage points. Excluding this item, the effective tax rate would have been 37.6%. Our adjusted net income for the first quarter was $1.3 million or an increase of 17% from $1.1 million in the prior-year period and our adjusted net income per diluted share was $0.05, an increase of approximately 25% from the prior-year period. Regarding our share repurchase program, in the first quarter we repurchased approximately 153,000 shares of Potbelly common stock in the open market for a total of approximately $2 million. At the end of the first quarter, we had $25.7 million available from our board authorized program for repurchases, which will continue as we move forward. Our CapEx came in at approximately $7 million and our balance sheet remains very strong with cash balance at the end of the first quarter of $27.4 million and we have zero debt. Now turning to our outlook for the full year fiscal 2017. We have seen a continuation of the negative traffic trends from the end of the fourth quarter 2016 which declined through the first quarter 2017. As we look out to the balance of 2017, we do not contemplate an improvement in the challenged macro environment in our plan and so we expect comparable store sales to decline in the low single-digit range in 2017. As Aylwin mentioned earlier, we were notified by the City of Chicago that we'd be required to vacate the space of our shop at Midway by the middle of May of 2017. For perspective, for the year ended December 25, 2016, our Midway shop represented approximately $7.8 million in revenue and approximately $2 million in income before taxes. We estimate the impact of the loss of Midway for the balance of the year to be approximately $0.04 of EPS. We continue to expect relatively modest level of goods inflation, accelerating slightly as we progress through the year given expectations around timing of inflation and our pricing. We still anticipate cost of goods sold in the range of 26.5% to 27.5% for 2017 and our food cost basket is about 80% locked for the year. We continue to expect labor as a percent of sales to trend around 30%. Our guidance assumes continued wage pressures from minimal wage increases implemented last year as well as expected minimum wage increases in 2017 in major markets in part offset by the price that we have taken. We will continue to manage our labor expense through continued efforts and investments to improve our labor productivity. 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. Therefore, we have revised our outlook for G&A expense to be in the range of $42 million to $43 million, down from our original guidance of $44.5 million to $45.5 million. For the year, we now expect adjusted net income in the range of $9 million to $10 million and adjusted net income per diluted share in the range of $0.35 to $0.38. This revision is driven by our softer sales growth assumptions and the closure of our Midway shop. In addition, we expect an effective tax rate in the range of 36% to 38% excluding the impact of the new accounting standard. As a reminder, our full year fiscal 2017 is a 53-week year and our guidance includes an extra week in our fourth quarter. For context, the impact of the fifty-third week is estimated to contribute approximately $7 million of revenue and approximately $700,000 of adjusted EBITDA. We do not expect a meaningful impact to our bottom line. On shop development, we reiterate our prior outlook and expect to open 30 to 40 company-operated shops and 15 to 20 franchise shops for a total of 45 to 60 total new shops, which we expect to be back end weighted waited but to a lesser degree as compared to 2016. We continue to expect to spend between $37 million and $39 million in CapEx in 2017. And although we do not provide quarterly guidance, I want to provide you with some color on certain puts and takes as you think about the cadence of our quarterly performance. As we discussed, we have seen traffic trends continue to decline from the end of 2016 through the first quarter. We expect comparisons to ease as we progress throughout the year. In addition, we expect inflation impacts to increase during the year while noting that our pricing from August of 2016 rolls off. On the unit development front, again I want to reiterate that we expect our shop development in 2017 to be back end weighted, again to a lesser extent than our heavily back end weighted cadence in 2016. So with that, I'm going to turn it back over to Aylwin for summary remarks. Aylwin?

[Aylwin B. Lewis:]

Thanks, Mike. I'm disappointed with the performance relative to sales in the first quarter. It's going to be a very challenging year in 2017. We're not going to wait and hope that trends get better. We believe we're focused on the right near-term strategies that will enable us to compete more effectively in the environment, particularly our focus on technology and innovation. We continue to place sharp focus on cost management and capital optimization to ensure that we have the resources we need to drive our strategic initiatives. The Potbelly brand remains strong. We believe in the long-term fundamentals of the business. We believe the actions we are taking now will leave us well-positioned to accelerate growth as the operating environment improves. We remain committed to achieving our long-term goals in the future. With that, we'll ask – open it up for questions.

[Operator:]

Thank you. At this time, we will be conducting a question-and-answer session. One moment please while we poll for questions. Our first question comes from David Tarantino with Robert W. Baird. Please go ahead.

[David E. Tarantino:]

Hi. Good afternoon. Just a couple of questions, the first one being a clarification on your guidance for the year. So, I think, you mentioned you expected comparisons to get better as the year progresses, so I'm just wondering if you could frame out how you're thinking about that a little bit more clearly. Are you expecting some progress on the comps in the second quarter? Or are you thinking more like we won't see progress until the back half? And if you can comment on current trends to date in the quarter, that would be helpful.

[Michael W. Coyne:]

Sure. I can start and then Aylwin can come in after. Yeah, I think that you should think more about the improvement in the comps coming in the second half of the year, while different in magnitude, consistent with our thoughts a few months back. So that's how I'd think about that. And then the quarter to date, what I'd say first about the first quarter at the minus 3.1% comp, March actually was our weakest of the three months and it's really those trends that have continued into April quarter to-date. So – and that's in part the March/April kind of trends where we're – off of what we're forecasting and it's really led us down the path, without seeing any brightening in the broader environment, led us to refine our outlook.

[David E. Tarantino:]

Got it. And then just a follow-up on that last comment. I mean, we've heard from several companies that March and April seems like it has gotten better for the industry overall and it doesn't seem like you're following that same pattern. So could you maybe opine on what you think is happening in your business and whether you're benchmarking versus other indicators that you're seeing that kind of weakness? Any perspective on that would be helpful.

[Aylwin B. Lewis:]

We're using the normal black box stuff. We've had three or four folks in with outside industry data that have more information than us and it's been pretty consistent when you look at the broad patterns. You may have some differences. The Easter shift definitely hurts in Q3 – that was in Q4, yeah, Easter shift hurts in Q4. It helped a little bit in Q3. So – and it's geographical for us. The middle of the country that is typically very strong is fairly soft. So we're seeing some decent stuff on the two coasts, but center of country is soft.

[David E. Tarantino:]

Okay. That's helpful. And then, Aylwin, just a question. As you think about the state of the business and where the stock is likely to be trading tomorrow, I think, investors have been asking is it the time to start thinking about other value-enhancing initiatives? And I guess, one that comes up frequently is a more aggressive approach to franchising and perhaps refranchising company stores and slowing down the capital deployment in the company stores. So could you just comment on that, I guess, strategy and whether that's something you're willing to consider at this point?

[Aylwin B. Lewis:]

Well, I mean, we don't have a tight philosophy on company versus franchise. We're definitely going to accelerate it. What's key is how you operate the business. If you're down, being down and you got close to 19% margin, it's still better than down and you've got a 6% margin. So I think our overall strategy is fine. The markets you would refranchise would be tremendously profitable. I don't see how that helps us with how we generate the cash. We're comfortable with the returns that our new shops are getting. We are moderating our company targets this year 30 to 40 versus 40 to 50 this time last year and we're being guided by the marketplace. We continue to open up shops with good sales and profit results. So, we're heavily looking for franchisees in California. We have a lot of multiunit agreements, so I feel like we're on track with that. It's a cycle in the industry that's really tough and particularly tough now we're public sandwich company, but we're also aware of what's going on in the – particularly the sandwich industry. So, I mean, refranchising is not a panacea to when you're in a down cycle. And we're not losing money. We're still making money. We still have (27

[David E. Tarantino:]

Great. That's helpful. Thank you.

[Operator:]

Our next question is from Sharon Zackfia from William Blair. Please go ahead.

[Matt J. Curtis:]

Hi, guys. Matt Curtis on for Sharon. I guess first question on average check. You mentioned it was a benefit of 3.1%. Could you just split that out into the price benefit versus mix?

[Michael W. Coyne:]

Yes, sure. The price was approximately 3.4% and the mix was actually down about 0.3%.

[Matt J. Curtis:]

Okay. And for negative mix, I'm just thinking about the Turkey Fresco. I think maybe that was lapping against Protein Power Salads last year, which was at I think a higher price point, close to $8. Is that what drove the negative mix? Or was it something else?

[Aylwin B. Lewis:]

Yeah. The protein and avocado, it was one period. We've only had one period of the Turkey Fresco, so first quarter it was Skinny Pear and pretty much what we had prior year.

[Matt J. Curtis:]

Okay. And then I guess just on the traffic weakness in general in the first quarter and continuing, I guess, is there really something you can point to that is specifically, it's stemming from Potbelly, like either having to do with the geographic distribution or something else? Or is it really more of a generalized industry trend that's impacting you?

[Aylwin B. Lewis:]

Like I said before, it's kind of the middle of the country where our strength is, has been in the past, and it's certain dayparts, but it is the middle of the country.

[Matt J. Curtis:]

Okay. Appreciate it. Thank you.

[Operator:]

Our next question is from Nicole Miller from Piper Jaffray. Please go ahead.

[Nicole M. Miller Regan:]

Thank you. Good afternoon. I'd just one clarifying point and then a question. Was the CapEx guidance of $37 million to $39 million maintained? And I'm sorry if I missed that. And then just the bigger picture question, there's a lot of great ideas and strategies that you covered in your prepared remarks, Aylwin. How do you prioritize what you do? And would we first see a positive sales impact or a positive margin impact? Thank you.

[Michael W. Coyne:]

I'll just start by saying it's the same guidance on the $37 million to $39 million as we stated before.

[Aylwin B. Lewis:]

So things like the management tools, you should see margin impact. So things like better selection tool, the productivity tablet where managers can make decisions and run the business from the floor. That's all geared towards productivity and that will help the margins. The Shop 2020 we definitely hope that's going to be a customer and sales piece. The branding and the storytelling is definitely the customer piece. We hope to reveal the new tagline with the birthday. I think, the birthday celebration is a great opportunity to reintroduce the brand to the world and so we're excited about that. That'll happen in June. June 1 is actually the birthdate that we are having a big shindig in Chicago. So what we're trying to do now is not leave any stones unturned relative to technology. We do believe technology and innovation, it has to accelerate if you're going to compete in this environment. And it is around from a customer-facing standpoint uberization. What I actually mean is uber convenience. And then the second part is just being very efficient with what we do. We're trying to become less paper, more efficient. So it's actually both. If I'm going to err on the side of upgrading the spending, it will be on the side of growing sales. So the digital menu boards, we tested it last year. We were ready to trigger that. We found a vendor that could save us about a third of the cost per shop, so fortunately we waited and got a better negotiation. We're going to accelerate the digital menu boards now. So that's a long-winded answer but customer-facing, technology broadly across the company as we try to become a digital company and you should see a margin impact and you should see a sales impact.

[Nicole M. Miller Regan:]

Thank you very much.

[Operator:]

Our next question is from Karen Holthouse from Goldman Sachs. Please go ahead.

[Gregory Lum:]

Hi. Good afternoon. This is actually Greg Lum on for Karen today. So I had a couple of questions related to the mobile app. So along with the mobile app launch, you actually offered free sandwiches with the trial. Just wondering what the impact to traffic was in the quarter. And then more specifically what line item we should expect to see the cost hit?

[Aylwin B. Lewis:]

I'm sorry. Can you repeat?

[Gregory Lum:]

Sorry. So a couple questions on the mobile app. So with the mobile app launch, you had a free sandwich offer with the trial of the app. So I was just wondering what impact that might've had on the traffic number in the comp. And then related to the cost, what line item we should expect to see the costs related to the free sandwiches hit?

[Aylwin B. Lewis:]

Yeah. The free sandwich was about a two-week to three-week period of time. That cost is already in COGS, so we're covering that through COGS and you see our COGS number is a pretty good number. At 200,000 sign-ups, you didn't have all 200,000 get the free sandwich. So you didn't see an impact on the sales. It is the foundation that you're laying. It's part of the technology. It's part of convenience factor. And then the big thing is that you're going to start getting data from those customers that you'll be able to use to market to those customers more directly. And then as we add more features that make convenience, over time we hope the business will grow using the app.

[Gregory Lum:]

Okay. And then how does – sorry.

[Aylwin B. Lewis:]

(34

[Gregory Lum:]

Okay. And then I was wondering if you had any data on just how usage compared at peak versus off-peak, and then whether you noticed any operational challenges with the rollout of the app?

[Aylwin B. Lewis:]

Yeah, I'd say it was an A minus rollout, and we did have some things and we jumped right on it. For instance, you had delivery zones and before we could specify by shop, we rolled out the app and it defaulted to the closest shop. And if you were a customer of ours and outside that default line, you couldn't order. So it took us about two weeks to solve that one. The thing with all of this stuff, this technology, is that you're tied to your POS. The MCR is the POS shop. Everybody knows in industry POS vendors are not the most innovative. We have two vendors from the Northeast that we're working with, that one did the app, the other one did the website. They're very progressive, very good developers. It's all governed by your POS. And so we had some issues. We resolved those issues and now we're working kind of on the second phase of the rollout with enhancements. The real thing that we think will drive business over time is the rewards program and that's meant to delight customers as well as to give them benefits and features based on how much they spend with us.

[Gregory Lum:]

Thank you.

[Operator:]

Our next question comes from Gregory Francfort from Bank of America. Please go ahead.

[Unknown Speaker:]

Hey, guys. It's actually John Michael (36

[Aylwin B. Lewis:]

We're at three right now. The goal is to have two to three this year and that's real. Eventually, we see catering kitchens almost in every city we do business. It's a great way to aggregate orders and really grow that business. You can maintain quality more effectively. The shops will always have a delivery function and a catering function, but we want to aggregate those big orders and get those big orders. And then folks say it's overbuilt. Folks say it's oversaturated. I can't say it'll shake out. You know better than me in terms of folks that are closing their doors. Our goal is with our balance sheet and our financial discipline, we can withstand this cycle and come out of it stronger. If we're in a marketplace where it's not wise to invest our capital, we won't do it. If we're in a marketplace because of closures, we can maximize our capital by getting into new marketplaces or getting into new neighborhoods, that's what we're going to do. So we feel like from a development standpoint, we're perfectly poised to maximize whatever the marketplace dictates. The fortunate thing is our franchisees are continuing to build, opening some really good success. And so we feel very good about the development effort and how we're managing the capital and how we're moderating based on market conditions.

[Unknown Speaker:]

Make sense. Thanks, Aylwin.

[Operator:]

And our next question comes from Steve Anderson from Maxim Group. Please go ahead.

[Stephen Anderson:]

Yes. Good afternoon. I'm calling to ask besides the economic difficulties that you've noted, but we've heard from some operators that more recently that they've seen some strength in the Midwest and also they've seen some milder weather. In Greater Chicago, they had the least amount of snowfall in more than 15 years and milder than usual temperatures. You typically – I mean, at the last call you said weather hurts you in the fourth quarter, but it would seem to – do you think it might have helped you this quarter, but what do you think happened in your markets?

[Aylwin B. Lewis:]

Yeah, it was a mild winter for January and February. March we had a major snowstorm in the East Coast that really hurt P3. (39

[Stephen Anderson:]

All right. Thank you.

[Operator:]

And as there's no further questions, I'd like to turn the floor back over to Mr. Lewis for any closing comments.

[Aylwin B. Lewis:]

Thanks for your questions and participation. Obviously, don't like the sales trend. As I've expressed in the remarks and through the answers is that we're working hard to abate it. Companies that will win and are winning today have done a really good job with technology, so we're trying to follow suit. We're going to have to disrupt your current service model so you can anticipate what the customers' needs are for tomorrow. And we're going to keep working at it. The strength of the balance sheet, the strength of the P&L, allows us to come out of this. We're spending capital judiciously. We're driving franchising hard and we think we'll come out of this in good shape. Midway hurts and the 16 years we have had that site, we felt it was a privilege. It was a brand-builder, but losing an $8 million shop and a $2 million profit shop is difficult, but we can withstand it. Definitely can withstand it better today than if it had happened three years ago or five years ago. So thanks for your interest, appreciate the support, and buy more sandwiches.

[Operator:]

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