Unverified Participant David James Boennighausen - Noodles & Co..

David E. Tarantino - Robert W. Baird & Co., Inc. (Broker) Nicole Miller Regan - Piper Jaffray & Co. Jake Rowland Bartlett - SunTrust Robinson Humphrey, Inc. Ryan Royce - BMO Capital Markets (United States).

Good afternoon ladies and gentlemen and welcome to the Noodles & Company's Third Quarter Earnings Conference Call. As a reminder, this conference call is being recorded. I would now like to turn the conference over to you host, Ms. Sue Daggett, (00:35) President of Finance. Please go ahead..

Thank you and good afternoon everyone and welcome to our third quarter 2016 earnings call. Here with me this afternoon is Dave Boennighausen, our CFO and Interim Chief Executive Officer. Let me start by going over a few regulatory matters.

I'd like to note that during our opening remarks and in response to your questions, we may make forward-looking statements regarding future events or the future financial performance of the company.

Any such items, including our guidance about our anticipated results in 2016 and details relating to our future performance, should be considered forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

Such statements are only projections and actual events or results could differ materially from those projections due to a number of risks and uncertainties.

The Safe Harbor statement in this afternoon's news release and the cautionary statement in the company's most recent Form 10-K are considered a part of this conference call, including the portions of each that set forth the risks and uncertainties related to the company's forward-looking statements.

I refer you to the documents the company files from time to time with the Securities and Exchange Commission, specifically the company's Annual Report on Form 10-K for its 2015 fiscal year.

This document contains and identifies important factors that could cause actual results to differ materially from those contained in our projections or forward-looking statements. Now, I would like to turn it over to Dave..

Thank you, Sue, and good afternoon everyone. Earlier today we reported an adjusted net loss of $0.04 per diluted share with comparable sales declining 0.7% system-wide comprised of a 0.9% decline at company restaurants, and a 0.6% increase at franchise restaurants.

Our adjusted EBITDA declined 29% in the third quarter, primarily the result of declining restaurant level margins due to a small segment of our total restaurant base that is significantly underperforming. I will discuss the impact of underperforming restaurants on our financials later on in this call as well as our strategy to address them.

We have seen modest sequential improvement from the time we last spoke and I'm pleased to note that this trend in comparable restaurant sales is continuing.

Our comparable sales quarter to date through yesterday, November 2, stand at negative 0.2% system-wide, including positive 2.4% franchise comparable sales, and negative 0.6% company comparable sales. We've also seen though, and will likely continue to see, volatility in the comparable sales figure.

As you think about our current sales trajectory and that volatility, keep in mind that last year, during the fourth quarter, we employed a significant amount of discount activity in addition to a marketing spend of 1.9% of sales, which was considerably higher than our historical run rate.

In contrast, during the fourth quarter of this year, instead of investing in short-term traffic building activities, our focus is on operational and menu improvements. This results in a more normal level of discounting and anticipated marketing expense of only approximately 1.2% of sales.

While this focus is likely to impact comparable sales during the fourth quarter, we anticipate it will enhance our long-term guest value proposition, operational consistency and profitability.

Despite the near-term headwind of reduced marketing activity, we do believe we are beginning to see momentum from the culinary and operational initiatives that we discussed on our most recent earnings call.

We believe firmly that in order to improve our revenue and earnings, we need to improve our core menu as well as improve both operational consistency and efficiency. We're taking a parallel path approach to reach these initiatives.

The first path consists of items that are being implemented nationwide to improve operational execution, stimulate a greater level of interest in our menu, and strengthen our team development. In mid-October, we made numerous changes to streamline our menu to improve operational consistency and to reduce guest confusion.

The most meaningful of these changes has been the elimination of our sandwich category nationwide. This category never quite resonated with our guests, ultimately representing only a few percentage points of menu mix. Moreover, they were some of the most challenging items on our menu to execute.

We had previously tested the removal of sandwiches in certain markets and we thus far have seen negligible resistance to-date as we have made this change system-wide. We also anticipate that the removal of sandwiches has the potential for a meaningful improvement in overall transaction times.

Also, in the first half of our strategy in mid-October, we launched nationally a return of our line of adult mac & cheeses, including a Buffalo Mac, Bacon Mac & Cheeseburger and BBQ Pork Mac.

These dishes affirm our strength in this popular flavor profile and allow us the opportunity to showcase our culinary skills while increasing average check and profitability. As you know, our globally inspired menu focused on noodles and pasta dishes is unique and differentiated in the restaurant space.

Much of the menu innovation that you will see over the next several months will seek to improve our core menu or add new menu items that exemplify these strengths.

While we simplified our menu overall and reintroduced our adult Mac & Cheese, we have also implemented nationally a number of smaller personnel and operational changes that we believe will improve both the team member and the guest experience.

These include changes to our food preparation and operations procedures as well as the introduction of new compensation programs and people investments to incentivize, retain, and develop our team members. While it is early, we are already seeing team member and guest satisfaction scores move in the right direction.

We expect this first strategic path to contribute meaningfully to the success of the brand, but we also firmly believe that for the brand to reach its true potential, we deployed the second parallel path of initiatives that can carry the brand to the next level.

Although more intensive, these are initiatives that we believe will have the most significant long-term impact on the guest experience and on our financial performance.

First, we believe there are important steps that we need to take to regain our culinary prowess and create the craveable amazing flavors that guests will return over and over again for.

For our primary menu, we are testing significant improvement, such as the addition of oven-roasted tomatoes in several of our Mediterranean dishes, more flavorful sauces, and higher quality core ingredients.

We are also testing the replacement of underperforming items with new items, such as a Thai green chicken curry, beef bolognese and pork adobo; all items that we feel support our World Kitchen positioning and will resonate with new and existing guests alike.

Supporting our culinary test, we are also testing a new menu layout that places much more emphasis on our global noodle and pasta flavors versus our prior category focus. As we test these menu improvements in our second strategic path, we are also testing significant changes to our labor and operational model to improve consistency and efficiency.

For example, we are testing guest bussing in several restaurants to reduce front of house labor pressures and improve cleanliness across the system.

We are also testing a more seamless pickup design to encourage online ordering, which we believe has the ability to improve order accuracy, provide labor savings, and meet the ever-increasing needs of today guests for convenience.

Finally, another initiative we are testing that we believe will help us reach the next level is our NoodlesREWARDS loyalty program, which we launched in a select group of restaurants a couple of weeks ago.

We are encouraged by the early results from this test as we feel a rewards program will allow us to increase frequency not only through those rewards, but perhaps more importantly by allowing us to gain a better understanding and a deeper relationship with our guests.

We feel all of these initiatives which are in different phases of test and select restaurants can really propel the business' trajectory over many years to come, and we anticipate that they will begin rolling out nationally in early 2017.

Aside from menu and operational initiatives, the other large topic from the last call that I'd like to discuss is the impact of certain underperforming restaurants and our strategy to address them.

This small segment of our overall restaurant base, which is primarily found in more recent classes has been a significant burden on both our human and financial capital on recent quarters.

As we've discussed in the past, we feel that our rapid growth, particularly in new markets that lack brand awareness put a strain on our ability to execute consistently and efficiently.

As we have also noted, we are slowing down unit growth as we address these challenges, with 10 to 15 openings expected in 2017, which will primarily be in low risk markets with strong brand awareness and proven success.

However, we also need to address the existing underperformers in the portfolio, which have been the primary cause of recent earnings and margin declines and they're also the cause of our modest reduction in earnings guidance for full year 2016.

To put this in perspective, our adjusted EBITDA of $6.2 million in the third quarter was negatively impacted approximately $2.6 million by the bottom 10% of our restaurants. We recognize that many of the restaurants that are underperforming have a substantial hurdle to overcome, will require a significant amount of resources to turnaround.

We are currently looking at several options for these underperforming restaurants, including possible closures as well as considering the potential for refranchising of certain markets to local operators who may be better equipped to develop these respective markets.

Aside from reducing the financial burden, we also believe these potential actions would allow us to focus our resources on our large base of successful restaurants that have greater earnings potential. We are looking at various alternatives to financially support these actions.

While we are not far enough along in this process to be able to share details, we are confident that we will arrive at the right strategy to help us best deal with these underperformers and meaningfully improve the profitability of the company.

We are also finalizing an amendment to our credit facility that will allow us the flexibility needed to pursue these alternatives. We anticipate filing this amendment in the coming days. At the end of the third quarter, we had $84.5 million in debt outstanding on our $100 million credit facility. Cash on hand was $2 million.

During the third quarter, we did book liability of $3 million related to the employee litigation matter that was disclosed earlier this year. We do not anticipate any cash payments of these liabilities until early to mid 2017.

Although we anticipate stronger ongoing operating cash flow given our slower unit growth rate, we are also implementing a few other actions to strengthen our financial position. As discussed on the last earnings call, in August of this year, we implemented a restructuring that will reduce our G&A labor overhead by over $2.5 million annually.

We have also made the decision to slow down our investment in naturally raised proteins, namely our steak and chicken offerings, as we have had difficulty securing supply at an acceptable price. We feel it will be important to balance our long-term goal of offering all naturally raised proteins with the current supply constrains in the industry.

Lastly, with regard to our ongoing CEO search, the board has retained a search firm and will be looking at both internal and external candidates to fill the position. We'll provide an update on that process as it concludes. In closing, I remain confident in the future success of Noodles & Co.

We have a unique differentiated brand, a tremendous team of caring, talented individuals and a strong infrastructure and asset base of profitable restaurants to build from. We are taking important bold steps to increase the culinary relevancy of the brand and to improve operational consistency and efficiency.

We believe these initiatives can and will provide a significant improvement in the business' trajectory and its profitability. We are also in the process of taking the appropriate steps to address the underperforming units that have been a persistent burden on the company's financial performance.

I look forward to sharing with you our progress on these initiatives over upcoming calls. I would now like to turn it over to Q&A. Emily, can you please open the lines..

And your first question comes from the line of David Tarantino from Robert W. Baird. Please go ahead..

Hi, good afternoon. Dave, I just wanted to ask on these underperforming markets or units. I guess how quickly do you think you'll be able to address those, whether it's through closings or refranchising? And then I have a separate question on those..

Sure, yeah. So, David, no, I appreciate that. We're looking at a lot of different alternatives and we do think we'll be able to move relatively quickly on them. That said, we are a little bit early in the process. So I don't think we can necessarily commit to a timetable on when we'll be able to effect any closures or refranchising..

I guess the follow-up on that would be, I guess, what is the decision matrix you're using related to those? I guess, what do you need to see to decide to close them, and I guess on the other hand, what scenarios would make refranchising possible?.

Certainly, so a couple things in there. We're evaluating the entire portfolio and looking, certainly, cash flow would be the number one thing that you would look at relative to what the occupancy costs are at that restaurant, how comfortable we feel about the trade area as well as our site characteristics.

As we go through that lens, ultimately that shakes out a group of restaurants that we believe either it's going to be too long of a road or require too much resources, too much distraction in order to make that restaurant be profitable, in which case you probably would be looking at closing it.

On the refranchising component, I think we're more looking at markets where there is good real estate, there is the opportunity to develop, significantly higher brand awareness, the ability to really unlock a lot of earnings from those restaurants where we feel that it would be too much of a distraction for us to try to effect that entirely from a company-owned perspective..

Got it. Okay.

And then could you explain, I guess, the changes in the credit facility, why those were needed? And if there are any terms that we should be aware of that are new related to compliant or covenants and interest expense?.

Sure. So we're still finalizing it. So it's still a little bit early on it. We'll be filing it probably tomorrow or Monday with the 10-Q. What really does – the reason for the credit amendment is, as we were seeing obviously the effect of these underperformers has had on our EBITDA, which was down 29% during this most recent quarter.

We know that we have a lot of great initiatives coming down the pike and we have a lot of great opportunity; at the same time, we want to make sure we have the flexibility to be able to pursue those items.

So really what you're looking at is primarily a loosening of what that rent-adjusted leverage ratio will be in the most recent quarters or the most part of the upcoming quarters, that's going to be the biggest change that you'll see. But you'll see the entire detail tomorrow or on Monday..

Great. Thank you very much and good luck..

Thanks David. Emily, do we have any more questions in the pipe? So we apologize everybody. Emily, who is our operator, the line dropped, looks like she is coming back on board..

My apologies there.

Can you hear me now?.

Yes. We can, Emily..

Thank you. Sorry about that. And our next question comes from the line of Nicole Miller from Piper Jaffray. Please go ahead..

(18:10) I'm just wondering how many are new versus existing markets? And then, what's the cadence? Do you want to start maybe front-end load those from a development or pre-opening perspective or do you – should we even them out from a modeling perspective?.

Sure, Nicole. So, I think you were cut off the first part of the question. I believe you were talking about the 2017 pipeline, correct me if I'm wrong..

Yes. Yes..

The cadence will be very much front-loaded, so you can expect actually seven or eight of those restaurants to be just in the first couple months of the year. The markets that they'll be in – keep my word, in 35 states as well as Toronto and Washington, DC.

So they're not concentrated significantly, but they tend to be much more in the markets like the Minnesota, Wisconsins, D.C.s, Colorados where we've gotten – we have much more brand awareness, much more consistency in how those new restaurants perform..

Okay. That's very helpful. And then maybe talk a little bit about the industry and external factors.

I think it's a great discussion around what's in your control and the lot of things you can do, but how do you feel about the consumer and grocery deflation and supply in the industry right now?.

Certainly, it's a challenging environment, Nicole. I think one thing that's a little bit lost site in our particular story is the fact that even, during what's been a challenging couple of years, we've been in that flat to negative 1% range, which is pretty similar to what the industry has been doing.

So the overall concept still has fundamental strength. What we do see is that in particular in the fast-casual side, just the sheer amount of restaurants that are entering markets is so substantial, that's certainly what we've seen here in our home market of Denver, which remains a strong market for us, but it's just had a large increase in capacity.

I personally believe that the consumer is actually okay. I think that there is definitely grocery deflation that's causing a little bit more eating at home. But overall I think that the future of restaurant space is still pretty darn bright.

And I think we're amongst several that have been slowing down the pipeline a bit to reflect the fact that there's been a little bit of a supply increase that needs to have demand catch up to it a bit..

Great. Thank you so much..

And your next question comes from the line of Jake Bartlett from SunTrust. Please go ahead..

Thanks for taking the question. Dave, I have a question on the 10% of the stores that look to be potentially sold or re-franchised. Can you help us understand what that does to the model? Maybe what the AUVs are, kind of roughly what the AUVs are? Looks like they are running about negative $10 million in annual EBITDA.

Maybe if you could help us model how that might impact restaurant margins versus G&A.

And then also whether these – the closing or the re-franchising would impact same-store sales? How these have been impacting the same-store sales trend?.

Okay, Jake. There is a one in five chance that I remember all of those questions, so correct me with what I missed. The impact on the financials, you're absolutely right, it's looking at an annualized number of about $10 million that these restaurants are impacting us by.

Keep in mind though that we're evaluating the entire portfolio first of all, and some of these restaurants are those that are on the upswing that we absolutely believe, in the long-term, the best thing for us to do is to continue to operate.

So I don't want to leave the impression that these 10% of restaurants we need to touch every single one of them with either a closure or a sale or refranchising of it. So I can't really necessarily address what the overall impact is going to be, because we're still going through that process.

What I can say from an averaging of volume perspective, we have talked about in the past that most recent classes have been closer to 80% of our company average, that historically had been 85% to 90%. So you can expect that these restaurants are 80% or below in terms of what their overall average unit volumes are.

Impact on same-store sales, relatively modest. These tend to be restaurants that were opened in the last couple years and they're not just gaining traction the way we need them. So I don't think that you can expect to see a same-store sales lift just from any activities that we do. From a cadence perspective, I do think it's too early.

We'll certainly keep everybody apprised of the actions. We do plan on moving with the right sense of urgency and swiftness, so that we can focus on our existing base that's so profitable. So we do want to do it swiftly, but I don't think we can dedicate a specific timeline to it.

The final question on G&A, again that's a little bit early depending on how markets get franchised versus if they continue to operate, which restaurants tend to be in individual markets where you might – individual markets that we already had a lot of successful restaurants, and to where you wouldn't be able to necessarily do a reduction in G&A like you would if you were exiting an entire market.

So it's still a little bit early, but we definitely think there's some meaningful opportunity there in the long term..

So when you look at the $10 million in negative EBITDA impact, that's really on the restaurant margin level..

It's primarily on the restaurant level margin. I think the neighborhood of Q3, that's really just restaurant level margin. We didn't assign a burn to it on G&A, but I think you can assume that it would be in the neighborhood of 2% to 3% of sales at the least..

Okay. And then a question on, it sounds like these are really weighing down your margins especially. Your top line has been disappointing, but as you said, not far out of line with what others have done in the industry.

But it also seems like you're making, you're trying to make a lot of changes to the system, like trying to fix something or just make change that, meaningful changes on a number of different levels.

Why do you feel like the system is so broken? I mean, do you feel like there's a risk of kind of trying to address too much all at once here, or is it possible that bussing is appropriate in the higher volume stores? And it seems like you're taking kind of a blanket approach, but there are some stores that probably don't have as much of these problems..

No, that's a good question. Certainly, we're very mindful of the speed with which we take initiatives and launch them nationwide. What I would keep in mind, certainly, I don't think the system is broken. I think that there is a fundamental strength in this brand in terms of how differentiated it is, how unique it is.

While I believe we have opportunities on the culinary side, I think our core menu is still is stronger than most. We do think, however, that as a system, we're not a happy with 0% to negative 1%. While it's similar to what the industry is, we believe that we have a brand that should be able to outperform that number.

So we think that overall the operations have gotten too complex. And as we look at the initiatives that we're testing, what's important to know is, as we talked about this parallel path. The first path is to make it easier to be a team member, make it easier to execute the brand as a whole.

So those are things like removing the sandwiches, those are things like going to volumetric measuring to where there is not as much needed in the heat of the movement when you're preparing the dish. It's going to a different way of prepping to make it easier for those teams.

What our intent to do is make it easier to execute the core concept, which we feel is so strong. And then from there, these things that we're testing, we believe will absolutely take it to the next level and allow us to greatly over-perform what the industry is seeing versus performing in line.

When it comes to guest bussing itself, that's why these are in tests. So guest bussing, I'm certainly pretty confident that that's an important element of allowing us to reduce some of the pressures on labor.

We also have the impact of when you have three or four tables that happen to leave at the same time, even if we have a good dish bus person, if they're not there right away, it can make the appearance of being a restaurant that's not clean. So I think there is great potential in it.

At the same time we will be looking at exactly what you're talking about. We'll see where is it most impactful, is it most impactful in high volume restaurants or lower volume restaurants, is it certain dayparts, is it certain mix of dine-in versus to-go.

We want to make sure that we test these appropriately and that we test them in a very disciplined manner, to where once we go nationwide with them, which will likely be phased over time, we've got a foundation in place and the right test results that we know we're putting our absolutely best foot forward..

Great. Thank you very much..

Your next question comes from the line of Andrew Strelzik from BMO Capital Markets. Please go ahead..

Thanks for taking the question. This is actually Ryan Royce on for Andrew. So just – couple questions. First on the menu simplification, I know you had mentioned removing the sandwiches from the menu.

Are you still looking at further opportunities to simplify the menu, or are you going to be introducing the new format of it and then seeing how it goes from there?.

Sure. Great question, Ryan. So we did also do a little bit more streamlining nation-wide in October removed the BUFF Bowls as well as simplifying our overall catering platform to where we have mainly one that we're selling versus we had two or three different kind of alternatives out there. So there is further streamlining that's actually been done.

When it comes to the changes that we think in the future, are important to increase culinary relevancy and have the menu be as strong as possible. The number of items is probably pretty close to what we think it should be.

What we do think, however, is that the actual makeup of those dishes, how they're prepared, how they're cooked, there are ways that we can engineer them to where they're much easier for our teams to execute and also much more craveable, much more flavorful for our guests.

Those are the things that we're really testing in some of these select restaurants and select markets that we feel can really allow us to capitalize on the variety of our menu without overwhelming the teams..

Great. Thank you. And then, just one more, I know – you had mentioned the pressures from the food at home versus food away from home spread.

How do you think about that in the context of pricing going out into 2017?.

Sure. So we think that given what you see – what we just talked about, the deflationary in the grocery store environment, we don't think it's a time where concept should be piggish when it comes to how they approach price. So we're going to be very prudent with it. What's important, we haven't done a pricing increase since April of this year.

We did not see any change in our value scores. So we don't think that there is necessarily a value proposition opportunity or issue that we have. That said, we think it's important to be prudent in how we approach pricing. So we don't expect there to be one in the very near future..

Okay. And then, just one more, if I may..

Go ahead..

Looks like it is the first quarter in a while that the franchise comps actually outperformed the company-owned.

Is there anything to call out there or any color would be helpful?.

Sure. So as we said in the past, it's a somewhat small base; we don't have that many restaurants that are in the comparable base relative to the company. So we tend to see a little bit more volatility in their franchise number. That said, we're seeing some very nice improvements in our operational metrics.

We've had very strong franchisees for a very long time. I'm very pleased with the way that they execute our brand and bring it to life. They're doing a great job of it and that's certainly a part of why their same-store sales has been stronger of late.

At the same time, I don't think the gap between franchise and the company performance is entirely due to that, there's also an impact of just having a smaller population that's a little bit more volatile..

Great. Thank you very much..

And your last question comes from the line of John Glass from Morgan Stanley. Please go ahead..

Hi. This is actually Brian on for John. Just a first question, you just – just kind of a follow-up on the last question.

You mentioned your franchise base is doing pretty well; as you think about what to do with those bottom 10% of those stores, do you see demand from your existing franchise base, just very initial demand obviously, don't know for sure yet, but....

Yeah. It's still early enough in the process that we haven't had very formal dialogs with our franchise community about potential expansion of their territories. As we said, we've had – continue to have very strong franchisees, they're making some nice progress. Demand that we've seen from an inbound perspective has been pretty consistent over time.

So it's definitely one avenue that could be taken. But it's a little too early to quantify what that might be..

Okay. And then, just the last one. You called on the past year off-premise mix was in the mid 40s. You mentioned kind of trying to streamline that testing that in some of your stores.

What kind of traction have you seen on that? Have you seen any lift in that off-premise occasion there?.

Yeah, the challenge with that one is that it's still pretty early. So what we've had in a few of our restaurants – downtown Chicago, as an example, for the last couple years, has been the ability for guests to order online, come into the restaurant, skip the line, pick it up from the shelving unit and leave.

We believe there's opportunity well beyond the central business districts to capitalize on that opportunity, but it's pretty early; we've actually only got it in a couple restaurants. So there hasn't been much material lift in that to-go occasion aside from just the natural predilection of the guest to move more in that direction.

So we're in that 44%, 45% range; online ordering continues to increase. I think that's been more organic. We have done some good promotions around it, but it's not been as much tied to what we're working on in test now with more of a shelving unit solution..

Got it. Thank you..

I'm showing no further questions at this time. Ladies and gentlemen, this concludes the conference. Thank you for your participation and have a wonderful day. You may all disconnect..