Matthew Revord - Senior Vice President, Chief Legal Officer, General Counsel and Secretary Aylwin Lewis - Chairman, President and Chief Executive Officer Michael Coyne - Chief Financial Officer and Senior Vice President.

Sharon Zackfia - William Blair Karen Holthouse - Goldman Sachs. Sam Beres - Robert W. Baird Joshua Long - Piper Jaffray Joseph Buckley - Bank of America Merrill Lynch.

Greetings and welcome to the Potbelly Corporation's Second Quarter 2015 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Mr. Matt Revord, Chief Legal Officer for Potbelly Corporation. Thank you, Mr. Revord. You may begin..

Good afternoon, everyone, and welcome to our second quarter earnings call. Before we get started, I'd like to note that certain comments made in 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 2015, 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're giving today can be found in our most recent Annual Report and 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.

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 second 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?.

menu innovation, digital media, throughput, and backline sales. Menu innovation. Late in the first quarter, we launched avocado to approximately 80% of our shops. We brought whole, fresh avocados directly into the shop and sliced them on the line when ordered.

It was important for our customers to recognize that we use real avocados rather than a pre-made spread. Avocado was a nice add-on that filled a menu gap. We saw attachment rates in the mid single-digits that helped drive mix and sales. We saw very little trade-down.

Though the avocado was largely incremental, it has earned its way onto the permanent menu. Our menu innovation pipeline is robust. Currently in Q3, we are promoting a pulled pork sandwich, our first heated protein of this type. Pulled pork is very popular in the marketplace right now, and our quality is exceptional.

We will update you on the progress of this sandwich during our Q3 call. Our digital media efforts involve mobile and social. We're attempting to drive awareness, trial, and traffic. The campaign started in Q2 and it supported the rollout of fresh sliced avocado.

Results have been largely positive relative to increasing the awareness of our brand in all the markets. We've seen markets where this effort has driven traffic. There's still much for us to learn, but this could be a very useful tool in helping us drive sustainable sales growth in the future. So we'll continue to monitor progress and report on it.

Throughput. We continue to drive our throughput efforts. We have automated our measurement, so our shops can see their throughput by half-hour increments in real-time. During the quarter, a large group of shops improved their throughput year-over-year. In fact, we had one shop set the all-time 30-minute record of at 186 transactions.

I think this demonstrates that we are not capacity-constrained. We're making good progress and we still have a lot of room to grow with throughput. Backline was roughly 14% of our sales during the quarter. Our average weekly volumes of backline business grew by double-digit.

We continue to believe this will be a large part of our growth story going forward. Our sales managers are having a dramatic impact on our backline business. This business will continue to increase over time as we update our tools, technology, and management acumen. Growing sales is very important to us.

We will use the aforementioned growth drivers to continue the trend that we have established. Our sales growth will always be a combination of mix, traffic, and price.

On the development front, we opened 10 new company-operated shops in the quarter, including our second location in Salt Lake City, which is our newest spoke city attached to our Denver hub.

Two of the 10 shops we opened during the quarter were airport locations, one in Portland Airport and the other one was a reopening of a shop in Terminal B of Dulles Airport. Our 2015 pipeline is essentially complete with over approximately 90% of leases signed.

We continue to execute our new unit development plan and are on track to achieve our stated openings this year of between 40 and 45 shops. Internationally, we opened one franchise unit during the quarter in Kuwait. In addition, last week, we opened our first franchise shop in London, England. This is the first Potbelly in Europe.

We're very excited to bring the brand to this global gateway city. We thank our partners for believing in the brand and bringing it to their hometown. It's early stages obviously, but the results last week were positive. We are on track to open our goal of eight to 10 franchise shops by the end of the year.

We successfully relocated our support center to a renovated technically advanced building in downtown Chicago, just blocks from our previous location. Our new space provide an economical way for us to be more productive and collaborative. We've had three quarters in a row of solid sales growth and strong profitability.

Credit goes to the men and women of the Potbelly Nation. First half of 2015 is strong. We feel good about the balance of the year. This is Mike Coyne's first call as CFO of the company. Mike joined us in early May. He has been transitioning into his role by following a detailed training plan that he will share with you. Mike, welcome to your first call..

Thank you, Aylwin. And good afternoon, everyone, and thank you for joining us today and for your interest in the Potbelly story. As Aylwin said, this is my first earnings call with Potbelly. I want to take just a minute to thank my new colleagues for the warm welcome into the Potbelly Nation.

As Aylwin suggested, my first 90 days has been spent immersed in an organized training schedule, including several weeks actually working in various Potbelly shops, meeting our talented people, and learning the strong culture that exists at every level of the organization.

I'm energized by the opportunity to work with such a dedicated and passionate group of people, and I'm excited to have joined a company with such a sound financial foundation in place to capitalize on the many growth opportunities ahead.

As Aylwin mentioned, I'll review the P&L and give you some of the highlights and color associated with our second quarter results. Starting at the top, we are pleased with our performance in the second quarter.

Total revenue increased about 15% to approximately $96 million in the quarter, driven by new unit growth and our increase in same-store sales of 4.9%.

Breaking down same-store sales, our average check grew approximately 4.8%, driven primarily by the price increases we implemented in July of 2014 and January of 2015 along with the mix increase from menu and add-on growth initiatives. We're pleased with the last three quarters of solid top line growth.

As a reminder, we do expect our comps in the second half of 2015 to moderate as our July 2014 pricing rolls off and we'll face tougher comps in the second half, especially in the fourth quarter. However, we are well-positioned to achieve our full year sales guidance of at least 3% same-store sales.

On the development front, with the opening of the 10 new company shops in the second quarter, we have opened a total of 40 since the second quarter of 2014 for a total unit growth of over 12%. We also opened one international franchise and we closed one international franchise during the quarter.

Moving down the shop P&L, shop level margin for the quarter was 20.6% of company-operated sales, which was 10 basis points better than prior year and in line with our expectations. Breaking down margin a bit, we start with our big two, which is our cost of goods sold and our shop labor.

We expect these two costs, in the aggregate, to be in line for the year with a slight tradeoff between them from a margin perspective. First, our cost of goods sold as a percent of sales decreased in the second quarter to 28.5%, down about 20 basis points from the prior year.

Similar to others in the industry, we incurred inflationary headwinds from dairy and certain proteins in 2015, which we offset as part of our January price increase. However, inflation has been lower than we initially expected when we started the year.

We expect our full year commodity inflation to be around 2%, which is at the low end of our initial guidance in the 2% to 3% range. Our food cost basket is roughly 90% locked for 2015, and we now anticipate our cost of goods sold to be slightly favorable to our previous range of 29% to 30%. Now on to labor.

Labor as a percent of sales was 28.4% for the quarter, which was an increase of about 30 basis points from the prior year. As we communicated last quarter, in general, we are seeing our shops do a better job of having the right number of staff in the restaurant at the right times, and this has continued into the second quarter.

As Aylwin mentioned, we drove our culture training deep into the organization in the second quarter, which was an expected incremental investment. All shop level employees from the general manager to associates attended a training session. Additionally, we have bonus programs all the way down to the shop level.

Our results in the second quarter of 2015 were better than 2014 and therefore the shop level bonus amounts this year have been higher. In addition, our new shop rewards bonus program continues to reward for excellent training and retention.

And as a reminder, there are several states, counties and cities in which we operate that already have or will be implementing minimum wage increases throughout 2015, including but not limited to Chicago, Washington, DC, Minnesota, Ohio and New York. Based on this current slate of increases, labor inflation is expected to be back-weighted in 2015.

As we have communicated previously, our labor will fluctuate by quarter based on sales, seasonality, and the timing of new unit openings as well as the labor inflation outlook. And so we now expect labor as a percentage of sales to trend toward the high end of our initial guidance of 28% to 29%.

Operating expenses as a percent of sales was 10.4% in the quarter, which remained flat to prior year. Occupancy expense as a percent of sales was 12.1%, which was a 20 basis point improvement from prior year, driven primarily by leverage of the fixed occupancy expenses.

Our general and administrative expenses were approximately $9.6 million during the quarter. After adjusting for one-time costs, such as support center relocation and other costs associated with shop closures, our G&A was $9.4 million.

This is approximately $500,000 higher than prior year, primarily due to the 2015 bonus reset and incremental advertising spend. For the full year, we continue to expect our general and administrative to range between $36.5 million and $37.5 million as previously communicated.

As Aylwin mentioned, our adjusted EBITDA was $11.8 million, which is roughly a 17% increase above prior year. Our adjusted net income for the second quarter was $3 million, an increase over the $2 million from the prior year, and our adjusted net income per diluted share was $0.10.

During the second quarter, we repurchased approximately 588,000 shares of Potbelly common stock in the open market for a total of approximately $8.1 million. As a result, at the end of Q2, we had $12.2 million available from our board authorized program for repurchases, which will continue as we move forward.

In closing, I'd like to reiterate our full year outlook for fiscal 2015. We expect adjusted net income growth of at least 20%, at least 3% comparable sales growth, 48 to 55 total new shops, and capital expenditures of between $34 million and $38 million, and in addition our effective tax rate not to exceed 40%.

Finally, we expect shares outstanding of between 29 million and 30 million shares, slightly down from the previous guidance, reflecting the year-to-date purchases. This outlook excludes the impact of any additional share repurchases.

In summary, we remain very committed to our stated long-term growth targets, which include total new unit shop growth of at least 10%, low single-digit comp store sales growth, shop-level profit margin of at least 20%, cash on cash returns of 25% or greater, and annual adjusted net income growth of at least 20%.

So with that, I'll turn it back over to Aylwin for summary remarks.

Aylwin?.

have a strong GM in every shop; drive a consistent same-store sales growth; finding, opening and operating great new shops at a high level of execution to produce the desired return. London demonstrates that we have tremendous white space to grow, not only in North America but in the rest of the world.

We are positive about the business, but we're not satisfied. There's much more that we can produce from this brand and from our assets. Thanks again to the Potbelly Nation for their hard work and their belief in our culture. Thanks for being on the call. Now, we will entertain questions..

Thank you. [Operator Instructions] Our first question comes from the line of Sharon Zackfia from William Blair. Please proceed with your question..

Hi. Good afternoon. So a couple of questions. I guess, first on the labor increase year-over-year this quarter.

Can you break down kind of what the impact was of the culture training you did, which I think would probably be more one-time in nature, versus the wage inflation versus the bonuses?.

Yeah. It's mainly the wage inflation. We do culture training every year, so it was kind of off-centered from prior year in terms of this quarter, but wage inflation was probably the biggest part of that.

And then the pay-for-performance bonuses - the results are better this year, so the pay-for-performance bonuses are higher this year versus last year..

Okay..

And this is Mike. The only thing I would add to that, if we actually remove the impacts of some of these bonus-related items, we'd actually have some slight leverage on that labor line, just for perspective..

Okay. Which kind of leads me to my second question, which - I guess, I'm wondering where your overall wage inflation is running at this point, and how you would expect that to trend in the back half of 2015 versus the first half. I heard you say it's going to be more back-end weighted, which makes sense given the minimum wage increases.

And what your first thoughts would be on 2016 wage inflation?.

Yeah. We'll have to look at the long-term impact and adjust accordingly. But we'll go with our stated comments, Sharon, it's going to be a little bit more aggressive and more toward the high-end of the range we've given for the back half of the year. And also, we're opening a ton of restaurants in the back-half of the year, too.

So we got some labor costs in opening and pre-opening..

Okay.

Have you taken any incremental price in the markets that are taking minimum wages up?.

As of this date, no, we haven't..

Okay..

We'll be looking at that. And if we do any actions, we'll report that in Q3..

Okay. Great. Thank you..

Our next question comes from the line of Karen Holthouse from Goldman Sachs. Please proceed with your question..

Hi. Thank you for taking the question. So congratulations on another strong comp in the quarter. Before break it down into pieces between pricing and mix and traffic, pricing is a little bit higher than it was last quarter with the January price increase included.

At the same time, particularly on a two-year basis, it looks like traffic and mix are decelerating a little bit, which is kind of contrary to what we've been seeing elsewhere in the industry.

How should we think about any sort of product promotional apps that might be contributing to that, or having now taken I think a little bit more price than you have in a number of years - in the past 12 months, are you starting to think maybe differently about your pricing power?.

No. We think our pricing power is strong and our philosophy is price will cover inflation and that's what we've kind of done.

The traffic number, it was a - what I'd say is that we had some very strong traffic growth in some markets and we experienced some real sluggishness in the parts of the country that came out that had a really horrible winter, which is similar to what the whole brand did. So that was a drag on the overall traffic.

But we feel pretty strongly about where the business is from a traffic perspective. And we try to drive the sales and, like we said before, it will always be a mix of price, mix, and traffic. But we're in a good spot..

And Karen, this is Mike. The only thing I'd add there is the mix number has actually increased a little bit for us over the last few months and the pricing figure, which has been about 4% or so has been pretty consistent for the last four months or so..

Okay. Thank you..

Our next question comes from the line of Sam Beres from Robert W. Baird. Please proceed with your question..

Hi. Good afternoon. Thanks for taking the question. Just want to talk a little bit about the comps as well and just in terms of the full year guidance of 3% plus after strong comps in the first half.

Maybe a little more perspective on your degree of confidence in maintaining some solid momentum in the back half of the year, obviously, as some pricing does drop off, but then also with traffic comparisons becoming more difficult.

So maybe just some perspective on the factors that you think will sustain kind of positive and healthy momentum as we move forward..

At this point, given our experience last year, we're going to be - we're conservative. So we're not raising the number. We have a view of the first half of the quarter and we feel decent about this current quarter. And so we're being conservative and that's probably the right thing for us to do given our prior experience.

And we'll be able to update, obviously, our sales number at the end of the next quarter when we report out. But we think that the number that we have is the right communication at this point and we're going to work hard to beat that..

Right. And this is Mike. The only thing I'd add there, too, is you said it right. The guidance calls for at least 3%, not 3%, and we have the pricing from the middle of last year rolling off. That's between a 1.5 points, 2 points and then obviously as you know the tougher comps as we head into the second half, in particular in the fourth quarter..

Thanks for the perspective. And then just in terms of avocado incidents, you said it was in the mid single-digits in Q2.

Was that pretty consistent throughout the quarter? And given that it is staying on the menu, have you seen any drop off in terms of the incidents you've seen? Or have you seen consumers kind of staying pretty steady with their purchase rates?.

It's steady now. I mean obviously, when we first rolled it out, it was higher, and then it moderated, and it stayed at this level. And things don't stay on the menu unless they're a healthy mix for us because we don't want to hurt our throughput.

So it's at the level where we feel comfortable that we'll be able to maintain quality as well as curtail waste. So it's at a nice level, but it started higher and kind of moderated, particularly after you stop talking about it with our advertising..

Great. And then maybe one last question. Sounds like the 2015 pipeline is pretty much wrapped up. So maybe just a little perspective on the performance for the new units that you've seen opened kind of in late 2014 and then early 2015. And then maybe your thoughts on how the 2016 pipeline is shaping up. Thanks..

We feel good about 2014, and we feel really good about this year. We've opened 17 so far. We have over 25 more to open. The pipeline is 90% leased. We know what the pipeline is. Most of those are under construction, so feel very comfortable with our guidance of 40 to 45 company shops, and then the franchise number.

So we're on track and we feel good about it. And we feel good about the performance so far..

Great. Thanks. [Operator Instructions].

Our next question comes from the line of Joshua Long from Piper Jaffray. Please proceed with your question..

Great. Thank you for taking the time today. I was curious on some of the initiatives you've had. Maybe it's around avocado or, Aylwin, you mentioned this being the first warm protein that you're going to be using on sandwiches.

Is there any sort of additional equipment or prep or kind of training that needs to go in place to be able to support this menu innovation, or is this largely being achieved on top of all the work that you've done on a regular basis and then over previous years behind the counter?.

Yeah. No new equipment. Work with our suppliers. We heat everything through the oven. That's the primary device we have. And the pulled pork works in that environment. It's a great product. We worked hard to make sure it's very lean and very tasty, and we're in the midst of rolling it out and we feel good about the performance.

We feel we have a robust pipeline of menu innovation for the foreseeable future. We really hustled last year to improve our testing and to get more ideas in, and you'll continue to see that as we go. And we have a clear view of what the pipeline should look like for 2016..

Great. Thank you for that.

And as we think about the ability for backline sales to really be a contributor, can you remind us how we think about backline ramping up in either new or more existing units? I would imagine that's largely a function of just getting into the community and raising that awareness, but what kind of procedures or processes are in place at the restaurant level to really help drive and sustain that strong backline sales growth trend?.

Well, a couple of years ago, we started down the path of, we added some technology to help us with backline orders that come in online. We've ramped up our training. We've isolated the staffing that you need, so you can take care of your frontline at not at the expense of the backline.

We've added sales people in a number of our markets that help us with big catering orders, which we really like. And we're very bullish about this business. Our segment, it's over $2 billion. We don't believe we have our fair share. We've stated that over the next three or four years, we'd like to double this business.

It's going to cause us to think about it in a much different way than we're doing now. But we're seeing decent double-digit growth. This is the second or third year we've seen that. So it continues to be a strong push in the business. It will be something we'll continue to drive.

We are going to have to modify our approaches and our techniques to get that doubling of the business that I've stated. But it's a great business for us to be in..

Great. Thank you so much..

Our next question comes from the line of Joseph Buckley from Bank of America. Please proceed with your question..

Thank you. First a question just on clarifying the sales numbers.

So I think you said the check was up 4.8% and is over 4% of that price? And could you give us a breakdown on what the price and mix impact is in that 4.8%?.

Yeah, Joe. This is Mike. You've got it right. Price is about 4% and the rest of that is the mix number..

Okay. And the backline sales.

What goes through that backline? Is it all catering or is it delivery orders? And maybe just remind us what goes through that backline and where you're seeing the growth?.

Joe, we call it backline because it's all the orders that don't come on the frontline. It's a combination of pickup. It's a combination of catering, which is big orders. It's a combination of delivery, which are small orders.

And the biggest component of that from a dollar perspective is catering big orders, get a fair amount of delivery orders, particularly around certain neighborhoods. And then pick-up, those orders come in on the backline, but obviously those customers are coming in to pick it up and we've been in that business for a long time.

We've solidified our approach to it about a couple of years ago with additional training and specialized tasks that you can manage the business with. And as we grow it, we're going to need to add more technology as well as more training and better management acumen of it. It's a great business to be in.

You can get most of those sales done before your rush start at 11:30..

Okay. And then just the last question. Just a question on the shop level margins. You had a really strong sales quarter and you picked up 10 basis points.

Are you expecting - what kind of comp would you need in the second half, I guess, to show margin improvement year-over-year?.

Well, the guidance that we put out there achieves that. We will have that lower single-digit number leading to our at least 3% for the full year. And that will give us modest improvement at the shop level margin level, both over the prior year and versus the first half, at least to how we're looking at it right now..

Okay.

So sequentially second half versus first half as well?.

As well. But in the same ballpark. I don't want to overstate how much. But it's a modest amount..

Okay..

All on that lower single-digit comp..

Okay. Thank you. [Operator Instructions].

There are no further questions in queue. I'd like to hand it back to Mr. Aylwin Lewis for closing comments..

Okay. Thanks for your interest. Thanks for being on the call. Again, another strong quarter. Potbelly Nation is working hard to meet our commitments and exceed expectation. We think we're doing that.

It is a function of staying very focused on a strong GM in every shop, growing our same-store sales through the growth drivers we've talked about, and opening and managing new shops at a great return. So thank you for your interest, and we'll talk to you next quarter..

Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time, and have a wonderful day..