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

Sharon M. Zackfia - William Blair & Co. LLC Joseph Terrence Buckley - Bank of America Merrill Lynch Nicole M. Miller Regan - Piper Jaffray & Co (Broker) David E. Tarantino - Robert W. Baird & Co., Inc. (Broker).

Greetings and welcome to the Potbelly Corporation Third Quarter 2015 Earnings Conference Call. At this time, all participants are in a listen-only mode. A 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, Matt Revord, at Potbelly, Chief Legal Officer. Thank you, Mr. Revord. You may begin..

Good afternoon, everyone, and welcome to our third 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 or 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'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 third 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?.

one, menu innovation; backline; throughput; and investment in digital, social and mobile media. We view menu innovation as a driver of sales. Late in the first quarter, we launched avocado in our legacy market. Avocado was a contributor to mix and sales during the second quarter and earned its place on our permanent menu.

We continue to see good customer incident, and avocado was a check driver for us in the third quarter as well. We continue to see strong add-on sales in the mid single-digits of avocado to both sandwiches and salads, helping to contribute to reinforce our high-quality fresh ingredients commitment. We launched pulled pork as an LTO in Q3.

At a $6 price point it not only drove news, but it also increased check. Customers like the high-quality pulled pork with a kick of spice and the sweet tangy flavor of Sweet Baby Ray's barbecue sauce.

This quarter we've launched Craft-Your-Own Mac & Cheese, appealing to both sandwich lovers using it as a side to accomplish their sandwich and as an entrée for those seeking a different eat at lunch or dinner.

Our Mac & Cheese is made from a four-cheese blend, and customers are able to customize using our unique Potbelly Hot Peppers and many other great ingredients. While early, our Mac & Cheese has been well received, and it's meeting our internal performance expectations.

You know we're a sandwich shop, but our menu innovation this year demonstrates it's just not about our sandwiches. We're committed to innovate beyond our core items and celebrate a flexible and diversified menu, while maintaining operational excellence and efficiency to drive peak throughput.

Our menu innovation pipeline remains robust, and we look forward to introducing new, relevant, high-quality products in quarters to come. The backline business, which is catering, delivery and pickup, continues to develop, and we believe it will be a larger part of our growth story going forward.

During the third quarter our backline business was over 13% of our shop sales. Our average weekly volumes of backline business grew by double-digits when compared to the prior year.

In addition to our national backline leader and our regional sales managers, we are dedicating more shop-level resources to increase focus on sales behaviors and processes to drive an efficient and effective backline growth. Throughput continues to be a focus in our business at peak.

We will drive throughput through investments in technology, equipment, staffing, to ensure great customer experience and strong speed of service. Finally, we are working to expand our digital, social, and mobile presence to drive the Potbelly brand outside the four walls.

As we previously shared, we increased our investment in digital advertising to grow the brand. In the third quarter, we continued to see a lift in overall brand awareness and strong digital media key performance indicators, including a robust return on ad spend for our attributable media.

Our digital media initiatives will continue into the fourth quarter to support the launch of Craft-Your-Own Mac & Cheese. And based upon the initial performance we're seeing, digital media will continue to be part of our 2016 plan.

We know this is how our customers want to access our brand, and we'll continue to test digital media campaigns to support menu innovations and to drive brand awareness, which should increase customer traffic over time. On the development front continue to find and build great shops.

During the third quarter we opened 11 company-operated shops, including our first shop in San Antonio, Texas. Three of the shops are drive-thru locations, which has historically been good sales and high return for us. In addition to the 11 new shops, we acquired one Potbelly franchise, which we expect to generate great returns for us as well.

We continue to execute our new unit development plan and are on track to achieve the midpoint of our stated openings of between 40 and 45 company shops by the end of the year. In addition to our corporate growth we strive to be a great franchisor. It's one of the core pillars of our strategic framework.

We recognize it's a sustainable way to grow the brand and balance our capital risk. During the third quarter we opened two domestic franchise units. We also opened our first franchised shop in London, England, which is our first Potbelly in Europe. We are on track for our stated openings of 8 to 10 franchise units by the end of the year.

We have signed an agreement with strong franchise group that would bring Potbelly to Toronto, Canada. We think Potbelly will be a great success in this country up north. We look forward to opening the first shop there next year. In addition to the Middle East, we think Canada and England are great additions to our Potbelly Nation.

We believe Potbelly has potential to be a globe iconic brand and we are excited to bring Potbelly to new parts of the world. While we are in the early stages of our franchising strategy, we are continuing to elevate our focus on franchise expansion.

As we have assessed our opportunities across the country, we have been very deliberate with how we roll out company-operated shops versus franchise shops. Our approach has been to franchise in secondary markets with single operators that earn the right to grow.

We have evolved from that model to signing multi-unit deals with franchisees in markets such as Charlotte, St. Louis, Iowa, Nebraska and North Dakota. We are learning that savvy business people want to be part of our great brand.

In addition and we think this is big news, our board of directors last week, gave us approval to begin expansion into California as a franchise-only state. We intend to diligently select the right multi-unit operators to be ambassadors for the Potbelly brand and culture.

The franchise-only approach in California allows us to have greater focus and increase the speed of our franchise development. Our belief is there is potential for several hundred units in this state. We are at early stages of building out our strategy and timing. We look forward to providing you with more details in quarters to come.

Our shop development front remains on track to deliver 48 to 55 system openings for the year. We have a solid pipeline in place for 2016. We believe franchise shops will become a more significant mix of our domestic shop footprint over the long-term.

As we look out at the geographic white space opportunity, we believe we are well-positioned to develop at least 1,000 shops in North America over time and we expect franchise shops to account for up to 25% of our total shop portfolio.

In summary, we're pleased with the solid top-line growth and comp store trends through the first three quarters of the year. However, recognize we still have work ahead of us in order to consistently deliver on a long-term growth and profit targets. Fundamentals of other business remained strong.

We remain committed to working very hard every day to deploy the appropriate strategic growth levers and drive operational efficiencies to deliver sustainable long-term value creation to all of our shareholders. I'd like to thank all the men and women of the Potbelly Nation that put forth a great effort to achieve these results so far.

Our teams remain confident and committed to finishing the year strongly. We believe we are well-positioned to obtain our full-year commitment. And now, I'll turn it over to Mike and he'll give you the details of the financial results.

Mike?.

Thanks, Aylwin, and good afternoon, everyone, and thank you all for joining us today and for your interest in the Potbelly story. As Aylwin mentioned, I will review the P&L and give you some of the highlights associated with our third quarter results.

I will also provide an update on our full-year 2015 outlook and some of the implied trends for the fourth quarter. Starting with the top-line, total revenue increased about 13% to approximately $96 million in the quarter driven by our new unit growth and our increase in company-operated same-store sales of 3.7%.

Breaking down same-store sales, our average check grew approximately 3.2% driven primarily by the price increase we implemented in January of 2015 along with the mix increase from menu and add-on growth initiatives that Aylwin have mentioned earlier.

In addition, we implemented a modest price increase in late August to partially offset some of the labor inflation. We are encouraged by the traction that we've achieved from the execution of our sales growth initiatives delivering solid top-line growth over the last four quarters.

As we have previously stated, we expect our fourth quarter to be the toughest comp of the year. With our sales trends through October, we now expect same-store sales in the fourth quarter to be in the range of 2% to 2.5% and for the full year, we now expect same-store sales in the range of about 4%.

This is compared to our previous guidance of at least 3%. Now moving down to the shop P&L. Shop level margin for the quarter was 19.1% of company-operated sales. Our cost of goods sold as a percentage of company-operated sales in the third quarter was 28.5% and flat to the prior year.

As we enter 2015 we incurred inflationary headwinds which we offset as part of our January price increase. And similar to others throughout the industry, the inflation was less than originally anticipated as several commodities moved favorably and that created good opportunities for us to lock in our cost favorable to initial estimates.

Our food cost basket is almost 100% locked for 2015 and we now expect to improve our cost of goods sold to the mid 28% range for the full-year 2015. This is favorable to our initial guidance of 29% to 30%. For the fourth quarter, we also expect cost of goods sold to be in the mid 28% range.

Onto labor, labor was 28.9% for the quarter which was an increase of about 70 basis points from the prior year. This is consistent with our previously stated range and in line with our expectations.

Much of our hourly labor force received wage increases in the quarter and therefore our total wage rate inflation was about 4% or about 50 basis points versus the prior year. In addition, our shop-level bonuses including our shop rewards program increased our shop level labor expenses by 20 basis points to 30 basis points.

For the year, we continue to expect labor as a percent of sales to be at the high-end of the 28% to 29% range. We expect labor in the fourth quarter also to be in line with our guidance for the year.

We will continue to manage our labor expense through continued efforts and investments to improve our labor productivity as well as through targeted price increases. Now, turning to occupancy expense. Occupancy as a percent of company-operated sales was 12.4% which was flat to prior year.

We are driving leverage to our rent expense through our sales increases, however, renewal rates are adjusting to new market levels and we are also incurring some higher reassessments of real estate taxes which are offsetting that leverage. Now, moving to operating expenses.

Operating expenses as a percent of company-operated sales was 11% in the quarter, higher than prior year by about 50 basis points. As a reminder, our operating expenses include items like repairs, maintenance, credit card fees, insurance, utilities and supplies and therefore we have variability from quarter-to-quarter in this line.

In this quarter we are incurring higher credit card fees compared to prior year as our mix of credit card transactions continues to increase. In addition, insurance premiums, which are based on sales levels have been higher in 2015 as our sales performance has been better than in 2014.

Also impacting our comparison to prior year is a change in accounting treatment of gift card breakage that we made in 2014. This change created a one-time favorable adjustment in 2014 of about 30 basis points that did not repeat in 2015.

All that said, given our continued top-line growth we expect to drive better leverage and productivity across our shop-level other operating expenses. Now, moving down to our G&A.

Our general and administrative expenses were approximately $9.2 million during the quarter and if we exclude the cost associated with our shop closures our adjusted G&A was approximately $9.1 million. Our adjusted G&A is 9.5% of total revenue, which is 60 basis points higher than prior year.

In Q3 of 2014, our Support Center bonus was adjusted down in accordance with our lower performance in 2014. Without this impact of bonus reset we realized leverage on G&A of about 40 basis points.

For the full year we now expect our G&A to range between $36.5 million and $37 million, refined slightly from our previous guidance of between $36.5 million and $37.5 million. As Aylwin mentioned, our adjusted EBITDA was $10.8 million, which is roughly a 2% decrease from the prior year.

And our adjusted net income for the third quarter was $2.2 million, a decrease from $2.8 million in the prior year. And our adjusted net income per diluted share was $0.08. These decreases are largely driven by the previously mentioned increases in bonus and shop-level expenses.

Our effective tax rate was 38.4% for Q3, and we now expect our full-year effective tax rate to be between 39% and 40%. And finally, an update on our share repurchase program. During the third quarter we completed our $35 million share repurchase plan, which was authorized in 2014.

The board authorized a new $35 million repurchase plan in September of 2015. For the third quarter we repurchased approximately 1.2 million shares of Potbelly common stock in the open market for a total of approximately $14.5 million.

At the end of Q3, we have $32.7 million available from our board-authorized program for repurchases, which will continue as we move forward.

And now to summarize our full-year outlook for fiscal 2015, we expect comp store sales growth of approximately 4%, 48 to 55 total new shops, an effective tax rate in the range of 39% to 40%, and capital expenditures of $34 million to $38 million, and adjusted net income of about $8 million.

We expect shares outstanding of between 28 million and 29 million shares for the year, and we expect our full-year EPS to be in the range of $0.27 to $0.28. So with that I'm going to turn it back over to Aylwin for summary remarks.

Aylwin?.

total new unit shop growth of at least 10%; low single-digit comp store sales growth; shop-level margin of at least 20%; annual adjusted net income of at least 20%; and return on new shop investment of 25% or greater. I want to thank Bryant Keil again for all his contributions to our company and to our brand.

And I want to thank the men and women of Potbelly Nation for their dedication and hard work. Thank you for your time today. We appreciate you being on the call and the support of our business. Now we'll open it up to the operator and be open for questions..

At this time we will be conducting a question-and-answer session. Our first question comes from the line of Sharon Zackfia of William Blair. Please proceed with your question..

It sounded very exotic. So I guess a couple of quick questions. On the guidance for the fourth quarter I think if you kind of go through the math, it implies restaurant contribution margin will be up nicely year-over-year and maybe flattish labor expenses.

Can you talk about what would be driving flat labor, given some of the wage pressure you're seeing on a year-over-year basis?.

Hey, Sharon, it's Mike..

Hi..

And yes, it was a very exotic sounding name, but Sharon's just fine with us too. So yeah. No, what we guided before last quarter was that we'd be at the high end of the 28% to 29% range. We had contemplated the wage pressures that we'd be seeing.

We also had factored in that we were going to do a little bit more on pricing, which you've noted some time ago. And we continue to drive productivity initiatives at the shop-level. So you're right about that improvement in Q4. And one of the line items that will help get us there is the labor line.

There are others there as well as you look at the cost of goods line. And if we hold that at that mid-28s%, which we had also said a few moments ago, and that would be a significant improvement over the COGS level that existed in the fourth quarter of last year..

I guess taking that kind of discussion on labor further out, if you're willing to take that price in some other markets where you've had the wage increases, do you think you have a chance at holding labor flattish in 2016? I know you haven't really given any outlook yet for next year..

Right. Well, two things in there. The pricing that we took in the third quarter, it was a bit more targeted and not to the same degree as we've done in the past. It wasn't just in a couple of markets though. It was across all of the major markets. Again, a bit differentiated, but I wanted to point that out first.

And you're right, we really haven't – we're kind of midstream on our 2016 planning right now. So we certainly would acknowledge that there will continue to be labor pressure. And we need to, in our planning process, determine what we're going to do to combat that. But I don't have an outlook for you yet on 2016..

Okay. And then the last question I guess on G&A, and this will probably touch a little bit on 2016 as well, but I know that you ramped up some different initiatives and then this year you have bonus accrual. I know it's kind of been hard for you to leverage that G&A over the past two years.

Can you talk about kind of longer term how you think G&A should grow relative to your revenue growth?.

Right, you're right on all fronts. As I had mentioned, if you de-noise a bit for that bonus difference, we did see some leverage. It gives us some confidence we can do that as we continue to grow.

We talk about, again, with that top line assumption of the low-single digit comp that we ought to be able to drive 30 basis points to 40 basis points of G&A leverage year after year..

Okay, great. Thank you..

You're welcome..

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

Thank you. Excuse me if they're a little repetitive. I was thrown off by Sharon's name, I liked the pronunciation.

On the pricing, can you talk about how much price you took during the third quarter? And I guess you gave us a price and mix combination contribution to the comp, but could you disaggregate the two between the price and the mix?.

Sure, sure. So we said with the overall same-store sales at 3.7%, we said that 3.2% was check, the difference being traffic. Of that 3.2%, roughly 2.4% was pricing and the rest mix, so 0.8% or so..

Okay.

And as you look at this year, where sales have been quite good but earnings have not really reflected the benefit of that, how do you think about your core structure going into next year? I realize a lot of the shop-level in terms of compensation levels and things of that sort, but do you have to up the ante again across the major cost centers for next year or how are you thinking about it?.

No, we actually think our cost control to be typical of what we've done for five and a half of the last seven years, and this year we got hit with a lot of things. Some of them expected, some not expected, but we're holding to our base formula of the big two between 58% and 59%.

We think we're putting plans in place to get more control over the other operating. And so we think the model still works. We think the last two quarters have been aberrations, and we're pressing hard to demonstrate that fact over the next couple quarters..

And then a little bit longer term question, talk about the decision to go to California, kind of why California, where I think we probably will agree the cost structure is pretty high, I realize you're doing it on a franchise basis, but I know you care about those returns for the franchisees..

Yeah. Well, we get a ton of questions of when you're going to California and we've always said we'd be strategic. California is still the most popular state in the country over 30-something-million customers. We think there's a ton of space for Potbelly. The operating environment is quite unique and difficult.

So our thinking is that we would get men and women who are in the business there that know the market more infinitely better than us. And it also gives the opportunity to concentrate our franchising effort. So if there are multiple several hundred possible franchise units in California, our future franchising efforts will be focused on that state.

Then that allows us to focus on the rest of the white space that we have domestically. We still will have opened the franchise geographies that we have now. And fortunately, our existing franchisees are in a growth mode, as well as we talked about the multi-units that we've signed.

So I think it gives a great blend of tackling the state that you need to be in, but we're deleveraging our capital risk by using franchisees and we'll pick men and women who have a demonstrated record of succeeding in building out concept like ours in California..

Okay. And, maybe just one last question on the franchising effort.

Is Florida on the radar screen for you?.

We don't disclose where we're going next. We say we do a hub city every 18 to 24 months. So that would imply we would start planning a new hub city in the middle of next year with the execution date of 2017..

Okay.

When you say hub city, you're talking on the company operating side, I assume?.

Yeah..

Yeah..

Okay. Okay, thank you..

As we talk – as get to a 1,000 units we see 25% franchise, we're at 10% now. So that implies over the next several years you'll see an acceleration of the franchise growth. And this is something we've heard from investors and our board. And so, we want to be strategic before you go tackle state like California.

You want to make sure you have the capability to do multi-unit agreements and to manage those well. We feel like we're checking the box off on that with the ones we have signed. And then, that sets us up to manage a franchise-only state in California..

Okay. Thank you..

Our next question comes from the line of Nicole Miller of Piper Jaffray. Please proceed with your question, Ms. Miller..

Thank you. A couple quick ones and then a bigger picture question.

Could we get the cash and debt for three quarter – third quarter end, please?.

Yeah, sure, Nicole, it's Mike. Cash is $42.768 million and debt is still $0..

Excellent.

And for the fourth quarter should we just model the same share count that was in 3Q 2015? Or would it be a little bit lower because of when you repurchased those shares in the quarter?.

Yeah, that's fair without making any statement about our purchases going forward. Since we've been active in the program, we did actually guide a little bit lower. And the shares we said the 28 million to 29 million. So to be a little bit lower, Nicole, would make sense..

Okay. And then I was just very curious about UK. Can you just tell us a little bit about the story behind opening there? Where is that restaurant? What size? What's the price point? And who did you bring over from the Potbelly Nation to help run that store? Thanks..

So a franchise partner group, they've been in UK for several years. They own another business which is publicly traded. In the summer of 2014 they were on holiday. They came to Chicago, met with Matt Revord, who runs International. He's also our legal beagle.

And we had dinner with them and for 70% of dinner I tried to convince them not to open a Potbelly in the UK. At the end of dinner after they looked at it, they were more adamant. So we worked to get an agreement. We got – within the span of 12 months we got the agreement done.

It's on the west side of – on the east side of London, at the Stratford Mall, which is a Westfield Mall. And the shop is about 1,800 square feet. It's priced at the same level of some of the other American chains that have gone over, a little bit higher than us. Goodie of the location is it's near the Olympic Village.

There is a rugby team that's going to locate there next year, and it's a flagship shop. It's you walk in and you see the Potbelly Nation. We sent dream teams over to spend multiple weeks as they opened. They have to send folks over, three or four people over to train in Chicago before we open.

And then we sent one of our best district managers, who's actually running the shop for them. And that person is on leave from us for 1 year to 2 years, depending on how we feel about it and how they feel about it. But it's a great story. Being in London is a gateway city.

They got a multi-shop agreement that they're executing against, and we think it's great..

Thank you..

Our next question comes from the line of David Tarantino of Robert & Baird (sic) [Robert W. Baird] (36:10). Please proceed with your question..

Hi. Good afternoon. A couple of questions. First on the same-store traffic trends, they did improve sequentially from the second quarter.

Could you talk about what you think drove that improvement? Was it something you did internally? Or do you think it was the environment? Or what do you think drove the improvement?.

Well, listen, we talk about traffic all the time internally here. You guys talk about it. We have felt comfortable about our ability to grow traffic across the whole chain. The last three quarters or four quarters, it's just that part of the world that had been a drag, was less of a drag.

And we're working hard to ensure that the mix of our sales is appropriate and kind of relates to what our investors are looking for. So I'm not going to take – men and women working hard on it. We're using the same tactics of backline, throughput, menu innovation, and digital.

All that stuff seems to have caught varying degrees of traffic – varying degrees of traction. And so it's a good improvement. And we look forward as we look into 2016 to see this continuing..

Great. Thank you. And then on the flow-through you mentioned several times, Aylwin, that you want to work on getting better flow-through.

Could you elaborate on perhaps what you're going to be working on to deliver that? I think you mentioned the other operating line, but is it also labor as well? So could you talk about what you're working on there?.

Yeah. So, Mike, you may add color, I'll start. Listen, we've had homegrown systems that we've used that we try to make investments as we could afford it. So we have a labor system that we've used. We're actively looking to upgrade that labor system going into next year. You would only do that if you thought you could gain productivity.

In this world of changing rate, wage rates in the middle of the year it is very difficult for individual managers to manage that as aggressively as we need. So the day that goes up, how you think about your labor, how you think your hours need to change. And the new labor system will allow us to help them adjust much faster.

So while we are in the range we told you guys there were opportunities. The other thing is we did make investments in this new bonus program to drive training, tenure and retention. We have been paying that bonus out actively.

We are seeing some positive results, so that's an add that we didn't have last year, but we think it's appropriate when you are in this high-growth mode.

And then below the big two we just had a perfect storm of a lot of expenses, some of it we should be managing better, some of it just happened to us we moved our servers from real servers to virtual servers. That caused the firewalls. I'm telling you much more than you want to know, but that caused the firewalls in the POS to turn off.

We had to turn off our credit cards for a long period of time. And that was an expense you don't expect to have in the future. So all that stuff we think we can manage through. We put a lot of pride in our ability to manage cost control at the very aggressive manner and we will continue to do that.

So I'm calmly telling you that it will improve, because we know how to do it. We're going to add new tools particularly on labor, but I guarantee you we are aggressively managing that as we speak right now..

That's very helpful. Thank you..

..

So, in conclusion, I think this is largely a very positive story. This is our fourth quarter of growing same-store sales. As someone has mentioned the traffic trends did improve this quarter over where we had previously been.

I think the news around franchising moving from the single owner operator to the multi-deals that we have now to saying, you're going to the most popular state and you're going to be franchise only is strategically smart.

It's a risk adjusted way to get into the state with men and women that know the real estate, know the neighborhoods, know the customers much better than we do know that operating environment.

The fact that we signed new franchise agreements in Toronto, which is a gateway city for Canada and also North America open unit in London, gateway city, definitely in the UK and arguably Europe, I think are positive. These folks would not be trying to attach themselves to the brand if they didn't see a positive story here.

We mentioned the flow-through needs to improve. We are all over that. We know how to manage cost. We need to add tools to help our men and women manage the labor in a go forward basis particularly with the variation in wage rates. So, overall, good story. Thank you to the men and women of Potbelly Nation.

Again, we want to give a final shout-out to Bryant Keil, who without his effort we wouldn't have a Potbelly Nation to talk about. We thank you for your interest and we look forward to talking to you in the future. Thank you very much..

This concludes today's teleconference. You may disconnect your lines at this time. We thank you for your participation and hope that you have a wonderful rest of your day..