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.

Matt J. Curtis - William Blair & Co. LLC Sam J. Beres - Robert W. Baird & Co., Inc. (Broker) Joshua C. Long - Piper Jaffray & Co (Broker) Gregory Paul Francfort - Bank of America.

Greetings and welcome to the Potbelly Corporation Fourth 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. I would now like to turn the conference over to your host, Matt Revord, Potbelly's Chief Legal Officer. Please go ahead..

Good afternoon, everyone, and welcome to our fourth 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 2016 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 fourth 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 and throughput. First, menu innovation. During the fourth quarter, we used Craft-Your-Own Mac And Cheese to grow the business successfully. This product will probably become a seasonal menu item in the future. Throughput at peak continues to be a focal point.

Because of this focus, our throughput increased in Q4 in our highest throughput shops. We're nowhere near capacity-constrained during the busiest time of the lunch period, so driving throughput continues to become a focus and we'll continue to report up on our progress.

Regarding development, during the fourth quarter, we opened 15 new company-operated shops for a total of 43 for the year, which is at the midpoint of our guidance of between 40 and 45 new shops in 2015.

During the fourth quarter, we opened six franchise restaurants and, for the year, we opened 10 franchise restaurants, which is at the high end of our guidance of between eight and 10 franchise restaurants. We once again surpassed our stated long-term development target of 10% annual new unit growth. Our 2016 pipeline is substantially complete.

Our plan is to open between 45 to 50 company-operated shops and between 10 to 15 franchise shops for a total company number of 55 to 65 shops.

Our results in 2015 reinforces our belief that we will achieve our long-term goals of low to mid-single-digit same-store sales, at least 10% new unit growth, at least 20% profit growth, 20% margins, and 25% return on invested capital. And now Mike will go through the details of the P&L for Q4 and 2015 and will preview our expectations for 2016.

Mike?.

Thanks, Aylwin, and good afternoon, everyone. Thank you all for joining us today and for your interest in the Potbelly story. As Aylwin mentioned, I'll review the P&L and give you some of the highlights and color associated with our fourth quarter and full-year results. I will also provide an update on our full-year 2016 outlook.

Starting with the top line, total revenue increased about 12% to approximately $95 million in the fourth 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 4% driven by our price increases and the mix increase from menu and add-on growth initiatives. For the full year, total revenue increased about 14% to $373 million driven by our new unit growth and increase in same-store sales of 4.4%.

Moving down to shop P&L, shop-level margin for the quarter was 19.8% of company-operated sales, an improvement of 150 basis points from the prior-year quarter and shop-level margin was 19.4% for the year, an improvement of 20 basis points from the prior-year period.

Our cost of goods sold as a percentage of company-operated sales in the fourth quarter was 28.3%, an improvement of 90 basis points to the prior year, driven by the combined impact of pricing and commodities that move favorably throughout the year.

For the year, cost of goods sold as a percent of sales was 28.5%, an improvement of 30 basis points as compared to last year and in line with our prior guidance. Labor was 28.8% for the quarter, which was an improvement of about 30 basis points from the prior year, driven primarily by sales leverage and improved shop productivity.

For the year, labor was 28.7%, an increase of 10 basis points compared to last year, driven by wage inflation, offset by pricing increases and improved labor productivity. Occupancy expense as a percent of sales was 12.7% in the fourth quarter, which was an improvement of 10 basis points compared to the prior-year period.

For the year, occupancy expense was 12.6% of sales, which was an improvement of 10 basis points compared to the 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 expected to continue to offset that leverage. Operating expenses as a percent of sales was 10.3% in the fourth quarter, an improvement of 30 basis points compared to the prior year.

For the year, operating expenses as a percent of sales was 10.7%, flat versus the prior year. 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 other expenses to offset cost pressures. Our general and administrative expenses were approximately $9.6 million in the quarter, or 10.1% of total revenue, an increase of 50 basis points compared to the prior year.

For the year, our G&A expenses were approximately $37.3 million, or 10% of total revenue, an increase of 10 basis points compared to the prior year.

The increase in G&A was driven primarily by the bonus reset, continued investments in our field staff to support our development plans, and an increase in advertising as we continue to invest in social, mobile and digital to better communicate with our customers.

Excluding one-time costs, such as support center relocation and other costs associated with shop closures, adjusted G&A expenses for the year were approximately $36.9 million, or 9.9% of revenue, which was in line with our previous guidance.

As Aylwin mentioned, our adjusted EBITDA was $10.8 million for the quarter, which is roughly an increase of 15% from the prior year. For the year, adjusted EBITDA was $41.6 million, which is an increase of approximately 13% from the prior year.

Our adjusted net income for the fourth quarter was $2.3 million or $0.08 per diluted share, an increase from the $1.7 million, or $0.06 in the prior year. For the year, we delivered adjusted net income of $8.2 million, or $0.29 per diluted share, an increase from the $6.7 million, or $0.22 in the prior year.

Our effective tax rate was 37.6% for the full year. Now an update on our share repurchase program. During the fourth quarter, we repurchased approximately 1.1 million shares of Potbelly common stock in the open market for a total of approximately $13 million.

At the end of the fourth quarter, we have $20 million available from our board-authorized program for repurchases. As Aylwin already mentioned, on the development front, we opened 15 new company-operated shops and six domestic franchise shops during the fourth quarter.

For the year, we opened 53 total new shops during the year, including 43 company-operated shops and 10 franchise shops. Our capital expenditures came in at approximately $36 million, which is at the mid-point of the range that we previously disclosed. And now, I'd like to walk through our estimates of the year ahead.

As Aylwin mentioned, we believe that we have the right initiatives to continue the strong sales momentum that we achieved in 2015 into 2016 and beyond.

Similar to last year, we are expecting inflationary headwinds in 2016, primarily as it relates to our labor costs, which we expect to be more impactful this year due to the continuing impact of minimum wage increases that were taken in 2015, as well as expected wage increases this year.

And so we have taken pricing of approximately 3% in January to offset these headwinds. These increases were strategically implemented across the menu and across our footprint, which also brought certain menu items more in line regionally.

With continued execution on our sales growth initiatives, in addition to the price increase, we believe we can continue the positive sales trends from 2015, and we expect company-operated same-store sales growth of 3.5% to 4.5% in 2016.

We expect relatively modest levels of goods inflation, accelerating slightly as we progress through the year, given expectations around timing of inflation and our pricing. We anticipate cost of goods sold in the range of 28% to 29% for 2016, and our food cost basket is approximately 60% locked.

We expect labor as a percentage of sales to trend between 29% and 30%. Our guidance assumes continued wage pressures from minimum wage increases implemented last year, as well as expected minimum wage increases in 2016 in major markets, offset by the price that we have taken to offset these pressures.

We will also continue to make investments in training and incentive dollars for certain shop-level employees as we continue to enhance our bench and shop turnover results. We will continue to manage our labor expense through continued efforts and investments to improve our labor productivity.

For our G&A expenses, we expect to be in the range of $40.5 million to $41.5 million. On shop development, we expect to open 45 to 50 company-operated shops and 10 to 15 franchise shops for a total of 55 to 65 total new shops, which we expect to be heavily back-end weighted.

We expect to spend between $38 million and $40 million on capital expenditures in 2016.

So to summarize our full-year outlook for 2016, we expect comp store sales growth of between 3.5% and 4.5%, 55 to 65 total new shops, an effective tax rate in the range of 39% to 40%, adjusted net income growth of at least 20%, and adjusted diluted earnings per share in the range of $0.36 to $0.38.

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 a reminder of our historical trends, the first quarter is typically our lightest sales and profit quarter.

I would also note that there were significant business disruption from the winter storms across the mid-Atlantic this year. In addition, we expect inflation impacts to increase during the year, while noting that our pricing from August of 2015 rolls off.

On the unit development front, again, I want to reiterate that we expect our new shop development in 2016 to be heavily weighted towards the back half of the year. So, with that, I'll turn it back over to Aylwin for summary remarks.

Aylwin?.

Thanks, Mike. We're very pleased with our solid top line and bottom line results for the quarter and for the full year. We had strong comp sales throughout the year. We opened 53 new shops, improved the bottom line. Looking ahead, we believe the fundamentals of our business are strong.

We remain very positive about this business in the short term and the long term. We have a strong team in the field and at the support center who are dedicated to growing the brand and delivering strong financial results.

We also remain very committed to our long-term growth targets, which include total shops growth of at least 10% each year, low to mid-single-digit comparable same-store sales growth, shop level profit margin of at least 20%, adjusted net income of at least 20%, and return on new shop investment of 25% or greater. Thank you for your time today.

I appreciate you being on the call in support of our business. Now we turn it over to the operator and open it up for questions..

Thank you. Our first question comes from Sharon Zackfia from William Blair..

Hi guys. It's Matt Curtis on for Sharon.

I just wanted to get the price/mix breakdown, if I could for starters?.

Sure..

In the fourth quarter..

Yeah. Right. The total check was 4% broken down 2.7% price and 1.3% mix, mostly driven by a combination of avocado and Mac And Cheese..

Okay. And then you guys took the 3% price in January.

So how much price do you currently have in the menu?.

Well, we had coming into this year, we had about the 2.7%, which has the 0.7% or so pricing that we took in August. The full-year 2015 pricing is a little over 3%, about 3.2% or 3.3%. So the 0.7% or so roll off in late August of 2015..

Okay.

And then, I guess, another question is what was the consumer reaction to the price increase?.

All our pricing over the last few years have been almost at a 99% to 100% acceptance rate from our customers..

Okay. Great. Thanks a lot, guys..

Thank you. Our next question comes from Karen Holthouse from Goldman Sachs..

Hi. Good evening. This is actually Greg Harman on for Karen today. I just had a quick question on new development for 2016.

How does the mix of drive-through units vary versus 2015? And if it's higher, should we expect that trend to continue going forward?.

It is higher. Over half the units we'll develop in 2016 will be drive-through, and we've always said as the fleet matures, drive-through would be 20% to 25% of our mix..

Thank you..

Our next question comes from Sam Beres from Robert W. Baird..

Hi. Thanks. Good afternoon and congrats on the great results. In terms of the Q4 comp, was there any variance in the comp between months during the quarter? Obviously you came in a little bit above I believe the 2% to 2.5% guidance you pointed to during the quarter.

So wondering if there are any puts and takes there?.

It got stronger as the quarter and period 12 was really outstanding. So that's the story..

Yeah..

And maybe to follow up on that, have you guys seen any direct impact from a weakness at another fast casual competitor? Do you think that's impacted your trends at all? And if not, I guess what really drove that acceleration in comps then as you proceeded throughout the quarter?.

This ought to be when you talk about this stuff. We had excellent weather in our Q4 and weather really impacts the sandwich brand. That was positive. I would also – our menu innovation for the entire year was very strong and the Mac And Cheese really drove a lot of business.

And then I would say the real focus we had the latter half of the quarter was really strong at the rest of the shop level with throughput, with back line and we just saw a real heightened awareness of execution in our shops. Everything else would just be speculation..

I think that makes sense. And then, maybe lastly, obviously a comment that there is significant disruption from the winter storms in the East during Q1.

But, any perspective on the underlying momentum in the business you've seen here to date in Q1? Or maybe, Mike, any other perspective you can provide kind of on the comparisons for 2016 in terms of the same store sales? I know that you're obviously lapping a very difficult comp here in Q1, but it comes against pretty soft performance in 2014.

So any additional perspective on how to think about those comparisons throughout the year would be helpful. Thanks..

Well, maybe I'll start and then Aylwin can jump in. I'd just reiterate what I already said. The range we gave for the full year of 3.5% to 4.5%, we're comfortable with that. We just wanted to provide a little bit of color because of what is maybe most obvious to most folks.

Those storms are pretty significant and so that certainly hurts our business in terms of comps, but we still remain committed to the full year range of 3.5% to 4.5%..

Yeah. We had significant disruption on the East Coast. It was closed down for about four-and-a-half days, lost two-and-a-half days in New York. So, I mean, since our last years, eight years I've been here, Q1 weather has been negative impact. We feel very bullish about the business.

Underlying trends, non-weather looks very strong for us and we're completely committed to the guidance that Mike gave and that we gave on the call..

Great. Thank you..

Thank you. Our next question comes from Joshua Long from Piper Jaffray..

Great. Thanks for taking my question. I wanted to see if we might be able to circle back to some of the leadership training and new tool sets that you mentioned, Aylwin.

Curious about how you're thinking about that going forward into 2015 and if it's really a focusing on a lot of the systems and tool sets that you already had in place and reemphasizing those or if there are new sets, new tool sets in place for the managers at the restaurant level that we could hopefully start seeing an impact in 2015 – sorry, 2016?.

So our culture training remains constant and strong. And so we're multiple times a year teaching the culture down to the front line. We have six main values and we pick a couple values a year and we take that cascade down. That won't change. What changed this year was, I've been talking about a strong GM in every shop for about a year-and-a-half.

And so what Mike – one of the questions Mike asked when he got to the company was, well, what does it mean? And so it forced us to look at how you take it from a rallying cry, a slogan to a really program. So we've actually defined what a strong GM in every shop mean. And it's based on our values, our leadership trait as well as use of our tools.

And we established a baseline rating of all our GMs at the recent conference so then their future development plan can address deficiencies in those three areas. And then we've recognized that as you grow, there's three levels of general managers in our business.

So you have a novice level, and those are people that are inexperienced, zero months to 12 months. There's a competent level, and those folks, they understand the job, they can do the job at an acceptable level. And then there's an expert level. And how you manage those three levels are very important. And we fail – we treat everybody the same.

And so with the district managers, who are the direct leaders, our general managers, who are putting curriculum in place to help those folks manage the novice, manage the competent people and then to manage the experts.

And so we're just bringing more detail and definition to this very important notion that we have as a way to drive the business, because the gating issue we have in successfully opening new shops each year is having leadership ready when we open the shops.

So the strong GM in every shop becomes more than just a rallying cry and a slogan to real operating, training and measurement plan..

That's helpful. Thank you for that. And in addition to having strong GMs in every shop, I know in the past you've talked about the importance of having strong GMs living and working in those markets that their stores are in.

Can you update us on that initiatives? And kind of give us a sense of where that's headed as we go into 2016 and beyond?.

Yeah. We're mid-60%s, strong GM living in every shop. It's complicated by the number of shops we're opening.

And so our goal is still eventually to get the 80%, and we'll look for that in our steady state markets, markets that are not experiencing the same amount of growth as other markets, but it is definitely an important part of how we market the business, and it's something we still believe in. So it's above mid-60%s..

Great. Thanks for that.

As we think about digital sales or sales online and sales that go through that back line, how do you all think about that, and could you help quantify that in terms of where is that now, and what the opportunity is going forward? I'm thinking about that in terms of being able to continue to drive throughput at peak just through your regular way of business, but then also leverage some of those online or digital toolsets to help drive sales as well?.

Yeah. It's mid – it's 14%, 15% of the business. Our intent is to grow it at least double-digit in those shops, and then what we're committed to, we said two years ago we want to double the business in two to four years, and we're on that path. The business will be different as we grow it.

So we have sales managers in markets, we're looking for ways to add catering kitchens, call centers, so those type of things where you aggregate big markets and really dominate that business in those markets. And so that's kind of the plan. We have a national leader who's been in place, who's driving the business.

So you still want the shops to do the 10% growth each year. That gets you part of the way and then it's changing the nature of the business through aggregating big orders..

Great. Thank you so much guys..

Thank you. Our next question comes from Joseph Buckley from Bank of America..

Hey, guys. This is Greg Francfort on for Joe. Two questions from me.

On the labor side, what was labor inflation in the quarter and for the year, and then what are you expecting on the wage inflation side for 2016? And then just on the renewal rates, could you give us a little more detail on what you're seeing in the market, maybe how much rates are getting pushed up when things come on for renewal? Any color there would be helpful..

Yeah, sure. On the labor inflation, we've talked about this before for 2015. It increased throughout the year and on average kind of 4% to 5% in 2015. We don't really see that abating and have a view that it'll be in that kind of 5% range in 2016.

Kind of the impact of the minimum wage increases that took place in the middle of 2015, still rolling into 2016 as well as those that are already planned throughout 2016..

Relative to the occupancy cost, listen, we don't anticipate that percentage to go up appreciably. Mike was trying to give some color to what we're managing against. You have a number of existing shops that at the 10-year mark have options.

So, the options are typically at market rates, and in some of the big cities those market rates are higher than what we had 10 years ago. But, that said, we don't expect that percentage on the P&L to grow up appreciably. We plan on managing it. And so – but it's a factor that we're managing against..

Just if I could add one more? Can you give us an update on where you stand on mobile, and how you plan on rolling that forward?.

Big project this year to enhance our mobile applications and make it more around engaging customers. There's a pay component that we'd like to have. There's also – we'd love to be able to drive order through mobile devices. So we have a very basic application now, and we'll be spending capital this year to upgrade that..

Thank you very much..

Thank you. We appear to have no further questions. I will turn the call back over to Aylwin Lewis for closing comments..

Yeah. So thank you, everybody, for your interest. We appreciate the continued support. We hope the results in the fourth quarter and for the full year, for those folks that are supporters, reinforces your faith in us. We believe we can continue to develop to have these type of results for the foreseeable future.

We have a strong team of leaders, of associates at the support center and in the field working hard every day to make this brand a great brand and a global brand and to deliver the type of financial results that we have committed. And so, we see 2015 as a reinforcement of those long term commitments and we'll work every day to continue that progress.

So thank you very much for your interest and go buy a sandwich today..

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