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 Sam J. Beres - Robert W. Baird & Co., Inc. (Broker) Karen Holthouse - Goldman Sachs & Co. Joshua C. Long - Piper Jaffray & Co. (Broker) Joseph Terrence Buckley - BofA Merrill Lynch Stephen Anderson - Maxim Group LLC.

Greetings, and welcome to the Potbelly Second Quarter 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. An interactive question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Mr.

Matt Revord, Potbelly's Chief Legal Officer. Thank you. You may begin..

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 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 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?.

Thanks, Matt. Good afternoon, everyone, and thanks for joining the call. During the second quarter, we generated revenue of $105 million, an increase of approximately of 10% driven by unit – new unit growth in company-operated comparable sales increase of 1.7%. We opened seven new shops, four company-operated and three franchise-operated.

We are pleased with our bottom line performance and our strong flow through. We delivered adjusted EBITDA growth of 15.4% to $13.6 million. Adjusted net income growth of 36% to $4 million and EPS growth of 50% to $0.15 per diluted share. We also delivered shop profit margins of 21.2%, an increase of 70 basis points over prior year.

Our comparable sales growth of 1.7% did not meet our expectation, as we navigated both internal and external challenges during the quarter, which impacted our traffic.

Looking forward, we do not believe we're immune to the market and the consumer headwinds that have impacted the broader restaurant industry, including a more cautious consumer, price deflation for meals even at home, and as we mentioned during our first quarter call, we experienced sales challenges at the start of second quarter, specifically related to weather in certain of our markets and challenging prior year comparison.

Unfortunately, the softness continued into May and June, further impacting our second quarter results. We believe that the persistent industry headwinds as well as our difficult second half comparisons will continue to put pressure on sales growth. At this time, we're revising our full year comp sales outlook to a 1% to 2% range.

While these external variables created challenges, as operators we look at factors within our control and we're focused on how we can improve our in-store execution. We continue to analyze how the macro environment is impacting our sales and we will use the appropriate sales and operational tactics to attack this trend.

Our main growth drivers are still very relevant. Specifically, we view menu innovation as an important sales driver. We continue to develop a pipeline that will complement our core menu, while maintaining our operational efficiency.

Our backline business, which grew in the high single digits during the second quarter, and was about 15% of our sales, continues to develop and will be a large part of the growth story as we go forward. We're continuing to test digital marketing, as a way to reach new customers outside of the four walls.

And we have started the upgrade of our mobile app, which when completed should enhance our sales over time. We're confident about the long-term opportunities, and remain extremely focused on identifying and implementing sales and operational tactics to drive growth in a challenging sales environment.

We will achieve this year's profit targets by aggressively managing our expenses. Turning to our new unit development. Our new unit development was consistent as a great growth story for the brand.

We opened seven new shops during the second quarter for a total net year-over-year unit growth of 12%, which again surpasses our long-term stated goal of 10% new unit growth. We're very judicious on how we make investments.

We have a disciplined methodology and we are focused on selecting the right site, paying the right amount of money for those sites, so we can achieve our desired return thresholds.

Given our disciplined approach and recognizing the broader challenges facing the industry, we have decided to reduce our CapEx spend in 2016 from our previously stated guidance and have elected not to pursue five new shop openings that are in the pipeline, which means we will reduce our target shop range by five, from a range of 45 to 50 to a range of 40 to 45.

Our franchise target remains 10 to 15 shops for a total system range of 50 to 60 shops. The growth rate is still significantly higher than our 10% target. In summary, we're pleased with our bottom-line performance and our margin expansion in the second quarter. The profit results given the top-line challenges were excellent.

We have revised our full year comp sales growth target, but remain committed to delivering adjusted net income growth of at least 20% and adjusted diluted earnings per share in the range of $0.36 to $0.38. Now, Mike will go through the details of P&L for the second quarter and our expectation for the re remainder of 2016 in greater detail.

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 second quarter results. I will also provide a summary of our full-year 2016 outlook.

Starting with the top-line, total revenue increased about 10% to approximately $105 million in the second quarter driven by our new unit growth and our company-operated same-store sales of 1.7%. Breaking down same-store sales, our average check grew approximately 4%, driven predominantly by price.

As previously mentioned, we revised our full-year sales guidance for the same-store sales growth to be in the range of 1% to 2%. Moving down to shop P&L, shop-level margin for the quarter was 21.2% of company operated sales, an improvement of 70 basis points from the prior year quarter.

Our cost of goods sold was 27.3%, an improvement of 120 basis points to the prior year. Food commodities have been better than expected and we now expect modest COGS deflation for the full year, therefore, we expect our cost of goods sold to be slightly below 28% for the full year, better than our initial guidance of 28% to 29%.

Labor was 28.7% for the quarter, which was an increase of about 20 basis points from the prior year, driven primarily by wage inflation, due in part to the continuing impact of minimum wage increases that were mandated in 2015 and in 2016.

We remain extremely focused on managing our labor expense through continued efforts and investments to improve our labor productivity as well as through targeted price increases. For the year, we continue to expect labor as a percent of sales to be in the 29% to 30% range.

Occupancy expense was 12.6% in the quarter an increase of 50 basis points as compared to the prior year, primarily due to lease renewals and higher real estate taxes. Operating expenses is 10.2% in the quarter, an improvement of 20 basis points as compared to the prior year due to better liability insurance and leverage and utility costs.

Our general and administrative expenses were approximately $10.3 million in the quarter, were 9.8% of total revenue, an improvement of approximately 20 basis points compared to the prior year period. For the year, we continue to expect our G&A in the range of $40.5 million to $41.5 million.

Our adjusted EBITDA was $13.6 million for the quarter, which was an increase of 15.4% from the prior year.

Our adjusted net income for the second quarter was $4 million, an increase of 36% from $3 million in the prior year, and our adjusted net income per diluted share was $0.15, an increase of approximately 50% from 10% per diluted share in the prior year. Now, an update on our share repurchase program.

During the second quarter, we repurchased approximately 900,000 shares of Potbelly common stock in the open market, for a total of approximately $12 million. In July, we completed the final purchase of shares under our program for repurchases.

Our balance sheet remains very strong with the cash balance at the end of the quarter of $29.9 million, and we have zero debt.

To summarize our full-year outlook for fiscal 2016, we expect comparable sales growth of 1% to 2%, 50 to 60 total new shops, including 40 to 45 company operated shops and 10 to 15 franchise shops, that'll be heavily backend weighted, $36 million to $38 million in capital expenditures, down from our original guidance of $38 million to $40 million, to reflect lower shop openings, adjusted net income growth of at least 20%, and adjusted diluted earnings per share in the range of $0.36 to $0.38.

We now expect an effective tax rate in the range of 37% to 39%, down from our original guidance of 39% to 40%, due largely to the recognition of certain federal employment tax credits. So with that, I'm going to turn it back over to Aylwin for summary remarks.

Aylwin?.

Thanks, Mike. We delivered strong P&L for the quarter. Macro headwinds curtailed some of our sales growth, and we will work tirelessly to offset those headwinds as much as possible. Given the market uncertainty, we have reduced our shop count by five for this year, but the system will grow still well over 10%.

Fundamentals of the business are strong and are reflected in our results.

We feel very good about the business over the long-term, and remain committed to our stated long-term growth targets, which include total new unit growth rate of at least 10%, low-single-digit comparable sales growth, shop-level profit margin of at least 20%, adjusted net income growth of at least 20%, return on new shop investment capital of at least 25% or greater.

Thanks for your time today. We appreciate you being on the call and your support for the business. Now, we turn it to the operator and will open up for questions..

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

Hi, good afternoon. Hopefully, you can hear me okay. I'm in a cab on the Kennedy. I am away home, O'Hare. I understand there are some challenges broadly speaking with consumer spending, I recognize you guys also took a pretty large price increase towards the end of last year, beginning of this year.

Can you talk about whether you are seeing more weakness in the areas where you took kind of a disproportionate price increase or whether you are seeing any kind of price elasticity or demand issues?.

No. we don't think our traffic issues are due to the price increase, in fact when we did quarterly reviews of our price versus our direct completion and we're still a good 10% to 15% below our direct competition. So we still believe we have pricing.

When we analyze our business, it's pretty clear to us what's going to happen and it's more directly related to deflation that's occurring for meals eaten at home versus meal eaten at home and that correlation is directly with us.

And so, we definitely see the softness in some geographical areas and some day part areas and that's what we are attacking, but we do not think it's due to price..

Aylwin would you be comfortable talking about which geographical areas or which day parts you're seeing the most weakness in?.

Not at this point, Sharon..

Okay.

Separately, I know you had talked about the LTO (14:17), the salad in April, maybe it wasn't up to your expectations, I'm wondering how you're doing with Pastrami that came out this summer?.

With most of these items, we're seeing really good mix and it appears to have some good driving capacities during our main – during lunch. But what we haven't seen is, how it carryover in the non-lunch period. So, the mix is well within the target range that we have.

And it's a great product, we're getting great feedback from our existing customers, just hasn't translated as much to the traffic growth as we'd like. Pastrami is performing a little bit better than the salads did earlier in the spring..

Okay.

And then last question, a lot of your peers do things with royalty or try to capture data on their customers, just any kind of updated thoughts on that from a Potbelly perspective?.

Yeah. In fact, we met with a vendor this morning that could give us really more insight into our customers from a marketing standpoint and real estate standpoint.

And we had them in because we recognized, we need to get more educated about our customers, we have a fair amount of data, but how can you predict, develop more predictive modeling around customer behavior.

And particularly since in the US, you can still have visibility on cell phone usage, which could really help in terms of where customers are coming from, how long they're staying in the shops, we want to avail ourself of that new technology.

So, we believe over the next – during this next month or so, we'll be hitching our wagon to a new contractor that will give us better analytics strictly for our customers..

Okay, great. Thank you..

Our next question is from Sam Beres from Robert W. Baird. Please go ahead..

Hi. Good afternoon. First, maybe a couple of clarifications.

Mike, within the average check of 4.0% for Q2, how much of that was price versus mix, and then also what was the benefit from the Easter shift during the quarter?.

Yeah, sure. Yeah, I'd mentioned that, 4% check was predominantly price, which is really about 3.9% was price, we got a couple of tenths from mix and then that differential is the negative traffic..

Great, thanks.

And then could you quantify the Easter shift, potentially on the Q2 comps?.

Yeah. It was probably about a 0.3% or so, 0.4% maybe kind of impact for the quarter..

Great, thank you.

And if I look at the comps guidance for the full year, I think at the midpoint of that, it maybe implies up 50 basis points in the second half of the year and commentary in the release said the full year target's reflective of current trends, so just want to clarify, is that meant to imply that comps are running slightly positive to-date in Q3, maybe near that up 50 basis points?.

Yeah. I think I would say, the – we're trying to make sure you understood that given the 1% to 2% for the full year, but also saying that, that implies for the second half to be running at the current trends. And we kind of kept ranges in there, but you should think of it is being in that 1% to 2% range for the second half as well..

Okay. That's helpful. And I guess, in terms of responding just to the slower industry environment, I guess what types of levers are you guys looking at to pull maybe more in the immediate term or the near-term here in order to spur more positive traffic or healthier traffic.

Is there more menu innovation you can talk about coming down the pipeline or is it really just in-restaurant execution? Any perspective would be helpful..

I think you always look at execution and quote us (18:22), it always starts with how can we increase throughput at lunch.

We still have a tremendously high focus on the backline which we still think is a big story for us now and in the future and we're aggressively pursuing kind of the third phase of that in our evolution of backline, in particular around catering.

And then, we're not a discount house, but the digital marketing and how we apply that and where we apply that is kind of levers we could pull. We essentially have the digital marketing in about seven of the markets that drive 80% of our volume.

We'll look to see how we can shift that balance of the year to be more targeted toward the weaknesses that we see in the business from a geographical standpoint, from a day part standpoint..

Great. That's helpful. Thanks..

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

Hi, a couple of questions. To start off, it the looks like the backline business, sort of reaccelerated from a bit of a slowdown in the first quarter.

Is there a change in compares that might have benefited that trend and if not, what do you sort of attribute the improvement to and do you think that's sustainable?.

No, it's just better execution and we're very serious about the business and – sorry, I'd say execution..

And then on – talking about meeting with vendors that give you some more opportunities around customer analytics, where do you see the biggest opportunities in applying those for unit growth and deciding where to put the units versus managing what's best for menu pipeline versus whatever other digital sort of marketing strategies might be out there, and as you think about those different areas, you could use it, what's the sort of turnaround until from sort of signing a vendor that we would start to be able to see reasonably some benefit from it?.

So you asked a mouthful here. Well it's just – evaluation affordability with us is the key, and so we know we got to get smarter, we want to have better predictive modeling around our shop development. We want to have better understanding of our customer flow and where we can gain new customers in our existing trade areas.

And so, the vendors we are taking to are folks that can get a lot of information that we don't have access to, that won't charge as a high margin for that information and to help us create predicting modeling. And then hopefully if you pick the right vendor, you have relationship over time with a refresh to data, so you don't get behind the curve.

It's not to imply that we don't have a good information today, we just want to get smarter. And again with the information we get from cell phones, we just want to avail our self, that kind of the new technology that we have no idea around.

And then, so you do that with the vendor and then hopefully one day you can attach that to your mobile app that we have started developing and those two things will give you the magic of how can I gain new customers, through the new app and through the new information? The timelines are, these folks take maybe a quarter, where they'd come in and get our data, attach it to their data, and then we'd work on the modeling and you start using it late this year, early next year.

And that would coincide with the new app also..

Great. Thank you..

Our next question is from Joshua Long from Piper Jaffray. Please go ahead..

Great. Thank you for taking my question.

Something you mentioned internal challenges during your prepared comments and I was curious if that was primarily focused on some of the menu initiatives you're working on? Or if there was something else there, if that was worth elaborating on?.

No. No, nothing worth elaborating. I mean, we're always looking to execute better. And as we rack and stack shops, you can imagine, you have the great ones and the goal is how do you get the ones that are not so great to be great, but that's just part of the deal.

Listen, the headwinds hit us and it was very dramatic and it was very sudden, and you just, one – the first thing you want to do is make sure you don't overreact to something that maybe temporary.

The ones we see it for several periods, then it's like, okay it's here and how do you react? So, the internal thing was more of the plans we had in place because they offset what we saw. And obviously, that's not the case.

So, now you just got to dig deeper, execute at a much higher level, and then dig deeper into the weaknesses we see from a geographic and day part standpoint..

That makes a lot of sense. I appreciate you're clarifying that. Thank you.

As we think about those units that were bumped from – that were on the plan previously and now have been extended out, has there been any longer-term strategic change? Or a change in thought as to where the markets – those units were planned to be? Or is this really just trying to be strategic about kind of the current environment and you'd revisit putting those units back in those markets at some point, when you have little bit more visibility.

Just trying to get some sense on the thought process behind that?.

Yeah. So, we haven't changed the growth rate. We're still very committed to the growth rate we've stated. And what we're just trying to be prudent. When you see clouds on the horizon, you just want to make sure you're making the right financial decisions for the business short-term and long-term.

We had room to move those five shops to next year, and not doing this year and we just thought that was prudent. We're not signaling anything around our new unit growth. We're not signaling anything around our – our commitment has not wavered to build in existing markets and new markets. This is we're just being prudent stewards of capital..

Got it. That makes sense.

In terms of the pricing plans for the year, as we think about that 1% to 2% in comp for the back half of the year, the better than expected commodity environment and then still some overall headwinds for consumer traffic industry wide, how do you think about pricing in the back half or maybe the value proposition? Is there some price that would roll off in 2Q, 3Q or do you think about bringing value more front and center, just thinking about how you kind of go after the tough industry environment there?.

Yeah. This is Mike. What I'll say is, we still face wage inflation and that's something that we're mindful of and looking to attack that with both pricing and productivity improvements. And you're right, we do have some pricing that would otherwise be lapping. We made a move in August of last year that if we didn't take action, would go away.

What you should expect from us is that, we will be – we are focused on replacing that increase with a like number, so you should expect our pricing for the remainder of the year to be similar if not slightly higher than the run rate that you've been at. And as to the value proposition, Aylwin already spoke to that.

We feel like we've got actually a terrific value proposition, we don't think we're coming close to disturbing that. In this particular case though we're looking at something where it's much more refined and targeted. We have taken a look at our catering business and we had really not looked at that pricing for quite some time.

And so we made some – we're making some refinements there and that should help us replace what we did last August..

That's helpful.

And so kind of thinking about pricing in the high 3% range in 2Q – rather in the second half of this year, so kind of in line with what we did in the first half?.

Yeah, I think we've been at that again, four points plus or minus a tenth or so. So that's the rate we'd like to be at that level or slightly above..

Okay. Thank you for the time today..

Thank you..

The next question comes from Joseph Buckley from Bank of America Merrill Lynch. Please go ahead..

Thank you.

Mike, I just wanted to clarify, so the guidance, the 1% to 2% that's guidance for the second half and not for the full year?.

No. Well, it's really both.

What we said was that the guidance of 1% to 2% is for the full year and what we said in the press release as well and in the prepared remarks is that it's based on experiencing the second half, what we've been experiencing over the last frankly quarter and into July as well, which likewise happens to be in that same range of 1% to 2%, Joe..

Okay, okay.

And then, on the share repurchase I think you said you completed the program in July, could you communicate how many shares that would have been and is there no current authorization in place then?.

We have – as you know, we finished the $35 million program and we had already done the $35 million program before that. So, there is nothing in place right now, we'll reassess after those two programs and Aylwin and I will be discussing with the board capital allocation priorities and what we would do next.

There was actually very little left at the end of the second quarter. We bought back 934,000 shares during the quarter and there is a little bit left that we finished up in the first week or so of July..

Okay.

And Aylwin, the backline sales growth, you did kind of highlight catering, but could you break it down a little bit more, the catering, the delivery, lunch pick up orders, just wonder what you are seeing?.

We normally don't make that distinction. It was high single-digit growth, which is higher than Q1. So we're fine with that, it's about 15% of the business. And listen, if we had our druthers, we'd love it to be 100% catering, which represents large orders, tremendous leverage off that business.

But the single orders to us, is a way to build relationships and a way to get future large orders. So, we are in both businesses and we deliver both businesses. As we refine that business over time, we definitely would like to be more large orders, but we're not in position to turn anyone away and we don't.

So, we'll take a single sandwich and they'll pay for delivery and we do see that as a way to build relationships and one day that single sandwich may come back as a large order. But the composition of the business has been very similar the last three years or four years between large orders and small orders..

Okay.

And on the new unit openings this year, are they tracking sort of those 25% cash-on-cash returns?.

Yeah. Yeah. No, we feel good about this fleet. We just don't have enough yet. The goal we got to work on and it's something we're actively looking at and moving the five to next year really helps us on that. We want to get a more even distribution. I mean our picture would be much different from a revenue standpoint, if weren't extremely back loaded.

We still have the bulk of the shops this year in the third quarter and fourth quarter, majority in the fourth quarter. And it puts a lot of strain on the business that we want to alleviate. Once you get into rhythm a like this it's hard, unless you actively move shops to rebalance.

And so, next year though we have goals internally, where we want to see a rebalance. Ideally, you'd love each quarter to be very similar, so that you have a smoothing effect. As you know, in a real marketplace that's hard, but definitely, half year to half year, we just got to do a much better job of rebalancing the openings..

Okay. Okay. Thank you..

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

Yes. Good evening. You just answered most of my questions, but I do have a one housekeeping note.

Just want to ask, when your next 53-week year is on your calendar?.

Next year, 2017..

2017. All right. Thank you..

And if there are no further questions, I'd like to turn the floor over to Mr. Lewis for any closing remarks..

So, thank you for your interest today. I do think the second quarter is, it's a good P&L and we're very proud of how the men and women are managing the business with significant flow through which is something we kind of didn't do last year, so we feel good about that.

Definitely, we're benefiting from terrific cost of goods sold and we see that continuing. We'll continue to manage the other parts of the P&L very tight. I think the main messages you should get from us is that we're very committed to hitting the profit targets this year and going to do everything to ensure that.

And then, the sales of 1% to 2% is obviously less than what we anticipated. We do believe that's enough to help us to get to our profits, but we're not satisfied and we'll attack the weaknesses that we see. We do believe, it's a macro issue.

We understand where it's hitting us geographically and from a day part standpoint and we'll do everything to attack that, but fundamentals remains strong. At the end of the day, we're still very committed to all the financial targets we have in place and we believe we're going to hit most of those this year. So thank you for your interest.

I want to thank our shareholders, thank you folks on the phone and more importantly thank the folks of the Potbelly Nation!.

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