Matthew J. Revord - Potbelly Corp. Aylwin B. Lewis - Potbelly Corp. Michael W. Coyne - Potbelly Corp..

Sharon Zackfia - William Blair & Co. LLC Joshua C. Long - Piper Jaffray & Co. Mary L. McNellis - Robert W. Baird & Co., Inc. (Broker) Joseph Terrence Buckley - Bank of America Merrill Lynch.

Greetings, and welcome to the Potbelly Corporation Third Quarter 2016 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce to your host, Mr.

Matt Revord, 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 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 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?.

Thank you, Matt. Good afternoon, everyone. Thanks for joining the call today. During the third quarter, we generated revenue of $104 million, an increase of 8% driven by new unit growth in company-operated comparable same-store sales growth of 0.6%. We opened eight shops including, six new company-operated shops and two franchised shops.

We delivered adjusted EBITDA growth of 11% to $12 million and adjusted net income growth of 38% to $3 million, and EPS growth of 50%, $0.12 per diluted share.

As we discussed in our Q2 earning call, we expect that the second half of the year to be challenging as we face the strong mix comparison from a robust menu innovation program with Avocado and Mac & Cheese last year and confronted the broader weakness in the industry that started to materialize in April and accelerated to the second quarter.

Unfortunately, these macro headwinds continue during the third quarter. Traffic, in particular, continued to decline from the second quarter to the third quarter and came in slightly below our expectations to put pressure on our sales growth.

As we look into the fourth quarter, we expect the continuation of the macro trends that we saw at the end of the third quarter. We remain focused on executing on the fundamentals of the business to drive sales growth and profitability, and we're on track to achieve a full-year outlook of comp sales growth between 1% to 2%.

Let me update you on our key priorities. First, menu innovation. We view menu innovation as important driver of sales. During the third quarter, we introduce a new hot protein Pastrami sandwich which performed to our expectation relative to mix and we saw solid attachment rate. This product will return in the future.

In September, we launched our Buffalo Mac & Cheese, which is really an extension of our Craft-Your-Own Mac & Cheese platform, which we introduced in the fourth quarter of last year. We expect Mac & Cheese to be an annual fall-winter item that we add to the menu going forward. We also brought back Buffalo Chicken Sandwich for this current quarter.

During the third quarter, we also introduced our seasonal Pumpkin Spice Cookies for those looking for a mid-day snack. The goal of our pipeline of menu items is to drive mix and traffic. And we believe we have a robust pipeline for the next 18 months to 24 months. Secondly, let me discuss the backline.

Our backline business grew in the low-double-digits during the third quarter and was between 14% to 15% of our sales. It remains a huge part of our future growth story.

We have an elevated position within the shops called Catering Coordinator, which is a dedicated role that manages the in-shop backline operations, interacts with our catering sales managers and with our outside customers, and goes out to canvas business to drive sales.

This role has its own career path, and we believe it will be a driver of sales in the future. We have implemented this role in about 50% of the shops. Our goal is to eventually have this role in all shops. We will add additional outside catering sales managers in 2017.

The catering sales manager growth will also match the growth of our catering kitchens in 2017. There are two additional topics that need to be addressed. One is investment in technology to grow sales, and the other is labor control. Investment in technology must continue in order for us to grow the sales and profits of the business.

There are two examples of this. We're testing digital menu boards in several shops. Tests go well, we plan on completely being in digital menu boards over the next several years. The ability to enhance our in-shop messaging should have a positive impact upon our sales. It will allow us to drive menu innovation as well as day-part sales.

Additionally, a new mobile app will be in beta test beginning the fourth quarter. We've worked on this app all year. Our mobile app will be best-in-class. It will have the ability for us to have ordering, pay, and customer engagement. The customer engagement program that we are contemplating will have several levels of membership.

We're excited about how the use of technology can help us grow this business. These are the two examples that we have ready to talk about and to implement. The second item is labor control. Hourly labor has to be addressed for a business like ours.

The government-mandated labor increases have produced additional cost without any obvious additional benefits. We have developed and are in the last stages of implementing a new labor management system. This system is designed to help us schedule and control labor more effectively. This is an important tool.

However, more needs to be done as the journey to $15 per hour continues across the country. Early next year, we will be picking a market to test changes to our operations that will be designed to mitigate the financial impact of the government-mandated labor regulations.

In my mind, there's no greater initiative in our company that we must test and find solutions. Bottom-line is we recognize the need to adapt and innovate in order to thrive in the current market environment.

We're confident about our long-term opportunities and remain extremely focused on identifying and implementing appropriate sales and operational tactics to drive near-term sales growth.

We're thoroughly examining our cost structure and we will remain extremely disciplined in our expense and our investments in order to ensure we meet our profits and return commitments. A side of that effort is the fact that, during this quarter, our shop margins increased 40 basis points versus 2015 of the same quarter last year.

As such, we remain committed to delivering a full year target of adjusted net income growth at least 20% and adjusted diluted earnings per share in the range of $0.36 to $0.38. Turning to our new unit development. We continue to find and build great shops.

As I mentioned earlier, during the third quarter, we opened eight new shops for a total year-over-year growth of approximately 10%, which is in line with our stated long-term development target.

We've opened six company-operated shops, five of which were drive-thru locations, which have historically generated good sales and return for us, and two franchised shops. In October, we opened our first franchised shop in Toronto, Canada. We're ecstatic to be in Canada and have Canada part of Potbelly Nation.

For the full year, we reaffirm our Outlook for the 40 to 45 new company-operated shops and 10 to 15 new franchised shops. However, we now expect to come in at the lower-end of those ranges. As we discussed in prior calls, we expect our shop development to be heavily back-ended weighted in the fourth quarter.

We recognize potential slippage of shops from December to January. However, we'll remain committed to delivering the 10% annual system in new unit growth. Now let me turn it over to Mike, as he'll go through the details of the P&L in the third quarter and our expectations for the remainder of 2016..

Thanks, Aylwin, and good afternoon, everyone. Thank you all for joining us today 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 a summary of our full-year 2016 outlook.

Starting with the top-line, total revenue increased about 8% to approximately $104 million in the third quarter, driven by our new unit growth and our company-operated same-store sales of 0.6%. Breaking down same-store sales, our average check grew approximately 4.6%, driven predominantly by price.

As we've previously stated, we expect our fourth quarter to be the toughest comp of the year as we continue to lap Avocado as well as our Mac & Cheese offering in the fourth quarter of last year.

Although, we continue to operate in a very difficult environment, we remain confident in our ability to achieve our full-year sales guidance for same-store sales growth in the range of 1% to 2%.

Moving down to shop P&L, shop-level margin for the quarter was 19.5% of company-operated sales, an improvement of 40 basis points from the prior year quarter. Our cost of goods sold was 27.6%, an improvement of 90 basis points to the prior year.

Food commodities continue to remain favorable and, for the year, we continue to expect our COGS to be slightly below 28%. Labor was 29.2% for the quarter, which was an increase of about 30 basis points from the prior year, driven primarily by wage inflation offset by pricing increases and improved labor productivity.

For the year, we continue to expect labor as a percent of sales to be in the range of 29% to 30%. Occupancy expense was 12.7% in the quarter, an increase of 30 basis points as compared to the prior year, due to lease renewals and higher real estate taxes. Operating expenses were 11% in the quarter or flat as compared to the prior year period.

Our G&A expenses were approximately $10 million in the quarter or 9.6% of total revenue, which is flat as 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 $12 million for the quarter, which was an increase of 11% from the prior year.

Our adjusted net income for the third quarter was $3 million, an increase of 38% from $2.2 million in the prior year, and our adjusted net income per diluted share was $0.12, an increase of approximately 50% from the $0.08 per diluted share in the prior year. Now, an update on our share repurchase program.

During the third quarter, we completed our $35 million share repurchase plan, which was authorized in September of 2015. In September of 2016, the board authorized a new $30 million program.

During the third quarter, we repurchased approximately 300,000 shares of Potbelly common stock in the open market for a total of approximately $3.8 million, which included shares from the new program, as well as from the previously completed program.

At the end of the third quarter, we had $29.6 million available from our board authorized program for repurchases which will continue as we move forward. Our balance sheet remains very strong with the cash balance at the end of the quarter of $29.7 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 at the lower-end of the range, including 40 to 45 company-owned shops and 10 to 15 franchised shops; $36 million to $38 million in capital expenditures; adjusted net income growth of at least 20%; and adjusted diluted earnings per share in the range of $0.36 to $0.38.

We expect an effective tax rate in the range of 37% to 39%. So with that, I'm going to turn it back over to Aylwin for summary remarks.

Aylwin?.

Thank you, Mike. We're not discouraged, although we are disappointed in the sales growth. We will continue to attack sales by the basics of backline, menu innovation, digital and mobile investments, and a focus on throughput. Our digital menu boards and our new mobile app are new tools for us to grow sales for 2017 and in the future.

Labor management will be helped by our new labor management tool and by the test market in early 2017 that will allow us to discover new ways to offset the government-mandated minimum wage laws. I want to thank the men and women of our Potbelly Nation for using the culture and using our tools to help us navigate the strong macro headwinds.

We remain committed to the following; at least 10% new unit system growth, net income growth of at least 20%, new unit capital of at least 25% return, and strong flow-through, so we can reaffirm all of our profit commitments for 2017. Now, I'll open it up for questions..

Thank you. And our first question comes from the line of Sharon Zackfia with William Blair. Please proceed with your question..

Hi, good afternoon. Just had a few questions. I guess, Aylwin, when you were talking about the test market for the changes in operations next year.

Are you thinking more front of house? I mean, people are doing things with kiosks for the customers or are you thinking more back of house, prep time, just trying to get a handle on what kind of operational changes you might be thinking of?.

It's a whiteboard and everything is on the table. We are looking to take out significant hours of hourly labor, and so we're basically starting with a clean sheet of paper and that's why we're picking a small market to test to see what can be scaled.

But given the dash to $15 an hour across the nation, it's this imperative that we come up with some solution. So we're not limited, at this point, to front of house, back of house, everything is on the table..

Okay. I think secondarily, just maybe a couple of questions on guidance for development. I know you expect to be heavily weighted in the fourth quarter this year.

I am just curious whether you have an opportunity to be more equal weighted in your development in 2017 on a calendar basis, and if you can give us any update on how the franchising process is going in California?.

So, we're still working on California, still anticipate 2017 to have units open from a franchise perspective. We are working hard to rebalance the new openings and we believe you'll see a change in 2017, first half of the year versus this year, I think we opened like 9 or 11 first half of the year.

We definitely will work to improve that and try to smooth it out. It – there's just a tremendous strain on the system when you – we still got about 19 to 20 shops to open before the end of the year. So the goal is to balance that out..

Okay. Great. Thank you..

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

Great. Thanks for taking my question.

I was curious if we might be able to talk about the cadence through the quarter this past 3Q? And then maybe go back to last year's 4Q and review the cadence there because it seems like you've got – optically you've got similar compares from a pure same-store sales level in 3Q and 4Q of 2015, but want to make sure that we fully appreciate kind of the timing of the product rollouts that were such strong contributor to your comp last year?.

Okay. Yeah, this is Mike. I can address that. So the cadence in this quarter was that we did see a little bit of worsening as we went from July into August, and we've really been at a similar level in August, September, and even in October at the similar level.

As we look last year and we've talked about this a few times, a challenging comp in the fourth quarter and that gets more difficult as the months go on. In particular, December of last year was a very strong comp, had the benefit of a very strong mix, which I believe you were alluding to, and actually had positive traffic as well.

So things do get a little bit more difficult over the next couple of months..

That's helpful. Thank you.

And then in terms of the average check during the quarter, we talk about the price – menu price that was in place then kind of the resulting mix contributor to the 3Q comp?.

Yeah, sure. No problem. Yeah, when I was referring to things got slightly worse, it was traffic that got a little bit worse as we went from July into August.

In terms of mix, well, let me just break-down the quarter overall so the 4.6% check that we just talked, 4.2% of that was price and four-tenths (19:46) of that was mix, and traffic was – averaged down about minus 4, that's for the quarter as a whole. As I mentioned, things got slightly worse by a matter of tenths as we went through the quarter.

Mix moved around a little bit, but we didn't stray too far from the average of the four-tenths that I just mentioned..

That's helpful. And then, as we think about kind of the current environment that we're in, we're obviously facing some headwinds on the cost front and then we also want to maintain the value and affordability of the core product.

How do you think about balancing the menu price aspect as we go through the back half of this year and into 2017 with some of those other initiatives you're talking about in terms of labor management and, obviously, the cost of goods sold environment that is currently favorable? Just trying to think about how you balance all those pieces in the current backdrop?.

We still have significant price value relationship to our direct competitors, so we'll price accordingly primarily to offset inflation as we look to it and inflation we see next year is primarily – it's still early but it's primarily labor.

We had good flow-through on the pricing and that's how we're thinking about it and not clear what's going to happen with the consumer.

Hopefully, after the election something break, but we're going to try to drive menu innovation and some of the technology tools I talked about that I think can help us, particularly the app we think can be a real business driver. So – but we still have significant pricing room when we look at our direct competitors versus our current price..

And just as reminder, the pricing that we did in late July of this year was focused on our catering business. It was not increases at all to the rest of the menu..

Got it. Thank you..

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

This is Lewis (21:51) on for Karen.

Can you elaborate on the slowing consumer trends you said impacted sales growth in third quarter and do you expect these trends to continue in the fourth quarter?.

Yeah, I think most people in the industry would say yes. We wish they had the crystal ball. But still the biggest thing we look at is the relationship of food eaten at home and food eaten away from home.

That gap is the biggest I've seen in a long time and consumers are getting tremendous value in the supermarket because of the low commodity pricing that's definitely helping our business.

So we don't know how long it's going to do that we're sitting on your wallet, that's why we're going to try to be aggressive with the technology investments with the app and the digital menu boards and the product innovation. But we're taking a wait-and-see attitude..

And, explicitly, the guidance we gave assumes the continuation of those trends that Aylwin just talked about..

Great. Thank you..

Thank you. Our next question comes from the line of Mary McNellis with Robert W. Baird. Please proceed with your question..

Good afternoon.

You mentioned that trends have stabilized here in September and October, do you think that that's more of a function of the year-ago comparison, or do you think that it's been helped by some of the internal drivers like new Mac & Cheese, and then just any perspective that you're going to provide on some of the levers you think you can pull in the near-term whether that's menu innovation or execution of a digital marketing to help you cycle these type of comparisons in the balance of Q4?.

Yeah, the technology innovation, that's going to be for 2017. We're doing a proof of concept now. We're beta testing the app, which we've been developing all year that should help us in 2017. I think, our attitude is, what happen in quarter three, from a consumer standpoint, is likely still going to happen in quarter four.

So the goal there is to manage costs really tightly, so we get really good flow-through so we could hit our profit commitment. We're going to work hard not to go negative on the sale and that's what we're trying to do every day, so let's do execution and treating the customers that come in the door with the exceptional care.

So, they'll come back more often. We have a Mac & Cheese platform. We have a Pumpkin Cookie. We have our Buffalo Sandwich. We have a fairly robust program for Christmas around our gift cards. So all that stuff we think would help and we just got to keep driving the business..

It's helpful. Thank you.

And then, I know you're not ready to provide specifics on the 2017 outlook just yet, but I'm wondering if you could just provide some high-level thoughts on how you're thinking about the unit development outlook for next year in terms of whether you expect to continue the pace of 10% plus comp – company-operated unit growth, or if there's potential for an increased mix of franchised growth as development from some of these multi-unit market agreement starts to accelerate?.

Well, we think the mix – we're committed to at least to 10% unit growth. We would like for that – for the system. We had a board meeting last week, and what we told the board is we want to – whatever happens in the marketplace, we want to be prudent and take advantage of it.

So, if there's dislocation that should cause us to slow down, we'll be in a position to do that. The dislocation of marketplace where real estate becomes available, that is attractive to us. With our balance sheet, we can take advantage. We're going to be very prudent.

We will have a conservative and kind of defensive bent, but the 10% system growth is what we're trying to drive. The interesting thing is, look at some of the pronouncements of our competitors is that – the labor thing is driving everyone to look at their business model and look at development.

And so, we're not alone in that aspect, but we're committed to 10% unit growth and with the appropriate mix of company and franchised..

Thank you. That's helpful..

Our next question is a follow-up question from Joshua Long with Piper Jaffray. Please proceed with your question..

Great. Thank you. Just wanted to make sure that I was clear on the current guidance and kind of the commentary we're discussing in terms of just the difficult macro environment and the tough year-ago comparison. Strong results in 3Q from an EPS and from a top-line perspective.

But just as I look at your guidance for the year of that reiterated range of $0.36 to $0.38 that does suggest some downside on a year-over-year basis, from an EPS perspective in 4Q.

And so just curious if that is largely being driven by the macro environment, the comparisons we talked about, or if there's other cost issues in kind of the middle of the P&L or items in the middle of the P&L that we should take into consideration as we fine-tune our models for this year?.

Yeah, I'll start maybe, first, it's in the – a bit of the backdrop of the macro environment which we make decisions around, whether we should revise that EPS guidance or not, obviously it's softer sales as you pointed out, the comps get a little bit tougher as we go through the next couple of months.

And Aylwin has also mentioned, we talked throughout the year about being very back-end weighted on our new shops. We have a tremendous number of shops that we're opening in the very end of the year. Those tend to be very inefficient initially and can be a little bit of a drag on the bottom line.

So, I would say, we're just being prudent in how we're approaching the guidance to the bottom-line..

Great. Thanks for the clarification..

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

Thank you. And I apologize if some of these have been asked – I got knocked off the call for a short period.

But with the heavy fourth quarter opening schedule, can you give us some help on what the pre-opening expense is going to look like in the fourth quarter?.

Yeah, I'm trying to think out a best answer. We haven't specifically guided on that line. As you know, it's – the pre-opening expenses we've seen so far year-to-date continue to be below where others may have estimated. So there would be a bit more of a catch-up in the fourth quarter.

I think where folks have been estimating that number without providing very specific guidance has been in the range – a reasonable range within where we'll likely come in..

Okay.

And then the new overtime rules that go into effect December 1, can you discuss the impact of those and how you're handling them?.

Yeah, we're in the process of internally communicating to the affected assistant manager group, and so we will implement solutions that would mitigate almost 100% of the financial impact for this year as well as in the future.

So, there are a couple options that you know very well because other folks have talked about it and we're going to implement one of those. I'm not being coy, but we haven't talked to our assistant managers. In fact, we talk to them next week.

So it'd be inappropriate for me to tell you specifically, but the cost will largely be mitigated by us and you shouldn't – that's not a line that we'd say we'd have cost inflation on for this year or for 2017..

Okay. And then last one, Aylwin, you talked about testing digital menu boards and I guess obviously hopefully rolling them out next year perhaps. Is that – talk about the investment behind that.

Is the significant capital investment or their cost and expenses associated with that that we should start thinking about or – just fill that out (30:44) for us a little bit financially..

Yeah, so obviously there's capital, but it will be done within the range of our capital plan. It will be a multi-year approach. We'll start kind of with high volume in new units, and it's like we did the fast oven. We didn't do all of those in one year; it took us three and a half years to get that done.

I am thinking about the same level of pace for this. It's a powerful tool that allows us to message in the shops. It should help us drive the menu innovation and also help us drive day-part sales.

So I think it's a tremendous tool, but we'll be prudent as we roll it out and it will be multi-year, and again it will be within the range of our current capital expenditure..

Okay. Thank you..

And, Joe, this is Mike. Just to add back to your question on pre-opening.

So one way maybe for you to think about is that our average pre-opening cost per shop really haven't changed significantly over time, so you just take your estimate of new shop openings for the fourth quarter and apply that what you've used in the past in terms of the average pre-opening cost. So that might help you get to a more refined number..

Thank you. There are no further questions at this time. I would like to turn the call back over to Mr. Lewis for any closing remarks..

I want to thank everybody for your interest to be on the call and for your questions. There are two strengths that this company has, strong culture and strong balance sheet. We believe these two things will allow us to maximize opportunities in the marketplace.

There are stronger headwinds that are impacting us, but we're very committed to driving our throughput and our profit. We're going to invest in technology that's going to help us grow the business in the future.

And we have a strong belief in what we're doing; fundamentals are strong and you should expect strong flow-through so we can meet our profit commitment for the balance of this year as well as the next year. So disappointed, but still very committed to the business and to our growth story. Thank you and get some sandwiches, please..

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for participation and have a wonderful day..