Matthew J. Revord - Potbelly Corp. Michael W. Coyne - Potbelly Corp..

Stephen Anderson - Maxim Group LLC Sharon Zackfia - William Blair & Co. LLC Nicole M. Miller Regan - Piper Jaffray & Co. Gregory R. Francfort - Bank of America Merrill Lynch Mary L. McNellis - Robert W. Baird & Co., Inc. (Broker).

Greetings, and welcome to the Potbelly Corporation Second Quarter 2017 Earnings 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.

I'd now like to turn the conference over to your host, Matt Revord, Chief Legal Officer..

Good morning, everyone, and welcome to our second quarter earnings call. Before we get started, I'd like to note that certain comments made on this call will contain forward-looking statements regarding future events or future financial performance of the company.

Any such statements including our outlook for 2017 or any 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'll be giving today can be found in our most recent Annual Report on 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.

I'll now turn the call over to Mike Coyne, our Chief Financial Officer and Interim Chief Executive Officer, who'll begin with his perspective on the second quarter performance, provide a discussion of our ongoing strategic initiatives, will then review our financial results and future outlook in more detail before we open up the call for your questions.

Mike?.

first, to better enable the launch of our new Feed Your Smile tagline in a simple, engaging and cost-effective ad that also reinforces key brand elements, and ends with a call to action to come try the new Turkey Club. We are committed to these strategic brand growth investments to help drive both sales growth and profitability over the long-term.

Now, I'll turn to a brief walk through of our P&L and then an outlook for the year. As I mentioned earlier, our total revenue was $108 million in the quarter with company operated same-store sales decrease of 4.9%. Breaking down same-store sales, our average check grew approximately 3.1% driven by price.

Our shop-level margin for the quarter was 19.2% of company-operated sales as compared to 21.2% in the prior period. Cost of goods sold was 26.7% in the second quarter, an improvement of 60 basis points from the prior year driven by pricing.

Labor was 29.4%, which is an increase of about 70 basis points from the prior year driven primarily by wage inflation, partially offset by our price increases.

Occupancy expense was 13.3% in the quarter, an increase of 70 basis points compared to the prior year due to sales deleverage and certain occupancy-related costs including lease renewals, higher real estate taxes and higher common area maintenance.

Operating expenses were 11.4% in the quarter, an increase of 120 basis points compared to the prior year due largely to sales deleverage and operating expense items such as repairs, maintenance, utilities and other expenses not directly variable with sales.

Our G&A expenses were approximately $10.9 million in the second quarter or 10.1% of total revenue, which is an increase of about $600,000 or 30 basis points as compared to the prior period driven primarily from severance and equity compensation charges related to the departure of our previous CEO.

Excluding these expenses, we achieved leverage of 60 basis points driven primarily by our cost control initiatives and the reduction of our performance-based incentive accruals given the company's performance to-date.

Our adjusted EBITDA was $11.8 million for the quarter, which was a decrease of 9% from the prior-year period, mostly driven from our decline in same-store sales and labor and occupancy inflation.

With income tax expense of $186,000, which is primarily driven by the negative impact of the adoption of Accounting Standard Update 2016-09, which pertains to the recognition of excess tax benefits and deficiencies related to share-based compensation.

The adoption of this standard resulted in approximately $158,000 of additional income tax expense during the second quarter or about $0.01 per diluted share. Excluding the new accounting standard and other immaterial one-time impacts, the effective tax rate would have been approximately 34%.

Our adjusted net income for the second quarter was $2.7 million or $0.11 per diluted share as compared to adjusted net income of $4 million or $0.15 per diluted share in the prior-year period.

Regarding our share repurchase program in the second quarter, we repurchased approximately 260,000 shares of Potbelly common stock in the open market for a total of approximately $3 million. At the end of the second quarter, we had $22.7 million available from our board-authorized program for repurchases, which will continue as we move forward.

Our capital expenditures came in at approximately $8 million. Our balance sheet remains very strong with a cash balance at the end of the second quarter of $21.2 million and we had zero debt. Turning now to our outlook for the full year fiscal 2017.

We have continued to experience negative traffic trends from the end of the first quarter through the end of the second quarter of 2017. As we look out to the balance of 2017, while we expect to see some benefits from our sales growth initiatives, we currently do not contemplate an improvement in the challenged macro environment.

Therefore, we have revised our comparable store sales guidance from a decline in the low-single digits to a decline in the mid-single digit range in 2017. We continue to expect relatively modest levels of goods inflation for the full year and our food cost basket is over 90% locked for the year.

Therefore, we now expect cost of goods sold to improve to the range of 26.5% to 27% versus the previous guidance of 26.5% to 27.5%. We continue to expect labor as a percentage of sales to trend around 30%.

Our guidance assumes continued wage pressures from minimal wage increases implemented last year as well as expected statutory and inflationary pressures in part offset by the price we have taken.

Due to the challenging top-line environment, we are tightly managing our expenses and reducing our pay-for-performance incentives in an effort to improve our bottom-line performance.

For the year, we expect our adjusted G&A expense to be in the range of $41.5 million to $42.5 million, excluding the full-year one-time cost of approximately $2.5 million related to our CEO transition cost. This G&A range is down from the original guidance of $44.5 million to $45.5 million.

Given the top-line challenges, we now expect adjusted net income per diluted share to be in the range of $0.30 to $0.33 for 2017. In addition, we continue to expect an effective tax rate in the range of 36% to 38%, excluding the impact of the new accounting standard. Turning now to our new unit development.

During the second quarter, we opened 16 new shops including 3 franchise shops and 13 company-operated shops.

As part of our ongoing strategic review, we expect to continue to moderate the pace of our company-operated shop growth going forward and we now expect to achieve 30 to 35 new company-operated shops, down from our original outlook of 30 to 40 new shops. In regard to franchising, we expect to achieve the low end of our outlook of 15 to 20 new shops.

With our expected moderation in company-operated shop growth, we now expect to spend between $33 million and $35 million on CapEx in 2017. In closing, Potbelly offers a welcoming environment with the best tasting sandwiches, hand-dipped shakes, daily baked cookies, all served quickly by really friendly people.

It's our goal to have every customer leave our shop with a smile. We've got a strong pipeline of menu innovation which will further strengthen our connection with our customers.

We've made and will continue to make investments in technology and convenience to drive a superior experience and there's an enormous opportunity to reach more customers using delivery, catering, and enhancing our marketing and engagement tactics.

As I mentioned, we are undertaking a comprehensive review of our business and have engaged a financial advisor to help us evaluate our strategic business options.

We believe that with our ongoing strategic review and the initiatives that we're implementing, we can navigate this challenging environment, drive our brand forward and create long-term sustainable value for our shareholders. Thank you all for your time today. We appreciate you being on the call and the support of our business.

Now, I will turn it over to the operator and open it up for questions..

Thank you. At this time, we'll be conducting a question-and-answer session. Our first question is from the line of Steve Anderson with Maxim Group. Please go ahead with your question..

Yes. Good morning. What we've been hearing from some competitors in the industry is that we have seen a lot more promotional activity from the quick-service burger giants, McDonald's, Burger King, been doing a lot more in the premium sandwich category.

I just wanted to ask about your comments on that and see if you're maybe seeing some loss of customers to some of the burger giants and I do have a follow-up..

Sure. Thanks, Steve for joining the call and thanks for the question. Yeah. Sure, we see the same thing that you see and others in the industry see. It's a highly promotional environment. It does make things a bit more challenging.

It's hard for us to individually tease out the impacts on our traffic to any one competitor or even subsector, but clearly that is one of the impacts, Steve..

Okay.

And with regard to your Potbelly Perks program and some of the sandwich giveaways we saw during June, what kind of impact do you think you are seeing in terms of increased additional food costs from those people who sign up for the Potbelly Perks program?.

Yeah, sure. Thanks for bringing that up. We were actually proud of where we are at so far in the evolution of Potbelly Perks with over 300,000 members so far, which is terrific. As to the cost, it's actually very much in line with what we anticipated when we set this program out, which means it's very profitable for us in the end.

It's factored in of course into our COGS number, which is really good and we've obviously revised our guidance downwards on that in a favorable way. So, it's maybe measured in a tenth or so in COGS, but not too much more than that, Steve..

All right, thank you..

Our next question is from the line of Sharon Zackfia with William Blair. Please proceed with your question..

Hi, good morning. Just a few questions.

This may have been implicit in your strategic review, but are you open, are you contemplating the potential to refranchise some company units? And then secondarily, I mean you don't need me to tell you that lunch has been pretty challenged industry-wide for a while, so as you think about the going forward strategy, is there any kind of effort to diversify the business away from what has historically been a heavy lunch business?.

Great. Good morning, Sharon. Thanks for joining. Thanks for the questions. So, yes, what I would say is, the words that we included in the press release and that I noted in the script are very broad, right? This will be a very comprehensive review and really looking at every part of the business.

So the words around potential ways to accelerate franchising, we're really open to anything. We are looking at getting ourselves a lot smarter about the ways in which we can do that, the resources that we would need to be doing it. And the role if any that refranchising would play. So that is certainly on the table for evaluation and exploration.

For the second part of your question, certainly with a concentration that's nearly about 60% lunch, looking at ways in which we can leverage other dayparts would also be part of the overall strategic evaluation.

Challenging, it's not easy to do when you become so well-known for lunch and we don't want to lose that, but we think there is opportunities for us to build business in other parts of the day..

Thank you. Our next question is from the line of Nicole Miller with Piper Jaffray. Please proceed with your question..

Thank you. Just a few questions.

On the franchising topic, do you envision as you embrace that more so going forward being small groups of restaurant entrepreneurs or would you even consider master franchising, what do you favor and why? And then what might be the right mix when you look really further down the road, is it a 50%-50% kind of model or would you go to 90% franchise, what makes sense in your mind?.

Thanks Nicole for the question. Yeah, what I would say is, we're really early on in the strategic review process and we need to learn a lot more about what makes most sense for us.

What I can safely say is that with our historical pattern of really going to kind of more one-off mom-and-pop kind of operations and we kind of are slowly evolving into three to four shop deals.

I think we certainly need to be open to larger deals, whether that evolves all the way to kind of master arrangements or not, premature for me to say at this point in our evaluation, okay. And then as to the percent, again, where I start there very safely, as we've said for quite some time that we want to move to 25% franchise and we sit here at 10%.

So, we've got a long way to go just to get to that 25%. So again, part of this evaluation will be, as you look at all of the economics, all the implications on cash flows, the P&L and ultimately balance sheet, amongst these different alternatives we will look at. In the end, it's all about what do we think will create the most shareholder value.

So, sorry to say, it's a little bit premature for me to give a percent out there yet in terms of mix..

No. That's fair and helpful. Just a second and last question, earnings have been relatively flattish just going back some time, just big picture.

So as you think about the drivers going forward, how would you prioritize things like, growing faster or cutting cost or levering up and buying back shares in order to generate more earnings power?.

Yeah. Great question. I think one of the key outcomes of the work, not to defer everything to this review that we're doing, will help us prioritize what makes the most sense. And everything you just named is on the table.

With the first part of what you said as to growing, I think that as we've implied on the call, we actually would look to be moderating, to a degree anyway, own unit growth for a bit during kind of where we're at in the cycle and our own performance.

We'll see how quickly we can get about the business of improving and growing the franchise side of the business. I think that we would continue to be buying back shares. I'm not in a position yet to say whether we would be accelerating that at any point, but it does make sense for us right now.

So we have all those opportunities and all of those will be with an eye toward improving our cash flows, yes, improving earnings, but importantly improving our returns on invested capital..

Thank you..

Thank you..

Our next question is from the line of Gregory Francfort with Bank of America. Please, go ahead with your questions..

Hey, Mike. I just had a few questions. And the first, I think you mentioned when you were talking that Perks, the potential to do external partnerships or that you were doing external partnerships.

Can you help frame up kind of what that opportunity is or what you guys are doing right now on the Perks external partnership side?.

Yeah. Sure. Maybe with a couple of examples. So, this is meant to be value add for the members, right. So, we're working with, for example, Yelp for folks who go there and place an order on the Yelp website, and this will go through our system.

We're working with one of the banks or credit card – actually one of the banks and one of the credit card companies that would – for our internal purposes of targeting acquisition. We're working with a couple of our own vendors.

So, one of our beverage vendors that for example, we could give away a free soda, right, to the members, whether it's a surprise and delight or having earned it et cetera.

So, those are the kind of partnerships we're working on so far and I think, there's lots of creative things that our marketing folks are working on to add value for the Perks members..

Great. Thanks. And then just switching back to the flowing unit growth. And I guess, maybe, can you help me understand how much new stores right now is a drag on restaurant margins? And then, I guess, also in terms of the G&A side, I think, you guys have G&A as a percent of revenue, I think, about 10%.

And a lot of the sort of non-growth casual diners are more like 5%. And is that an opportunity where if you weren't opening up stores you would have G&A as a percent of revenue at more like 5%? Or I guess maybe is there something structural in the Potbelly business where G&A should be higher than sort of other non-growth names.

I guess I'm just trying to think about, if you guys were to cut off store growth, where would G&A go as a percent of revenue and then kind of roughly how you think about that?.

Yeah, sure, thanks Greg. Let me try to get at maybe the second one first.

So I may be a little less familiar with a kind of industry average or maybe you meant it was casual dining, I don't know, at 5%, certainly at 10% we've always said we're looking to improve upon that over time and, yes, in the past we've said in incremental ways of 20, 30 basis points a year and ultimately getting kind of into the 8%-plus kind of range.

So I'm less familiar, so I can't really to speak to the 5%. And so what we have to do, and this is part of putting the whole picture together and that's why the strategic review – as we use very broad language here because there's a lot that goes on as you make this, as you moderate own growth, and perhaps looking for avenues of franchising more.

There's a lot of implications for the balance sheet and the P&L and the cash flows. And so you have to be very mindful as the nature of your top-line – if it's to change, and I'm not presupposing anything here, you have to be very mindful of how you lever the G&A and how that evolves over time.

So I know that's maybe a bit of a vague answer, but I guess the first part is, less familiar with the 5%, but certainly know that we've been trying to make progress on getting below 10% and into the high single-digits, and then secondly as we work through our analysis here, we will certainly be mindful of how G&A can lever over the future.

And I'm sorry Greg, your first question..

The other question was just on restaurant margins and, I guess, maybe what has been the performance of the new stores on the margin side, and how much of a drag do you think that is on your annual restaurant level margins, just the pace of openings right now?.

Yeah. Sure. Maybe I'll give you a qualitative answer to that. Certainly our kind of static comp group is well in excess of the overall margin that you would see on our P&L. And as you look at those shops that are one month old or three months old or six months old, those certainly are well below that average.

In some cases, they start off at a single-digit margin, so that's a fairly significant drag. But they fairly quickly get themselves into low double-digit, low-teens and then make their way up as we expect them to normalize.

We always talk about how we get to year two and when we do our assessment of return on invested capital, we expect those to be kind of fully functioning, up to speed, scale, operational productivity et cetera.

So there is a drag and that's why when you do a little bit less new shops, at least in the short-term, you get a benefit to shop margin which helps the bottom line in that short-term..

Got it. And maybe, I may sneak one last one in here. How many stores in your portfolio right now are beyond a year or two, sort of I guess excluding the new stores.

How many of your more mature stores are cash flow negative right now? And, I guess, I don't know if – do you think about that on an EBITDAR basis and how many in the portfolio are negative as we stand today?.

Yeah, sure. So, as part of that, while I might not have a specific number for you, we look at it both on a shop margin or near to your EBITDA kind of number but, yes, we also look at it on an EBITDAR level, so looking at it before rents as well.

And we are focused on those shops that are the least profitable, in fact one element of our strat review is looking at those shops that are least profitable and trying to figure out are there things that we can do creatively with those, whether they are negotiating lease terms or getting out from under the shops and closing them.

So we are focused on them and that will be again one of those outcomes of our strat review..

Got it. Thanks. Thanks for the time..

Yeah. Thanks, Greg..

Your next question is from the line of Mary McNellis with Robert W. Baird. Please proceed with your questions..

Good morning. Thanks for taking the question. First, just a couple of clarifications.

Mike, within the average check of 3.1% for Q2, can you just break out specifically how much of that was price versus mix and then also what was the drag from Easter during the quarter?.

Okay. So the drag from Easter, I've got Andy (28:47) here to help me out here.

Had a few tenths drag on the quarter?.

Yes..

Yeah. And then, yeah, the breakdown, actually that was all price, that check, it was essentially all price. It was a very modest impact from mix..

Okay. That's helpful. Thank you. And then we've heard from several companies the trends exiting Q2 and in early Q2 have gotten softer, kind of, for the industry overall.

So I was wondering if you'd be willing to comment on whether you're seeing a similar trend in your business and then maybe related to that, if you're willing to provide any perspective on how you're thinking about the progression of comps for the second half of the year given the easier comparisons?.

Yeah, certainly. So what I would say about the progression within the quarter. It was kind of up and down throughout the second quarter, in that May was a bit better than April and June.

As we ended the quarter, I would say by a matter of a couple of tenths, June was a little bit softer than the Q2 average and then as we entered July and this is what you've heard from many others, we've read it from many others, there was a softness as the quarter ended, and a softness that continued in July, not dramatically so but, again, measured in a few tenths.

And so, back to your question about outlook and what I said during the prepared remarks, part of the reason why we revised our outlook for the second half is that we expected that as we came upon easier comparisons, which we had to some degree in June and to a little bit greater degree in July, we didn't see that improvements that we expected.

We saw what the industry saw, which is a little bit of softening overall. So, that in part is what caused us to refine our overall guidance for the full year and thus the second half..

That's helpful perspective. Thank you..

The next question is from the line of Steve Anderson with Maxim Group. Please go ahead with your question..

Yes. This is a follow-up question, certainly we've heard from a few operators talking about some of the weather impacts during the quarter, particularly in the East and Central U.S.

Just want to see if some of the heavier rainfalls had any impact on your foot traffic and if you'd be able to quantify that?.

Yeah, sure. What I would say is, I wouldn't attribute much. We did have some modest negative impact if you look at the quarter as a whole. What I would say geographically, we didn't see much in way of differences across our geographies in terms of performance. As I said, yes, there were some weather impacts in some parts versus others.

But part of some of what we've read from industry players and in the various indices out there is that, when they looked at geographic differences, I think there's some favorability on a relative basis in the West, where we're not, perhaps there was some favorability in the Southeast, where we're not.

So, those parts of the country where there was that continued softness and maybe a little bit more so at the end of June and in July in the Midwest, in Texas et cetera. Those are places where we're pretty heavily concentrated.

So, as to weather, not significant; I would call it a modest impact, and then geographically those are the comments I've just made..

All right. Thank you..

Thanks, Steve..

Thank you. At this time, I'll turn the floor back to Mike Coyne for closing remarks..

Terrific. Thanks, operator. Thank you all for attending. Let me just reiterate that while we're in a tough part of the cycle and disappointed with our top line, we're working hard to maintain margins, get our flow through, we've got a great brand, great opportunities ahead. We believe in the strength of our people, the fundamentals of the business.

As I said, on the one hand we're focused on our near-term initiatives to drive sales and very focused on what I mentioned in terms of a comprehensive strategic review. So, thank you and thank the many people of the Potbelly nation who work very hard every day on our behalf. Thank you..

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