Good afternoon, everyone, and welcome to Potbelly Corporation's Third Quarter Fiscal 2019 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded.

I would now like to turn the call over to Mr. Matt Revord, Potbelly's Chief Legal Officer. Please go ahead, sir..

Good afternoon everyone and welcome to our third 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 2019 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 rise 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 will be good today, can be found in our most recent annual report on Form 10-K under heading Risk Factors and MD&A and in our subsequent filings with the Securities and Exchange Commission, which are available at sec.gov.

Our presenters there are Alan Johnson, our Chief Executive Officer; and Tom Fitzgerald, our Chief Financial Officer. After our prepared remarks, we'll open the call for your questions. I'll now turn the call over to Alan..

Thank you, Matt. Good afternoon everyone and thank you for joining us today. I'm going to spend some time discussing how our strategic efforts to reposition the company are performing and then Tom will provide more specific details on our third quarter results. I'll get started with a few high-level results for the quarter.

Same-store sales were down 3% as weaker traffic trends persisted throughout the quarter. Our strategic initiatives are showing positive results as this is the second quarter in a row of sequential improvement, and we are seeing a continuation of that trend through the first few weeks of the fourth quarter.

However, these initiatives have not been enough to offset the impact of weaker traffic and so we are going to talk today about our plan to accelerate our turnaround progress. First, I want to update you on our four strategic pillars.

One, our many optimization efforts continue to drive positive results as they have helped grow our average check by 580 basis points year-over-year. Two, sales for our off-premise and digital channel were up 18% in the quarter, driven by the DoorDash national rollout that took place in early July.

And as you saw last week, we recently announced a new nationwide partnership with Grubhub. We see this as an important step as we expand our delivery reach and digital brand awareness. Off-premise and digital sales represent 21.6% of our Q3 sales, which is an all-time high for Potbelly.

Three, as we shared on our last call, retention is critical to our success and we remain committed to building brand awareness and are creating a simpler Potbelly Perks program that we plan to roll out in 2020. Four, we continue to evaluate the right mix of message, media and creative to grow our share of the market.

As we communicated in our last call, we have pared down our marketing spend as there are components of our business that still need to be fixed before our marketing efforts can reach their full impact. Switching gears, I'd like to walk through a few strategic decisions that we have made.

First, we have effectively halted company-owned shop growth until we see more positive traction in our traffic trends. The exceptions would be where we need sites to further refine or Shop of the Future concept or we see opportunistic and highly profitable locations like airports.

This will have a positive impact on our cash flow by reducing our CapEx spend for new shops and will lead to lower CapEx in 2020. For context, we spent $7 million in new store CapEx in 2018 and anticipate spending $2 million in 2019.

We need to keep 100% of our focus on turning around our business, specifically improving traffic and continuing to accelerate franchise shop growth. Our franchising strategy has been a big win for us this year. We signed deals for more units in the first half of the year than we have in the last eight years.

We have a robust pipeline of highly qualified franchise candidates, and we are excited about the momentum we have in this business. Lastly, we want to make clear that we are also open to refranchising opportunities.

There are certain core markets that we would likely not refranchise but that is a much shorter list than the list of markets that we are willing to refranchise. While we aren't in a position to talk specifics about those markets, we want to make it clear that Potbelly is open to refranchising opportunities in the majority of our markets.

As I've step back and look at the progress we have made over the last 18 months, I feel encouraged. We have constantly been testing and learning and these results have informed our initiatives thus far. We have significantly changed our corporate culture, leadership and the way we do business.

While a lot of progress has been made, we are still looking for that exact right formula. It's clear to us that we need to gain further insights into consumer needs and trends in order to further sharpen our brand position and competitiveness.

Therefore, we decided to bring in a top-tier consulting firm in June that has a proven track record of helping other companies in our space turn the final corner. We felt we needed an outside-in perspective to develop the fact-based consumer insights that create a winning strategy.

In working with this firm over the past 16 weeks, we have been fundamentally addressing the strategic question of where are we going to play and how are we going to win. This project is all about topline profitable growth.

The consulting companies' quantitative research method is proven in the restaurant space and was the catalyst of the successful turnaround of several fast casual and QSR concepts. Typically, these larger restaurant companies did not disclose that they had engaged a management consulting firm to do this type of work.

However, given its impact on our P&L this year is approximately $3 million, we felt it was important to communicate on this call. Looking forward, we do not anticipate any significant ongoing costs for consulting work for this project beyond Q4.

This has been a collaborative effort, and needless to say, we are very excited about the opportunity in front of us. We plan to launch a couple of large-scale tests in the first half of 2020 and roll out the successful elements in the second half of the year to our company-operated and expanding franchisee base.

These tests are designed to bring the strategy to life, building on what's already working well in our business like off-premise and digital and menu optimization. This initiative is 100% focused on delivering sustainable and consistent profitable same-store sales growth.

There are two things that I am willing to share with you today as it relates to this project. First, this strategy will leverage the core strength of what the Potbelly brand represents. It is not a radical departure, but it is clear that our brand is not as differentiated as it needs to be.

Second, this project includes significant competitive benchmarking. Suffice to say that we identified some opportunities to improve in-shop customer experience. We have rallied our operators to address these gaps by focusing on the fundamentals to improve the customer experience.

We believe this will improve customer satisfaction, positively impact traffic and retention, and complement the results we have already accomplished with our four pillars. This will lay the foundation for the strategic changes that follow in 2020.

Beyond those two things, we are not going to elaborate further on the strategy or any of the initiatives today. We will provide updates once we have results from the various tests. In the meantime, we are going to continue to operate with tight G&A management, focus on the fundamentals and gear up for the tests we have planned in 2020.

With that, I will now turn the call over to Tom, who will walk us through our financial performance in the third quarter..

Great. Thanks Alan and good afternoon, everyone. I'll walk through our financial performance and then briefly discuss our 2019 outlook before handing the call back to Alan for his closing remarks. All comparisons are versus the comparative prior year period, unless otherwise stated.

Now, before I get into all of the financial information for the quarter, I want to step back to the bigger picture for Q3. As we've communicated in the past, Q3 of 2018 was one of the strongest quarters in recent memory in terms of traffic growth, where same-store traffic was virtually flat to Q3 of 2017.

That was the first time we experienced a flat traffic quarter since Q4 of 2015. The traffic improvement last year was the result of very high levels of discounting, coupled with very high level of advertising spend compared to our typical spend on advertising.

This year, going into Q3, we made the conscious decision to pull back on both the level of discounting and the level of advertising spend based on what we've learned in the first half of this year. As a result, gross margin comps were negative 2.9% in Q3, that's 230 basis points better than the result in the first half of 2019.

That improvement coupled with the reduction in advertising versus last year's spending levels resulted in an adjusted EBITDA decline of 11% year-over-year in Q3 compared to the 44% drop in adjusted EBITDA that we reported in the first half of the year.

That was an important test for the business as we seek to become less promotional and more focused on driving more sustainable and profitable results. Now, let me turn it back to the financial review.

Starting with the topline, total revenues decreased 2.6% to $104.2 million in the third quarter, driven predominantly by a 3% decrease for our company-operated shops. Breaking down same-store sales, our average check grew by 5.8%, driven by a combination of price and mix, and our traffic declined 8.3%.

Our third quarter comps increased 100 basis points compared to the second quarter of this year, and our two-year comp stack also increased 100 basis points compared to the second quarter's two-year stack. Our same-store sales gap to Black Box narrowed to 210 basis points, the best result this year.

As Alan said, our four strategic pillars are clearly having a positive impact. As we expected, same-store traffic fell by 240 basis points compared to the second quarter of this year, but our two-year traffic stack increased by 80 basis points versus the second quarter's two-year stack for traffic.

In the quarter, we opened one new shop, which was a U.S. franchise shop. We closed two company-owned shops for a total of 11 year-to-date. And our last international franchise shops was also closed. Our shop level margin for the third quarter was 14.9% of company-operated sales as compared to 16%.

Cost of goods sold as a percentage of sales was 26.6% in the third quarter, a decrease of 20 basis points. For the quarter, labor was 31.3%, an increase of roughly 80 basis points, driven by wage inflation and sales deleverage. Occupancy expense was 14.3% in the third quarter, an increase of 10 basis points.

Other operating expenses were -- or 12.8% in the quarter and an increase of 20 basis points due to expenses related to third-party delivery. Our general and administrative expenses were approximately $11.3 million in the third quarter or 10.8% of total revenue, an increase of 140 basis points.

The increase was driven primarily by an increase in consulting fees.

Adjusted G&A, which excludes store closure costs, CEO transition costs, restructuring costs, proxy-related costs, and the consulting fees for the project Alan mentioned, and which we believe is the best indication of the core G&A expenses in our business, was $8.7 million in the third quarter and 8.3% of total revenue.

Adjusted G&A was down $0.4 million in absolute dollars relative to last year, primarily due to the pullback in advertising. Our adjusted EBITDA was $7.8 million for the third quarter compared to $8.8 million. During the quarter, we had income tax expense of $0.10 million.

Our adjusted net income for the quarter was $0.9 million or $0.04 per diluted share compared to adjusted net income of $2.4 million or $0.09 per diluted share. In the third quarter, we repurchased approximately 162,000 shares of Potbelly common stock in the open market for a total of roughly $750,000.

At the end of the third quarter, we had $37.9 million available from our board authorized program for repurchases. Our capital expenditures came in at approximately $4.3 million in the quarter and our balance sheet remained strong with a cash balance of $15.8 million at the end of the third quarter and zero debt.

We are comfortable with balance sheet and are focused on maintaining ample cash and liquidity to fund the turnover. Now, moving to our 2019 outlook, we are reiterating our same-store sales and adjusted EBITDA guidance. We anticipate coming in at the low end of both ranges based on how results have come in for the first nine months of the year.

For 2019, we currently expect flat to low single-digit decrease in company-operated comparable store sales. Adjusted EBITDA between $25.0 million and $30.0 million, including the impact of ASC 842; cost of goods sold to be between 26.7% and 27.3%, and labor as a percentage of sales to be between 31% and 32%.

In terms of adjusted G&A expense, we are lowering that by a couple of million dollars and now forecasted to rain -- forecasted to be in the range of $40.0 million to $42.0 million.

While we're still expecting to close 15 to 22 total shops, including nine to 12 company-operated shops, we are slightly lowering our outlook for total shop openings from 10 to 15 to eight to 13. We also expect two to three company-operated shop openings this year, a reduction from our -- from the previously communicated four to five.

As a result of lower shop openings, we are reducing our CapEx guidance from $19 million to $22 million to what is now $17 million to $19 million. I will now turn the call back over to Alan for his closing remarks..

Thanks Tom. Before I turn the call over for questions, I want to provide a brief update on our Shop of the Future. We opened our first Shop of the Future on the corner of Logan and Elston in Chicago just a few weeks ago.

As a reminder, our Shop of the Future has been completely redesigned from the bottom-up and will help improve the ordering process and the overall customer experience. In addition, the new design will reduce the capital investment by approximately 25% and reduce the payback period for a new company shop or franchisee by approximately one year.

We invite everyone to stop by and see the new shop. In closing, we've taken aggressive steps over the last 18 months to reposition this business for a return to growth and we believe that the additional support we brought in last quarter to sharpen our brand focus is helping us ensure that we know where we want to play and how we will win.

Supported with consumer insights and competitive benchmarking, we can now adjust and sharpen our brand position, menu offering and overall experience to put us on a path to delivering sustainable positive traffic and comp growth. We look forward to sharing additional details with you on our progress in 2020.

With that, I would like to conclude our prepared remarks and turn the call over to the operator for Q&A..

Thank you. At this time, we will be conducting a question-and-answer session. [Operator Instructions] Your first question comes from the line of Joshua Long with Piper Jaffray. Please proceed with your question..

Hi, great. Thanks for taking my question. Wanted to see if you might be able to talk about how trends progressed through the quarter. And I think, Alan, during your comments, you mentioned customer that momentum has been carried into 4Q.

So, I appreciate the year-over-year context in terms of maybe comps are still down but we're more profitable as we're not discounting, we're not spending as much on advertising, which is exciting. But I was hoping you might be able to parse out some of the core underlying momentum and kind of how we should think of be thinking about that for Q4..

Yes. Hey, Josh, it's Tom. Thanks for the question. We typically don't break it out, but directionally, comps got better in -- through the quarter, particularly in the P9, the final period of the quarter. And as Alan said, we're continuing to see the similar trend going into Q4.

The first month of Q4 was similar -- slightly better, in fact, than where P9 was. So, that's where we got comfortable staying in the range that we had guided to on a full year basis, although being clear about that we'll be at the lower end of that range. .

Yes. And I'll just add something to think about as you saw the press release, Josh, on our Grubhub national rollout. Obviously, that impacted just a small part of Q3 and we'll have the full impact of both DoorDash and Grubhub in the full fourth quarter..

Great. Thanks for that. And then thinking about that digital off-premise sales category, some really nice growth there.

Can you talk about what you've learned from the consumers as you've -- coming through that channel, either through data or purchase pattern behavior? And then how you think about utilizing that going forward? It seems like your product travels well and really lends itself to this channel.

So, curious on how you're thinking about that as a longer term opportunity while still acknowledging that there's a lot of upside and opportunity and work to be done..

Sure. Yes, thanks. Let me address that. If you recall, there's three parts of that business. There's the catering business, there's the delivery business, and then there's the pickup and go. Interestingly enough, all three of those are a convenience play, right? The consumer is desperate for more and more convenience.

The great news is that all three component parts of that off-premise business, catering, delivery, and pickup, are all positive and contributing towards being 21.6% of our business. And bear in mind that, that wasn't that long ago that it was around 17%. So, with off-premise, we've had 15 consecutive quarters of positive comp growth.

So, it's not a flash in the pan. And I'll take you back a year ago. Remember, we said we were making investment spends in this area and we're now bearing the fruit of those investment spends. Every single component part of the off-premise business is vastly different than it was one year ago. It has a dedicated catering website.

We now offer delivery in every single shop, every single day, every single hour that we are open, that was not the case at this time last year. And then lastly, we have pickup shelves that you can order using our app on the website in every single one of our shops across the entire system..

Great, that's helpful. And I know a piece of -- a large piece of that -- what's driving all of the work, even though maybe it gets obfuscated by some of the numbers, you had put a lot of investment in processes and team members and really built out your executive team and their associated teams.

So, wanted to see if you might be able to update us there in terms of, are we now through that? Do we have everybody that we need to have from a creative human capital perspective? Are there more investments here needed as we go through the rest of this consulting project? What else is really needed there to gain that traction and really realize the vision that you guys have in 2020 and beyond?.

Yes. From a leadership, we're done. From a cultural change, we'll never be done, but we needed to make a quantum shift. And we also needed to change how we were doing business. If you remember correctly, we were very insulated. We were an inside looking inside company with no outside perspective.

That's why it was absolutely critical at this point that we take an outside perspective from a top-tier consulting firm with a proven track record in our space that also was one of the catalyst behind successful turnarounds to help us and understand our position in the market.

And for the first time, I'm delighted to say as an organization that we've got consumer insights and fact-based competitive benchmarking that is driving our strategy. So, this now allows us to be a heck of a lot more focused on our brand position, our menu offering. And the experience that we offer is now aligned to the needs of the consumer.

So, I think the successes that we've enjoyed around the things that are working off-premise and menu optimization, two good examples, allows us to sort of build on those successes, but also build on our core strength.

So, yes, I'm very excited with the direction that this has put us on and we look forward to delivering sustainable, positive shop comp for the years to come..

Great. Thank you..

Your next question comes from the line of Gregory Francfort with Bank of America. Please proceed with your question..

This is actually JonMichael on for Greg. I just wanted to ask on the store portfolio, where it stands today. And given where sales are, if you're considering a broader asset review? And then on refranchising, I think you've been talking about doing more franchising deals for a while now.

Where do you stand on that? If you can just give a little bit more color in terms of the timeline.

And then maybe where you stand in terms of determining valuations or finding the right partner?.

Yes. So, why don't I address the refranchising and then Tom can address the second part of your question. I think suffice to say, we've deepened the limits. One, we've all but halted our company development, made that very clear. Other than the odd exception, if a great airport location makes itself available, we'll certainly consider that.

But on that front, we're focused on fixing the traffic, focused on franchise growth. And no better example of the fruits of our labor is in the last six months, we've done more shop deals that we've done in the last eight years, and we see I had line of sight as to the quality of the pipeline and I'm very encouraged with that.

On the refranchising front, we are open to refranchising in the majority of our markets. We're taking a very strategic approach to it. In the core markets, it's not likely that we will refranchise in those markets, but that's a very small list. In all the non-core markets, it's a much longer list, and we're absolutely open to refranchising.

Yes, it's important for you to also remember that all the deals that we have done, the four deals that make up, I think its 42 shops in the last six months, are all deals in virgin new market territories. So there was no refranchising opportunity in those markets.

That's not that we didn't want to refranchise, there just wasn't an existing portfolio of sites there. And for sure, let me be clear, we're not going to give away the business just so we can say we've done a refranchising deal, and no deal is better than a bad deal. But we'll evaluate every opportunity on its merits.

And so far, I think Jeff and his team have really turned the corner and now are full throttle on making sure that we attract quality franchisees.

Tom, do you want to address the--?.

Yes, I think you also asked about valuation, which Alan covered, JonMichael. But just as -- just to put another point on it. We adjust our expectations on those valuations based on the market. And I think we're being aggressively realistic, for lack of a better way of saying that.

And what we really want is somebody who will take the market and build it out further and not just do the initial transaction, obviously.

In terms of the assets that we have, as we've said, we -- and you saw that we closed another shop, we continue to use our internal team as well as an external resource to try to get out of the shops that we -- that are losing money and that we don't see a reversal in their economic position.

Having said that, the vast majority of them, when we think about our sort of bottom 25, all of them, the loss is less than the occupancy cost so it makes sense to run them and we don't have the ability in all of them to just exit and go dark.

So, it makes sense to run them but also to be very active in the discussions and the negotiations to get out of them. And we've written some pretty large checks this year to do so and we'll continue to do so, but -- when the deal makes sense and not when it doesn't. .

Got it. Thank you.

And then I was just going to ask on the updated G&A guidance, how much of that reduction is on the lower advertising expectation?.

That's a big piece of it. But we also, as Alan said, continue to tighten our belts here and make sure that we're frugally managing the business, appropriately managing the business given where we are.

And I would say reallocating some of our costs and resources to make sure we can spool up the test that we want in the first half of the year, that goes to the strategy and the work that Alan mentioned, without it being an incremental spend..

Got it. Thank you very much..

You bet..

Thanks JonMichael..

At this time, there are no other questions in queue. I would like to turn the call back to Alan Johnson for closing remarks..

Thank you, Hector. Thank you again for your time today and your continued support. I look forward to updating you on our progress. Have a great evening..

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