Ronald Shaich - CEO
Jeffrey Kip – Sr. VP & CFO
Michele Harrison – VP IR
John Glass – Morgan Stanley
Robert Derrington – Morgan, Keegan
Rachel Rothman – Merrill Lynch
Chris O’Cull – SunTrust Robinson Humphrey
Sharon Zachfia – William Blair & Company
Steven Rees – JP Morgan
Nicole Miller – Piper Jaffray
Jason West – Deutsche Bank Securities
David Tarantino – Robert W. Baird
Steve West – Stifel Nicolaus
Panera Bread Company (PNRA) Q3 2008 Earnings Call October 22, 2008 8:30 AM ET
Welcome to today’s Panera Bread Company third quarter 2008 earnings release conference call. (Operator Instructions) At this time, I would like to turn things over to Vice President of Investor Relations and Corporate Development, Michele Harrison; please go ahead.
Welcome to Panera Bread’s third quarter earnings call. Here with me this morning is Ron Shaich, our Chairman and CEO and Jeffrey Kip, our Senior Vice President and CFO.
Let me first cover a few regulatory matters. I’d like to note that during our prepared remarks and in our responses to your questions, certain items may be discussed which are not based on historical fact.
Any such items including targeted 2008 results or conditions and details relating to 2009 performance should be considered forward-looking statements within the meaning of the Private Securities and Litigation Reform Act of 1995. All such forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially.
Now I’d like to ask Jeffrey to review Q3 with you, Ronald will then provide some color commentary on our strategic plans to move the business forward, Jeffrey will then return to provide our targets for Q4 2008 and 2009 and Ronald will then return with some closing comments.
Thanks Michele, let’s get right into the third quarter results. We are pleased to have been able to deliver earnings per share of $0.45 net of a $0.01 charge for write-offs related to our investment in the Columbia strategic cash fund.
This means earnings per share was up 22% in the third quarter. More importantly operating profit was up 41% in the third quarter as well and were able to deliver these results despite continued pressure from input costs up nearly 8% in our bakery cafés and over 100% in our fresh dough facilities year-over-year.
We also accomplished this despite an increasingly weak economic environment that we believe helped drive negative transaction growth of negative 3.2% at our company owned Panera bakery cafés.
Quite frankly our plan to improve margins while minimizing transaction fall off and strengthening return on incremental invested capital all while driving long-term concept differentiation has worked even in the current environment.
Let’s now turn to some details in the quarter starting with revenues, our third quarter total revenues increased 15.4% to $315.2 million in 2008, $273.2 million in the comparable period of 2007. Net bakery café sales amounted to $268.5 million or 85.2% of total revenues, an increase of 15.6% in 2008 from $232.2 million and 85% of total revenues in 2007.
This growth was driven by both new bakery cafés open and by comparable bakery café sales increases. In terms of new units we opened 24 bakery cafés in the third quarter, seven of which were company owned and 17 of which were franchise operated.
Average weekly sales for new company owned units in the third quarter were $36,383. Year-to-date that number is $36,505 up 11% versus last year and in line with our full year target of $36,000 to $38,000.
Let’s move on to comparable bakery café sales, our comparable bakery café sales increased 3% at company owned locations during the third quarter consisting of approximately 6.5% of year-over-year retail price. The aforementioned negative transaction growth of minus 3.2% year-over-year and compression in the average check of approximately negative three-tenths.
Let me note that in the first two quarters average check growth had been in line with our retail price increase, in September for the first time we saw about a point of negative mix impact from lower check on our comp store sales.
This is a result of our category management strategy actually which is to drive gross profit per transaction not average check per transaction. So we’re getting the profit even though the check is not tracking totally with price.
We’ve set up our menu, our pricing, and our promotion so that the customer leaves us more profit after the cost of the meal. Probably the largest factor between August and September impacting check was the change in celebration as of late August and the rotation out of our higher priced summer salads at that time.
Moving on, franchise royalties and fees increased about 11% to $18.1 million in the third quarter of 2008 from $16.3 million in the same quarter of 2007 driven by comparable store sales increases of 3.5% at franchise operated locations, and new units opened over the last 12 months.
As a percentage of total revenues franchise royalties and fees declined very slightly to 5.8% from 6.0%. Final component of total revenues is fresh dough sales to franchisees and that grew 15.8% to $28.6 million in 2008 from $24.7 million in 2007 and was relatively stable as a percent of total sales moving from 9.0% a year ago to 9.1% this year.
Now let’s discuss our third quarter expense and profit margins, first our restaurant profit was higher by 23% versus the same quarter in  driven by strong base store operating performance. In addition restaurant margins improved approximately 80 basis points in the third quarter of 2008 versus the same quarter in 2007.
We feel very good about the margin improvement and more so because we absorbed approximately 100 basis points of margin detriment on our 3.2% transaction decline. Each point of transactions all else equal generates approximately 30 to 40 basis points of margin unfavorability year-over-year.
Let’s go through the bakery café margin by component now, first cost of food and paper products improved by about 80 basis points year-over-year to 30.4% of restaurant sales and was essentially flat on a sequential basis.
Together our category management initiatives and price taken to offset cost drove 190 basis points of favorability while the impact of wheat versus last year drove an offsetting 110 basis points of unfavorability.
Labor as a percentage of restaurant sales improved 20 basis points year-over-year to 32.3% of restaurant sales. This improvement was less then we had expected due to labor and efficiencies created from lower transaction levels which offset the 100 basis point margin benefit from the removal of fixed labor associated with [inaudible].
In terms of key costs and expenses below restaurant margins fresh dough cost of sales to franchisees as a percent of fresh dough sales to franchisees increased 270 basis points over the prior year. Increases in diesel costs per gallon from about $3.10 to $4.60 year-over-year drove about 200 basis points of this unfavorability.
The all in cost of wheat was approximately $15 a bushel in the quarter versus $5.80 per bushel last year resulting in a rise of approximately $4 million in additional wheat costs, however as of the beginning of the third quarter we have fully rolled in our dough price increases to offset these cost increases.
So the remaining 70 basis points of unfavorability in the margin is driven primarily by the margin deleverage you see when you take just enough price to cover cost the numerator and denominator both go up the same amount so the cost margin averages up.
General and administrative expense in the third quarter improved 40 basis points to 6.3% from 6.7% of total revenues versus the prior year driven by the operating leverage in our business against the G&A line.
Moving below operating margin the effective tax rate for the quarter was 37.2% compared to 27.8% of the comparable period of 2007. In the third quarter of 2008 it is important to note we previously expected an effective tax rate of approximately 40% but on a net basis we didn’t realize the up to $0.02 negative impact we forecasted given a favorable ruling on an income tax related matter.
We expect a similar rate to the third quarter actuals in the fourth quarter of approximately 37.5% and we continue to target on a long-term basis about 39% as an average rate allowing for variability from quarter to quarter.
To sum the P&L our net income again for the third quarter was $13.7 million after a charge of $0.01 per diluted share connected with the write-down of the Columbia strategic cash portfolio. Including the impact of this charge EPS was $0.45 a share again 22% growth versus EPS of $0.37 on net income of $11.9 million in the third quarter of the prior year.
Let me conclude with a few key cash flow and balance sheet items for the quarter we commonly get asked about. First the company generated about $27.5 million of cash from operations and employee stock option exercises and we had capital expenditures of about $14.7 million.
Additional we were paid $18 million of our credit facility in the third quarter. At the end of the third quarter the balance on our credit facility was zero dollars. We have no debt. During the third quarter also we adjusted the net asset value of our investment in the Banc of America Columbia strategic cash portfolio from $0.89 on the dollar to $0.80 on the dollar resulting in a net $0.01 hit per diluted share to earnings.
The continued deterioration in the credit environment in many asset classes beyond mortgage backed securities which everybody reads about every day, has led us to believe that a net asset value of $0.80 on the dollar more accurately reflects the risk in the remaining portion of the portfolio.
Including the impact of this adjustment and the fact that we received approximately $5 million in redemptions in the third quarter at about $0.97 on the dollar we ended the quarter with $8.1 million of investments left in the Columbia strategic cash portfolio which compares to the year-end 2007 balance of $23.2 million.
Just after the end of the quarter I just want to note we received an additional $1 million redemption so total redemptions exceed more then 65% of the original investment and we’ve gotten them at about $0.98 on the dollar.
Our current expectation based on what Banc of America has told us is that the fund will continue to liquidate in 2009.
So in terms of our total cash position, we ended the quarter with $23.4 million in cash excluding the $8.1 million of NAV in the Columbia strategic cash portfolio so cash and short-term investments together total $31.5 million.
Finally on average for the quarter there are approximately $30.6 million fully diluted shares outstanding. This includes the impact of about 1.5 million stock options with an average exercise price of $40.35.
Now I’d like to hand it back to Ronald to review our strategic initiatives.
Thank you Jeffrey, good morning. As you all know we have been deeply focused on our plan to move the business forward. Our plan is clear. As Jeffrey indicated we remain intent on improving margins while minimizing transaction fall off and strengthening return on incremental invested capital; all while driving long-term concept differentiation.
Despite being hit with inflationary cost pressures far worse then we ever expected and an economy far weaker then we ever contemplated, our plan is working. The proof is in the results we expect to produce in 2008 and beyond.
I’d now like to walk you through the three prongs of our plan and the progress we have made on each in Q3. Let’s begin with margins.
As Jeffrey indicated we are extremely pleased with our operating margin being up 130 basis points year-over-year. We’ve been able to do this through our category management initiatives and the operating leverage inherent in our business model.
Specific to our category management function, we continue to enjoy strong growth in gross profit dollars per transaction in Q3. This is largely thanks to our teams’ ability to manage our product mix, to affectively introduce new products with a higher gross profit, and to price existing products consistent with our high-low pricing strategy.
A measure of how successful category management has been in managing product mix is the sales of You Pick Two which is among our most profitable items. Sales of You Pick Two are up approximately 15% year-over-year and this despite the media that is being run by any number of casual dining restaurants attempting to pick up You Pick Two sales.
And while it is true that we’ve seen compression in the size of our average check we are still getting the gross profit dollars per transaction growth we desire thanks to category management strategies like You Pick Two.
Another example of the impact of category management is our new tomato mozzarella panini. This new product is drive strong gross profit per transaction growth. We kicked it off in celebration four in late August by focusing our guests on this product.
Not only does it provide a strong gross profit margin but it also supports our brand positioning beautifully. In fact I have been having this sandwich almost every day for lunch for the last several months. Its made with fresh mozzarella, roasted and fresh tomatoes, fresh basil and all natural sun dried tomato pesto on our delicious fresh baked Ciabatta bread.
This is a product our customers have been waiting for particularly our vegetarian customers and it shows that we can successfully drive both margins and transactions. As you know our category management team has also been very effective in helping us effect disciplined price adjustments.
To that end we’ve been intensely focused on executing our high low pricing strategy. As you know the manifestation of this work has been several carefully tested price and menu adjustments in the past 12 months.
Specific to Q3, we executed an additional 1% increase across the lunch menu in late August. I am pleased to report that consistent with our test results we have seen little or no negative impact on transactions as a result of our late August price increase.
I’ll provide data that backs up this view a little later in my comments. Let me mention though another way in which category management has been able to build gross profit per transaction and that is the reintroduction of returning seasonal favorites at higher price points.
In early Q3 we benefited from the reintroduction of our summer salads at a significantly higher price point. As you may recall in the summer of 2007 we underpriced a number of products which may have helped our transaction growth but certainly hurt our gross profit per transaction growth.
I can assure you this did not happen in the summer of 2008. Our category management team priced key items like our strawberry poppy seed salad and our frozen lemonade when they were rolled back in in 2008 such that each drove up our gross profit per transaction significantly.
Looking forward I am pleased to tell you about a system wide change category management is leading which will further build gross profit per transaction. Beginning in mid November we are adding a 12 oz. soup to our menu.
This bowl will replace the 8 oz. soup which will be available only as part of a You Pick Two combination. Frankly a larger bowl of soup is a natural fit on Panera’s menu. We offer two portion sizes all in half for sandwiches and for salads, but have never had a larger soup alternative for customers looking to use soup as their entrée.
Additionally the larger soup bowl brings in more gross profit per transaction. Based on our tests we estimate this change has the potential to provide as much as 1% of sales in gross profit lift. The larger soup portion will also help us drive more soup in a bread bowl sales which will be offered at the same price point as the 12 oz. soup.
And soup in a bread bowl which has high perceived value to the customer offers us a very high relative gross profit per transaction. Let’s now turn our attention to a discussion of transactions as that’s the second prong in our plan.
As you know we saw transactions fall off several hundred basis points in Q3, but before we discuss what is causing this, let me tell you why we believe our price increases have not caused this. Let’s look together at the data.
If we do, we see the same transaction trend line post the price increases, that is to say the trend line in the months of September and October as we saw in the months of July and August which were before the price increase was effected. Indeed if you look at the data you’ll see we have been continually negative 300 basis points of transaction growth for all of those months and that the trend has continued at that level literally through yesterday.
Today and let me pre-release our comparable bakery café sales for the first 27 days of Q4. Company comps in those 27 days were approximately 2.1% with negative transactions of approximately 3.4%. Let me also note that franchise comps during those first 27 days of Q4 were approximately 3%.
Additionally I’d like to note that there is other data to help us understand the impact of price increases on transactions. When we took our price increase in late August we took price only on our lunch items. As a result if our price increase had negatively impacted transactions, one would have expected to see lunch and dinner transactions fall at a more rapid rate then breakfast obviously where we didn’t take price.
The fact is this did not happen as all day parts have been essentially consistent in their fall off in transactions for the last four months.
Additionally I should add a couple of other notes, we have received an all time low number of comments about price on our Contact Us website this quarter. You tell me how that’s working and why. Finally and most importantly our monthly internal tracking studies indicate our value perception has not changed at all during this year and in fact has remained among the highest in the industry consistently throughout the last year.
I should note that our most recent tracking study completed just last week provided data consistent with this view.
So if its not price that’s driving down transactions, what is it? In our view there are two things, first Panera is not recession resistant. While we’ve been able to provide customer enhancements to offset some of the fickleness in the consumer environment the economic doldrums and the uncertainty has impacted us at least to some degree as well.
The good news is that while others in our industry are seeing 5% to 10% transaction fall off, Panera has seen only about 3% transactions fall off and this in the face of very significant price increases.
Let me share with you the second reason why we believe transactions were down in Q3. It is rooted in the media we were running in 2008. It is rooted in the timing of that media. In Q2 2008 when transactions were positive about 1%, we ran significantly higher year-over-year levels of media when compared to the prior year.
In Q3 2008 we ran almost no media. Though Q3 transactions seem to be hurt by the lack of media the upside is that this seems to indicate that radio advertising moves transactions for Panera. I should mention that in November and early December we will be back on the radio.
In our view this radio should serve as a net positive to Q4 transactions. Let me also share with you one other observation relative to comp growth. Our franchise comp growth is again now exceeding company comp growth.
This is because our franchisees lagged our company stores on certain operational and category management initiatives that we took early in the year and are now fully benefiting from their adaptation.
In fact our belief is that 2008 results based on these initiatives will turn out to be the most profitable year in our history, not only for our company stores but as well for many of our franchisees and most importantly we believe this augers well for future development.
Before I conclude, I’d like to discuss one other transaction building initiative we have on the docket and that is our breakfast celebration rolling out in the new year. In January it will be truly something for everyone on Panera’s morning menu.
In addition to our delicious grilled breakfast sandwiches, we’re adding a new yogurt parfait to the menu. Its made with low fat organic yogurt, fresh cut strawberries, and a proprietary granola developed by our head baker, Tom [Gumble]. This is the perfect health breakfast offering and I’m pleased to say I eat everyday as its in test in the store in my neighborhood.
And additional key element of the January breakfast celebration is our new coffee program. It features two new blends both a light and a dark roast. We have been developing these blends for over two years. With the new coffee, will come brand new packaging and a strict one-hour kill time, both elements that will ensure our customers receive a cup of coffee as good as our food.
Now let me turn our attention to our progress on the third prong of our plan, return on invested capital. We know that average weekly sales of our new bakery cafés is a key driver of our return on invested capital. As Jeffrey told you our average weekly sales of new cafés in the class of 2008 continues to be significantly stronger then the prior year.
Year-to-date our new store openings are $36,505 per week, which is 11% higher then new unit AWS at this time last year. In fact we are quite bullish on our openings and we expect to end the year with average weekly sales close to $37,000 per week.
Let me now talk about the other driver of return on invested capital, base café margins. Let’s be clear, our 130 basis points of operating margin improvement is clearly driving improved return on invested capital for the entire system.
Let me add one final note on our ability to deliver improved ROIC going forward, with the commercial real estate market weakening we are already seeing better deals. We’re expecting those opportunities to only improve which in turn will drive even better return on invested capital going forward.
In fact our experience says the best time to grow all else considered, is during times of recession. With that, I’d like to turn it back to Jeffrey who will take you through our targets for Q4 and full year 2009, I’ll then return for a brief closing comment.
Thanks Ronald, I’d like to now lay out for you our financial outlook and targets for the fourth quarter of 2008 and offer some perspective on potential targets and key metrics for 2009.
In our press release last night we reaffirmed our previously issued fourth quarter target for EPS in the range of $0.82 to $0.86 per share which represents 46% to 54% growth. We’re going to deliver this performance in the face of several challenges including real inflation and commodity costs year-over-year and an increasingly difficult consumer environment.
So how are we going to deliver a 50% quarter considering all this? Let’s look at the key metrics, first margins. Let’s start with the cost of wheat. In the fourth quarter wheat will be up over 100% in cost from the fourth quarter of 2007. However, as previously mentioned we’ve now taken the price we need to be neutral to profit line in our fresh dough facilities.
Secondly while diesel gasoline is up over 2007 we expect to be down significantly versus our previous $5 per gallon expectation providing a benefit against prior guidance.
Additionally we expect to continue to generate margin improvement to our category management initiatives and operating leverage. In fact our performance on margin initiatives is allowing us to reaffirm our guidance despite the deteriorating consumer environment and likelihood of continued headwinds on transaction growth.
So let’s talk about transaction growth, previously we guided to negative 2.5% to negative 1.5% transaction growth for the quarter. We are now expecting negative 4% to negative 2% transaction growth consistent with our trend over the last few months.
Given pricing of about 6% and mix impact of negative 1% on average check, we’re thus expecting comps of 1% to 3% in the fourth quarter. As a footnote, we expect mix impact in the fourth quarter to be a little lower then in October where we saw about negative 1.5% because the new soup size will be accretive to check.
In terms of other fourth quarter assumptions we expect to see our company new unit AWS to again be within our range of $36,000 to $38,000 for the quarter and the year and these are the sales levels we need to deliver our 15% differential cash flow ROI hurdle.
We expect to finish the year with as we’ve maintained all along about 100 new bakery cafés with an approximate 35-65 split between company and franchise.
So to wrap up on the fourth quarter we’re expecting a continuation of the difficult transaction environment of the last few months. But these headwinds are buffered by strong margin improvement. In summary we still expect to deliver our guidance of $0.82 to $0.86, up 46% to 54%.
But to be clear the transaction headwinds [buys] us more conservatively towards the low end of our range whereas previously we might have biased towards the high end of the range.
Adding our fourth quarter targets to our financial results from the first three quarters, our 2008 full year EPS is now $2.20 to $2.24 for EPS growth of 23% to 25% over the $1.79 we earned in 2007.
Let me state the obvious, we could not be more pleased with 2008 given the inflationary environment in wheat and other commodities in which we’ve operated and the recessionary environment into which we’ve now entered.
I’d like to take a little time now and offer a few thoughts on how fiscal year 2009 might play out, a few months ago we argued that it would not be wise to estimate 2009 EPS growth any higher then 20% and we’re give or take in the same place today.
Currently the EPS estimate range among analysts is approximately $2.55 to $2.71. In our judgment this is reasonably appropriate for 2009. Given the extraordinary volatility in our economy, its increasingly difficult at this time to project fiscal 2009 earnings.
However the company is comfortable today setting targets at this level which is a range of $2.55 to $2.71 as many of our cost inputs are already locked in and clearly understood.
Let’s walk through the metrics for a little more clarity starting again with what is already reasonably known, margins, moving on to what we feel we have very solid assumptions on, new unit development and return on incremental capital, and finally concluding with the area of greatest uncertainty which is transactions.
So let’s start with what is most clear, margins. First as of a few weeks ago, we finished locking in 100% of our requirements for wheat for 2009 at approximately $9.50 all in per bushel consistent with our purchasing discipline.
As we noted in our second quarter earnings call we previously locked in the front half of the year at $10 per bushel or about $8.75 for futures and $1.25 for basis per bushel. We have now laddered in the second half of 2009 at $9 per bushel or $8 for futures and about $1 for basis.
Secondly we’ve made some real inroads with our bakery café purchasing and are now expecting non wheat inflation of approximately 4% including inflation in paper and packaging and allowing for the investments we’re making which Ronald referred to in our new paper coffee cups and soup bowls as well replacing the old Styrofoam.
We have pretty high confidence in the 4% at this time because the majority of our ingredients are now locked in. To offset this 4% inflation we’re planning and are confident we can achieve price increases of approximately 3.5% while being very protective of the impact on transactions.
We’re also planning additional gross profit per transaction to offset the inflation through initiatives we have in the pipeline most notably the new soup program Ronald talked about.
Let’s now discuss 2009 development and return on incremental capital, we current project 80 to 90 new unit openings in 2009 split roughly 40-60 between company and franchise. We also have good confidence based on our success this year that our company new unit volumes will again be in the range of $36,000 to $38,000 per week; where they need to be to deliver our ROI hurdle.
Finally let’s talk about the area with the most uncertainty, transactions. We’re targeting negative transaction growth of negative 4% to negative 2% for 2009, more negative early in the year and then less negative later in the year as our comparisons grow easier.
Transactions at this level combined with 3.5% price and 0.5% of additional net check growth driven primarily by soup will yield overall company comp store sales in the range of zero to 2% for the year.
Before I turn it back to Ronald for his closing, I’d like to comment briefly on our operating margin improvement goals which we’ve talked about through the course of the year.
At the beginning of the year we commented that we’d set an internal target for 2009 of 150 to 200 basis points of improvement at the operating margin line over 2007 operating margin.
While we continue to hold that as our goal we noted at the time a few key assumptions including negative 3% to negative 1% transaction fall off in 2008 and flat transaction growth for 2009. While we have made even more progress on our key initiatives relating to margin then anticipated in 2008, and continue to expect improvements in 2009, targeted transaction loss in 2009 will generate and operating margin detriment of 100 basis points or more versus our original thought making our internal target extremely difficult to achieve.
While we continue to work through achieving this margin improvement the full realization of our 150 to 200 basis point goal may wait until we return to a more stable consumer environment and begin to grow our transaction counts back to their pre-recession levels.
However my comments here are all consistent with the $2.55 to $2.71 EPS guidance which I’ve just finished giving. With that I’d like to turn it back to Ronald for closing remarks.
Thank you very much Jeffrey, before we turn it over for your questions I’d like to share a few perspectives. A year ago the question we were hearing was when will Panera get going again. Some people were asking us, is Panera just a former growth company with a modest future ahead of it.
And others were inquiring of us, is the weakness of 2007 an anomaly, or is it indicative of Panera’s future. After a string of much stronger quarters the question has now become, can Panera continue to build this business as it has in the past well into the future.
My answer to you as it is my answer to all of us, is an unequivocal yes. Despite the impending recession and despite the nervous consumer we are confident that Panera’s future will be bright. As you know we expect Q4 EPS to be up 46% to 54% and we currently expect 2009 EPS to be up 15% to 22% and this despite the recession.
Let me be as clear as I can, we are prepared for the challenges of an uncertain economy in 2009. The reversal in the price of wheat versus the hyperinflation in wheat of 2008 provides a real cushion for our profit growth over the next four quarters.
That’s the good news for Panera but the bad news is we all must be concerned about whether the consumer will show up in 2009. And in our view discretion is the better part of valor. As a result transaction guidance for 2009 is being set at a level more conservative then anything Panera has ever run in its history and it gives us some comfort to know that though everyone in a consumer business may be impacted by a broad recession we believe we’ll feel less of the effect of the recession then most in our industry.
Think of it this way, Panera is essentially a breakfast and lunch concept. We learned that very well in 2007. as a result we are far less at the effected cutbacks in discretionary spending then many other concepts.
In addition the better demographics of our target customer which suggests that she is less likely to cutback on her relationship with Panera in order to balance the family budget. Our target customer make cutback from a Lexus to a Toyota, but those three meals a month at Panera are far down the list of [Oprah’s] disposable discretionary items.
In fact our view is that a recession is really a depression for some people. For the others who are not in the situation where they are under intense financial pressure, its life that goes on as normal.
Clearly if there’s a spike in unemployment less people will have jobs and less people will be able to enjoy the Panera experience. We must be prepared for this. But barring significant year-over-year spikes in unemployment we expect Panera to be less at the impact of a recession then others.
Let me share with you one concluding thought, the question our Board is asking our management team today is this, how does Panera take advantage of the meltdown in the economy that we all expect next year to create a great 2010 and beyond?
Our Board knows we have a strong concept that wins every customer satisfaction award in our industry. They know we have one of the few concepts that was able to significantly boost our returns and store level profits in 2008 and they know that our stores generate very strong cash flow and they know our company is anchored by a debt free balance sheet.
So the question they are asking of us is how we use those strengths to our advantage for the future success of our company. In fact the question our Board really wants to know is how we use the challenging environment we expect in 2009 to set ourselves up for expanded earnings in 2010, 2011 and beyond.
And what is our answer to our Board? Our answer is that as the rest of the world responds to the intense short-term pressure from investors and banks and as a result moves to cut costs by optimizing their menu, we will continue to improve the quality of our food and the quality of the Panera experience and drive real concept differentiation.
In our minds this is how we create a real value distinction for the long-term, and as well now is the time to use our balance sheet and our concept appeal to lock in high return on invested capital locations for the future.
Finally this is the time to strengthen our organization with strong operators and franchisees fleeing other organizations.
And as I told our Board this is exactly what we intend to do. This concludes our formal comments. At this time we’re open to taking your questions.
(Operator Instructions) Your first question comes from the line of John Glass – Morgan Stanley
John Glass – Morgan Stanley
Following on your last comment about unit growth what are specifically the unit plans for company stores versus franchise stores in 2009 and can you talk about is this a better environment to increase the franchisee percentage of the business given the cost environment, is it a worse time, can your franchisee grow, are they willing to grow at the rate you are growing?
Let me start and say as you saw, as we’re projecting for 2009 we’ll be basically one third, two-thirds company franchise roughly. We expect to again stay at essentially that rate into 2009. So no change in the mix of development, just the normal puts and takes.
Relative to the larger question of development there are many pluses and minuses. I think you can probably see it when you think about the question of franchise financing capacities. Let me start and state that we have generally larger franchisees and they generally have existing material lines of credit with the banks. For those kinds of franchisees I don’t think there’s any issues to their capabilities. They’re operating under existing lines and I think to a person they feel very positive.
I think that the issue for franchisee financing if it exists at all, is with franchises that have under five stores and they don’t have lines in place or they’re considering growing and they have no lines. I think there are potentially issues for them but nothing material. But I think its worth noting that that’s where the action is I think in the stall that we’re seeing or the pullback that we’ve seen relative to franchise financing. I think that where you will see it, which is less of an issue for Panera, is I think there’s almost no money available that we know of for transactional deals. That is to say franchisees buying other franchisees and particularly with any level of debt applied to those deals.
I think that any deals that might have been in the hopper between franchisees will certainly be limited within Panera unless they have very strong cash flow. I would note something else that may impact all this, we’re seeing the development community be at the effect of the credit crunch, and it’s both a negative and a positive. The negative is there’s a slowdown in turning over projects particularly in new centers and that slowdown is caused because these developers are not able to finish their projects or in some cases because of bankruptcies or pullbacks, they’ve lost their large tenants and they’re not prepared to open the center.
That could have some effect to us secondarily but it could have some effect to us in our ability to get stores opened and what the speed is. On the other hand we also see that as there has been significantly more pressure on the development community there is a renewed interest in doing deals more favorable to very strong developers like Panera and its franchisees. I think in sum you can read into our development projection for next year which is 80 to 90 stores a real sense that its steady as she goes, development is right down the line of where we were this year but a healthy dose of conservatism rooted in the uncertainty that operates, that exists in this environment.
You made a comment should we expand franchising in this environment and I think just to reiterate how we’re thinking this there is a price at which we sell stores and franchise more, there’s a price at which we buy stores and take them in as company, and the way we think about it is the allocation of incremental capital against incremental cash flow. So if I can buy a store and yield in excess of a 15% cash flow return on my incremental capital [inaudible] a great deal in terms of buying our own business and running our own business. Likewise if the price a franchisee would pay would be a 10% return for us, its about what our investors are going to get outside of us and that’s probably a price we should take.
I’d say our bias is a little more towards keeping our mix where it is and not buying so our hurdle is probably higher on a franchise purchase right now. But as long as we’re reallocating our capital against the right returns I wouldn’t say that now is a better or worse time then any other time just because people are forecasting a recession for the next X months and I think that’s pretty consistent with where our philosophy has been.
Your next question comes from the line of Robert Derrington – Morgan, Keegan
Robert Derrington – Morgan, Keegan
Just curious when we step back, your guidance for the last three quarters in a row now has certainly appeared to be relatively conservative relative to the results you reported yet as we look out into 2009 obviously it’s a tough operating environment and by your own admission you talk about the very difficult to project transaction growth or trend, why in that regard would you set expectations as you have? Would it be more reasonable to give a little bit more cautious guidance? What’s your view there?
I guess we’re walking in areas many people aren’t. I think we’re able to offer the guidance we have and we’re able to because so much for us is known for 2009. We feel very comfortable having locked in our wheat 100% for next year. Many of our commodities are locked in. We feel very comfortable with some sense of development horizon for Panera. I think the big unknown is the economy and its impact on transactions. And thus we are trying to be very clear in indicating to you what our transaction guidance is. We think its got a reasonable dose of conservatism in it but everybody can make their own judgments. To be clear, transactions are the wildcard. Nobody was able to predict the stock market fall off when it occurred and I don’t know who has a crystal ball relative to transactions.
The only thing I can tell you is the many things that we’re working on to drive transactions and to continue to fuel our margins. But I think all in, we feel comfortable with the guidance we have given.
Your next question comes from the line of Rachel Rothman – Merrill Lynch
Rachel Rothman – Merrill Lynch
On the 2009 outlook, I think originally the 150 to 200 basis points EBIT margin expansion had assumed flat commodities, it now looks like maybe you’ll hit somewhere slightly below that range but basically all based on lower wheat costs. Can you help us strip out what the benefit of wheat is and where EBIT margins would be on a standalone or core operating basis if wheat had not declined from 2008?
I think there’s enough layers to that question that will probably take a lot of time. I’d be happy to go through it offline.
Rachel Rothman – Merrill Lynch
Do you think that the core business EBIT margins would be up or down had wheat prices not declined based on your current guidance?
Your next question comes from the line of Chris O’Cull – SunTrust Robinson Humphrey
Chris O’Cull – SunTrust Robinson Humphrey
My question relates to the new bowl of soup and some of the product category management changes you’re making, if you see guests shift from the Pick Two combo to the new bowl of soup or some of the other paninis you’ve introduced, how will that impact the profit dollars? Are you looking at the mix shift? Can you talk a bit about what will happen?
We actually think the mix shift is to a much greater degree up from the single cup of soup to the bowl of soup that’s presently being bought. In essence we’re attempting to raise the rent shall we say, the gross profit per transaction rent on a small cup of soup which is a significant part of our purchases.
I think there will be some fall off relative to You Pick Two but I think that there’s significantly greater gain relative to the single cup of soup and so this change will be a net positive to gross profit per transaction. I think that I would add that the profitability for us on that bowl of soup is such that we’d much rather have you buy You Pick Two, its not a complete meltdown.
Your next question comes from the line of Sharon Zachfia – William Blair & Company
Sharon Zachfia – William Blair & Company
On next year, when we look at 2009 and obviously you’re expecting some restaurant margin expansion should we expect that all to be coming in on the COGS line and basically to get some deleveraging on labor and so on given that zero to 2% comp?
Broadly to give a simple answer if you’re going to run minus two to minus four transactions you’re going to see significant deleverage at the labor line. I think you are going to pick up significant leverage in the cost of sales line because that’s where your wheat benefit comes and that’s where our continued category management initiatives are going to hit and most of the rest of the P&L is pretty stable. So I think that’s the right way to think about it.
Your next question comes from the line of Steven Rees – JP Morgan
Steven Rees – JP Morgan
I’m curious to hear your thoughts on what looks to be an increasing price focus and even discounting environment at many of your casual dining competitions with some pretty compelling price points at lunch and with where You Pick Two is running it doesn’t sound like its had much of an impact but are you seeing anything in any market where you think this is becoming an issue for your customer and if so do you think Panera needs to respond and change its value strategy?
No, that’s the simple answer. I’ve seen no impact and I think there’s no reason in the world Panera would change. Let’s start, there are a number of casual dining operators that are promoting a $5.99 version of the You Pick Two. But when you really think about it that $5.99 You Pick Two comes with the 15% tax called the tip and so you’re talking about really a You Pick Two that isn’t $5.99, its really $6.99 and that’s before a beverage that’s probably more expensive then Panera.
You put on top of that the wait time and the situation of getting in and out and then maybe you have the quality of the food if I may say, and I think that Panera is certainly is in the eyes of many consumers a significantly better value. It has had no impact that we know of on us, I can’t pull out every single element but there’s no perceptible impact we’ve had, our You Pick Two sales continue to go up. I think that one of the messages you should get in my closing comments is we believe that as others optimize, discount and really try to pull costs out of their menu by economizing, this is the time for Panera to further separate from the pack. And so our belief is that the most important thing that we can do is not cut the price $0.50 or $1.00 more, the most important thing we can do is continue to put more onto the plate and I don’t mean size, I mean quality.
And you’re going to continue to see us driving a number of quality initiatives. What Panera wants to be doing is offering a $12 salad for $6.50 not competing with a $5 salad for $3.50 and I think that’s very important to understand how we intend to compete and we intend to go through the recession.
Your next question comes from the line of Nicole Miller – Piper Jaffray
Nicole Miller – Piper Jaffray
What do you want to do with all the cash you’re going to generate next year and just if you could remind me do you have a share repurchase authorization or are you seeking one?
We don’t have an authorization in place. It’s a matter we review every quarter with our Board of Directors and as it pertains to that, without speaking for them we have a modest bias towards having more cash in the environment but not a huge one, and they’re going to look at it quarterly and make a decision. Obviously in the past they’ve made a decision to buy in shares at certain levels so it could be an option that’s on the table and discussed as it always is.
Your next question comes from the line of Jason West – Deutsche Bank Securities
Jason West – Deutsche Bank Securities
I know you mentioned that you’ve seen a bit more trade downs starting in September you referenced the salads rolling off at that time, could you talk a bit more about what you’re seeing from consumers in September, if anything else has changed notably in terms of regional differences or day parts or things like that.
A couple of things, one is I don’t think we really look at it as trade down. I think we look at is as the premium salads rolling out of the menu and the mix coming off a little bit. I think most notably our transaction counts have gone from, they’ve been very stable, negative 3% and change for July, August, September, and now October and I think that in general the industry has gotten progressively worse. So we still have our customers coming through at the same levels, and we have had a little bit of modest check shift and it mainly relates to how we classify products. Its not really related to overall how things are progressing and most importantly we’ve really designed our whole category management strategy to allow the consumer to choose the check but we’re choosing the profit.
We’re more then happy to have the consumer walking away saying, hey I spent less money and I got better value and we take the same profits to the bottom line. That’s a win win for everybody and frankly we weren’t envisioning a credit crisis when we set the strategy up, but its even better in the context of what’s going on today. So that’s how we think about it.
What do we see regionally? It’s the same as everybody is reporting to you. We see relative to our own transaction or comp growth either way, modestly more weakness in California, southern California, in Phoenix, in south Florida, and to some degree obviously Detroit and hard-pressed parts of the upper Midwest.
Other markets we see continuing to be very strong but net net we see a bit more variance then we’ve seen in past years but it nets out to the numbers that we’re reporting to you.
Your next question comes from the line of David Tarantino – Robert W. Baird
David Tarantino – Robert W. Baird
On marketing plan for November and December, are you planning to spend at the same rate you did in Q2? Is it going to cover the same number of locations and could you give us an idea of the magnitude of the lift you’ve seen when you’ve spent on advertising in the past?
I think you can expect us to spend, its complicated because what you really want to look at is quarter over quarter, year-over-year within the quarter year-over-year expenditures. So its not simply a question of is it the same as Q2 or different then Q2, its what was its comparison in that quarter to the prior year. We will spend, the important thing to recognize is in Q2 we, for the full year we’re spending exactly what was in our plan. We’re not changing our plan. The way our plan laid out is that in Q2, the way it came to manifest itself was that in Q2 because we got off to an earlier start this year it was materially more radio in 2008 than in 2007.
The way it worked was in Q3 of this year we had essentially no radio, and in the last year we had a heavier weighting. In Q4 we’ll have modest amounts, not as much as we had in Q2 but more then we had in Q4 of last year where we had none again. So its really a question of year-over-year timing.
Relative to its impact obviously we like most things, try to look at the long-term and have some fairly disciplined marketing leading indicators we’re looking at, at awareness. We’re looking at measures of [inaudible] awareness. We’re looking at measures of trial. We know that this is more then paying for itself over a 12-month period.
Its something that we’ve now tested for over three years in incremental levels and so we’re getting our payback at the 12 month mark. And I think that’s basically the way we think of it.
David Tarantino – Robert W. Baird
Is this something that you’re planning to utilize again in 2009 as a potential traffic driver?
I think Panera is the 14th or 15th largest food service company in America today. Among the top 20 food service companies in America, Starbucks included. We are the least advertising intensive of any of those top 20 companies. I think as many of you know we have a national ad fund that gives us a right to ask of our franchisees 2% plus and I think we’ve never [broke] more than 0.7% of it.
The truth is Panera has been the least advertising intensive. In the context of that, having said that the reason we haven’t is because we try to be fiscally disciplined and we have a moral responsibility to our franchisees and to ourselves to prove that this stuff actually pays for itself not drives up comps that pays for itself. We continue to work through that, we’ve done some very disciplined pre and post test [versus] control testing that began 18 or 24 months ago. It led us to a position where last year we were in six or seven markets, this year we were in about half the markets in this country in which we were efficient. We can expect that I think all of our thinking is this will continue into 2010 though I want to suggest to you its nothing, don’t think of it as a dramatic element but simply the continued sophistication in growing out Panera.
The question we continue to ask ourselves, the essential question, you can expect of us from now into the future is how do we take advantage of the scale we have in such as way that we actually add value and build our sales and how do we do so in a way that the media and the messages we use don’t destroy that.
Your final question comes from the line of Steve West – Stifel Nicolaus
Steve West – Stifel Nicolaus
On the breakfast celebration you’re talking about you mentioned the yogurt and the dark and light coffee roast, will those be at price points premium to what you currently have in there and was there a third one you mentioned that I missed?
Well you’ve got the breakfast sandwiches in place, you’ve got the yogurt parfait, you’ve got the coffee but let me just generally speak to it. I hope that you picked up from our comment, we’ll be bringing it all together and that’s really the point of what we’re doing which is to say, Panera is a real breakfast alternative and can cover you in any number of ways with real food, a protein based breakfast, and a carbohydrate based breakfast with accompaniments like the low fat yogurt and a coffee that is equal to any out there.
We want to bring that message to our consumer and celebrate that. Having said it, like I think everything else in Panera, we try to create differentiation. These are unique products, I think they are better then anything in the marketplace as I think our breakfast sandwiches are. I think there’s no question about it and I think that given that they are differentiated and high quality we will continue to seek premium pricing that’s warranted.
I’d like to thank you for participating in our call. Thank you and good afternoon.
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