Panera Bread Company Q3 2009 Earnings Call Transcript

Panera Bread Company (PNRA)

Q3 2009 Earnings Call

October 28, 2009 8:30 am ET

Executives

Michelle Harrison – Vice President, Investor Relations & Corporate Development

Ronald Shaich – Chairman, Chief Executive Officer

Jeffrey Kip – Senior Vice President, Chief Financial Officer

Analysts

Steven Kron – Goldman Sachs

Jake for Matthew Difrisco – Oppenheimer

Jason West – Duetsche Bank

Jeffrey Farmer – Jefferies & Co

Steven Rees – J. P. Morgan

John Glass – Morgan Stanley

Sharon Zackfia – William Blair & Co.

[Mitch Phiser – Buckingham Research]

Bryan Elliott – Raymond James

Robert Darrington – Morgan Keegan

Nicole Miller – Piper Jaffray

David Tarantino – Robert W. Baird

Steve West – Stifel Nicolaus

Jeffery Bernstein – Barclay’s Capital

Presentation

Operator

Welcome to today’s Panera Bread Company 2009 third quarter earnings call. (Operator Instructions) At this time I’d like to turn the call over to Michelle Harrison

Michelle Harrison

Good morning to everyone and welcome to Panera Bread’s third quarter earnings call. My name is Michelle Harrison, Panera’s Vice President of Investor Relations and Corporate Development. Here with me this morning are Ron Shaich, our Chairman and CEO and Jeff Kip, our Senior Vice President and Chief Financial Officer.

Before we get started let me cover a few regulatory matters. I’d like to note that during our opening remarks and in responses to your questions, certain items may be discussed which are not historical facts. Any such items including targeted 2009 results or conditions and details relating to 2009 and 2010 performance should be considered forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially.

I’d like to now turn it over to Ron to kick off our call today.

Ronald Shaich

Good morning folks. Let’s get right to it. As you read last night we reported earnings of $0.61 net of $0.04 of unexpected non recurring charges. The $0.65 of EPS before the non recurring charges is directly comparable to last year’s earnings of $0.45. Essentially, our operating EPS is up 44% on a year over year basis.

While for many investors our strong EPS growth may be the thing that you’re focused on, we at Panera think the big news is comparable store sales growth and the real transaction growth we are seeing. To be specific, company comps were up 3.3% in Q3. In fact, in each period in Q3, company comps grew sequentially stronger.

In July company comps were up 2.6%. In August comps were up 3% and in September comps were up 4.4%. Maybe of even greater significance to us is that company comps have been up 6.9% on a calendar basis in the first 27 days of Q4. Franchise comps in addition have kept pace and they were up 6.3% in the first 27 days of Q4. But here in our judgment is what really matters; Q3 transaction growth was up 1.8% and Q4 to date transactions were up 3.2% on a calendar basis.

Quite frankly, while we can’t expect transaction growth to continue at this torrid pace, we do think that this trend speaks to the strength of our business and the success of our strategy. In fact we challenge to name another large restaurant operator with transactions as strong.

As you may recall, over the last several quarters Jeff and I have spoken to you about our commitment to invest in our business to benefit the customer and to utilize the recession to build competitive advantage. In simple terms, our strategy has been to put more on the plate for our guests, not less.

Folks, the strength of our earnings growth and the strength of our comp growth and in particular the strength of our transaction growth proves that our strategy is working. In a weak economic environment where few if any restaurant concepts are generating positive transaction growth, Panera’s significant transaction growth means we are delivering a better competitive alternative for our guests and it means we are taking market share and it is our view that this gain in market share will serve us particularly well as the economy begins to rebound.

Let me now turn it over to Jeff who will give you the details on the quarter. I’ll then come back with some color commentary on what has fueled our success in Q3 and our plans for the future. Jeff will finish with Q4 and our 2010 targets and then we’ll spend half an hour or so answering your questions.

Jeffrey Kip

Last night we release earnings for the third quarter 2009. We’re pleased to deliver a solid quarter, $0.61 earnings per diluted share net of charges of approximately $0.04 implying growth after and before the charges of 35% and 44% respectively over the third quarter of 2008.

The $0.04 in net charges were primarily associated with ongoing state sales tax audits, partially offset by a gain of partial redemption on our investment in the Colombia strategic cash portfolio.

I’d also note that in the third quarter net income grew by 38% to $19 million and operating margin expanded 230 basis points from 7.2% to 9.5%, our sixth straight quarter of greater than 100 basis points of operating margin expansion. Our trailing 12 months operating margin is now 10.0%, up nearly 200 basis points from the operating margin for the four quarters ending third quarter 2008.

We feel very good about both our third quarter performance and our success in meeting or exceeding our key metrics. Our third quarter company owned comps were up 3.3% as the trends we saw in the back half of the second quarter continued to build throughout the third quarter and the month of November.

Let me also note franchise operated comparable Bakery comp based sales were up 2.5% in the quarter and system wide comparable Bakery comp based sales were 2.8% for the third quarter 2009 versus the comparable period in 2008.

Let me now walk through some of the details of our financial results starting with revenues. Our third quarter revenue increased 6% to $335 million versus $315 million in the comparable period for 2008. Let’s now look at the components of revenue growth.

Net Bakery Café sales were up 6% to $286 million in the third quarter and comprised approximately 85% of total revenues. The 6% increase was driven by the positive comparable store sales growth and by Bakery Café’s opened in the trailing 12 months.

In terms of new units, we opened 19 new Bakery Café’s during the third quarter, nine of which were company owned stores and 10 of which were franchise operated. Third quarter year to date AWS for company owned new units opened in 2009 was $37, 068 versus the prior year period of $36,505.

Moving on to franchise royalties and fees, our franchisees also experienced solid sales growth in the third quarter driven by positive comps and Bakery Café’s opened in the trailing 12 months. Franchise royalty revenue and fees increased 7% to $19 million for the quarter.

The final component of revenues, fresh store sales to franchisees grew 4% to $30 million in the third quarter; largely the result of new Bakery Café’s opened in the prior 12 months. As a percent of total sales, fresh store sales to franchisees were 8.9% down 20 basis points year over year.

Let’s now move on to third quarter expenses and profit margin. Bakery Café margin increased 80 basis points year over year primarily as a result of purchasing initiatives and modest sales leverage from positive comp growth.

Let’s touch on the key components of restaurant margin. Cost of food and paper as a percent of sales was favorable by 110 basis points year over year driven by purchasing, food cost deflation and lower wheat and diesel fuel costs and category management initiatives. Both the labor and occupancy lines as a percent of sales were essentially flat in Q3 versus the prior year on our positive comps.

Other operating expenses as a percent of restaurant sales in the third quarter were up 20 basis points versus the prior year due primarily to the impact of our marketing investments on that line.

Let’s now look at key costs and expenses below restaurant margin. Fresh dough cost of sales to our franchisees improved 1,120 basis points in the third quarter driven by a year over year benefit of wheat and diesel costs, approximately $3 million.

G&A expenses as a percent of revenues is improved 30 basis points in the third quarter versus the prior year primarily as a result of leverage on higher sales. Below operating margin we had a net $1.6 million of other expenses from sales tax reserve, offset in part by the Columbia gain.

The third quarter effective tax rate was approximately 38% compared to approximately 37% in the comparable period of 2008 where we had a benefit from the reversal of a FIN48 tax reserve that it turned out we did not need.

Net income for the third quarter of 2009 was $19 million or 5.6% of total revenues compared to $14 million or 4.4% of total revenues for the same period in the prior year, 38% growth year over year.

Let me now conclude with a few key cash flow and balance sheet items for the third quarter. Operations and employee stock option exercises generated cash flow of approximately $71 million for the third quarter. We ended the third quarter with approximately $172 million in cash excluding the Columbia strategic cash fund investment and zero debt.

Capital expenditures for the third quarter were about $15 million. We ended the third quarter with less than $1 million book value of investments in the Columbia strategic cash fund, or approximately 5% of the original units currently valued on the balance sheet of approximately $0.66 on the dollar.

Columbia funds anticipate returning all but 1% of the original units by year end. At the time we expect to receive 99% of our original $26.6 million investment at approximately $0.94 on the dollar.

Finally, on average for the quarter there were approximately 31.1 million fully diluted shares outstanding including the impact of one million stock options outstanding with an average exercise price of $42.75.

Let me now turn it back to Ron to discuss key initiatives.

Ronald Shaich

For the past few years we’ve told you about our multi-plan to move the business forward. We are intent on growing gross profit dollars per Bakery Café through transaction growth and through growth in gross profit per transaction.

We are intent on driving operating leverage and we are intent on using our capital smartly all while investing in our business to benefit the customer, to build competitive advantage and to capture market share.

As such, our work this year has been focused not just on G&A cuts, labor reduction and full cost optimization to avoid the impact of negative sales leverage as it is today at so many companies, but rather our work has been built on increasing our long term future earnings growth potential by putting more on the plate for guests, driving greater market share, building high ROI café’s and creating an ever stronger organization.

And frankly, contrarian as that may be, this plan is working for Panera. Comparable store sales growth is the best proxy you have to understand the underlying trends in gross profit dollars per Bakery Café. So let’s review the recent trends in comp store sales.

As Jeff and I both told you earlier, in Q3 company comps were up 3.3% and franchise comps were up 2.5%. Even more significantly, our calendar basis comps for the first 27 days of Q4 were up strongly, 6% for the company and 6.3% for the franchisees. And what’s most gratifying to us is that this comp growth has been fueled by transaction growth.

So what has driven our comp and transaction growth? It’s not all that complicated. We’ve been doing a better job for our customers at a time when most competitors are doing less for customers. Frankly, we see the results in our monthly customer tracking.

In September 2008 56% of customers told us they were likely to recommend Panera to a friend. This September, a year later, 69% of our customers are telling us they’re likely to recommend Panera to a friend. As well, in our September 2009 survey, three times as many customers told us we have become more special over the last year than tell us we have become less special.

So what is the reason for the increased customer satisfaction with Panera? As ever, it is a slew of factors, but I would suggest it begins with serving food that people really love. Crucial to our success in recent months has been our extraordinarily successful Summer Celebration. These celebrations were centered around our salads which feature our improved heart of the romaine lettuce.

Our chopped Cobb salad and our barbeque chicken chopped salad have been winners. Salad sales have grown over 30% year over year this past summer. In addition, the success of our salad program has generated higher check and higher gross profit dollars.

We also introduced a new and improved Napa almond chicken salad sandwich this summer. This chicken salad is prepared fresh each day by our Bakery Café associates and features an all natural, anti-biotic free chicken, fresh red grapes, diced celery and sliced almonds. It’s a light chicken salad utilizing olive oil rather than the heavy mayonnaise we used to use and is a significant improvement over the chicken salad we had served in the past.

And not only does it offer some of the best consumer ratings we’ve ever seen, but it also has offered us higher gross profit dollars than the existing chicken salad sandwich.

Let me tell you about something else. We made improvements in our breakfast program. For breakfast, we introduced a healthy power breakfast sandwich to support continued breakfast growth.

This power breakfast sandwich is made with all natural, freshly cracked eggs, a thin slide of Vermont white cheddar cheese and lean ham, all grilled between two slices of our fresh backed in the café whole grain bread, and with five grains of fiber and 24 grams of protein, it is less than 400 calories. It also added a more healthful option to our breakfast lineup that customers are appearing to love.

Let me also note something else. We’ve had real success this year with our coffee program and our smoothie program. Let me talk about our bakery. From a bakery, we computed a new line of brownies and blondies along with our cinnamon crunch bagels as a means to drive the afternoon business.

We also introduced a reformulated French baguette this year. This product was our Bakery team’s answer to my charge, to continue to innovate to ensure we do serve the best bread in America. This baguette, the one we are now offering is proof that we’ve done just that. In my view, it’s simply exceptional and I encourage you to try it.

But that’s not all. We have equally exciting items coming down the pike in the next celebration beginning in November which we believe will continue to fuel our comps and transactions. We’re excited that as part of our next celebration we will be rolling out Macaroni and Cheese to compliment our kids menu as well as our lunch and dinner day parts.

Now this isn’t the standard blue box children’s Mac and cheese seen in so many establishments. In fact, if I tell the truth, I enjoy the Mac and cheese as much as my six year old daughter and my ten year old son, and that is by intent.

We knew the world didn’t need another mediocre Mac and cheese so our chef’s created a macaroni and cheese that not only pairs perfectly with the flavors of our signature salads and sandwiches, but will also provide a hearty warm option this winter.

Also taking center stage this November will be our bread heritage and retail impulse initiatives. To remind you, bread heritage is the title we use for our effort to sell more bread for better merchandising of our Bakery products. As part of this effort, we will be merchandising gift breads, specialty seasonal breads, daily breads and bulk baked goods including bagels, scones and muffins for take home and the office in an effort to spur more purchases and Bakery sales.

As such, these products will be merchandised as special fixtures placed directly in the path of the guest. Specific to this coming holiday season, you’ll see Panera celebrate our gift worthy breads, things like Pantone and Holly bread, and we’re very excited to see this take form.

Our retail impulse initiative will also take form this holiday season. Customers will experience at every register this holiday season, baked goods individually wrapped in environmentally friendly packaging. The products will change with the seasons but you can expect to see our new gingerbread man cookie in early November and we expect these products will serve again to be excellent add on and gross profit per transaction builders.

Finally, as we talk food, let me give you an early peak into product development expected in 2010. Expect to see us introduce a number of exciting new products including another protein, salmon, to our menu. We expect that the salmon will be used in both salads and sandwiches and provide both a high degree of customer satisfaction and higher gross profit per transaction.

As we talk food, we need you to know that we’re making preparations right now to roll out a new Panini grill in mid 2010. By utilizing this grill, we’ll be able to make all of our Panini’s to order and be able to bring them to serving temperature in significantly less time than existing equipment.

The result will be less waste than we presently experience from the pre-made Panini’s we presently use and as well, we fully expect that product quality will improve materially. For us, equipment is a means to deliver food and a major point of competitive advantage.

Q3 was also positively impacted by another factor; our marketing efforts. Let’s talk about that now. As we told you on our last call, we had more media impressions in Q3 2009 than in Q3 2008. We also began testing our first TV advertising in three markets in the early summer and I will report to you that we have seen material lift in those markets.

The TV test and our other media initiatives are working. They are essentially paying for themselves through the sales they generate. But more importantly, it is our expectation that these investments will generate deeper relationships with our target customers and ultimately provide incremental net returns over time.

Let me talk about marketing in 2010. As we head into next year, we expect to increase our media spend significantly while buying better yet again. Expect us to add online to our existing portfolio of billboard and radio advertising.

We will also be using television in an expanded number of markets. However, please be aware our analysis indicates that it is not yet economically feasible for Panera to execute a national cable nor a national television buy.

Let me now discuss our loyalty initiative which is again, a piece of our marketing effort. Many of you know our loyalty program has been in test in one major market. Let me update you by sharing with you the news that we are pleased with the results and expect to expand the test to several additional markets in early 2010.

And let me also tell you that we expect a final decision on the roll out of loyalty should be made in 2010.

Let me share some additional news. Panera has recently added a new Senior Vice President and Chief Marketing Officer, Michael Simon. We sifted through 600 potential candidates to arrive at an extraordinary addition to our team. Michael joins us with several decades of retail and packaged goods experience. More recently, he was the General Manger of the snacks division at Pepperidge Farm.

Let me conclude my comments on marketing by sharing with you a perspective. Panera now has a great understanding of its target customer and Panera now has years of experience at various media. While we all know that marketing is not a silver bullet, I have come to believe marketing will be an important tool in our arsenal if executed with discipline.

Indeed, it is our belief that marketing represents a real opportunity for Panera to further leverage its scale with our target customers and to create further competitive advantage and you can count on us to do just that in 2010 and beyond.

Catering has been yet another success for Panera in 2009. All of us know that catering has been under huge pressure this past year. It simply makes sense. CFO’s across the country have been cutting budgets and catering is the easiest cut of all.

In Q1 and in Q2 catering at Panera was off 5% per store. We in fact have read that others in our industry have reported catering sales down as much as 20% or 30%. So here’s the view you might find surprising.

I think the weakness in catering has been a good thing. Why? Because when demand for catering was strong and money was loose, everyone with a catering program looked like a genius, Panera included. However, when the demand for catering faltered, most companies suffered and most have yet to recover.

But at Panera the story took a different turn. Back in Q1, with sales weakened, we began the hard work of determining what really mattered to building catering sales. Our team became intensely focused on getting more catering customers in the door. Likewise, we committed to reducing customer churn.

To that end, we have brought new discipline to our catering sales organization and we’ve brought new tools to support the team. In fact, I believe the result of this new found discipline and accountability we’ll bring to catering is helping us create a much stronger catering sales organization and it offers the ability to build catering sales well into the future. Thus, I am pleased with what we’ve seen happening to the catering business this year.

And I’m also pleased to be able to report to you that our commitment to executing catering well is already paying off. In Q3, catering sales were up over the prior year and we now expect catering sales to be up 5% to 10% in Q4.

Let me now comment on the impact of category management. As in the past our team will continue to work to improve gross profit dollars by driving sales of higher gross profit items like our signature salad and [You Pick Too.] You will also see us introducing new items that deliver higher gross profit per transaction than existing products on our menu. Our summer salads and our new Napa almond chicken salad sandwich are examples of this.

As well, our initiatives to drive add on sales through programs like Bread Heritage and impulse are being driven from our commitment to category management.

Lastly, our category management team is looking for ways to offer customers opportunities to build gross profit per transaction without forcing customers to purchase items. The You Pick Four program we currently have in test is an example of such an effort.

The You Pick Four program is a program in which the customer, if they choose to order an entre, that is to say a soup, salad, sandwich or You Pick Two, and they choose to order a beverage, will be offered the opportunity to purchase a baked good to complete their meal at a lower price. Since our cost on a marginal baked good are relatively low, this is potentially a real gross profit per transaction booster.

Let me inform you that we are presently testing You Pick Four in multiple markets and it could potentially roll in mid 2010.

As we told you last quarter, we are prepared and feel comfortable given our strong value scores on our monthly tracking research in taking price in 2010 to match the inflation we expect in costs other than food. Specifically, I’m talking about inflation in costs like labor, benefits, occupancy and utilities all of which we now expect to go up in 2010.

To that end, we will go into test on a 2% price increase in November. If that test proves successful, we will roll that price increase in March 2010.

Before I comment on development, I’d like to add one last note on comp and transaction growth. While many of the initiatives we have rolled out have been successful in improving the quality of the customer experience, none of these could have happened without improved operational excellence.

The quality of our operation is up at almost every measure we track so operations are never given credit for driving sales, I am convinced we would not be having the success we are without having improved operations.

I am also convinced that the success of our joint venture program, now 50% of our company operators is a fundamental underpinning of our ability to deliver higher quality execution and management turnover of less than 16% year to date.

Further, I believe our commitment to maintain our staffing levels and our compensations for retail associates is providing significant competitive advantage and is fundamental to our transaction growth.

Now let’s talk development. As you know, AWS, average weekly sales is a key driver of a return on incremental investment capital. The good news is that our AWS continues to rise despite the recession. New company owned unit average weekly sales are $36,930 for Q3.

Further, we continue to feel very confident that our class of 2009 will be one of the strongest in history and will deliver results for the full year at or near the high end of our target average weekly sales range of $36,000 a week to $38,000 a week.

On the real estate and development front, I think you all know costs are down 10% or more. We’re certainly seeing it. Given the strength of our openings, and given the reduction in the cost of development, now is the time to develop. Despite the issues we’ve had getting some new Bakery Café’s open in 2009, we expect to execute a material uptick in development in 2010.

As I’ve said to you before, this is the most attractive opportunity to build high ROI café’s that I’ve seen in the last 10 years. Rest assured, we will act on that knowledge. The company expects to increase its new unit growth approximately 50% in 2010. We are committed to taking advantage of the real estate downturn to building high ROI units when the opportunity is right.

Let me conclude my color commentary with this perspective. Taken together, I think you have to agree that Panera has seen real results from our strategic plan. Our initiatives have driven improved transaction growth. They have driven improved gross profit per transaction. And they have improved our operating margins all while allowing us to smartly invest our capital back in the business.

The outcome is the 35% EPS growth we delivered in Q3. As well, our efforts to increase market share, take advantage of a weakened development environment and improve our organizational capabilities are having impact. We believe these initiatives are part of the stew that will enable Panera to come out of the recession with an even stronger competitive position that it has today.

And based on these efforts, we have even greater confidence in our ability to deliver our earnings targets in Q4 2009, in 2010 and beyond.

With that, I’d like to turn it back to Jeff who will take you through our targets for Q4 ’09 and our full year 2010 initial target.

Jeffrey Kip

I’d like to now provide you with our updated targets for the fourth quarter and preliminary targets for the full year 2010.

As Ron just discussed, the investments we’ve made in the business are providing measurable results and increasing our confidence in the inherent strength of our business even in the face of the lingering recession.

Let me now walk you through our fourth quarter targets and the corresponding metrics and assumptions behind these targets. First, the company is targeting diluted earnings per share of $0.85 to $0.87 in the fourth quarter of 2009. This target is net of $0.05 of charges associated with expected asset retirements, meaning that on apples to apples operating basis, we’ll earn $0.90 to $0.92 per share for 13 weeks in the fourth quarter of 2009.

At the mid point of this range, this averages $0.07 per week. This compares to an EPS of $0.84 for 14 weeks in the fourth quarter of 2008 which averages $0.06 per share per week, so our average operating earnings per week are targeted to grow more than 14% year over year over our EPS per week in Q4 2008.

Let’s now walk through the key metrics underlying our fourth quarter target starting with comps. On a calendar basis, we’re targeting comps for the quarter at 5% to 6% based on transaction growth of 2% to 2.5% and check growth of 3% to 3.5%. Check growth consists of a year over year price increase of 2% and mix impact on check of 1% to 1.5%.

By period on a calendar basis, last night we announced 6.9% comps for the first 27 days of the 28 day October period and we’re targeting 4.25% to 5.37% comps for both November and December.

So how do we get our comp projection for November and December after our October comp? Our calendar comp for the 27 days period to date is 6.9%. By week this breaks down to 5.8% for week one, 9.7% for week two, 7.6% for week three and 4.6% for the first six days of week four.

We believe that the week two comp is an outlier result that is the impact of the increasing the period to date result by more than a point versus the true underlying comp in the period of approximately 5% to 6% because it was the only week in the month with a negative comp a year ago to compare it to, and that was a negative 1.2% that week in 2008.

We also believe that our comps will see some additional lift in October with an easy compare to the year ago period given the Lehman and stock market melt downs and corresponding impact on consumer behavior in late September and October of 2008.

Based on this analysis, we believe the mid point of the stable comp range for the rest of the quarter is approximately 5% on a calendar basis comparison, thus our range of 4.25% to 5.37% for November and December resulting in an overall range of 5% to 6% on a calendar basis for the quarter.

On a fiscal basis, we’re targeting comps for the quarter of 3.5% to 4.5%. Comps by period on this fiscal basis were 8.2% for the first 27 days of the 28 day October period and we’re targeting .075% to 2.25% to comp for November, and 2.75% to 4.25% of comp for December.

So many of you are wondering why we’re giving two different comps, calendar and fiscal. This is because fiscal is what we report on and what ties to our P&L results, but the fiscal measure is misleading because it’s an apples to oranges comparison to the seasonality and the holidays of the prior year.

Calendar comparison on the other hand, is the best way to understand the underlying business because the seasonality and holidays line up between this year and last resulting in a more stable number. So comps on a calendar basis match the same specific weeks on the calendar in 2009 to the same specific on the calendar in 2008 and comps on a fiscal basis do not.

Further, as stated in this release, the fourth quarter of fiscal 2009 will have 13 operating weeks which is different that the fourth fiscal quarter of 2008 which had 14 operating weeks. In order to provide a clear business comparison however, the fourth quarter target was developed comparing the 13 weeks of the fourth quarter of fiscal 2009 versus just 13 weeks in the fourth quarter of 2008. Remember the 13 weeks on a calendar basis are different by a week from the 13 weeks on a fiscal basis.

To be specific, fiscal Q4 2009 began on September 30, will end on December 29 of this year and will include the Christmas holiday. The comparable apples to apples 13 weeks of fourth quarter 2008 on a calendar basis began on October 1, ended on December 30 and also included the Christmas holiday.

However, the comparable 13 weeks of the fourth quarter 2008 on a fiscal basis began a week earlier on September 24, ended a week earlier on December 23 and excluded the Christmas holiday. With this holiday shift between calendar and fiscal results in the difference between the comps on a calendar basis and a fiscal basis.

There is also some modest seasonal impact which shows itself primarily in the October differential you see between 8.1% fiscal and 6.9% calendar comps.

Let’s move on from the comps and discuss our operating leverage metric. Our fourth quarter target for operating market improvement is zero to 50 basis points. However, as discussed, the fourth quarter EPS target is net of $0.05 of EPS or $2.5 million in pre tax dollar of expected asset retirement expenses that will hit primarily the other operating line to a certain extent the depreciation line in the Bakery Café P&L.

These expenses include approximately $700,000 in accelerated depreciation on our old Panini grills given our plan to finish rolling out the new improved models in company café’s in the first quarter and approximately $1.8 million in expected charges for the expected closures of three local volume Bakery Café’s.

In aggregate, these charges will impact operating margin by about 75 basis points. So without these charges we would show improvement of 75 to 125 basis points. The 75 to 125 basis points of improvement will be driven by sales leverage in the fourth quarter, improved purchasing and cost efficiency and category management initiatives.

Finally, our last metric in terms of uses of capital, the company is targeted approximately 20 system wide new unit openings in the fourth quarter of fiscal 2009 which would bring us to about 66 for the year. A few openings have slipped from 2009 to 2010 given the state of the commercial real estate industry.

Average weekly sales for these new units on the company side for the fourth quarter, we’re targeting at $38,000 to $40,000. The full year number is expected to land in the top half of our original target range of $36,000 to $38,000, so another good year for our company on new units.

Let’s now discuss 2010. It’s still early and we’re still in the midst of our detailed planning cycle, but the numbers of variables have been locked down and thus provide us with a basis to offer the following initial target.

For 2010 we’re targeting EPS range of $3.05 to $3.15 which represents growth of 14% to 18% over the mid point of our 2009 range. Let’s move on to the key metrics underlying the 2010 EPS target starting with comp sales growth.

We’re currently targeting comp growth in the range of 3% to 5% based on current one and two year comp trends leading into the year and our current intention to continue to invest in product development, catering, marketing and operations.

As we’ve updated you, food cost is expected to be modestly deflationary in 2010 with modest inflation in other costs. As Ron indicated, we’re prepared to take modest price increases in 2010 to offset any cost inflation.

In terms of operating leverage, we’ll continue to leverage our size for cost improvement and operating efficiencies in our supply chain and as ever, closely watch the growth of our G&A line while continuing to invest in the concept.

Moving to new unit development, we’re targeting 80 to 90 new Bakery Café’s in 2010 with 50% plus of that coming from company owned development. Remember however, that increased development primarily impacts the P&L on the cost side in both the pre-opening expense line and the G&A expense line as we support the additional openings.

Our AWS range for new units remains unchanged for 2010 at $36,000 to $38,000 per company owned new units, a level which will generate our desired 15% return on capital as it has for the last two years.

Lastly, let’s talk about overall higher ROI deployment of capital. We’re going to continue to look to opportunistically use our available to drive earnings growth and shareholder returns. As we’ve discussed in the past, we have the following priorities for using our capital.

First, we want to build high ROI new Panera’s. We’ve covered our plans for 2010 with you. Secondly, we’ll acquire essentially our own business and operate it, meaning as in the past opportunistic franchisee acquisitions for highly synergistic acquisitions of our business under a different name as was the case with our acquisition of Paradise.

And then third, we’ll return capital to our shareholders through share repurchase or potentially regular dividend. We’ve not made public any plans for a buy back or a dividend, but as discussed on previous calls, this is a subject that our Board reviews each time they meet and our Board will meet next in November.

In closing, I’d like to say the following. We are extremely pleased to be delivering positive comps at approximately 7% fourth quarter to date and earnings growth for the third quarter of 44% before charges.

Further, our investment in the business which has truly paid off in 2009 provides us with confidence that we’re well positioned for 2010 and beyond.

At this time, we’re open to take your questions. As is our custom we request that you ask only one question at a time in order to give as many of those on the call an opportunity to weigh in as possible. If you have additional questions, please return to the queue. We’re happy to stay on the line with you until all questions have been asked or until the market open at 9:30 am.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Steven Kron – Goldman Sachs.

Steven Kron – Goldman Sachs

A question on the margin line, this quarter very nice quarter of margin expansion. It seems as though embedded in your fourth quarter and into 2010 pretty big deceleration in the margin expected. Can you drill down a little bit in the cost of sales? What do you think the benefit has been from category management versus the commodity basket being down and what that’s going to look like on a go forward basis?

Jeffrey Kip

I think you’re talking about a smaller basis point improvement year over year so I think it’s a deceleration of the magnitude of improvement. I think you’re going to see a stable to improved operating margin at the level it’s at now.

And in terms of category management versus cost improvements, I think you’re looking at a relatively even split the last couple of quarters and something comparable next year.

Operator

Your next question comes from Jake for Matthew Difrisco – Oppenheimer.

Jake for Matthew Difrisco – Oppenheimer

I had a question about marketing. I know you’re spending or planning to spend more in the second half in 2009 than in the first half. I was wondering what you can tell us about 4Q, whether the delta is similar. I know you don’t have as many product launches to support. And if you could talk about 2010 as a percentage of sales your marketing spend versus 2009.

Jeffrey Kip

I would start and say to you in terms of marketing spend, I think we’re going to be very cautious about now trying to indicate individual marketing spends by quarter, percentage versus the prior year. It may be more detailed than as a rule we’re prepared to give and is productive.

I will say to you that relative to marketing spend year over year in 2009 I think that it is back loaded. It was more heavily back loaded. It was more heavy year over year in the third quarter than in the fourth quarter, but still moderately higher in Q4 in 2009 over 2008.

I would say to you that again next year we’re still making our plans so I can’t tell you specifically what it will be but we fully expect our marketing expenditures to be up modestly, moderately. With more stores out there and with better buying, the cost per impression is going down so I think that will be more impact.

I think generally you can assume that there will spread evenly throughout the year. We’ll give you more detail as appropriate and as we learn next year.

Operator

Your next question comes from Jason West – Duetsche Bank.

Jason West – Duetsche Bank

I wanted to get a little more color on the acceleration in comps more recently. You talked about the third quarter benefited from the salads which were very strong, but then things picked up again here in October. I’m curious what your thoughts are on if it was more a consumer improvement as well or just some of the new products working well, what your thoughts are there.

Ronald Shaich

I think we were very surprised by how strong we were in the week of Lehman’s meltdown a year ago. We were double digit. Beyond that, as I think Jeff discussed, and I did, I think there’s a stew of factors and I think those factors include the products that we’re putting out. I think they include the marketing.

I think they include the catering. I think they include category management and I think that most definitely includes operations. I think brought together, if you’re looking for one thing, I would say it’s Panera’s willingness and commitment to put more on the plate for our guests in every form and in every way.

I don’t know how when you talk about salads, you can just connect them from the way we serve it. Or you can connect that from the people that make it. It is the integrated totality of the experience that we’re focused on and I think that what we have made a bet on is that by continuing to increase the quality of what we offer our guests, we will drive competitive manage and it certainly seems to be manifesting itself in transaction growth and in comp growth.

I guess I would say to you, like all of you we test things extensively, but when it hits national roll out it takes on a life of its own and we couldn’t be more pleased by the results that we have seen.

Operator

Your next question comes from Jeffrey Farmer – Jefferies & Co.

Jeffrey Farmer – Jefferies & Co

When you introduce new products, especially the salads do you expect to see some cannibalization of your existing products? Are you seeing same store strength to suggest that’s definitely not the case? Are you able to monitor new customer traffic or measure existing customer visit frequency and if so, what are you seeing on that front?

Ronald Shaich

I’m not sure I understand your question. Your question is, is frequency going up or down?

Jeffrey Farmer – Jefferies & Co

For existing customer base and then comparing that to new customers, are you able to monitor your ability to attract new customer or whether or not your increased traffic is really a function of getting increased frequency from your existing customer base.

Ronald Shaich

I would say that there are elements of both in there. I think that we have essentially seen frequency stable to improve in which I think frequency has been off. Again, it depends on what time you’re measuring but I’m referring to the last several quarters where we have tracking data. I don’t have tracking data for the last four weeks.

And I think that we have also brought in new customers. Again, I think this approach to try to pull out one aspect, how did that salad do versus that, I think it’s the totality of the experience. I think certainly if you have new products that come in, they are going to cannibalize other products.

In our case the good news is, they cannibalize lower profit products but they are going to cannibalize. I think the net is, we’ve been able to hold our frequency and at the same time bring in new folks.

Operator

Your next question comes from Steven Rees – J. P. Morgan.

Steven Rees – J. P. Morgan

Just a question on wheat costs. It was a pretty significant benefit this year and can you talk about where you stand today on your contracts for wheat in 2010, how much is fixed versus floating and at what all in price per bushel you expect in 2010 versus the average in 2009.

Jeffrey Kip

We’ve bought about 80% of next year as we ladder in in a layered way over the course of the year. It’s probably a little over eight all in. We have less space to slot and more bushels of wheat locked. I think we’d expect it to land a little over 8.25%.

Operator

Your next question comes from John Glass – Morgan Stanley.

John Glass – Morgan Stanley

In 2009 I think excluding the charges you’ll probably end up earnings somewhere in the $2.80 range so the high end of your guidance next year of $3.15 really is only about a 12% earnings growth rate and that seems low relative to your comp expectations and accelerating unit growth and your comments about some favorability in terms of food pricing. Is there an element that we’re missing in terms of margin expansion or are you just trying to be conservative in setting that initial expectations?

Jeffrey Kip

Let me give you a couple of comment and then I think Ron will add a couple. The thing you have to understand is that accelerating unit development, my earlier comments doesn’t help you when you step it up over the prior year. With our company unit development going up more than 50%, maybe 60% year over year, that’s actually a drag on the P&L because new units are less productive, have training, pre-opening costs etc. in addition to pre-opening rent that GAAP now makes us charge.

So that’s a drag on the P&L. Your real unit growth actually comes from what you did the year before, so that’s A. And then you get less leverage at a lower unit growth number, so at 3% to 5% comps we actually think the number that we’re putting out there is what we expect given the way we are seeking to reinvest, differentiate and continue to take market share all the way through 2010.

Operator

Your next question comes from Sharon Zackfia – William Blair & Co.

Sharon Zackfia – William Blair & Co.

I was wondering on the marketing side, I know you don’t want to get too specific on the plans, but given the TV test and how successful its been you said you would increase the markets. Can you give us any kind of order of magnitude and how do you assess at this point whether or not to increase the ad fund contributions of franchisees?

Ronald Shaich

Let me start with the TV. I think you should consider TV one of our media, not the end all and be all. We look at what it costs us and what we get from it. In those, we have been pleased with what we’ve seen in the three markets we ran it this year. We’re making adjustments both in the buy and the creative.

We’re getting smarter and I think part of what Panera’s success has been about is reiteration and we’re getting smarter in it. I think that there are a number of markets where a spot purchase, that is to say buying it locally makes sense. It’s all driven by what the costs are and what the breakevens are and what we think the impact can be.

So I think you’ll see TV as an element of our marketing stew, not the end all be all in 2010. I would further add, as you think about all of this, our view is that the key to marketing is to understand who you’re talking to, who the target customer is. I think we have a deep understanding of that.

I think we’d like to think we’re the experts in understanding our target customer, and then finding ways to talk to them that are relevant to them. I would further add that our approach to marketing is maybe different from others. It’s rooted in an understanding. It has to have continuity.

Nothing we do is about let’s go out and buy television for four weeks. We lay it out for the year. We want to be in the marketplace. We want to be in our target consumer’s environment both in online, in radio, in billboards, potentially in television where it works. But it’s well in local store marketing.

Some of you may or may not know, Panera donated over $100 million between ourselves and our franchisees last year in product; very important in building that relationship. We’re using all of these elements as part of our effort to seek out, find and touch our consumer.

I think that our view is that Panera is one of the least hyped of any brand. I think that we undersell and have only come from over delivering. And what our marketing efforts are about are about informing people about what the Panera difference is.

The issue of franchisees, as I think many of you know our national ad fund, we have a contractual right to a national ad fund in all of our franchise contracts of 2.2%, significantly higher than what we have been charging. We met with our franchise community and that will go up. We’re well below that number. We will increase it modestly next year somewhere in the range of about .5% next year. So the community as a whole is committed and behind us and sees the same comps that you see.

Operator

Your next question comes from [Mitch Phiser – Buckingham Research]

[Mitch Phiser – Buckingham Research]

On the October numbers, because it was such a nice acceleration, I think you told us traffic was up maybe 3.2% in the first 27 days so that does imply maybe the mix piece did accelerate versus the third quarter. I guess my direct question is on the bulk bakery, how much of that is in the system. I know it’s not national officially yet, but do you think that was a contributor in October and when should we see the full throttle market initiative if you would share that comment. I’m sure it’s sometime in November but if you could be a little more specific.

Jeffrey Kip

Mix flipped positive in September, probably half a point positive on mix in September and our mix in October is consistent with the higher end of the range we gave for the fourth quarter. So you’re right. That’s what we are seeing.

Ronald Shaich

I think that the reason it flipped is three different factors; predominately the salads which offer higher gross profit per transaction and the sandwich, the smoothies and the relative strength of catering. I think that the retail impulse in bread Heritage initiatives which have been rolled out to some stores, are rolling out as we talk has had impact that is material.

I will say though that as ever, I keep referring to this, it’s a stew. Much of that impact has also offset. What we’ve also seen this year which is some reduction in bulk bagel sales. So I would not suggest that net impact of, and it’s had a real impact but I would say to you the net impact as you mix it in to the total mix has probably been more neutral.

Operator

Your next question comes from Bryan Elliott – Raymond James.

Bryan Elliott – Raymond James

I just wanted to make sure I’m understanding the comp guidance correctly and maybe one way to make sure I am is to think about it not on a comp basis just on an average weekly sales basis that would be consistent with the comp guidance, and given that the 14 week fiscal ended December 30, the 13 week fiscal this year on December 29, there’s reasonable comparability there from my standpoint, so is the guidance for comps in line with something like a 5% to 6% corporate Bakery Café average weekly sales in the fourth quarter?

Jeffrey Kip

Just to be clear, we are giving a 13 week to 13 week number on two different basis. You have essentially three sets of Bakery Café’s. The comps really address one set. You really have the stores open last year which are in the comp and then the stores opened this year which are in the comp that also factor in the AWS.

So what I’d tell you is what we’re saying on an apples to apples calendar comparison basis, so if you look at October, four weeks of October this year versus four weeks of October last year, we ran about 7%, and we’re saying that that’s stable apples to apples four weeks in November to four weeks of November and four weeks of December to four weeks of December is going to be about 5% with the comping group of café’s.

Now if you look at release, the stores open last year are relatively stable with their AWS from last year because their AWS isn’t changing. That would actually pull down modestly, very slightly your overall AWS growth, and then your new stores are up in the quarter and year to date 1.5% of so, so then also wouldn’t give you a total AWS growth of 5% for the last two periods either.

So I don’t think necessarily total AWS is the right way to cut it. We’re trying to give you that base group that’s been open for 18 months and that’s growing at a stable rate about 5%.

Operator

Your next question comes from Robert Darrington – Morgan Keegan.

Robert Darrington – Morgan Keegan

When you look at the pipeline for new products that you’ve got, how do you measure how not to overload the restaurants or the café’s with all of the ideas and all of the products that you’ve got.

Ronald Shaich

That’s a great question and one we spend a lot of time on. I think we often test things together to be able to understand that. We’re certainly concerned about that with the salads and the pressure on chicken. In fact, we tested it all together.

I think in the end, you speak to what I’m really trying to say which is it it’s a stew of factors. You can’t pull out one. It’s the interrelationship of product, operations, communications/marketing and catering. And this team gets together, the top 40 people every four weeks for several days and reviews the programs that are in test and formally the Senior Vice Presidents sign off on it.

And it’s just to that question you raised, the interrelationship of those four factors and their impact on our ability to execute for the customer that matters. My most fundamental view is that all of these factors have to be considered and that the biggest mistake we make in looking at a company whether we’re analysts or the people running it, is to take one aspect and ignore its impact on everything else.

Operator

Your next question comes from Nicole Miller – Piper Jaffray.

Nicole Miller – Piper Jaffray

I’m just wondering if the 3% to 5% comp guidance for next year includes or how much of the 2% price that you might test at the beginning of the year? And could you please speak to the transaction and mix of trends in catering.

Jeffrey Kip

I think we’re looking at a modest price increase next year. We’re going to be rolling in half a point or so. If we take a point or a point and a half next year, we’ll end up with 1.5 to two points, not a big deal, and we do have to test it and go through it.

Therefore, we’re going to get mix on the other part of the comp. In terms of catering, if same store catering goes up about 5%, that’s going to add about 30 basis points to your check and your total comp because catering check is so big, you almost don’t feel the impact of the transactions. You really feel the impact on your check growth.

So in terms of our catering transactions are actually what’s driving the lift in catering because we’re if anything, not getting and real check expansion there in this economy. But it impact it really has is on mix.

Nicole Miller – Piper Jaffray

Just to clarify, in the 3% to 5% comp the price is included in there.

Jeffrey Kip

Absolutely. We always include price in our comp guidance.

Operator

Your next question comes from David Tarantino – Robert W. Baird.

David Tarantino – Robert W. Baird

A bigger picture question on development, given the momentum that you’re seeing in the business and the deflation you’re seeing in the cost environment, why not go even more aggressive after new unit development than what you are? Maybe if you can talk about what the limitation is for 2010 and also whether you’re building the pipeline for even faster growth beyond 2010.

Ronald Shaich

I think it gets back, partially my answer to Bob’s question and that is to say everything was clear intent. Everything was appropriate conservatism and moderation. In other words, Panera is a large company. We don’t want to be jerking ourselves around from this position to that position.

For us, the most important thing is that development is a disciplined process. The way we think companies get in trouble is when they lose that discipline. Same way we think about marketing, same way we think about investment and product, same way we think about operations, discipline is key.

So our development effort starts with a disciplined return on investment model and a commitment to delivering that.

Secondly, we held the line this year and we’re continuing to in terms of assuring ourselves that not only do we meet our ROI goal, but that we are meeting our operating goals which is to say make sure the occupancies are coming in reflective of the new world of commercial real estate.

Putting those two pieces together and understanding that development is a front loaded process with fairly significant resource needs, I think that we think that a step up in our growth next year of 50% is quite aggressive, is appropriately aggressive, let me say it that way.

It’s the right thing to do. Anything more than that I think in the context of staying both disciplined and resource sensible would be not the wisest decision. Where we go beyond that, we’ll discuss that as we get there.

Operator

Your next question comes from Steve West – Stifel Nicolaus.

Steve West – Stifel Nicolaus

Just a follow up question to the development area, can you talk about why do you think the franchisees aren’t accelerating their unit growth to keep up pace with you. Typically the unit growth has gone in lock step with your franchise and company owned. It seems to be tailing off here in the last couple of quarters and into 2010.

Ronald Shaich

I would suggest to you that they’ve actually hopped around. If you look at over 10 years, they’ve been ahead of us, they’ve been behind us. I think they tend to trail us as opposed to being leading drivers of us.

And I think they tend to be a bit more reactive to whatever is the underlying business condition at that moment because they’re oftentimes leveraging their investments and they come at it with a different perspective.

Having that said that, I’ll say this. Each franchisee is a different situation. There’s no universal, there may be generalizations but there’s no universal situation. I think that our franchisees just like we do and much like you do see the comps. They see the strength of the new AWS’s and they see the decrease in development costs and the ever improving ROI’s.

So I think they, like us, begin to make judgments about how much risk they want to take to their personal net worth, how many stores they want to open next year, whether they want to incur any cannibalization at all or they’re going to be absolutist about that.

Everything has a range of judgments that they make, and I think history, if history says anything, the franchise community tends to follow us because our direction is generally driven by underlying economics.

Operator

Your next question comes from Jeffery Bernstein – Barclay’s Capital.

Jeffery Bernstein – Barclay’s Capital

A follow up question on the economic development side; you mentioned some franchisees now may be more concerned or reactive to the current market situation. I just wanted to know what you think longer term, is there any concern with the over weighting of the company stores, or perhaps better yet, is there a certain target? I know the company percentage keeps increasing and historically it seemed like you were more included to push it franchise driven. If you could tell us what that uptick in company operated growth, what your thoughts for CapEx in 2010 with the incremental units and the Panini Grill.

Ronald Shaich

Let me be very clear. There is zero change in our philosophy, in our direction between company franchise mix and not only is there no change of philosophy, there can be no substantive change in the mix. We’re at 1,400 plus Café’s. We almost couldn’t move the numbers even if we wished to other than the margins.

I think that we will continue to be a predominantly franchise system, roughly 60/40 in that range. I think that on the margin, the company has given some very significant cash resources has been a bit more aggressive in getting out of the flock and moving development in the context of the commercial real estate delta and I think that’s all you’re picking up. There is no philosophical change whatsoever.

Jeffrey Kip

We obviously haven’t guided to our CapEx for next year which I’ll give you a simple way to think about it. If you were to think about the core assumptions, I’d take this year’s CapEx, I’d say we’re increasing the company growth more than 50% next year and we have a couple of capital projects on top of that.

That means for the 30 company stores, we’ll build 15 plus more, so that’s $15 million plus in new stores. And then add a couple of capital projects and you’re $20 million plus more than this year. So it’s just a very simple way for you to think about it even though we haven’t guided yet.

Ronald Shaich

With that, let me just note that Jeff promised to continue questions until the opening market. I said we’d stay on for half an hour in my comments. I think we will end the questions as this point.

Once again thank you for your support of Panera and your confidence in us and just know that myself, Jeff and Michelle are here and available for anything you need throughout the day and as ever. Thank you and good morning.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: [e-mail]. Thank you!