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Panera Bread (NASDAQ:PNRA)

Q3 2013 Earnings Call

October 23, 2013 8:30 am ET

Executives

Michele Harrison - Vice President of Investor Relations, Corporate Development & Treasury

Roger C. Matthews - Chief Financial Officer and Executive Vice President

Ronald M. Shaich - Co-Founder, Executive Chairman and Chief Executive Officer

Analysts

Brian J. Bittner - Oppenheimer & Co. Inc., Research Division

Michael Kelter - Goldman Sachs Group Inc., Research Division

Alton K. Stump - Northcoast Research

David E. Tarantino - Robert W. Baird & Co. Incorporated, Research Division

Joseph T. Buckley - BofA Merrill Lynch, Research Division

Alexander Slagle - Jefferies LLC, Research Division

John S. Glass - Morgan Stanley, Research Division

Jason West - Deutsche Bank AG, Research Division

Jeffrey Andrew Bernstein - Barclays Capital, Research Division

Jeffrey D. Farmer - Wells Fargo Securities, LLC, Research Division

Operator

Good day, and welcome to the Panera Bread Third Quarter 2013 Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Ms. Michele Harrison. Please go ahead.

Michele Harrison

Thank you. Good morning to everyone, and welcome to Panera Bread's third quarter earnings call. Here with me on the call this morning are Ron Shaich, our Chairman and CEO; and Roger Matthews, our Executive Vice President and Chief Financial Officer.

Before we begin this morning, let me cover a few regulatory matters. I'd like to note that during our opening remarks and in our response to your questions, we may make forward-looking statements regarding future events or the future financial performance of the company. Any such items, including targeted 2013 and 2014 results and conditions and details relating to 2013 and 2014 performance should be considered forward-looking statements within the meaning of the Private Litigation Securities Reform Act of 1995. Such statements are only predictions, and actual events or results could differ materially from those predictions due to a number of risks and uncertainties.

I refer you to the documents that we file from time to time with the SEC, specifically our annual report on Form 10-K, which was filed on February 15, 2013. This document contains and identifies important factors that could cause actual results to differ materially from those contained in our projections or forward-looking statements.

With that, I'll turn it over to Roger.

Roger C. Matthews

Thanks, Michele, and good morning, everyone. Yesterday, we reported Q3 EPS of $1.48, up 19% versus our reported Q3 EPS in 2012. This figure includes a $0.13 one-time tax benefit related to a favorable resolution of some state and federal tax matters. In addition, this EPS included a favorable impact of $0.02 from share repurchase completed during the quarter. Net of these benefits, EPS would have been $1.33. Relative to our 2012 third quarter operating EPS of $1.20, which excluded one-time acquisition and share repurchase benefits, this quarter represented operating EPS growth of 11%.

Today, Ron and I will go through our diagnosis from our recently completed internal analysis, as well as discuss our game plan for the next several quarters.

Our total revenue was up 8%, as we saw increases in company-owned bakery-cafe sales, franchise royalties and sales of fresh dough and other products related to our franchisees. Comparable same-store sales growth was 1.7% at our company cafes, all our franchisees experienced 1-year comparable same-store sales growth of 0.9%. What is interesting is that while our same-store sales results were below expectations, our sales year-to-date in new company and franchise cafes opened this quarter exceeded last year's record levels when you adjust for urban cafes. This has always been, for us, the best gauge of strength for the Panera brand.

And I will take a few months to talk about margins and the trends that we saw in the business this quarter. I will also spend a few minutes on our use of cash. Our third quarter operating margin was flat year-over-year as we had a number of puts and takes within the P&L.

Let me spend a minute looking at the factors. Bakery-cafe margin de-levered by 90 basis points compared to the prior year. Let me break it down to its components. Food cost as a percentage of sales increased 20 basis points, primarily the result of a positive year-over-year shift in our product mix. Similar to the second quarter, the relative success of items like pasta and this summer's shrimp products placed downward pressure on the percent margin, but resulted in higher absolute gross profit dollars. This is an intended consequence as we view these new products as both well received from customers and ones that generate gross profit growth when a customer trades up from an existing product to these. Pasta has settled in well as a permanent item in our sales mix and has helped further drive our dinner business. Additionally, we see products, such as shrimp, as truly differentiated and an offering that many other brands in the restaurant space would struggle to replicate.

Consistent with the second quarter, we took price increases of 1.7%, which offsets both the modest inflation in food commodities and the higher inflation in other cafe costs like benefits. We continue to expect all-in paper and food cost inflation for full year 2013 to be approximately 1.5%. Remember that this figure for us represents both the inflation seen in our raw food inputs, as well as our ongoing efforts to elevate product quality. Our preliminary read on 2014 is that we should see very modest levels of food inflation and only slightly more inflation in packaging.

Labor expense as a percentage of sales was flat year-over-year as we focused on ensuring proper labor scheduling and discipline in the cafes. The focus this past quarter was aligning on core metrics, as well as ensuring discipline in how our general managers are deploying associates throughout the day. As we look ahead to the fourth quarter, however, we would expect labor to de-lever relative to the prior year. Ron will discuss this in detail.

We saw occupancy de-lever by 20 basis points. This is a result of several factors, including state and local municipalities' increasing real estate taxes in many of our jurisdictions, as well as modestly higher occupancy costs in our new suburban bakery-cafes that reflect the strengthening real estate environment. Other operating costs de-levered by 50 basis points, primarily the result of higher marketing expense and other controllable expenses in the quarter. As part of our internal analysis to understand and ultimately enhance throughput, we spent an additional $2 million this quarter to restore smallware inventory in our cafes to our recommended levels. This is a tangible manifestation of our need for investment to allow our cafes to keep up with demand. The move will ensure that our cafes have the correct level of utensils, plates and bowls, that is critical to allow a cafe to make it through a key day-part stretch like lunch without needing to deploy someone to run a dishwasher. This also preps our cafes to be ready for increased transactions next year as we move forward with several drivers of demand.

Now let's turn to our fresh dough margins. In the third quarter, our supply chain business benefited from the lower cost of wheat. Margin improved year-over-year by 40 basis points, although this had only a negligible impact on overall company operating margin. On a sequential basis, fresh dough margins declined as the cost of wheat increased relative to the second quarter. Recall that a forward laddering of wheat is intended to mitigate risks and secure the average price of wheat over an extended period of time. We would expect to see fresh dough margins down very modestly in a year-over-year basis in the fourth quarter, and our outlook for wheat next year is very modest deflation.

In the third quarter, our G&A as a percent of sales decreased by 80 basis points and offset other increases in the P&L. The decline in G&A expenses in absolute dollars and as percentage of sales reflect several forces at play. First, there was lower incentive compensation as the quarter's performance did not meet expectations. Secondly, the timing of some of our corporate hiring was more back-end loaded, and at the same time, there was good discipline at our G&A at the corporate level as we seek to look for efficiencies that leverage our scale. Finally, the roughly $20 million in investments that we discussed at the end of 2012 to build capabilities that was expected to mostly impact Q3 and Q4 G&A has shifted somewhat more into Q4 and into 2014. Net-net, the total amount of these investments in 2013 will be closer to $13 million. Keep in mind, however, that the remaining $7 million will be spent in early 2014 as part of additional investments to be discussed by Ron.

Lastly, our effective tax rate of 33.4% was below our normalized rate as we benefited from a $3.8 million refinement of estimated tax amounts and filed returns, settlement of tax audits and other tax adjustments. For the full year, we expect our tax rate to be approximately 37.5%.

Now let's turn to use of cash. We continue to prioritize the deployment of our cash to the construction of new bakery-cafes. These new units have a highly stable and long-term track record of producing attractive returns anywhere in the United States. During the quarter, we opened 32 new bakery-cafes systemwide, 17 company-owned and franchise-owned, bringing the total for the first 3 quarters of the year to 91 cafes. We now believe that we will be above the high end of our original 2013 target of 125 new units. New company-owned bakery-cafes had year-to-date average weekly sales of $45,205 versus $47,438 last year. As we called out last year, however, urban cafes significantly inflated the 2012 figure. Netting out the impact of urban cafes in both 2012 and 2013, our new unit year-to-date average weekly sales for this year is $44,779 relative to last year's comparable AWS of $42,642. Franchise-owned new bakery-cafes saw similar increases with year-to-date average weekly sales of $48,432 versus $47,680 last year. As we continue to look at the various markets in which we operate, we are increasingly confident we can do [ph] penetration with attractive financial returns as we grow our awareness and create more convenient locations and ways to access Panera.

During the quarter, we deployed just under $175 million of capital for share repurchase. Subsequent to the quarter end, we have deployed an additional $69 million for further repurchases. In total, we have repurchased approximately 1.4 million shares since the end of the second quarter. For the fourth quarter, we would expect that shares repurchased since the end of the second quarter through yesterday will enhance our EPS by approximately $0.10 per share.

As we discussed in our call last quarter, we will look to opportunistically deploy excess cash. As our stock price moves lower, we saw an attractive opportunity to be more proactive in our approach around our use of capital, and we believe, enhance long-term shareholder value. Our intention remains to proactively deploy excess cash when share repurchase or acquisition opportunities appear. However, it would be unrealistic to assume we will deploy a similar magnitude of cash on share repurchase next quarter. We remain committed to maintain significant balance sheet capacity to be opportunistic in the future.

We generated approximately $66 million of cash flow during the third quarter, resulting in roughly $23 million of free cash flow after approximately $43 million of CapEx. We ended the quarter with approximately $194 million of cash on the balance sheet, but given the subsequent share repurchase we completed after the end of third quarter, cash balances are now lower. We have not drawn on our $250 million credit facility.

Now let me turn it over to Ron to talk about our business and our game plan going forward. Ron?

Ronald M. Shaich

Great, great. Thank you, Roger. Thank you very much. Let me begin my comments by reviewing with you how we see the Panera business today. Panera has had an extraordinary run over the past 2 decades. When you study Panera, you'll realize our success has tended to come in 5-year waves. Generally speaking, our success occurs when we've been able to deliver for our guests, an ever better competitive alternative. And our success coincides with step function investments that build out that vision and ultimately create new inflection points for the business. We are, again, at one of those points.

As I begin my color commentary, let me speak first to the issue most on your minds, comps. This is the issue that we discussed at length on our last conference call, and it remains the issue of the day this morning. Simply put, with 1.7% company comps in the third quarter and 1.6% company comps for the first 27 days of the fourth quarter, our comps remain weaker than our expectations and below our historic track record.

In our conference call last quarter, we suggested it was best to understand our comps by comparing them to the all-industry composite called Black Box. So let's compare our third quarter results to Black Box again. In the third quarter of 2013, we ran 190 basis points better than the all-industry composite. This compares unfavorably to the results that we've generated just several years ago when we ran 300 basis points or more better than the all-industry comps composite.

Allow me now to provide you with a breakdown on the comps. Price and mix were up 1.7% and 1 point, respectively. Price growth was modest as inflation was low in Q3. Mix growth was also modest, as catering sales growth was only 10% in the third quarter. I will comment on the inhibitors impacting catering growth when I discuss operations in just a few minutes.

Transaction growth in the third quarter fell by 1%. We find it helpful to aid our understanding of our transaction performance by looking at that performance versus the all-industry composite here as well. In the third quarter, our transactions were 81 basis points better than the all-industry composite. This performance also compares unfavorably to our results several years ago when we saw 200 basis points or greater favorability in our transaction growth versus the all-industry composite.

Folks, we get it. The trajectory of comp growth and the trajectory of transaction growth are headed in the wrong direction. But before we review our plan to bend the arc of our comps trajectory, I want to insert an interesting fact into the discussion. While our transactions were actually down 1% in the third quarter, our entrée growth was up nearly 1%. Importantly, we have come to understand that entrée growth is a significantly better measure for demand in the cafes than the transactions, as the entrées per transaction metric has increased steadily since 2011. As a result, while transaction growth itself has been slightly negative for several quarters, entrée growth has continued to grow significantly faster each quarter, quarter-after-quarter, for several years running. Here's the point: despite limited transaction growth, the growth in entrées tells us the real demand on our operating systems and capacity has grown materially in the last few years. So let's now discuss how we hold our comps. As we said last quarter, our comp performance in the past few years could've been viewed as an 8 or 9 on a 10-point scale. Today, to be very frank, we're performing at the level of a 6 on that same 10-point scale. And from our perspective, not only as trajectory heading in the wrong direction, but this performance is not acceptable to us at Panera.

The outgrowth of these results is that the last quarter has been a time of intense self-examination at Panera. We've done a top-to-bottom review of what's going on and looked at a fair amount of research. Here's what we've come to understand: the Panera brand is strong. Our average unit volumes are growing in excess of 20% over the past 5 years. Over the same 5 years, store-level margins are growing nearly 400 basis points from 16.3% to 20.2%. Today, each Panera unit, on average, is generating roughly $2.5 million in sales annually, up from $2 million just a few years ago. Over the past 16 quarters, we've enjoyed average comp growth of approximately 5.8%, despite taking just 2.5% of price on average. And our new cafe units continue to set records almost every year. Indeed, that success may be part of the problem we face today. Based on our detailed self-examination and our research, we've concluded that our success at growing sales rapidly over the past few years has outstripped some of our capabilities in some of our cafes.

Let me give way to this by way of a story. Walk into our cafes at 12:30 p.m. during the lunch rush, and you'll see the lines. It's clear that the demand for our product is not the issue. Our problem is keeping up with in meeting that demand with an in-cafe experience that delivers something truly differentiated. Roughly 6 customers per cafe per day equates to approximately 1% transaction growth. Indeed, the difference between the successful or unsuccessful transaction growth at Panera, at least as we hold it, is just 6 to 12 customers per cafe per day. And yet, anyone of us can visit a Panera and see that -- and see that many customers walk out of our cafes every day when they can't or won't wait in the line. In fact, you don't have to be a very astute analyst to understand there's a real opportunity at Panera in generating greater throughput per cafe.

Let me share something else. We've directly surveyed our customers, and the top reason they cite for coming less often is the diminished in-cafe experience. More than a quarter of those polled identified slower service, less comfort and the accuracy of orders, among other experience issues, to explain why they aren't visiting our cafes more frequently.

On top of that, there's an additional challenge facing our business. We've been hard at work for the better part of the last 2 years on a series of demand drivers that we believe have the potential to significantly improve our guest experience and grow our transactions. But here's the conundrum we face: if capabilities are not in place today to handle the business we're presently doing, how can we expect the benefit from the additional demand fueled by our initiatives.

So let's now turn our attention to a discussion of how we face off against the operational challenges we see. As we've spent time in our cafes in the last several months and really listen to our managers and observe them, what we've found is that they were overly focused on efficiency and cost balancing at the expense of an effective customer experience. So first, we've been refocusing our operational leadership team on delivering against the commitment that has been at the core of Panera's historic success. That core has been focused on product, on environment, on great service and on people. We've also demanded from our operations leadership a renewed focus on key operating metrics, including speed of service and accuracy. Secondly, we have used our ops services and our industrial engineering teams to analyze and determine the labor needed to meet the work -- to meet the workloads in our cafes. Based on that analysis, we recently made the decision to add approximately 35 additional hours per week into each of our cafes. This amounts to approximately $15 million in incremental annual labor expenses. Yes, certainly, it's a lot of money, but it's necessary. We know it's necessary in order to remain in integrity with our people and to grow our sales.

Let me note that we're also very focused on executing these labor investments in a methodical way, so we don't see the labor run away from us. Third, we analyzed every cafe to assess its physical capacity levels. What we found is that approximately 10% of our cafes are capacity constrained today and approximately 1/3 of our cafes would be constrained should we have a meaningful lift in transactions.

Let me add, the vast majority of these constraints aren't related to the size of the cafe, but rather to very specific production limitations that exist in those cafes today. Here's what we're doing about the problem. By next February, we expect to have added into most of the affected cafes the necessary additional production equipment needed to handle both the existing demand and much of the incremental demand that we might hope for in 2014. Fourth, we are focused on improving our human capabilities. That is to say, we want to ensure that we have the proper number and the appropriate quality of associates with the capabilities and the availability necessary to meet the current demand of our sales and the demand as we grow sales into the future.

Fifth, we're testing, and in 2014, expect to roll out into our cafes a number of significant process improvements. These includes state-of-the-art kitchen display systems, which facilitate communication, as well as several process changes rooted in our philosophy of total quality management in an effort to drive up the accuracy. Sixth, we're developing improved back-of-house forecasting and labor scheduling capabilities for our cafes. Simply put, our goal is to remove as much administrative burden as we can from our managers so they can focus on creating value by delivering a great experience for our guests.

Seventh, we are moving to make modifications to our procedures to reduce the complexity and degree of difficulty of operating a high-volume Panera cafe. We have completed a turf study, and we will be reducing our menu modestly post-Thanksgiving. We are also looking for ways to reduce the prep load in our cafes. As well, we are making plans to dramatically reduce the number of phone-in orders coming into our cafes.

It's amazing to me, but presently 10% of our customers call in, and we have to drop everything. We have to actually leave the counter to take that call. And then they waltz in, and they come up to the counter and expect us to come over to them and bring the food to them at that moment. We know the phone-in business is best served and will cause significantly less disruption and cost significantly less to serve when those orders are moved to the web. Finally, we are making a change in how we handle catering. Presently, catering is nearly 8% of our sales, but the rate of catering growth has stalled at about 10%. Frankly, catering growth is now limited by cafe capacity constraints and is limited by the attention and the focus of our management teams. It's for that very reason that we have been testing dedicated catering hubs. These catering hubs work to support the catering volumes of 2 to 5 cafes. Such hubs have proven that they can free the manager to focus on growing retail sales, which when we've set up these catering hubs, is actually what happens, the retail sales go up. And with the dedicated catering facility, it also leads to our ability to grow those catering sales more intensely and with far greater focus. Though catering hubs will take years to roll out across the full system, expect us to create scores of these catering hubs in 2014.

Now let's briefly discuss what you can expect on the food and the content front. Post-Thanksgiving, you should expect to see a new country-style mushroom soup with truffle oil. You should expect to see a new chicken tortellini alfredo dish, and you should expect to see other pastas, along with a new signature Fontina grilled cheese in our cafes. Honestly, I think the new grilled cheese is wonderful, but you're going to have to come to Panera after Thanksgiving to try it for yourself.

Let's now discuss pricing at Panera. Our strategy has been to always elevate quality in a way that, that is what differentiates us from competitors. Right now, many in the restaurant industry have chosen to dramatically discount, and in many cases, reduce the quality of their food to offer those discounts. We simply don't see this as a viable approach, long term. Our target audience will remain those customers who value the elevated experience and the quality of ingredients that we offer. We continue to believe, and every study we perform confirms this, that if we can deliver on the full experience of food and service, the full Panera experience, our customers are more than satisfied with the value they receive for the money they've spent. Every survey we conduct tells us our customers love our food. However, we do believe that we can offer our customers alternatives for those occasions when they want to eat lighter.

The introduction of half sandwiches this past year was just an example of that effort. Next year, we will introduce flatbreads in a way that only Panera can, freshly baked from fresh dough, artisan flatbreads in the style of the Indian tandoori, paired with great proteins and interesting flavors. The flatbreads we've developed are designed to be -- individually or in pairings, and these products will offer the customer new options. They will offer the customer the option to choose their portion size, and ultimately, their check size. Importantly, though, this product will open up a whole new platform for Panera as we think about snacking and how our customers may want to eat across day parts into the future.

There's one other thing I would like to mention relative to pricing. We will introduce a new menu structure in 2014 that groups item by price point. Expect this menu structure somewhere in the second quarter. The new menu structure will allow customers to choose to purchase each Panera favorite as a half, as a whole or as part of the You Pick Two. While our testing shows no indication of any change in gross profit as a result of this new menu structure, we do expect that customers will perceive significantly more lower-priced, lighter options available to them at Panera.

Let's now discuss marketing at Panera. Our media spend was 1.4% of sales in 2012 and will end at approximately 1.7% of sales in 2013 as we continue to test low weights of national media buys. Our expectation is that we have now reached the point, where in 2014, we will begin national broadcast media and anticipate we'll spend approximately 1.9% of sales. You should expect to see our media launch in the second quarter of 2014, and you should anticipate that our advertising will consist of both product and brand communication. We believe that this national broadcast effort will significantly enhance Panera's reach in a number of markets, and we think expensive media markets like New York, Boston, Atlanta, Dallas and L.A., in particular will feel the benefit.

However, let me offer one note of caution relative to the national media. While we do expect the national media effort to generate new Panera relationships and drive transaction growth, we want to caution investors to moderate their expectations, as our level of national broadcast media and the nature of the messaging we'll be doing will be relatively light when compared to many national advertisers.

Let me now briefly update you on our loyalty program at this point. We continue to believe that our loyalty program will allow us to build deeper and more personal relationships with guests and we'll strategically market to individual consumers. As well, we know the MyPanera program provides us with an extraordinary level of insight into customer behavior. Much of what we've learned relative to customer behavior and attitudes towards Panera are derived from the loyalty program. The MyPanera loyalty program now has over 15 million members, and it continues to grow. In fact, in the third quarter, just under 50% of our transactions were attached to a MyPanera loyalty card. Indeed, to the best of my understanding, this is, by far, the highest participation rate of any loyalty program in the industry and is a powerful weapon in Panera's arsenal.

Let me now comment on our long-term initiatives. During the last year, we shared with you the news that we are making significant investments to enable an improved and differentiated guest experience. Our investments, primarily in technology, are meant to create an enhanced eat-in experience and an enhanced to-go experience for our guests. While as a rule, we don't comment on tests, I did want to indicate to you that our efforts are on track and our excitement, relative to these projects, continues to be high. Indeed, we now think the possibility exists that certain elements of our improved guest experience could be rolled into parts of Panera in the second half of 2014. Let me also note that we intend to show you some of what we plan to roll out as part of these efforts at an analyst meeting that we expect to hold in the first quarter of 2014.

Let me now conclude my comments with this perspective. Investments are typically a step function, but sales tend to be more linear along an upward or downward trajectory. I want our investors to be clear. It is our most fundamental commitment to our shareholders to make the tough decisions now and to make the adjustments today to bend the arc of our sales growth trajectory. I also want our investors to remember this: if you study Panera's 2-decade long history as a public company, you'll find that Panera has succeeded time and again because we have made smart bets that do bend the arc of our sales growth trajectory. Indeed, when you study our history closely, you'll find that approximately every 5 years, we've made step function investments that ultimately produce outsized shareholder returns.

Folks, let me conclude by saying, all of us at Panera are intensely focused on producing such outcomes once again. I say thank you, and I turn it back to Roger for our guidance.

Roger C. Matthews

Thanks, Ron. Let me now spend a few minutes reviewing our targets for the fourth quarter. Since our goal is to enhance both our capacity, as well as the guest experience at our cafes, and at the same time, prepare for increased transactions on the back of the demand drivers that Ron discussed, this will require true end-to-end solutions. Many of these initiatives are sequential, requiring successful implementation in order to move [indiscernible] step. As such, it will take some time for our customers to see the both -- full benefits of these initiatives, and thus, we believe that our comparable sales and EPS growth could be modest for the next several quarters, followed by acceleration.

For the fourth quarter, we are now expecting modest comparable same-store sales growth of 0% to 2%. While this range may appear conservative relative to the trend we've seen in the first 27 days of the quarter, we would prefer to be conservative at this point in the journey, given the deliberate timing of our various initiatives.

Based on this lower comp guidance, we are lowering our Q4 EPS target range to $1.91 to $1.97. The revised earnings guidance represents an increase over last year between 9% and 13%. Remember, however, that this fourth quarter includes a 53rd week unique to this year, which adds approximately 700 basis points of favorable impact in the quarter. We expect operating margin to be down 100 to 150 basis points, which reflects the lowered same-store sales comparable guidance, as well as the stepped up labor investment Ron discussed. We don't intend to today to give specific guidance to 2014. Instead, our objective would be to speak to that in early 2014.

As Ron said, we will be hosting an Analyst Day in Boston to invite our shareholders and analysts to see more directly the investments we are making and to hear our strategic vision for the next several years. At a high level for 2014, though, we would say the following: You've heard us use the word investments throughout today's discussion. This is deliberate, and it's meant to encompass several key areas of focus for us: First, investments in our cafés to strengthen and enhance our in-café foundational capabilities; secondly, investments in technology and systems that will enable our managers to refocus their energy on the customer and allow us to significantly improve the guest experience; third, investments to drive awareness, primarily our move to national advertising and continued leveraging of the MyPanera program; and finally, investments defined as start-up costs as we activate several of our key drivers of demand next year and incur the onetime cost associated with that start-up. As a result of this comp trend and the investments we will make in 2014, our EPS growth for the full year in 2014 will likely be modest, below the low end of our long-term model. This is based on a 52-week to 52-week comparison. However, we would expect to see better sales growth, as well as EPS growth in the second half of the year as those initiatives take effect. Capital spending will likely increase over 2013 levels, given the investments we are making, as well as our expectation to increase the number of company units built in 2014. We are confident that the steps we are taking today and in the near future will position the company for future significant growth in both sales and profitability.

With that, operator, we'd like to open the line for questions. [Operator Instructions]

Question-and-Answer Session

Operator

[Operator Instructions] And we'll take our first question from Brian Bittner with Oppenheimer & Co.

Brian J. Bittner - Oppenheimer & Co. Inc., Research Division

The question is going to be on 2014 guidance. I understand that you guys don't want to give exact guidance at this time, but I've heard the word modest and I've also heard just under the long-term rate of 15% to 20%. So from our perspective, it's hard to gauge what are we saying here. Are we seeing low single digits? Are we seeing low double digits? Because at the end of the day, we need to project the earnings for your company after we get off this call and it's just tough to understand where we're supposed to go with this.

Roger C. Matthews

Yes. So Brian, it's Roger. Look, the use of the word modest, at this stage, was deliberate. The low end of our guidance -- of our long-term model is 15%. It's our belief that we'll be below that 15%. That being said, at this stage, it's difficult for us to estimate exactly where that will settle out. And again, it has to do with the timing of the way the initiatives will play out. So again, we're being conservative, trying to get a sense where we are, but that's as most as we're going to talk about at this stage.

Operator

And we'll go next to Michael Kelter with Goldman Sachs.

Michael Kelter - Goldman Sachs Group Inc., Research Division

Yes. I wanted to ask, you talked a lot about the investments that you intend to make to improve the Panera experience at the store level. And all of them make sense when you list them out. But I'm just -- I'm not sure I understand what the cost of all this is going to be to your P&L. And even if it's still preliminary, the only number I remember hearing was $15 million for the increased labor and no other numbers. Can you maybe go -- re-go through that list of 7 or 8 things with the directional estimate on the cost by project? Something to help us understand what investments you're going to be making.

Ronald M. Shaich

I think what I can do for you is go through it piece-by-piece and give you some color commentary, but trying to parse out individual objectives and then try to define the cost of that, I think it's actually going to take us down lots of rabbit holes that are overstating it. So let me see if I can sort of take you through it. Let me start and say the first piece of it is refocus and focus on very specific metrics. I don't think implicitly there's any cost at all. It's really where we put our energy and what we ask of our team members. Secondly, relative to the capacity additions, I think that, that capacity addition will take form mostly as moderate capital expenditures. It's not a big deal, but it will mostly take form as capital expenditures as we add equipment into the stores. There may be some very modest disruption in the P&L as we add it into individual stores, but it's a matter of 1 day or 2, and nothing material relative to that. I would say to you, third, relative to the question of the 35 hours. I think that's very real and direct against the P&L. I think we've indicated to you we think the 35 additional hours, which we put in beginning last week, amounts to about $15 million in annual expenses, or somewhere in the range of about $3.75 million a quarter in expenses. And you can tie it out from there, that's relative to our company stores. I would say to you, fourth, relative to human capabilities, I think we're talking about making certain that we're staffed and that we have the ability to deploy properly in our cafés. There may be some modest expenditure around HR and sort of indirect overhead relative to that. There are some costs in getting -- as we add in more people into the thing to be ready for some of the transaction drivers, some step-function nature to that relative to hiring and training. But I think of it as roughly moderate and not material and a big deal in and of itself. I don't think we're going to be talking about it later in the year. I'd say, fifth, relative to the process improvements, I think that the equipment that we're bringing to bear, like the KDSs, has no cost. I think as we demand process discipline, there is some modest labor cost because we're actually doing it right as opposed to accepting doing it less than right or in a sort of expedient way. I would say that, sixth, as we talk about the forecasting and labor scheduling capabilities, again, that's buried in the technology investment, and I don't think we're going to see anything in the P&L. I would say, seventh, relative to shifting the phone-in orders out, that will have no material cost relative to the issue of catering. As we start up these hubs, there's a step-function cost because you got to get them up and going, there's an incremental, physical cost. Though, to be clear, we're not doing them in separate facilities. We're doing them with separate management teams, but sharing the same physical space generally where we can. And so I think that it's probably measured in relatively small numbers. It's not one of the things that are going to affect the year in a way, though there could be $0.5 million or $1 million or give-and-take expense as we start them up. I would say to you, probably, the 2 biggest things that will affect the P&L, and I'll sort of bring it together, is to say this: I think you got the real labor cost, and we know we've got to do that. And I think, in some way, the cost of doing it right and focusing on being effective and not simply efficient, it is absolutely the right thing to do looking at the sales trajectory and what we need to do could have some modest impact on labor leveraging. We may ultimately delever the labor in some modest ways, but I think it will more than pay for itself in the sales. And I think most importantly, what we're really dealing with here is making sure we have a strongly sustainable long-term business model. And how we operate and how we compete is at the core, and that's really what we're talking about. I hope that was helpful.

Roger C. Matthews

Yes. And Michael, maybe -- it's Roger. The one thing I would add to it, I absolutely agree, as Ron went through that list, of any one of these items isn't really material. I will say the totality of the things we're doing do add up over the course of the year. And so that's why we're being conservative and cautious because there -- a lot of this really is around, when you add up all the initiatives. What we're 100% convinced around is that the totality of all these initiatives are going to generate real growth within the business, but we can't parse it out and tell you that each step along the way generates exactly this amount because what we know is, we have to bring the experience level in the cafés up to where we know it needs to be, and you can't quite tie each little initiative to exactly what percentage of improvement in the experience it is. So that's the only item I would give you in terms of a little bit of color around the totality.

Operator

We'll go next to Alton Stump with Northcoast Research.

Alton K. Stump - Northcoast Research

A quick question, I mean, this will be the fourth year in a row that you have accelerated your new store growth based on our model which that's a good thing for the business long term. But is there any -- as you have been working, as you looked at what's driving a comp sales slowdown, is there any possibility that part of it may just be cannibalization as you have been ramping up your store builds?

Roger C. Matthews

Yes, it's Roger. Look, that's something we monitor, I mean, literally in every new store we open. We try to factor in, as we build out the return threshold, what our estimated cannibalization would be and we kind of matched it up against what actually occurs. While there certainly is some cannibalization as we build out certain markets, we're not seeing a dramatic correlation, frankly, between our same-store sales growth and where that cannibalization is going. And so as I think I alluded to last time, our new unit construction is a mix of markets where we're building stores in what we call mature markets, we're building stores in slightly less mature markets and then we're building stores into new markets. And so, again, that's something we keep track on. We continue to see very attractive returns on the new units. And so I think, for us, our belief is that we want to basically keep -- deploy the capital we generate in building those stores, but we laser-like are watching the returns on those stores and how they open to kind of make sure we're being honest about hitting the return thresholds that we think are appropriate.

Operator

And we'll go next to David Tarantino with Robert Baird.

David E. Tarantino - Robert W. Baird & Co. Incorporated, Research Division

Just a clarification and then a question. Ron, you mentioned in the press release that Panera now has a less differentiated experience in your mind. I just want to make sure you're just talking more in the operations side and not something else related to value proposition. And then, I guess, that's first. And then second, on all of the initiatives you're talking about on the operations side feels fairly complex. I think it was a 7-step plan, as you outlined it. Just wondering if you could comment on the degree of difficulty in implementing so much change all at once and your confidence level in getting all of this in place before you turn on some of your sales drivers in the second quarter next year.

Ronald M. Shaich

Yes, those are great, David. I start and say, I think there has been some confusion in this differentiated word. I think that what we mean by that is, ultimately, the totality of the experience because the totality of an experience that people judge, not the elements of it. And I think we would say that when you have less than the kind of execution we think of ourselves as delivering, you end up having a less differentiated experience. So we're speaking very directly to the operations and execution, understanding that, that is part and parcel, part of the totality that people experience. You can't separate it out, but the focus is on there. I would say to you secondly, I wouldn't make too much into these 7 steps. I would actually say, if you really want to cut through the whole thing, Panera's committed in a no-baloney kind of way to executing well. And I think we've been accepting efficiency at the cost of effectiveness in too many ways. And I think that what we're really trying to say to you, and maybe more importantly to ourselves, is we've got to draw a line in the sand and we've got to stay committed to doing it right. And so everything flows from that. That's the governing principle. That's the only thing we're really saying is a fundamental commitment to execute for our guests, and to do so in a solid and consistent way. And these are the things that flow out of that and that flow from it. And they support that, but it's always going to come back from that. I'd say, last, relative to our ability to do it, I've done this a long time. I am completely sure, personally, that we will get there. Can I tell you it's going to happen next week? It's going to happen a quarter from now or 2 quarters from now? I don't know. But I absolutely know that the kinds of things we're focused on, execution, building connection through media and creating a better guest experience works. I've seen it. I've seen the results. I've seen it both from my own experience and I've seen it from testing. And every ounce of what I know, knows it. And so in one breath, we haven't done it yet. So there's a certain level of intention -- of tension internally. On the other breath, there's a certain relief and a certain excitement that we're going to get there and we're going to do this.

Operator

We'll take our next question from Joe Buckley with Bank of America Merrill Lynch.

Joseph T. Buckley - BofA Merrill Lynch, Research Division

Ron, I had a question on the less differentiated experience as well. I'm really wondering if you didn't get your execution, Panera's execution, decreasing or the competitive execution increasing. And then just how the investments sort of play into that? Can you change some of that simply with focus and the labor commitment? Or do you think you need the KDS and, you've referred to, equipment? I'm assuming that's something beyond KDS. Do you need all that to raise that experience?

Ronald M. Shaich

Yes. Joe, I'd say to you this way. I think that, again, the differentiation is the whole. It's not -- it can't be by -- the customer doesn't come in to look at one piece of experience and not the other. And clearly, look, we're not trying to pull punches here. The competitive environment is extraordinarily red hot. You got fast food trying to be Panera. You got casual dining. Everybody and their brother doing some version of You Pick 2 at a price point. You've got the independents and the regional guys. Everybody's trying to do some version of it. However, what we're trying to say to you, straight up, is what we're saying to ourselves. Like, which is, "It ain't them, it's us." Right? It isn't that we're sitting here being the victim of competition. It is that the very nature of running a business is continuing to drive competitive advantage and competitive position. And we believe that at the core driving competitive position and competitive advantage is, for us, very much rooted in how we execute. And what we're really trying to say is we are deeply committed to executing well. And in some ways, we have been the beneficiary of this extraordinary success, this extraordinary margin expansion, a number of other things. And I think that we need to step back just a little bit, make certain that we're investing properly in these stores and intensify our structure -- our effort on being that better competitive alternative, much of it rooted in execution. But also, we're rooted in taking advantage of scale to our ability to build connections with guests and, ultimately, through our vision for a new guest experience, a newly enabled guest experience that is much less frictionful for the guest. Lastly, I would say to you, each of these pieces is a layer, Roger indicated to you. It's not like one of these pieces does it. Again, it's the totality of the experience. And we expect to be rolling out a number of -- some of these things we've already begun to roll out, right? I don't think that you're going to somehow see our sales grow as a step function. I think you're going it steadily get stronger, that's the bet I'm making. That we're going to strengthen this thing up, and you're going to see the impact of that. We're certainly betting on that, and these things will be cumulative and supportive of each other. I mean, lastly, I think we've got investments to making both the capital side of it and, to some degree, in what we invest into our stores. It's a matter of integrity with our team members. It's also a matter of integrity with our guests and about competitive advantage. But again, taken as a whole, I don't think that it's one large investment that we're talking about.

Operator

We'll go next to Alex Slagle with Jefferies.

Alexander Slagle - Jefferies LLC, Research Division

I'd like to get your perspective on urban development opportunities now that you've had some more time under your belt. Do you feel incrementally positive and want to accelerate urban expansion? Or do throughput issues hit harder on this business and lead you to hesitate until further research is done and the operational initiatives are rolled out?

Ronald M. Shaich

Alex, I'd say both are true. We're more positive by the opportunities in an urban environment. These volumes are extraordinary and we also get completely that the challenge of executing properly is even that much more difficult in an urban environment. And so the very -- so on one hand I want you to hear we're pushing forward urban. We know it's got high potential for us. But you're also hearing, if there's any place we need to bring to bear, the kind of things were talking about, it's in the urban environments where we have a sandwich coming out every 10 to 12 seconds. I mean -- and you can't simply just make it, slop it together and throw it up on a counter and not have problems in that experience.

Operator

We'll go next to John Glass with Morgan Stanley.

John S. Glass - Morgan Stanley, Research Division

Just first, maybe just a comment really more than a question, which is, I mean, I agree with you're trying to simplify the operations to get better throughput and a better experience, but you're changing operations, menu board, menu items, equipment and technology. That's a lot to do. And I wonder if it's just a phased approach that takes longer than, say, a couple of quarters might be a better approach. That's just an observation. It may be off. Can you -- my question regards mix this quarter since mix is decelerating. You tied some of that to the catering. Is catering slowing because of the demand? How do you know it's not the demand and it's simply the throughput opportunity? And what else is going on within mix? Are people changing the way they order things on the menu? Is it the daypart mix? Or is it more buying lower-priced items, for example, than higher-priced items?

Ronald M. Shaich

We got a lot in there. First, relative to your comment, as ever, we would love to have breakfast with you and hear any of your thoughts relative to it. I would simply make this comment. Again, it's why we're trying to be less precise relative to '14 because we really don't know. These are not easily projectable any more than the sales are so easily projectable. They're not easily projectable based on testing. You've got to bring the whole together. I will say to you, relative to the timing, I think -- I take your comment well. I think the real challenge of the management is to find the balance, is to find the optimum. We want to move quickly. We want to move intensely, but we also want to do it in a way that's solid and stable. And I think we've had that -- that's been our experience and that's what we intend to do. And so if we think that we're pushing too hard, we'll slow it down. If we think we're not pushing hard enough, we're going to increase it. I guess I would take away from my comments that we think we haven't gone fast enough. And we're increasing our focus on execution. And we'll continue to update you on that process and our progress against that mission over the next couple of quarters. Relative to the question of catering, I would say to you, I don't know that we know, in an absolute sense, to what degree it's demand and what degree it's capacity. The only thing I can tell you is we've been testing things like these catering hubs now for several years. This is not something that we invented last week. We have a number of these that have been up. And we find, when we do it, time and again, that when we pull the catering out, the retail business goes up because they're able to focus on the retail. And we find that the catering business goes up because it has dedicated, focused people. And it simply makes sense. I mean, right now, you'd place a catering order, comes in, in 11:15 or 11:30 into a retail store. It's a big catering customer. What do they do? They're not going to turn it away. They're not going to say no. They take the order. Where do you think the resources get pulled from? They get pulled from the counter. The people get pulled off the counter. They make the food and they make the delivery. Who do you think suffers? The retail customer. Simultaneously, when a store is under intense pressure, there's a line out the door, a catering order comes in, what do you think they do with the phone call? How do you think they limit the demand coming on them? They don't take the phone call. What do you think they got as the catering sales? It seems very clear to us why, when we've been able to bring greater focus and clarity to the business, it's worked. Relative to mix, again, we haven't seen -- we don't see extraordinary changes in the mix in some way at all. We see more change in the mix of dayparts that affects us. And we see more change in the relative impact to things like catering. As it has either a -- as it has, historically, a significantly larger growth rate relative to the retail business. And that, in turn, has affected our ability to grow gross profit per transaction. But we don't see, at the retail level, huge changes, if I can say, in the mix. And remember, we're lapping a very powerful celebration last year.

Operator

We'll go next to Jason West with Deutsche Bank.

Jason West - Deutsche Bank AG, Research Division

Just a couple more around sort of the outlook and the catering -- or the catering hubs. So just to clarify, you're talking about these are stand-alone units that you're finding real retail space for that are separate buildings from the current stores? Or are they sort of a separation of the back of the house and existing stores? And then on the unit growth for next year, I mean, that should be something you guys have a feel for today that may help us in getting the models together. Should we think about unit openings on the retail business similar to what we've been seeing in the last 12 months?

Ronald M. Shaich

Jason, I think both comments were -- both questions, 2 questions there, were picked up in the commentary, but I'll give voice to both of them. Relative to the first question, very specifically, these are not separate physical units, these catering hubs. We're not talking about building out an infrastructure of catering hubs that are separate physical units with their own production. What we are talking about is where we have taken areas in our back, where we have taken areas in a new café, generally, they -- where we've taken those spaces, we've put in there dedicated management, dedicated folks taking the phone call and dedicated drivers dealing with the catering needs of 2 to 5 cafés. That's generally what we're talking about as a model for this. And so there is an incremental investment of any substance, and their shared labor relative to the baking and the production. What there is, is intense separation of focus between the management of the catering business and the management of the retail business. And because we're doing it for 2 to 5 stores, the actual sales from the catering are much more level and stable, and thus, are more projectable and can be staffed more appropriately. So just to be clear relative to that piece, and I thank you for giving us the opportunity to make sure we're clear with people. Relative to the second one, I think we did say in a general sense that we're increasing our growth again next year. Is that correct, Roger?

Roger C. Matthews

Yes. No, I mean, in order of magnitude, you look at the number of units we opened this quarter and where that brings us here to date, you can imagine we're on target to do a company number that's in the mid-60s in terms of the number of units. The number next year will be higher than that. Again, not going to be dramatically higher, but it will be higher. And so at this stage, that's where the guidance we'd like to give and leave folks with, and we'll talk about in more detail in a couple of months.

Operator

We'll take our next question from Jeffrey Bernstein with Barclays.

Ronald M. Shaich

We'll take 2 more questions, operator, if that's okay. We'll take Jeff's, and then we'll go from there.

Jeffrey Andrew Bernstein - Barclays Capital, Research Division

Great. My question is the significant transaction driving initiatives you talk about, seems like the national marketing is the main driver. I'm just wondering, in your experience in test and as you've ramped up the spend, how you measure the contribution, whether it be the comp, or whether you measured GRPs? Just wondering what you're anticipating in terms of the pickup in demand, and whether or not, if by the second quarter of next year, your systems aren't running at great capacity and this takes longer than the couple of quarters that it might look to take, whether that could be changed. Because obviously, you don't want to start driving in all this traffic if your store can't handle it. And then just to follow up, Roger, I think you mentioned, from a share repurchase standpoint, that you look at it as an attractive opportunity this quarter. I'm just wondering, is that still formula driven? Has anything changed in terms of your approach to share repurchase in recent quarters versus in past years?

Ronald M. Shaich

Oh, we got our second guy in here with 2 questions, Roger, what do you think? All right, all right. Well we'll -- is that our last 2 now? We won't do that to you, Jeff. All right. So let me take each piece. I think relative -- and then we'll let Roger take the capital question. I would say relative to the national advertising, I don't think we fully know what the impact is, right? And nor are we capable of because we haven't done it, right? I think that we think -- what we do know is this, and this is the way most of the things we think about. We think about probability assessments, not being able to be clear, particularly as we do something new. And what we know, from having done extensive analysis and data that we've triangulized on 3 different ways, with the kind of metric models, testing control models and the like, is that the advertising we do more than pays for itself. Can I tell you how much more? No, I really can't. Can I separate it out from other things we're doing? No. But it does drive in new customers. It does seem to have a more-than-positive impact. So based on that, we made the decision to go forward with it. I think we're counseling you because of the nature of what we're doing because it will be not -- it's still going to be at modest levels, this isn't going to blow it out. We're getting into here as we do -- we're going to make a step-function investment into it. We're counseling you not to take away from this that this is going to be a blow-out inflection point in Panera. We don't think so. And we don't want anybody walking out of here or off this call thinking it is. We are telling you we're going in this direction, we think it's a positive thing, but we're not trying to tie direct results to it in a short-term sense. I would say to you, finally, I think your comment is very astute, too, to the trade-offs just like John's. I mean the reality is the reason we're so focused on these executional capabilities right now, is we think we have powerful demand drivers coming down the pike. We think that national advertising will help us. I clearly think that the work we've been doing for several years on an enhanced guest experience, when you realize and understand it, we think it's powerful, powerful stuff. But we think it will mean nothing, and it will be for naught if we can't process people through the system. And we can't process them with discipline and with accuracy. And the reality is, at the volumes that we're doing, we're not doing that as well as we like and we know where we're going with the potential demand, we won't do that well. So you are so insightful in saying that what we're doing here is trying to put the base in place so we can be the beneficiary of some of these demand drivers we have scheduled. Okay, we'll take one...

Roger C. Matthews

Yes. Just quickly on the share buyback. I mean, I would say what hasn't changed and then what has. What hasn't changed is 2 things: number one, we always will prioritize our cash flow to build new units because we feel that is -- the returns we're getting on those units are fantastic, number one. And number two, the more we make Panera easier to get to the customer and the closer we get to the customer, the better it is overall across the system. So that's priority number one. Probably number two is, we're always going to have and maintain significant liquidity as a company. Now, that being said, we found ourselves sitting on a lot of cash. And our belief was that was not the best use to sit on all this cash. And so as we watched the stock, it drifted lower. And we think about long-term return on the stock buyback. And so for us, we viewed it as an attractive opportunity to deploy the cash. On an ongoing basis, I think we are -- we try to be very disciplined, very formulaic. We're going to think about a world where we deploy excess cash flow as it gets generated and will always evaluated share buyback and other opportunities. But I think that's the best I would say, at this point, in terms of being clear around it. Last quarter was a little bit of an aberration because we had -- we were sitting on so much cash. I think going forward, though, we will look to continue to be opportunistic.

Operator

And we'll take our final question from Jeff Farmer with Wells Fargo.

Jeffrey D. Farmer - Wells Fargo Securities, LLC, Research Division

So just on question again on the mix side. You had the mid-July introduction of the half sandwiches. I'm just curious sort of what percent of sales mix you saw that represent and how that product trended as you went through the Q3?

Ronald M. Shaich

So I don't actually have the hard data in front of me. I would say to you, it was relatively modest. We've always had half sandwiches and we just put it on the menu. And we didn't see a dramatic or meaningful, that we would be talking about here, changing the nature of our business based on it.

Jeffrey D. Farmer - Wells Fargo Securities, LLC, Research Division

Okay. And then on the clarification part. I think I heard this correctly, but maybe I did not. Roger, did you say that your 2014 EPS growth guidance would be based off of the 52 week 2013 as opposed to the 53rd week?

Roger C. Matthews

Yes, yes. So I mean, just to give clarification, the way we think about the world is -- we've been very open about this year, having the 53rd week. We think about a world where it's a 52-week, 52-week comparison. I think that's a relevant comparison. So I think that's really where our focus is when we talk about the word modest and being slightly below our -- low end of our range.

Jeffrey D. Farmer - Wells Fargo Securities, LLC, Research Division

And then you did say that's -- that 52-week or the 52nd -- or the 2013 would actually include the tax benefit as well. So that's the way to think about that?

Roger C. Matthews

We -- because we've broken it out and we view it as kind of a onetime item, again, I think at this stage, Jeff, I wouldn't want to be so precise as to tell you it's exactly one versus the other because we're only giving -- we're using the word modest, and everyone's going to read into that. But, again, I think what I would just say is it's definitely 52 over 52. And again, the word is modest and slightly below the low end of that range.

Ronald M. Shaich

Roger, I think that does it. We appreciate everybody's interest and attention. And as ever, all of us are here to take your calls and any your questions.

Roger C. Matthews

Thank you very much. Good morning.

Operator

That does conclude today's conference. We appreciate your participation. You may now disconnect.

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