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Einstein Noah Restaurant Group, Inc. (NASDAQ:BAGL)

Q2 2014 Earnings Conference Call

July 31, 2014 4:30 PM ET

Executives

John Coletta – Chief Financial Officer

Michael W. Arthur – Interim President and Chief Executive Officer

Analysts

Michael Tamas – Oppenheimer & Co. Inc

Joshua Long – Piper Jaffray & Co.

Paul Westra – Stifel Nicolaus & Company, Inc.

Operator

Good day, and welcome to the Einstein Noah Restaurant Group Second Quarter 2014 Earnings Conference Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to John Coletta, Chief Financial Officer. Sir, you may begin.

John Coletta

Thank you. Good afternoon, everyone, and thank you for your time today. Let’s begin by covering a few regulatory matters. During our formal remarks and in response to your questions, certain items may be discussed which are not based on historical fact. Such items, including statements indicating our beliefs, projected trends, plans, expectations, assumptions, anticipations, guidance, projections, estimates or the like should be considered forward-looking statements within the meanings of the Private Securities Litigation Reform Act of 1995.

All such forward-looking statements are subject to risks which could cause our actual results to differ materially. For more details, please refer to our earnings release issued today and to the risk factors and our recent SEC filings.

With me this afternoon is Michael Arthur, Interim President and CEO. After some opening remarks from Michael, I’ll review our financials and discuss our updated guidelines for 2014.

Now, let me turn the call over to Michael.

Michael W. Arthur

Hello, everyone, and thank you for joining us. As Interim CEO of these past five months my primary objective has been to help our very capable management team, develop and execute our 2014 Brand Revitalization Plan. And these efforts which I’ll highlight are on target and working.

We realized record second quarter revenues and 4.1 revenue growth while improving our conversion rate of revenues towards profit. We are also simultaneously growing the brand and have 36 more units operating today than at this point in 2013. So far this year we have added 20 unit system-wide with plans for 75 to 85 total openings across our three channels, company franchise and license by year end.

We have increased our CapEx budget by more than 70% compared to last year and in doing so are demonstrating our confidence in the business. For 2014, we expect to grow revenues for normalized profit and grow our operating footprint thus providing significant momentum going into 2015.

Now, let me highlight our progress on the 2014 revitalization plan. In terms of growing our top line, our efforts produced system-wide same store sales growth of 1.6% and company same store sales growth of 0.9% for the second quarter. We have several core traffic building in Einstein Noah, as we ramped of both bill traffic and same store sales overall, which I will now discuss.

We have spoken in the past about our plan to win initiative to increase traffic were improved guest satisfaction. Our overall satisfaction story continues to climb and we now exceed the industry average. Top quartile stores are generating industry leading scores while we work our bottom quartiles up.

We are focused on basic area such as guest interactive measurement, order accuracy and store condition. These with the perfect start to our revitalization efforts and most across the customer royalty. Our improved store maintaining program has now evolved into major remodel work as we plan to refresh 75 stores across the system this fiscal year.

Our average store is nearly 15 years old and we have decided to invest additional capital to upgrade these stores. We are remodeling market-by-market followed by a market wide brand opening promotion.

We will spend $14 million and additional CapEx this year behind the remodels, new units and maintenance CapEx as part of our overall spend of $30 million to $35 million a 70% plus increase. We tested remodels earlier in the year in Orlando and have seen favorable return that more than covers our cost of capital. Our second new market of 15 stores, trade is now complete and we’re moving forward with 15 stores in San Diego next week another remodels are planned through year end.

Another major traffic driver is catering. Catering for the second quarter is up 17% over prior year while two year comps compounded is an even more aggressive plus 37%. Catering is now nearly 10% of sales and we expect we can grow this business to nearly 15% by serving the occasional customer along with a growing number of standing accounts.

Our catering menu was attractive and mirrors the store menu and program includes the added convenience of delivery. Our typical catering order competes 30 plus people which is a great average from our stores to capital audience. Although in order only counts as a single transaction in our measure of traffic provides great sales leverage. Combination of catering and unit growth is the reason why we’re selling 9% more Bagels across the system than prior year regardless of how we measure traffic by POS transaction events.

We’re spending nearly 3% of sales on marketing but with less discounting, couponing and bundling than before. We’re placing more emphasis on the long-term quality and growth of the brand and profitability. We’re currently on the identification testing and learning phases on repurposing our spend to give more effective means.

Approximately two-thirds of our business is breakfast representing as many breakfast dollars per unit as the average McDonald's. This is the base of our business. However, we know that our lunch business have not been fully tapped we must offer more appealing on appropriate items for lunch hours and I’ve began to do so. This includes the recent relaunch of the Hebrew National, Bagel Dog and we’re rolling out high quality hot sandwich offerings such as the chicken breast sandwich paired with brie cheese more items to follow. We’re now investing back in things such as premium eggs and thicker bacon over that increasing pricing. We have a quality brand and our higher end demographic locations deserve that quality.

We have revisited our cost structure and are optimizing our resource spend. John, will talk more about that shortly.

Importantly, I would like to cover our unit growth. As I mentioned earlier, we expect to add 75 to 85 units across all three channels within the system. We are using our strong free cash flows to develop 15 to 18 company stores. And then our current franchises are executing on their 150 existing development commitments and we’ll add 20 to 25 franchise locations. We are also signing additional franchise partners and commitments.

Licensed units constitute the major portion of our franchise and licensed royalty income. We started the year with 280 licensed locations most of them with our strong national partners Sodexo, Aramark and Compass. We are looking at 40 to 42 locations this year and as part of the total we are adding eight airport locations for total of 24 of these higher volume units.

I would be remiss if I did not provide an update on the CEO search. We have a rigorous process in place and continue to review the candidate pool. We are now down to a handful of exceptional candidates and the board is taking the needed time to ensure that we have the right fit for the person that will lead our company.

Hope to be able to make an announcement over the next few months. Thankfully in the meantime I’m surrounded by a strong and capable leadership team and we are executing well on everything that I have reviewed today.

And with that I’ll turn it back over to John to discuss our financial performance and updated thoughts on 2014.

John Coletta

Thanks, Michael. Let me first remind everyone the beginning last quarter, we reclassified certain manufacturing revenues and cost of goods in order to present a more useful depiction of our costs and sales does they occur on our wholesale business with third parties.

We also adjusted our manufacturing revenues to reflect additional historical sales through our franchises. Our discussion this afternoon will therefore be based upon results that have been reclassified in both effected period as reflected in the tables at the end of our earnings release.

With that let’s delve into our financial results. Total revenues increased $4.4 million or 4.1% to a record second quarter of $112.4 million from a $108 million. System-wide comparable restaurant sales increased 1.6%. While our company-owned comparable restaurant sales increased 0.9%, the later consisted of 4.7% increase in average check that was offset by 3.8% decrease in transactions. The raise in average check was a function both of a reduction and discounting moderate price increases as well as favorable mix to continuing catering growth. The reduction and discounting at some impact on traffic, but did not impact the net of same-store sales and profit overall.

Company-owned restaurant revenues increased 3.2% to $100.2 million compared to the year-ago period.

Turning to cost, our prime cost which consist the cost goods sold and labor decreased 40 basis points for a combined total of 56.2% of restaurant sales compared to 56.6% in the prior year. Cost of goods inflation was offset by pricing and fell 20 basis points. And we also managed labor cost effectively which fell 20 basis points.

Rent and related expenses increased 50 basis points to 11.6% from 11.1%. This was primarily due to having added higher-cost, higher-quality locations as part of our newer store openings. Other operating costs increased 80 basis points to 11.9% from 11.1% due to investments on our plan to win and mainly consisted of higher repair and maintenance cost, as we operate our facilities to higher standard now and an doing so improved customer satisfaction.

Our investments and marketing increased slightly an absolute dollars compared to the same period in 2013 and was 3% of restaurant sales. Year-to-date, we are at 3.2% of restaurant sales and we generally expect our total spend to be closer to 3% annually. Taking these expense categories together, restaurant gross margin fell 100 basis points to 17.3%.

Franchise and license revenues increased 12.9% to $3 million, reflecting higher unit counts for both franchise and license stores and positive comparable sales during the quarter. We added five franchise units compared to the three last year creating greater franchise fee revenue recognition and royalties over the prior year.

Manufacturing revenues from our Whittier facility increased 11.1% to $9.2 million as wholesale customers such as Costco made additional orders as they expand their footprint with us. In addition to sales to franchisees and licenses. Gross margin, as a percentage of manufacturing revenues, increased 90 basis points to 20% from 19.1%, as we benefited from higher operating efficiencies related to our partially-baked products along with other cost saving initiatives.

General and administrative expenses increased $10.5 million in the second quarter of 2014 from $10.2 million last year, while held steady at 9.4% of sales as compared to last year’s period.

As mentioned in our press release, we eliminated resources which were non-essential to our current strategic imperatives. And their end reduced our support staff by nearly 10% this should save us and estimated $2.7 million annually over the prior pay and $1.4 million for the reminder of 2014.

Pre-opening expenses were $207,000 compared to pre-opening of $327,000 in the prior year period. And we’re related to the two company openings in the second quarter as well as expenses for several openings planned for the third quarter.

Income from operations decreased 22.5% to $5.3 million from $6.8 million primarily due to management transition costs and related expenses of $1.2 million, while adjusted EBITDA was $11.5 million essentially unchanged from the second quarter of 2013. I refer you to the reconciliation tables located in our earnings release for a detailed presentation of how we arrived at those numbers.

Total debt at July 1, 2014 was $101.5 million, compared to $125.5 million at the end of the second quarter last year, as we lowered our indebtedness by $24 million over the trailing 12 months period. This into lowered our interest expense by $0.6 million to $1.1 million in the second quarter of 2014 from $1.7 million in the second quarter of 2013.

As mentioned in our press release, we amended our loan facility lowering our borrowing rate by 50 basis points and removing various restrictive covenants.

Using excess free cash flow, we return capital to shareholders via a $2.3 million quarterly dividend and $1.7 million buyback under our $20 million authorization during the quarter. We used an effective tax rate of 39.6% in the second quarter of 2014 compared to an effective rate of 35.7% in the year ago period. This year’s effective tax rate excludes federal employment tax credits which have not yet been renewed.

Although federal employment tax credits have decreased our effective tax rate annually by an average of 1.8% over the past three years, the recognition of these federal employment tax credits for 2014 new hires may or may not occur and cannot be predicted and cannot be included in our estimated annual effective tax rate until enacted into law.

Net income in the second quarter of 2014 was $2.5 million or $0.14 per diluted share, compared to net income in the second quarter of 2013 of $3.3 million or $0.19 per diluted share, included in our net income this year is pre-tax management transition and related reorganization expenses of $1.2 million or $0.04 per diluted share after tax.

Adjusted net income was $3.3 million or $0.18 per adjusted diluted share compared to adjusted net income of $3.3 million or $0.19 per adjusted diluted share.

As of July 1, there were 857 restaurants across 42 states and the District of Columbia. During the quarter itself, we opened seven restaurants across the system and this consisted at two company-owned restaurants and five franchise restaurants. A total of twelve store is also closed of which were five more company, five were licensed and two franchise respectively.

Turning to our 2014 guidelines, we have the following guidance for the 52 week period ended December 30, 2014 75 to 85 system-wide openings, capital expenditures of $30 million to $35 million. Cost of goods inflation of approximately 1% to 2%, pre-opening expense of $65,000 to $75,000 per new company-owned restaurant, general and administrative expense of $9.5 million to $10.5 million per quarter versus previous guidance of $10.5 million to $11.5 million.

Interest expense of $4.25 million to $4.75 million versus $4.5 million to $5 million per previous guidance. An estimated annual effective tax rate of approximately 39%; however, the company expects to only pay minimal cash-taxes for the near future.

And now I’d like to turn the call back over to Michael.

Michael W. Arthur

We just highlighted our revitalization efforts and financial results to demonstrate improvement in our business in many favorable ways, their mature system of stores and infrastructure. We focused revitalization finally underway. Our Bagel brand and consumer sentiment strong, so that our revitalization efforts should payoff nicely. Overall, we expect to end year having grown revenues, going normalized profits and growing our operating footprints. This will set us up well going into 19, into 2015 with momentum.

With that said we’re ready to take your questions. Operator?

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) We’ll take our first question from Brian Bittner with Oppenheimer & Company.

Michael Tamas – Oppenheimer & Co. Inc

Great, thanks, this is Mike Tamas on for Brian. Just two quick questions, first one is on the restaurant margins, I think last quarter did you guys talked about the restaurant margin being similar to 2013 including the reclassifications, but that seems pretty aggressive at this point given year-to-date performance. So I’m just kind of wondering with the updated thoughts around that? Thank you.

John Coletta

No good question Mike, I appreciate it. We are still that’s still a fair comment from our view, it will take the work and initiatives to get there we expect to get there. But the reason for the ramping pace partially we told you in the past that our marketing expenses were a little front ended in the year, we spend a little more of our rate in Q1 a little less in Q2. So, it’s timing of marketing is part of it. In addition to the economies and leverage of sales in the fourth quarter which is our best period. So generally speaking we still stand by that comment to approach the end of the year total year sort of restaurant margin that we saw last year on a reclassified basis.

Michael Tamas – Oppenheimer & Co. Inc

Great, thanks. And the second one is on traffic, I mean that hasn’t been positive in quite a while and then there is a ton of improvement that we are seeing coming through. So, I’m wondering can you kind of help us understand what you think is going on and maybe what you can do to return the positive traffic or at least to see a nice improvement from where we are today?

John Coletta

Well, one comment Mike that’s hard to make is, we have changed our discount rate. And we believe that bringing down some of our discount rate in the past has affected traffic, but not profit. So, if we talk about traffic running in the 3.5 minus 3.5 plus range. We believe at least a percent or more of that is because of reduction in the discounting. But we don’t believe that debt reduction in discounting cost us on the bottom line or same store sales overall.

And the other comment I would make is catering has a whole lot of traction and as Mike will talk about, we’re putting a lot behind it. So, I would say on a normalized basis, because of what I mentioned with some of the discounting. We are bending the trend, but we have work to do and it’s the work that Michael highlighted.

Michael Tamas – Oppenheimer & Co. Inc

Great, thank you.

Operator

And we will go next to Nicole Miller Regan with Piper Jaffray.

Joshua Long – Piper Jaffray & Co.

Great, thanks, this is Josh on for Nicole. I wanted to circle back to the reinvestments in the food that you mentioned. And then kind of pairing that without an increase in pricing how is that going to be communicated to guess and how should we think about kind of the evolving brand measures as we go through the back half of the year?

Michael W. Arthur

Well. We’re really aren’t going to spend a lot of money communicating that because we want to make sure advertising dollars focused on some of our promotional events. Like we took quality out or quite some time and we certainly are putting it back we’re not raising prices and the important thing is all the things for the customers to understand what we are doing as they come into our stores.

Joshua Long – Piper Jaffray & Co.

Great. Without necessarily putting an explicit message around the reinvest in food, but maybe let the customers discover it along with the normal marketing cadence?

Michael W. Arthur

Yes and no, we also – if you remember when we had our egg sandwich promotion the Applewood Bacon it was thick bacon and we had that’s much thicker than we had put in before and that’s now currently part of our regular line.

Joshua Long – Piper Jaffray & Co.

That’s helpful thank you. So then also thinking on the strength in catering so 10% of sales of now with the opportunity to move up from there do we need this or more investments around that side of the business needed to ultimately get to the 15% there is it more around execution and brand awareness and so how should we think about that’s evolving over time as well.

Michael W. Arthur

That’s a good question because we’re putting a lot of emphasis on catering we have the sales force we have call center and so we’re proactively seeking catering business as opposed to waiting it for come our way. And the other part of that is ensuring that we have good standards and quality in delivery and performance.

Joshua Long – Piper Jaffray & Co.

That’s makes sense. You go ahead.

Michael W. Arthur

And we just said it’s important to us and we’re putting a lot of emphasis on it.

Joshua Long – Piper Jaffray & Co.

Thank you for that. And the last question for me as you mentioned the impact of higher cost and also higher quality location and so we certainly know that quality of real estate makes a big impact. But then it also seems that the pre-opening spend on a per store basis as more or less inline with where it has been historically. So just wanted to see if there if you might be able to dive into maybe that real estate selection model and how that’s updated or maybe how we should think about those pre-opening dollars being spend now that we’re going into maybe higher quality, higher cost real estate over time.

Michael W. Arthur

We’re in the high quality and better locations, the spend on pre-opening is the same because we’ve always put great effort into that. And that hasn’t changed as we know the rent costs are up and the competition for good sites is there we’re doing very well. We feel comfortable with the sites we’re opening and we feel comfortable that the spend on the pre-opening is also inline.

Joshua Long – Piper Jaffray & Co.

Thank you for the update.

John Coletta

Thanks Josh.

Operator

(Operator Instructions) We’ll take our next question from Paul Westra with Stifel.

Paul Westra – Stifel Nicolaus & Company, Inc.

Good afternoon. Can you talk a little bit more about both the breakfast, lunch day part maybe give us a little idea where are the comp and traffic numbers are by day part and maybe a little color around for competitive pressure are you seeing in each place. And a little update on how the third quarters strategy is going to roll out as far as new products and marketing efforts?

Michael W. Arthur

We’ve been losing transactions as we know in both breakfast and lunch. And to continuing story working on it, competition is strong in both parts. Clearly we have a good menu and breakfast and the catering is picked up and it’s really a strong part of our breakfast. Lunch is a challenge for us we’ve makes bones about it. For Bagel Dog is a good start, two sandwiches were introducing at the end of August. A chicken with Brie and fig jam and the other one was the chicken and beer cheese are two winters. And that’s only the beginning its tough business, but we only need a small percentage of the lunch business to gain attraction. So that’s what we are working on you don’t build it overnight, but it’s slow and it’s steady and we’re committed to making happened at this time.

Paul Westra – Stifel Nicolaus & Company, Inc.

What is the marketing mix between generally breakfast and lunch and are you move – it’s giving a little bit more incrementally toward lunch given?

Michael W. Arthur

It’s always been over two-thirds of our business and that will state two thirds. Lunch has not going to be in the short-term major impact because of all the competition, but we just one piece and that we’re going to feel our way until we’re not going to give up on the under promotion on breakfast, at lunch we did that lunch before and it didn’t work and it’s still pace our sales as we move forward on both entities.

Paul Westra – Stifel Nicolaus & Company, Inc.

How does catering shake out as far as breakfast and lunch?

Michael W. Arthur

Catering is a same menu we have now, and we are little challenged in hot sandwiches and that part of our business and we’re working on better packaging keeping at hottest and moves through the line and as we add lunch that’s going to be a big. And impact on catering, because it will move us from just breakfast catering into lunch which is you can imagine an officers is a big chunk of business.

Paul Westra – Stifel Nicolaus & Company, Inc.

Yes, I know you’re offering lunch now or is you are about to?

Michael W. Arthur

We have it…

Paul Westra – Stifel Nicolaus & Company, Inc.

You always have it?

Michael W. Arthur

Right, right.

Paul Westra – Stifel Nicolaus & Company, Inc.

But this is going to be an incremental prices?

Michael W. Arthur

The idea these will be more exciting lunch offerings.

Paul Westra – Stifel Nicolaus & Company, Inc.

Great. Okay then question the manufacturing you mentioned Costco potentially expanding its usage of your product and then more locations can you give us an idea of what percentage of their store base has your products now and where it’s going?

Michael W. Arthur

Well, Costco is a very strong partner of ours and we’re going to continue to grow with them. And other than that I think that we feel comfortable and that’s what we belong at this point. And as they grow hopefully they will keep us as a honored partner and we’ll give us more business – it’s a solid relationship and we expected to continue because we nature that relationship well.

Paul Westra – Stifel Nicolaus & Company, Inc.

It’s your Costco as your product nationwide and with that real Costco?

Michael W. Arthur

Yes it is.

Paul Westra – Stifel Nicolaus & Company, Inc.

Okay, great. And then lastly on the remodels when you I guess you are doing market-by-market, how long is it taking you to do those 15 years Detroit and the upcoming 15 in San Diego is that done?

Michael W. Arthur

We feel pretty good about that has taken us less than a month we got a system in place to get it done properly. And hopefully that will be even better as we coordinate our efforts. So this is something we began certainly over needed and we feel about good the focustration of this. So we have as we said we have Detroit we’re working on the next store San Diego and certainly have one market maybe two for the rest of the year.

Paul Westra – Stifel Nicolaus & Company, Inc.

And what’s the plan for next year as far as remodels where you stand it by the end of this year. How many stores need to be remodeled in 2015, 2016 period.

Michael W. Arthur

Well as we said lot of the stores are 15 years old and more. And just as most of the things we’ve done this year since we talked about revitalization this is not really a one year program we’re committed to continuing in. And so we’re going to continue remodeling, we’re going to continue opening new stores our franchisees and licensees are committed to growing. So we think that this is a good story for us and we feel good about where we’re going.

Paul Westra – Stifel Nicolaus & Company, Inc.

But as far as we had a best guess as of now the remodel pace would be near the 75 a year that you are doing this year for next year.

Michael W. Arthur

We’re looking at that continuing to program I don’t want to commit the numbers expect what we’re talking about is consistency.

Paul Westra – Stifel Nicolaus & Company, Inc.

All right. Okay, thank you.

Michael W. Arthur

Thank you.

John Coletta

Thanks, Paul.

Operator

In appears there are no further questions in the queue at this time. I would like to turn the conference back over to management for any additional or closing remarks.

Michael W. Arthur

I appreciate everybody staying on the line and we’re looking forward to the next quarter. Thank you.

Operator

That does conclude today’s conference. Thank you for your participation.

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