Michelle Harrison – Vice President, Investor Relations & Corporate Development
Jeffrey Kip – Senior Vice President, Chief Financial Officer
William Moreton –President, Chief Executive Officer
Jason West – Deutsche Bank
Joe Buckley – BofA/Merrill Lynch
John Glass – Morgan Stanley
Jeffrey Bernstein – Barclays Capital
David Tarantino – Robert W. Baird
Sharon Zackfia – William Blair & Co.
Mitch Speiser – Buckingham Research
Bart Glenn – D.A. Davidson
Phillip Juhan – BMO Capital Markets
Steve Anderson – Miller Tabak
Panera Bread Company (PNRA) Q2 2011 Earnings Call July 27, 2011 6:00 AM ET
Good day everyone and welcome to today’s Panera Bread Company 2011 Second Quarter Earnings Call. Today’s call is being recorded. At this time it is my pleasure to turn the conference over to Michelle Harrison. Please go ahead.
Thank you very much Nicole. Good morning to everyone and welcome to Panera Bread’s second quarter earnings call. I’m Panera Bread’s Vice President of Investor Relations and Corporate Development and here on the call with me this morning are Bill Moreton, our CEO and President; Jeff Kip, our Senior Vice President and Chief Financial Officer.
Before we begin, let me cover off on a few regulatory matters. I’d like to note that during our opening remarks and in our responses to your questions, certain items may be discussed which are not based on historical facts. Any such items including targeted 2011 and 2012 results or conditions and details relating to 2011 and 2012 performance should be considered forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially.
I would like to now turn the call over to Bill.
Thank, Michelle. Good morning everyone. I’m pleased to report another strong quarter with our second quarter EPS growth growing 39% over the prior year. This marks the 12 out of the last 13 quarters that our EPS has grown 20% or greater. It’s important to note that we’ve delivered these results while continuing to invest in the quality of our food, operations and overall customer experience, which we believe will drive our performance in 2012 and beyond.
Our second quarter comparable company store sales were 4.4%, primarily driven by strong transaction growth of 2.9%. We should note that we’re rolling over comp store sales increases of 9.6% in the second quarter of last year, making our two-year comparable company store sales growth equal to 14% on a two-year basis, representing a slight acceleration from our first quarter two-year comp run rate.
For the first 27 days of our third quarter, our comparable company bakery café sales have grown 4.8%. For us, there seem to be an anomaly in the July fourth week with the timing of the holiday. Our comps that week grew only 1.8%. Excluding the July fourth week, our company comparable store sales have grown 5.7% so far this quarter.
While we believe that our one and two year comparable store sales results remain amongst the very best in our industry they did fall approximately 1% below our expectations.
The biggest headwind we've seen over the last few months, and expect to continue to see, is what we believe stems from macro economic pressures on the consumer. The impact of the economy on a consumer is always hard to gage and harder to quantify. However, we believe that between high gas prices, food cost inflation in grocery stores, the difficult housing market and an unemployment rate that continues to hover around 9% the consumer has been a bit more cautious in their spending. Although we are well positioned with the quality and value of our offerings and overall customer experience to perform well in difficult economic environments as we’ve shown throughout the recession we believe that this is a primary driver of our slightly lower comparable store sales than our second quarter target of 5% to 6%.
Despite these headwinds we expect our comps to run a little stronger for Q3 and Q4 than recent trends, more like 5% at the midpoint of our range than 4.5% or so that we’ve seen over the last four months. I'd now like to update you on our key initiatives that drove our 39% EPS growth in the second quarter. First I’d like to note that our growth was driven by success in all of the business that we serve. Breakfast, lunch, chill, dinner and catering, all grew in profitability compared to the prior year. This has been true for the last eight consecutive quarters where each of those businesses has grown compared to the year prior. Let's look first at the work we're doing on our menu.
The biggest initiative that we have this year is the establishment of the hot sandwiches as a key platform for us. As I mentioned on the last call, we rolled out our second generation Panini Grills beginning late last year and finishing up early this year. As a reminder this growth heats more evenly throughout and produces a much better paninian breakfast sandwich. The growth also allows us to make each Panini to order instead of having to pre-make them and hold them in a heating cabinet as we had to do before.
We rolled out steak as a new protein for Panera in the second quarter and highlighted the Steak Panini and the Steak breakfast sandwich. Both products performed very well and helped grow our breakfast, lunch and dinner day parts.
Sales of our signature Paninis were up 10.2% in the second quarter and our breakfast sandwiches were up 18% in the second quarter. In fact this marks the 10th consecutive quarter that our breakfast sandwich sales have grown 10% or more.
We are going to continue to build on our hot sandwich platform with the introduction of our new Roasted Turkey and Artichoke Panini later in the third quarter and our new Steak Balsamico Panini in the fourth quarter. Both products performed very well in test. I would also like to note that our signature salad category continues to perform very well. Being up approximately 15% year-to-date this trend has continued into the third quarter as we brought back our Strawberry Poppy-Seed Salad which is our strongest performing seasonal salad.
We also continue to drive our soup category in the second quarter with the roll out of our new Lemon Orzo Soup, a very light tasteful soup, which helped drive an 11% increase in the soup category in the second quarter.
Finally, looking at our smoothie category which is a big driver of our chilled business, it also has continued to perform very well this year being up 45% year-to-date helped by the Wild Berry Smoothie that we rolled out in the first quarter.
In addition to the quality of our menu offerings, two of our big initiatives to drive transaction growth this year are our increased investment in media and our loyalty program. Let me update you on these initiatives. First our media program.
We believe that we continue to see the lift from our multiyear investment in media that we have targeted. Without being specific we continue to believe that our media investments are more than paying for themselves within a 12 month period. We expect that our year-over-year media spent would be up approximately 40% system wide this year, representing 1.4% of our total revenue which as we’ve commented on before is a relatively small amount compared to many competitors.
We will have our highest year-over-year growth in media in the third quarter as we roll out our Make Today Better campaign. We expect to see lift from media build through the quarter. Every bit is important as the amount we are spending on media is the quality of our messaging. You may have seen our new creative roll out in certain markets. We continue to refine the message and get closer to capturing the soul of Panera with our new ads.
I have two favorites – two of my favorites. The first one is an ad with one of our real bakers getting up in the middle of the night to go bake for the next day, which really captures his passion for his craft in Panera and speaks to our bakery heritage. My other favorite is with Ron, talking about Panera’s concept essence and how we approach the customer experience. If you haven’t seen these spots you can find them on our website and I really encourage you to take a look. They really are capturing what Panera is all about.
Next I would like to update you on our loyalty program. To provide context we want you to remember our My Panera loyalty program is a significant long term initiative for us with three primary objectives.
The first is to deepen our customer relationships to building us close to a one-to-one marketing problem as possible, which we believe will result in greater frequency of visits. Second, is to acquire actual customer specific purchasing data to gain broader consumer insights and determine the key drivers of our customer’s buying behavior. The third is to have the My Panera program to be breakeven or modestly have a profitable impact on the business.
I'm glad to note that the program has been solidly profitable since its inception. However, frankly, deepening our customer relationships and getting actual purchasing data would have been worth an investment on a standalone basis. But to those points, enrollment in the program has continued to grow at a quicker pace than we originally expected, with nearly 7.5 million registered users to-date. I mean, that is a rich, rich, data pool for us. We’ve also clearly seen the program build stronger affiliation with our customers, particularly our most frequent customers from whom we have seen the greatest transaction increase.
We’re also beginning to use our program data as another tool in customer insight’s toolkit and we are in the first spinning in that effort and we expect it to be very fruitful over the next several years.
Looking forward, we are running several tests over reward cadence and reward relevance to leverage the program to drive even greater response on a more cost-efficient basis.
In sum, it’s very difficult to parse off the exact pieces of what drove our 2.9% transaction increase in the second quarter. As we have often said, we believe that our sales increases have stood at many factors.
On the last earnings call, our best estimate was that our transaction increases were driven about two-thirds by loyalty and one-third by media. Based on our most current reads, our best estimate is that our transaction increases in the second quarter were driven more by an approximately 50:50 mix between media and loyalty. The key is that we believe both programs are driving profitable sales growth and we expect that to continue for the foreseeable future.
The two other areas of focus I would like to talk to you about this morning are our catering business and our new bakery café growth. Catering has had an outstanding year thus far. Our catering sales were up 32% in the quarter and 29% year-to-date respectively. We have now had six consecutive quarters of 20% plus growth in our catering business.
Online ordering is now rolled out at 70% of our bakery cafés system wide and is contributing to that growth. We believe that our online volume will continue to increase as people become more aware of it, and we rollout some digital advertising in the fourth quarter. As we said before, we believe catering will be a strong driver of our business for the next several years.
Finally, we continue to be very pleased with our new bakery café performance, both in terms of number of units and the quality of the openings as demonstrated by the average weekly sales volumes. We’ve opened 47 new bakery cafés in the first half of the year which is a 124% increase over the last year. Even more importantly than the increased number of units is the average weekly sales volume of those new units.
Our company new bakery café average weekly sales are $43,449 year-to-date, which is ahead of last year’s record pace. Our franchises new unit volumes are $44,550 a week, which is a 13% increase over the prior year.
The discipline that we’ve been able to bring to our site selection process and our results over the last few years has increased both the company’s and our franchise’s confidence to continue to accelerate our new unit openings. When combined with the lower occupancy and build out cost compared to historic norms the last two classes of new openings will be amongst the very best in Panera’s history in terms of return in investment.
Based on our success last two years, we expect to again be able to increase the number of new units we open next year and we are setting an initial target of 100-110 new units for 2012. I would now like to turn it over to Jeff who will give you a more detailed perspective on our second quarter results and our updated targets for the remainder of the year. Jeff?
Thank you Bill. Good morning everyone. Again in the second quarter we enjoyed 39% EPS growth, a net income growth of 34%, operating earnings growth of 24% and revenue growth of 19%. Our total revenue growth breaks down as follows.
Bakery café sales were up 22% year-over-year in the quarter on comps new unit development and the impact of acquisitions of our New Jersey and Milwaukee markets from franchisees. Franchise revenues were up 6% year-over-year including the impact of acquisitions. Those sales of franchisees were down 1% year-over-year also including the impact of the company’s acquisitions of the New Jersey and Milwaukee markets.
Let’s walkthrough the bakery cafés section of P&L first starting with bakery café’s sales. As if I just noted, bakery café’s sales were up 22% in the quarter. This is based on 4.4% company owned comp store sales growth, 9% new unit growth over the trailing four quarters and the remainder was from revenue growth from acquisitions less the impact of closures.
Our second quarter company on comps of 4.4% break down into 2.9% transaction growth and check growth of 1.5%, which consists of effective price of approximately 2.5% and a negative 1% mix impact on a check. Please recall that we had a modest check compression in the first quarter close to 50 basis points, driven by low retail mix and average down lower ticket incremental loyalty transactions.
Our overall check compression increased in the second quarter from the first quarter, as our summer salad celebration started a little later than last year calendar-wise and we fully estimate the impact of that calendar shift, and because we continue to experience check compression on incremental loyalty transactions at a little higher rate than our previous experience that indicated (inaudible).
Looking forward, we’re now targeting 4.5% to 5.5% comps for the third and fourth quarters for 2011, and approximately 4.5% for the full year to lower end of our prior full-year range.
In terms of components of those comps, our third and fourth quarter transaction growth targets are now approximately 2% and flat respectively, and our full year target for transaction growth is approximately 1.4% to 2%.
The difference in transaction growth targets between the third and fourth quarters is driven by first, the distribution to media - we have larger dollar increase year-over-year in the third quarter than in the fourth quarter, and second, the anniversary of our loyalty rollout in the second half and primarily in the fourth quarter of last year. Recall of loyalty was rolled in about a third on a weighted-average basis of our company-owned stores in the quarter and nearly 90% of our company-owned stores in the fourth quarter of 2010, as it really reached full rollout by the end of the year.
In terms of check growth, our targets for the third and fourth quarter are 2.5% to 3.5% and 4.5% to 5.5% respectively, averaging with the first and second quarters to approximately 2.5% to 3% for the full year.
In terms of components of that check growth, year-over-year price increases would be about 2.5% for the third quarter up to 3.5% for the fourth quarter. That bump-up is driven by an incremental 100 basis points of price we’re taking in September to offset higher inflation, and then we’ll average to about 2.5% for the full year. That leads us with mixed impact on check, which if you would do the math ends up being 0% to 1% for the third quarter, 1% to 2% for the fourth quarter, and thus averaging to about 0 to 0.5 point for the full year 2011.
So we’re expecting mixed impact on check growth to accelerate for the remainder of the year driven by three factors; first, we’re going to see stronger celebration mixed comparisons as we move through the year; secondly, as we anniversary last year’s loyalty rollout were at favorable comparisons to the check compression we’ve experienced, which happens especially early in the program’s rollout in a market and across the system.
And finally, we’ve tested and launched higher customization of loyalty customer award tracks, which are designed to drive the same relationship and transaction growth as the initial program but it reduce reward levels with the result being reduced discounts and thus increased net check, which is what you see in the comps at the same transaction lift or better.
So, to wrap up our discussion of comps, as we look forward to 2012, we think we can again achieve between 4% and 5% comps supported by all the investments we have discussed today and Bill just discussed on initial targets of approximately flat transaction growth, roughly 3% price year-over-year, and 1% to 2% mixed growth which will be driven by both our retail and our catering businesses, and will be a continuation of the trends we’re seeing in the last couple of quarters of this year.
Moving on to new unit development in sales; we opened 28 new units in the quarter - 13 company, 15 franchise. Bill noted for the second quarter our company year-to-date new unit AWS was $43,449 and franchise year-to-date AWS was even higher, which is a great sign at $44,550. We expect that our full-year AWS will be at or above the high end of our initial range of $37,000 to $39,000 for 2011, which is a performance we really feel great about.
Bill mentioned earlier that we provided our total new unit target to the upper end of our original range or between 100 and 105 new units for 2011, and that we have established an initial target of somewhat higher of a 100 to 110 new units for 2012. We expect our 2012 company-owned AWS to come in at least on par with our targeted 2011 performance.
Let’s move on from top line to our Bakery Café margins. Total Bakery Café margin as a percent of sales expanded 50 basis points versus the prior year as structural labor gains were offset by high food inflation. Labor margins specifically improved 190 basis points year-over-year based on continued and better than expected structural improvements.
Recalling that we’ve been able to achieve great wage and medical benefit savings this year; first, our operators have done a great job imposing discipline on both off-cycle raises and the wage rate we bring in new hires at; and secondly, the benefits network restructuring, you may recall we went from one to two networks and switched networks that we completed in the fourth quarter last year has given us significantly improved discounts on in network medical care.
To-date, we’ve seen both less growth in our average wage meaning that disciplines work better than expected year-over-year, and higher in-network medical benefits utilization rates that we had anticipated, meaning that our associates are staying in network with their medical care and within actuarially where we thought. We thus expect continued better than expected margin improvement through the end of the third quarter.
In the fourth quarter however, we will anniversary these significant improvements that we started to see in the fourth quarter last year and further we don’t anticipate leveraged share in 2012. In fact, we expect to see deleverages benefits inflation now that we put in this one time structural purchasing benefit will likely return to its historical level of 8% to 12%.
On the other side of the coin this quarter our cost to food and paper margins were 160 basis points unfavorable to the prior year driven by food inflation which reached approximately 4.5% in the quarter. As we’ve discussed previously, we are going to continue to see significant deleverage in the third and fourth quarters as this inflation continues and in fact accelerates. We are currently expecting food inflation of approximately 4.5% again in the third quarter and rising close to 5% in the fourth quarter.
In 2012, we again expect deleverage, our current inflation outlook for next year is between 4% and 5% again that’s improved from our last call when we expected north of 5%, but still higher than the approximately 3% of year on price we currently plan to take next year. It is worth noting just to be fully transparent that if inflation for some reason runs lower and comes in at the lower end or if possible at the lower end of that – below the range, we’d likely take less than 3% pricing because we think our customers tolerance for price increases will be lower if they are seeing less cost inflation elsewhere.
Let’ take a look at a couple of key expense margins below bakery-café margin. First, cost of those sales to franchisees deleveraged 380 basis points, primarily on nine-week food inflation and diesel cost, modest impact from our zero profit produce distribution program and then please recall that we haven’t taken transfer price in that area for a while. We are, however, anticipating taken that later in the year, which I’ll come back to later.
Just to note on the cost of wheat, in 2011 overall the per-bushel cost will be about the same as 2010 due to our laddering purchasing strategy. The price per bushel, however, by quarter ramps up throughout the year, so we are going to see increased deleverage on this line as the year continues. As I just noted, we are going to take price in the fourth quarter. This price will offset dollar for dollar, the per-bushel inflation of wheat of approximately $3 a quarter that we are going to see in the fourth quarter of this year and then across next year.
However, since the price increase on our dough sales to franchisees is just on a price to cover inflation on a dollar basis, and really food inflation on the dollar basis but not margins, our margins are going to continue to de-lever as labor and other inputs are also going to inflate in the fourth quarter in 2012 without being offset by price.
We did enjoy G&A margin of 90 basis points in the quarter, better than we expected, plan program spent and some new hire slipped out of the second quarter into the second half of the year, the benefit we enjoyed on the later than expected hires won’t repeat because those positions are hired, but it also won’t reverse. However, the program spending which slipped out of the second quarter just on timing is going to be spent in the third and fourth quarters will have modestly more G&A expense in the second half of the year than we previously expected just a timing issue.
Overall, we enjoyed operating margin favorability of 50 basis points year-on-year in the second quarter at the high end of our expected range and based on this performance our third quarter target for operating margin improvement is now roughly 50 to a 100 basis points. We continue to anticipate negative year-over-year operating margin comparisons in the fourth quarter as food inflation reaches approximately 5% as we anniversary the structural labor pickups we’ve mentioned and G&A timing shifts a little bit towards the end of the year.
For the full year 2011, we expect to finish at the high end of our targeted 0 to 50 basis point op margin improvement more than offsetting our lower than targeted comp store sales expectation at the EPS level.
Finally, in 2012 again we expect challenges in terms of leveraging operating margin given inflationary pressures and we’re currently targeting flattish operating margin next year. Wrapping up with tax rate shares outstanding from cash flow and cash on our balance sheet, our tax rate was 37.5% in the second quarter, we expect the rate of 38% to 38.25% for the remainder of the year and we expect the full year to end up in the same range.
We had 30.2 fully diluted shares outstanding in the second quarter and year end we expect a full year 2011 to run at about $30.3 million. Cash flow from our operations was $42.2 million in the second quarter, we had $24.3 million of non-acquisition CapEx go out the door. We closed the quarter with $229 million in cash on our balance sheet.
In terms of other uses of cash, we closed the Milwaukee acquisition in the quarter for approximately $41 million, no material P&L impact due to transition cost. We do expect accretion of $0.01 to $0.02 in the third and fourth quarter together and $0.04 to $0.06 overall in 2012 which is $0.03 to $0.04 incremental to our 2011 EPS. We also enjoyed about $0.06 of accretion from the share buyback we completed last year and the second quarter this year.
Let me just recap quickly for you our third quarter, fourth quarter and full year 2011 targets and offer a few comments on 2012. Our third quarter EPS targeted $0.92 to $0.94, 23% to 25% growth versus the prior year on a comp target range of 4.5% to 5.5% and operating margin improvement of 50 to 100 basis points. Fourth quarter EPS we’re currently targeting at a $1.35 to $1.37 12% to 13% higher than the fourth quarter of last year, comp target will also be 4.5% to 5.5% for that quarter and we expect our operating margin to be unfavorable to last year’s fourth quarter operating margin.
For the full year we are targeting EPS in the range of $4.54 to $4.58 up 25% to 27% from 2010 and up $0.07 from our prior targets. It is based on comp at the low end of our prior target roughly 4.5% for the year, a 100 to 105 new units at or above the top of our 37,000 to 39,000 range for AWS, again both at the high end of our prior targets, and then operating margin improvement at the high end of our original 0 to 50 basis point range.
We will also enjoy approximately $0.22 to $0.25 per share benefit from use of capital in 2011 or 6% to 7% of our earnings growth will be contributed by uses of cash. On $0.06 to $0.08 benefit from the New Jersey acquisition, impact from the Milwaukee acquisition of $0.01 to $0.02 and $0.15 of benefit in 2011 from the share buyback we completed in 2010, cumulatively that share buyback will have contributed $0.25 in 2010 and 2011.
We right now have no expectation of incremental use of cash in our targets for the rest of 2011 although we’ll certainly deploy our cash if appropriate opportunities present themselves.
Finally, let me offer a few words on 2012 targets. As Bill noted we today expect our 2012 EPS growth to fall within our long term guidance of 15% to 20% on comp store sales growth continuing in the range of 4% to 5% driven by the investments we are continuing to make in our concept and customer experience and new unit growth of a 100 to 110 new bakery cafes.
However, given a couple of factors today we would also point to the low end of that range. First, we do continue to expect significant inflationary pressures in 2012, 4% to 5% food inflation, $10 million of unfavorability on wheat cost, which means that we don’t expect operating margin much better than flat to full year 2011 in 2012.
Secondly to-date the only cash we’ve been able to deploy with an impact on 2012 EPS growth is the $41 million to acquire the Milwaukee market, which at $0.03 to $0.04 accretion will provide less than 1% earnings growth for 2012 as opposed to the nearly 5% per year impact on earnings growth we have averaged over the last four years on cash deployment. To be clear, our full intent is to deploy as much cash as we are able at appropriate returns during the remainder of 2011, fiscal year 2012, whether through the acquisitions of either franchisee owned Bakery Cafés or Panera Bakery Cafes under what we might call a different shingle such as our paradise business or alternately through the repurchase of our own shares at appropriate evaluations approved by our board of directors.
If we are able to deploy additional capital we will be able to revise our target for EPS growth upward above the low end of our long term 15% to 20% EPS growth target. With that we will bring the formal part of our call to conclusion and move on to take your questions. Operator?
(Operator Instructions) Our first question comes from Jason West with Deutsche Bank
Jason West – Deutsche Bank
Yes thanks. Just a question around the loyalty program, it sounds like you guys are tweaking a few things there, maybe reducing some of the rewards a little bit, just wanted to sort of understand a little bit more about what’s going on there, you know, was this sort of something that franchisees are pushing for, were you just surprised that the hit you have taken on mix and margin, if you could talk a little bit more about that that would be helpful.
Sure, sure Jason. Let me give you perspective. First of all we view loyalty as a very significant investment and initiative for us and it’s a long term one, it's really a bridge to build the kind of relationships, a deeper relationships with our customers that we really want and that really differentiates us from others. So what I’d tell you is we continue to be in a learning mode with loyalty. As Jeff mentioned, really the bulk of our roll out was in the latter half of last year with a great deal emphasis on the fourth quarter. So what I’d tell you is, we are doing what we do with loyalty with everything we do at Panera, that’s to come out with a hypothesis, work on it, get the best program we can go forward, test, learn and reiterate, and that’s what we are doing with it at this phase.
What I would tell you is what are the things that loyalty has helped us really see fairly clearly is, we’ve separated our customers into different bands by the frequency in which they visit Panera. And what we have been able to see is how different bands of people their behavior differs based on a number of factors. So what the whole program started out as is it was a fairly general program at first concentrated on hard rewards, free items based on certain number of visits.
And what we’re seeing is different band of customers perform differently, so one size doesn’t fit all. So what we are learning is and what we are testing with and experimenting with as we tried to say earlier is looking at different bands differently, recognizes that different customers use Panera differently and trying to make those rewards even more relevant. So to some bands of customers we’re actually going to increase the frequency or the cadence of the rewards, to others we are going to take it down, to still others we’re going to try to shift a little more into soft rewards and things that make it special where they get to again know what come in and taste the new menu items that will go on the menu next quarter earlier than other customers, because that’s really what some people like to affiliate with the brand.
So I would tell you we are very much in the learning phase and that’s what we’re trying to say and be respectful of as we’re going forward. But I want everybody to understand how important we believe the program is and how successful it’s been so far. I mean it’s solidly profitable and we have 7.5 million customers already enrolled and registered and active users, which is really far exceeding our original expectations. So I hope that helps Jason.
Our next question comes from Joe Buckley with Banc of America, Merrill Lynch.
Joe Buckley – BofA/Merrill Lynch
Thank you. Can you talk about your expectations again on mix why you think mix which is a negative, is going to shift positive in the second half if I understand it correctly?
Yeah, I think Joe the three reasons I gave you are the right ones. A, we expect our celebration mix to get stronger, B, we’re going to get favorable comparisons on loyalty check compression as the year goes forward, and the third one is escaping me. Embarrassing me though. I think those are the two primary ones. We really expect our celebration mix to get better. We had a timing issue in the second quarter which frankly we miscalled a little bit, it had a greater impact than we thought. We think that will effectively go away on a run rate basis. We do think that year-over-year our comparisons look better.
And then early in the loyalty program really you have a greater check compression naturally as we have intra rewards to get people into the program and we saw that last year. Anniversary now will just have a natural shift for us, so we actually feel pretty confident in this working this way.
Right. Just expanding from that on what Jeff said in quarter two, the celebration shift. We actually started our second quarter celebration a couple of weeks later this year than last around the strawberry Poppy Seed salad which is a tremendously powerful celebration for us. So, it did have a little bit of a negative mix impact in the results in the second quarter that goes away in the third quarter, so.
Right. And then the third one, I am sorry, is also loyalty just that – as we test these new tracks, we are going to see what’s effectively a discount reduction. So, we don’t expect our gross check than what we expect our net check to move. So we’ll see some averaging up of what you see in the comps which is a net check. Sorry about that.
John Glass with Morgan Stanley has our next question.
John Glass – Morgan Stanley
Hi good morning. What evidence do you have – you started by saying that there was a little bit of macro weakness, do you think that’s impacting the business. But if I looked at the quarter, particularly the traffic growth, it was really right within our expectation, it was really a mix issue that was probably fell short of what you thought throughout the numbers you gave us and that was probably more related to loyalty. So, I don’t connect all those, so can you talk about, are you seeing a negative mix outside of the loyalty program that’s giving you the inclination or you are seeing trend, even the current quarter’s numbers seem somewhat robust. What is the connection to the macro and what are you seeing in your business that gives you that evidence?
I’ll offer a couple of thoughts and then Bill will have a couple of comments. I think globally understand how we try and talk about our business. We boiled down to transactions and check as discrete movers in our business because we think about moving the business by getting more people through and getting more profit per person coming through, and we think about initiatives on that way. In reality, people don’t say, am I going to go again or am I going to spend more this time. There is a solid calculus that takes place against the array of stimuli that we offer in the Panera Bakery-Cafe that we call our initiatives.
What we did see in the second quarter was clearly we sold 1% less goods effectively than we expected. Macroeconomic indicators kind of across the board are down and if you think about it our core customer is a very loyal customer. Our most loyal people are actually in our loyalty programs. And we’re seeing greater royalty check compression than we anticipated and without pinning everything down exactly we believe that our core customer is not changing their frequency but they’re buying a little less each time in response to all these factors still mentioned, CPIs, accelerated, housing indicators are weaker in the second quarter than in the first quarter year-over-year, price at the pump had a much greater increase year-over-year. And frankly unemployment, the labor market has it's either stagnant or you’ve seen it pick up each month of less units. We think all of these things are happening and we’re selling less to everybody every time they come through and we triangulate that way.
I think Jeff pretty well covered it, so. Great.
Thank you. Our next question comes from Jeffrey Bernstein with Barclays.
Jeffrey Bernstein – Barclays Capital
Great, thank you very much. Just kind of looking for some thoughts as you look at into 2012. Well, broadly speaking I’m just wondering why perhaps we’re getting the color now and then as it relates to case usage components which you commented on, I’m just wondering other than organic growth, I think you mentioned share purchase to fill the top priority, I don’t know whether kind of the use of cash whether you’re now more considering the dividend or potential push further on acquisitions or what not, you seem to mention a 100 to 110 new units in ’12 and I don’t know if you can share a little color as well on what the mix is between the company and franchise and what impediments there might be to accelerating that.
So broad towards on 2012 and the cash usage. Thanks?
Jeff, why don’t you start and then I will add.
In terms of 2012, Jeff, we are always trying to give you our best visibility and transparency. So where we are looking in our planning at a number of different forces we think it’s wise to communicate openly with you guys about how we expect things to play out. We just think that’s good investor relations.
We also want to be opportunistic and make sure we get great ROI. We believe that keeping the money in the business and not dealing with double taxation on dividends is a good way to do it if we can get appropriate returns. The franchise acquisitions we’ve done are, it’s a tremendous return when you are buying it five to six times and frankly you are buying your own business. When we buy like soup salad sandwich concepts like paradise we were lower than our franchisee acquisitions on a synergy adjusted multiple with that deal and it really worked very well for us. So, we think that’s a tremendous return use of cash too. And then we think buying our own stock that – again evaluations we consider to be great return, it is also great because it’s tax advantage, it lets shareholders want to exit, exit, and take the cash, and it can – it keeps our priority set.
There is a level of cash which we get to and we haven’t said what the level is for the price, are considering a dividend in all fairness, but we don’t think we’re in that range today as we talk to our board. So, Bill?
And just to add a couple of things to Jeff’s comments. If I look at cash and our use of cash over the last couple of years, in 2010 we were able to buyback a significant number of shares, and then in late ‘10 we were able to make the New Jersey acquisition of our franchisee and so far in ’11 we’ve made Milwaukee acquisition.
So I think the point is that we are out there today utilizing the cash in a way that Jeff described that we feel is good and the right thing and the right returns for our shareholders, it’s on an opportunistic basis and it isn’t a certainty.
So I think that was some of the comment and transparency that we were trying to make talking to you about 2012 so far. And then the second piece of your question on new units, which we actually believe is the best use of the cash, the single best use of our cash is to build new Panera Bakery Cafes.
We have seen – what we have talked about in the past, we brought a discipline, a discipline to our real estate site selection really starting back in 2008 and 2009 and I think we’re seeing great dividends from it 2010 and 2011 through those average weekly sales increases that you’ve seen.
There is also, as we’ve talked about before for a while, been a dislocation between tenants that are in trouble, landlords and their banks, and we see that starting to come down a little bit although certainly companies like Borders liquidating provides opportunity and things of that nature but we are seeing that start to come down. So we are able to find the right sites for us that we feel very confident will provide us very high returns so we have been able to increase our number of new openings this year and again next, and Jeff will go as quick as we can without losing our discipline.
I think that there is many examples that people have seen in our industry and retail over the years where I think people get too excited and they start reaching for sites and they start to lose their discipline. And I think we’ve done a really nice job over the last couple of years of maintaining that and I think we are really seeing the dividends with the new unit average weekly sales and the returns we are getting on these classes. So you’ll see us continue to accelerate but in a way that doesn’t lose our disciplines.
Jeffrey Bernstein – Barclays Capital
We’ll go next to David Tarantino with Robert W. Baird.
David Tarantino – Robert W. Baird
Hi good morning. Jeff or Bill, just a question on the comps guidance and specifically the traffic component you are assuming as you get to Q4 and into next year it looks like flattish type traffic, yet your current trajectory seems to be above that. So just wondering how you reconcile what you are seeing today versus what you are expecting in the future and then perhaps the second part with media spending continuing to ramp and I assume that will be the case again in 2012, why wouldn’t you be able to drive traffic growth as you look out to those periods. Thanks.
Let me give you a construct David. I think – let’s start with what we might call the do-nothing case on transaction growth. If we just ran our business as it is going forward, we think it’s hard to grow transactions. We think if you are taking price, and if you are not differentiating, we believe in constantly investing ahead of the curve to differentiate. We think if you are not doing that, you are going to lose traction overall. So, with initiatives going against everything including media offering in neighborhood of a point or whatever, we actually feel good about being at neutral given economic conditions, the fact that we are going to take price to deal with inflation and that has an impact on traffic. So we feel that netting these factors we can drive ourselves at flat transaction growth and that’s a good result with returns we are able to drive on our business and it also allows us to keep investing so that in going forward we have people continuing across the street to come into our cafes and keep the health of our concept and our customer relationships up longer term.
Right. Just adding to that a little bit I think David, you know, as we look out we do think that there is a little uncertainty around the impacts of several things on the consumer. So I mean the guidance that we always try to give, the targets that we try to set are reasonable best estimates giving all sorts of uncertainty and then we go to work every day and work very hard every day to do our level best to try to exceed and beat those target. So, I mean to your point we have a number of initiatives that we are working on to try to move traffic and we are trying to be respectful of some of the uncertainty and the macroeconomic thing setting the consumer and we will do our level best to be able to exceed those targets that we have set.
But, that’s where we think is a reasonable place at this point, so that’s why we put it out that way.
Our next question comes from Sharon Zackfia with William Blair and company
Sharon Zackfia – William Blair & Co.
Hi good morning. This is a quick question on the week growth outlook for next year. I guess, Jeff, out of that 10 million, could you break that up for us between the restaurants and the fresh dough facilities and are you planning on passing on that increase to the franchises?
So our system is close for 50-50, it’s 47-53 approximately. And so, $4.7 million to the company at 5.3 million to the fresh dough facilities, which is where it shows up for the franchises. And then I think secondly, yeah, as I mentioned, we are doing a transfer price increase in September which will dollar for dollar hold us flat on food ingredient inflation in the FDF but not – it will deleverage our margins and frankly will cover other forms of inflation. So that’s how we’re thinking about it.
De-lever our company bakery café margins, right.
Yeah, and our bill cost of sales to franchises.
Mitch Speiser with Buckingham Research as our next question.
Mitch Speiser – Buckingham Research
Thanks very much. Jeff, I think you mentioned or if you can maybe repeat in terms of the amount of cash, your comp having on the balance sheet, I think in 2008 it was as low as $75 million now you have $220 million, as we all know it’s returning probably hardly anything given the interest rate environment. So if you can maybe just again tell us what your minimum cash levels are, and why share repurchase even at a minimum level would not be beneficial as a source of value to shareholders? Thanks.
Yeah, thanks. $229 million on the balance sheet and as I noted, we think a couple of hundred million is not a bad place to be in the current credit environment and maybe a little more. So, we don’t have a rock solid rule where something kicks in. We’re looking at general levels and we’re looking at what we think opportunities are over the next 18 to 24 months or so to deploy the cash and then we’re making judgment. So we don’t think 229 million or even a little higher is a bad place to be. To be honest, we look carefully at potential buyback levels with our board every quarter, we’ll do so in our upcoming board meeting and the judgment is always to look at three, five, ten years out and do some scenario analysis and make a judgment as to where an appropriate place to deploy the cash and share buyback versus holding it further opportunities and we obviously look at relative returns. So it’s a board level discussion we’re trying to make sure we do the most responsible thing with the business, our shareholders et cetera with the cash.
(Operator Instructions) Our next question comes from Bart Glenn with D.A. Davidson.
Bart Glenn – D.A. Davidson
Thank you. I was just curious if you could give us a little color on the unit growth, a component of company versus franchise for next year?
Yeah, I would say Bart, it’s – both are accelerating and rough rule of about 50-50 would not be far off. So that’s a fair estimate. I think the important thing, your franchisees are always a great leading indicator for you I think. Because, again there are very much believers in Panera and they’ve done very well over an extended period of time. But they make those decisions on how they invest their capital everyday and many of them have multi-concepts that they are franchises of. And what we’ve seen them do over the last several years is start to shift their capital towards building out Panera at even a quicker pace than they’ve been doing.
So we’re very gratified by their confidence and belief and I think it’s a great leading indicator of where we are going and we see the same elements and the same opportunities. So you’ll see both company and franchisees increase the pace of growth and if you think of roughly 50-50 that’s in the ballpark. Thank you.
Our next question comes from Phillip Juhan with BMO Capital Markets.
Phillip Juhan – BMO Capital Markets
Yeah. Hi Jeff. Your cost of sales deleverage is a little greater than expected given the degree of price and food cost inflation in place in the quarter. So you can maybe quantify perhaps the loyalty or the mix shift impact across the sales and how do you expect that playing out on the back half of the year. Thanks.
It is, low double digits basis points, I don’t know, 20 or so, we haven’t really looked at it that way to quantify it externally. So, obviously there is some impact going on there. But it’s not – the loyalty piece is mutually material and the rest is mix. In terms of next year, we see the same types of impacts happening. Keep in mind that if you average your check up with higher ticket items we may not look to hold our margin level, we are looking to deliver value to the customer and greater profit dollars and not necessarily focus on margin. So we don’t really focus on managing tool margin, we focus on growing our sales profitably. And so, you are seeing a little bit there as it happens this quarter. Fair enough.
Our next question comes from Steve Anderson with Miller Tabak.
Steve Anderson – Miller Tabak
Good morning, it’s Miller Tabak. And just I wanted to go with you on your expansion plans, last quarter you talked about some of your urban expansion into the (inaudible) New York and some of the other markets, can you update us on that?
Yeah. What I would tell you is we continue to experience success on our urban market development. Again, we’re expanding in Boston, Chicago and then we are going to have our first three sites in Manhattan later this year. One in Chelsea area, another in the Upper East side, and then in one in the Bryant Park area. So I mean those will be opening. But what we are finding is that not surprisingly Panera does very well in the urban course and we really try to find in those areas – it’s not the right downtown CBD districts there, five days a week driven by the office traffic, really our success, Steve, has been driven more by the office traffic. Really our success Steve has been driven more by finding the downtime areas on the edge where there is a mix of retail residential and business drivers. And they have been some of our very successful stores and so you will see us continue to go in those areas in Washington DC and DuPont circle, there is a very good Panera Bakery Café that opened fairly recently.
And the whole thing to us is to make sure that we get the same returns because obviously the rents are higher, the sales are higher and we are looking to get the same return on our investment in a downtown urban location as we are our normal suburban prototype, and to-date we believe that we are. So we feel very good about that and we think that provides us additional opportunity to certainly add some flagship type locations that are helpful to continue to expand the presence and awareness of the brand. So we feel very good about that strategy.
Our next question comes from Rachael Rothman of Susquehanna Financial.
Hello, this is Jake on for Rachael. I’m hoping you can quantify the impact on margins that your franchise acquisitions have had with the one this year as well as the one last year in New Jersey. Thanks.
The easiest way to do it Jake is to look the delta in franchise royalties and fees. So that’s pretty much a 100% profit. So if you look at it, that shipped at 60 basis points and that’s roughly a straight flow through on your operating margin if you do the dollar math that they move a little bit on the rounding, but that’s a good way to think about it.
So, again, more dollars but it’s a percentage difference so.
As Jeff mentioned before, I think it’s really that is important to reemphasize. I mean, we don’t manage to margin percentages or things like. We are trying to provide a great customer experience and then flow down as many profitable sales dollars as we can, so.
At this time there appears to be no further question.
Thank you very much and we will talk to everybody next quarter. If people have questions in the meantime we are all available for your call.
Take care everyone.
Thank you. With that we will conclude today’s conference. Thank you all for your participation. You may now disconnect.
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