Jeffrey Kip - Chief Financial Officer and Senior Vice President
Ronald Shaich - Chairman and Chief Executive Officer
Neal Yanofsky - President
Rachael Rothman - Merrill Lynch
Robert Derrington - Morgan Keegan
Chris O'Cull - SunTrust
Joe Buckley - Bear Stearns
Steven Reese - JPMorgan
Sharon Zackfia - William Blair
Jeffrey Bernstein - Lehman Brothers
John Glass - CIBC
David Tarantino - Robert W. Baird
Jason West - Deutsche Bank
Ashley Woodruff - Friedman, billings and Ramsey
Fitzhugh Taylor - Banc of America
Panera Bread Co. (PNRA) Q3 2007 Earnings Call October 24, 2007 8:30 AM ET
Welcome to today's Panera Bread Company Third Quarter 2007 Earnings Release Conference Call. Today's call is being recorded. At this time I would like to turn the call over to Mr. Jeffrey Kip.
Thank you very much. Good morning, everyone, welcome to Panera Bread’s third quarter fiscal 2007 earnings call. Let me cover a few regulatory matters. I’d like to note that during our opening remarks and then our responses to your questions, certain items may be discussed which are not based on historical fact. Any such items including targeted 2007 results should be considered forward-looking statements within the meaning of the Private Securities and Litigation Reform Act of 1995. All such forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially.
I'll begin our call by reviewing the third quarter results and key metrics. Ron will then discuss the issues the company faces and our plans going forward. He will also give some broader perspective about how we feel the company has progressed. Neal will then conclude with our views on the fourth quarter and our initial view on 2008.
With that, let's get into the third quarter 2007 financial results. Consistent with the first and second quarter, these results are consolidated and include the operations of Paradise Bakery Cafe.
Last night, we issued our third-quarter 2007 earnings release for the 13 weeks ending September 25th. Our net income for the third quarter was $11.9 million and EPS was $0.37 per dilute share versus a net income of $10.9 million and EPS of $0.34 per diluted share in the third quarter of the prior year.
Third-quarter EPS of $0.37 included a one-time tax benefit of $0.05 reflected an effective tax rate of 27.8%. The $0.37 EPS and tax rate of 27.8% is directly comparable and based on the same tax assumptions as found in our original and revised EPS guidance.
To be clear our tax rate target has been consistent in each guidance we’ve issued this year. The principle underlying factors effecting EPS in the third quarter are as follows; one, a mix shift within the Bakery Cafe menu away from soups and sandwiches to higher food cost salads, and secondly away from bread and bagel self-manufactured in our fresh dough facilities.
Two, product ingredient and input prices outpacing product increase of approximately 0.6%. And three, increased labor cost from first the investment of labor in the lunch day part to improve ease of use in the form of the Expeditor, and second normal wage increases of about 3% versus our existing price increase.
Let me now review our key metrics for the third quarter. Our system-wide comparable Bakery Cafe sales increased 2.6% in the quarter, with 3.4% company-owned locations and 2.1% comps in franchise-operated locations.
Our system-wide average weekly sales came in at $38,051, a decrease of 0.1% over third quarter 2006. This represents AWS of $37,136 for company-owned Bakery Cafes and $38,711 for franchise operated Bakery Cafes.
We opened 35 Bakery Cafes in the third quarter, 19 of which were company owned and 16 of which were franchise operated, and we closed two Bakery Cafes in the quarter, one company owned an one franchise operated. In addition our Bakery Cafes were open a total of 14,931 operating weeks in the quarter.
Now I would like to move on to the key-line items of the third quarter versus the comparable period a year ago, starting with total revenue. Third quarter revenues increased 33% to $273.2 million in 2007 versus $205 million in the comparable period of 2006.
The breakdown is as follows. Net Bakery Cafe sales increased 40.6% to $232.2 million in 2007 from $165.1 million in 2006, driven primarily by sales from units open in the last four quarters and in part by acquisitions over the same period.
Franchise royalties and fees increased 7.9% to $16.3 million in the third quarter of 2007 from the same quarter in the prior year driven by new franchise operated Bakery-Cafes opened in the trailing four quarters, partially tempered by the acquisition of franchise operated Bakery-Cafes by the company.
Fresh dough sales to franchisees remain consistent at $24.7 million in both 2007 and 2006. Those sales to franchisees have not grown in pace with franchisee-operated sales because of a shift in Bakery-Cafe mix previously noted away from the bread and bagels we self-manufacture in our fresh dough facilities.
As a result of these differential growth rates, we continue to experience a shift in total revenue mix as Bakery-Cafe sales as a percent of total revenues increased to 85% in the third quarter of 2007 compared to 80.5% in 2006 while over the same periods, franchise royalties and fees declined to 6.0% from 7.4% and fresh dough sales to franchisees declined to 9.0% from 12.1%. The shift in revenue also resulted in part from the increased number of new company-owned Bakery-Cafes as a percentage of all new Bakery-Cafes open.
Moving on to margin analysis. Restaurant margins were lower by approximately 260 basis points in the third quarter of 2007 versus the same quarter in 2006. Let's go through this Bakery-Cafe expense by component now. First, cost of food and paper products increased by 200 basis points year-over-year. Approximately half the increase is driven by margin de-leverage, given ingredient cost pressures versus and year-over-year price increase of approximately 0.6%.
The other half of the year-over-year increase is tied to mix shifts effecting both our FDSs and our Bakery-Cafes. Again we have seen the movement away from the sale of bread and bagels which we self-manufacture and additionally our customers purchase more salads with a higher natural food cost and fewer lower food cost soups and sandwiches, increasing the cost of food and paper products. We saw the trend stabilize in period nine and as we seasonally would have expected. Although it’s important to note to weather this fall has slowed our shift into soups.
Labor as a percentage of restaurant sales rose 90 basis points in the third quarter versus the comparable quarter in the prior year. Approximately half of this increase as a result of the year-over-year addition of the Expeditor position at lunch to drive ease of use for our customers. Our bias will continue to be toward investing labor in the Bakery-Cafes to improve the customer experience.
The other half of the increase is driven by our normal approximately 3% wage increase outpacing our 0.6% price increase, and this factor’s partially offset by improved labor management versus the prior year.
Occupancy costs in the third quarter increased 60 points versus the prior year to 8.0% of restaurant sales based upon somewhat higher average per square foot costs in immature stores outpacing the growth-of-sales during the third quarter of 2007 as compared to 2006.
Other operating expenses in the third quarter fell 90 basis points versus the prior year to 14.0% from 14.9% of restaurant sales. Approximately 75 basis points of the decrease relates to higher advertising costs incurred in the prior year connected with the Crispani rollout. With significantly higher openings expected in the fourth quarter this year versus last year, we expect to leverage on this line to reverse in the fourth quarter.
Moving on from restaurant margins, fresh dough cost of sales to franchisees as a percent of fresh dough sales to franchisees improved 60 basis points over the prior year. The improvement was driven by the continued growth of the income we earned on the sales of contract manufactured baked goods, such as soufflés, scones and cookies to our franchisees versus prior year, which offsets the de-leverage from cost increases versus flat sales in our FDF system.
Depreciation costs in the third quarter remained consistent at 5.5% of total revenues in both third quarters of 2007 and 2006. General and administrative expense as a percent of total revenues improved 140 basis points over the prior year in large part from the presence in the prior year of 40 basis points of one-time legal expenses and 50 basis points from the national brand component of the Crispani roll.
Pre-opening expenses in both the third quarters of 2007 and 2006 remain consistent at 0.7% of total revenues. Now let's turn our attention to other income which declined by 30 basis points to 0.1% of total revenue in the third quarter 2007. The reason for this decline was lower interest income driven by lower cash balances in the third quarter than in the prior year.
Let me conclude with a few other items we traditionally disclose on our earnings call.
As I noted previously the effective tax rate for the quarter was 27.8%. Included in this tax rate is the benefit of $1.5 million or 9% of the rate reflecting the favorable resolution of a tax matter we previously reserved for under FIN 48.
We expect the tax rate for the fourth quarter to be approximately 37% and for fiscal 2007 to be approximately 34.2%. We currently expect the 2008 tax rate to be approximately 37.2%. There are approximately 32.2 million fully diluted shares outstanding including the impact of 2.1 million stock options outstanding with an average exercise price of $36.48.
The company finished the quarter with $17 million in cash and zero debt on its balance sheet versus $72 million in cash and investments and zero debt at the end of the comparable period in 2006.
In the quarter, the company generated $27.5 million in cash from operations and employee stock option exercises and had capital expenditures of $32.9 million.
Let me now turn it over to Ron.
Great, thank you, Jeff. As many of you know our team has spent the last few months talking to investors about Panera. It is our sense that the real question investors want to determine is, ‘where is Panera in its life cycle as a growing company?’
People have been trying to determine whether Panera is a former growth company with only a modest future ahead or if the industry-leading concept experiencing short-term margin pressure and one which can be expected to return to strong and stable earnings expansion. Essentially, the question is, ‘is the weakness experienced in 2007 going to be repeated in future years, or is 2007 an anomaly?’
In order to help investors answer that question, I think it is helpful to understand what has happened with our business over the last year and a half, and while we find our margins weaker today than in 2006. But first, let me tell you, what isn't impacting Panera.
It is not the concept. It is not any weakness on our appeal to the customer. And it is not competitive encroachment. We know the strength of our concept given our continued industry-leading customer satisfaction ratings, our high and consistent unit values, and our strong Bakery-Cafe return on investment.
So what has been going on and how did we get in this situation? In other words, what is management been focused on? And how do we end off with market contraction? Let me start by stating that it has been our long-term objective to attempt to increase our competitive position and industry-leading cafe volume substantially, while operating in an ever more complex environment with incredible cross winds - and by that I mean inflationary pressures and a very sensitive consumer.
To understand this better let me take you back to Q1 2006. At that time we were running 15% two-year comps and we were feeling quite expansive. In fact in early 2006, we just completed an internal exercise exploring the question of how to take our industry-leading volumes from $2 million to significantly more than that.
Throughout 2005, we had been testing a pita-like product called Crispani, which we believed had the potential fuel or our next negative growth. In 2005, our market test with Crispani produced strongly positive consumer reactions but modest sales. As we looked forward into 2007 and beyond, we believed Crispani had the potential to perform as so many products at Panera have before it with strong organic growth built over several years. Our experience told us product quality drove long-term growth and expansion in sales.
In May of 2006, we made the decision to rollout Crispani, and in the fall of 2006, we did so. In Q4 of 2006, we focused on that rollout and we focused on introducing Crispani to customers. As Q1 of 2007 rolled around, we began to see something we had not anticipated.
Crispani was delivering sales as we expected, but more significantly to our surprise all income in Q4 2006 and Q1 2007 were much weaker than we thought they would be. Yes, gas prices were up, weather was bad, and the consumer was weak.
But nonetheless, the comps in Q4 2006 and comps in Q1 2007 were much weaker than one could expect with the addition of Crispani. As we looked deeper and deep near the comps, we began to realize that Crispani was in fact covering up another problem: negative lunch transactions that began in Q4 2006 and continued into Q1 2007.
Frankly, this was very disturbing. This was the first time in the recent history of our company that we've seen transactions fall off. In response to this problem, we prepared the strongest transaction-building sales initiative we have ever mounted for the summer of 2007.
In Q2 and early Q3 2007, that salad initiative was rolled out and proved to be a success beyond our expectation. In fact, it drove our lunch transactions strongly positive once again. But to our surprise, despite the growth in transactions, our retail in FDF profitability was weaker than we would have expected.
So we asked ourselves, what was this all about? As we focused on the root causes of our margin compression, we realized that there were four main issues that were driving down summer margins. Let me explain the first cause of margin degradation.
Yes, transactions were up, average check was up and comps were up. As we looked deeper, we discovered penny profit per transaction--that is to say what is left over after the food costs is subtracted from sales--was down year-over-year.
In fact, in our desire to protect transaction growth, we successfully driven salads, but cannibalized our biggest profit items on the menu, things like our You Pick Two. As a result, total penny profit dollars, that is to say those dollars left over after food cost is subtracted and those dollars are available to cover inflation and labor and other costs was flat. The result: margin degradation.
So why did we let this happen? Quite frankly, we focused on the wrong metric. We should have been focusing on growth in total penny profit dollars, which is the product of growth in transactions and year-over-year growth in penny profit per transaction.
Instead, we were focusing in on comps, which is the product of year-over-year growth in transactions and year-over-year growth in average check. We certainly learned a lesson. The cash the consumer brings in the door is not the same as the cash they leave behind after we pay for the cost of the food they purchase.
The second thing we discovered as we looked under the hood to understand our weakened margin in summer 2007 was our FDF profits were off significantly. This showed up in increased food cost on the P&L. Significant increases in commodity cost and a shift by the consumer away from the products manufactured in the FDF de-leveraged our facilities and our P&L.
Third, Crispani, with its large fixed labor component was not helping us. Fourth, the larger year-over-year mix of relatively younger stores, as a percentage of our total store base was negatively impacting our margins.
So, the question in recent months at Panera has been, how do we react to this situation? How do we rebuild our margins while growing transactions? And how do we once again regain your confidence?
Here is what we are doing to improve our business, to grow our margins while growing our transactions and to regain your confidence.
First, on November 14, we will be taking a 2.5% price increase across our menu. This includes, an approximately 5% increase on our baked goods. The intent of our price increase is not just to drive the average check and offset the margin pressure, but also to a) drive transaction growth by making the menu easier to use; b) broaden our pricing spread to protect everyday use by more price-sensitive target consumers. We want to do this while offering options for customers willing to spend more and leave more in profit.c) we want to stir people toward choosing items that drive more penny profit per transaction like, You Pick Two at lunch and higher penny profit specialty itemsl and d) we want to cover the inflationary pressures we experience.
Let me further add, we are committed to protecting our margins in these inflationary times. And as a result, we are now planning to review our pricing every quarter in 2008. Second, as part of our plan, we introduced a category management function to help us strengthen our margins. This team exists to help us increase penny profit per transaction.
Already, the team has been instrumental in helping us reorganize product placement of the new menu panels rolling out November 14. By doing so, we expect greater ease of use for our customers and we expect to be able to encourage purchases, which lead to a higher penny profit per transaction.
Additionally, our new menu panel labeled Be a Hero encourages consumers to take Panera back to the office or home via home purchases.
Finally, our category management team is working with our food development team to strengthen both the transaction building and penny profit-building impact of upcoming celebrations.
Together, our category management team and our food development team are increasingly focused on doing fewer products that are more differentiated in the marketplace and awarding higher penny profit per transaction, while simplifying procedures for others.
Third, as part of our plan, we are in the process of evaluating Crispani and its impact on margins. Frankly, sales are not growing as we had originally expected for Crispani and we are concerned. Our view of Crispani is it cannot stay as it is. You should know that we have a number of tests in place to determine our ability to strengthen our sales of Crispani and to take advantage of the fixed costs that are in place. Simply put, the answer on Crispani is either more sales or we pull the program.
Fourth, a lot of energy is focused on locking in 2008 purchasing. This includes soup, distribution, dairy and wheat.
Fifth, as part of our plan, we’re taking a number of actions to impact our FDF margins. These have been hurt significantly. We will execute an FDF price increase of approximately 5% which, given our contractual agreements with our franchisees, will be in place, December 26.
We will also continue to introduce new bakery products that appeal to customers and bring down our costs. We recently introduce new focaccia and ciabatta breads that are naturally lower in fat, higher in fiber and have no trans fat or cholesterol and they are delicious.
The breads are a great example of the product we are proud to serve and that our customers lust for. In the coming period, you will see similar initiatives come out of our Bread 2.0 program.
Sixth, as part of our plan, we are focusing on rebuilding margins and we are focused on doing so while continuing to grow transaction. This is very important to understand. Our plan includes building both margins and transaction growth.
Our medium-term “circle of warmth” goals, as we call them, revolve around eliciting feelings of lust, trust, relationship, and ease of use from our customers. As a result, our operatives continue to focus on speed, accuracy and on improved customer experience.
We evaluate our performance monthly to understand our success in improving our speed, accuracy and customer service; all three metrics have improved this year. We believe this translates into transaction growth in the future and we know it is a key to differentiation.
Just as importantly, Panera continues to have a number of other initiatives in place to build transactions. We’ve introduced a new line of delicious artisan pastries. And just as we always have, you will of course see us continue with our traditional rotations of new sandwiches, salads, paninis and soup throughout the year. We are also deep in test on our breakfast sandwich filled with fresh eggs and all natural meats. But more on these sandwiches from Neal, in just a minute.
Our food people are focused on fewer, better products and upcoming in-cafe celebrations, you’ll see us celebrating favorites already on the menu and bringing back some old favorites. You’ll see more add on and more bulk alternatives.
There is one last element of our plan to boost margins I would like to cover with you today. We made a decision recently to tighten up our real estate decision-making process. We think the company is better served with fewer stores in immature trade areas or Greenfield locations. Simply put, we believe it is unnecessary to open stores of this sort at a time of margin pressure. Moving forward, it is our intention to knock out these potential locations that our model indicates will be at the low end of our ROI goal in the short-term, and/or have a long maturation cycle.
Many of you will certainly ask, ‘what can you expect from these initiatives and when will they have a meaningful impact?’ To be truthful, we don't know. What we do know is there’s much optimism in the organization and many good things happening that we expect will make a real difference.
And we know that the underlying strength of Panera remains robust, but we also understand it’s our responsibility to deliver improved margins and transactions and deliver the earning growth that you’ve grown to expect from this team. Know this. Though we are very cautious after a year of under-delivery, we feel positive our team will get the job done.
Thanks, Ron. Let's start with our expectations for the fourth quarter and then look beyond the end of the year toward our targets for fiscal 2008. We are currently targeting fourth-quarter fully diluted earnings per share of $0.53 to $0.59. This target is based on our projected performance on our key metrics, which are as follows.
Comp store sales increase of 1% to 3.5%, 60 to 65 new Cafe openings with 21 to 24 of those franchise and 39 to 41 company. Average weekly sales for new openings of $39,700 to $40,700. And Cafe operating weeks of $15,450 to $15,500.
As always a major driver of our short-term results is our comp performance, and we are indicating a fairly broad range for the quarter. Comps are always difficult to foresee, and more so now as we implement a price change in the middle of the quarter.
In addition, the November 14th pricing move is more than a price increase, although it is a price increase. It is also a change in our pricing structure and strategy, aimed in part and improving our penny profit per transaction.
So, although we are targeting a comp range for the quarter as we always do, we will be more closely watching the effect of our various initiatives on the penny profit per transaction. Having said this, I can report our initial read on comps for period 10, which has just ended.
We expect period comps of 0.3% to 0.6%. Now, this is below the range we have set of the quarter as a whole. Why then do we believe our comp performance will improve in periods 11 and 12? Do we simply think that cold weather, if it ever arrives, will help us sell more soup?
Well, it should, but more notably in period 10 we were running over the second month in which we had substantial marketing support of Crispani in 2006. In periods 11 and 12 last year, comps relaxed by about 175 basis points. So we expect to strengthen against that easier comparison in the latter part of this quarter. In addition, we will have our price increase in place and company Cafes for about half of period 11 and all of period 12, which would help support comps.
On the key metric of development, we are expecting 39 to 41 company Cafes to open in Q4 or about 50% more than the 26 we opened in the fourth quarter of 2006. The opening costs associated with these Cafes, which will each average only about five weeks of operation in the quarter, will create some short-term drag on our earnings for the quarter.
We also intend to continue to invest in labor that supports the quality of our customer experience and therefore, supports transactions growth. And while we have a number of margin-oriented initiatives in the works, these will just start rolling during the quarter and so, will not have a material short-term impact on earnings.
So let's now turn our attention to 2008. We’ve established the following targets for our key metrics. New Cafe openings of 160 to 175, which is just about the same as this year. Comps in the range of 1% to 4%; average weekly sales of $38,400 to $39,600. And Cafe operating weeks of $68,000 to $68,500. These lead to an EPS target growth rate for fiscal 2008 of 10% to 20%. This is the broader range than usual for us, and it reflects the current uncertainty there is on several key variables.
First, there is the general economic environment and consumer confidence. You don't need me to repeat the litany of ills we all read about daily in the paper: housing values down; gas prices up; consumer confidence waning.
With more and more economists beginning to invoke the "R" word, recession, we feel it is appropriate to approach 2008 with a healthy awareness of the potential for our transactions, our average check or both to be dampened by further deterioration in the broad economic environment.
These are certainly not typical economic times for many of our customers. On the other hand this is not the first soft economy in which we have operated. And we have not found our business to be hypersensitive to economic downturns.
The second external factor is the severe increase in the cost of wheat. Earlier this year, wheat crossed above $5 for only the third time in the past 30 years. But what six months ago seemed like a dramatic spike today appears to have been a bargain. As wheat has continued to climb to $8 and beyond.
We are not currently committed forward for 2008 in our flour purchases. So, this commodity remains a potential source of earnings volatility for next year. Here is how the price of wheat flows into our cost. We expect to use approximately 140 million pounds of flour in 2008. That is equivalent to about 3.25 million bushels. So, a move of $1 in the price of a bushel of wheat translates into about $3.25 million change in our cost. Wheat futures for 2008 now average about $7.70. And our 2008 target assumes wheat at this price.
The $7.70 price is about $2.50 above the average we will pay in 2007. So this creates a potential of more $8 million hit to earnings or $16 per share. We think we’ll be able to offset much but not all of this potential impact through further price increases beyond those planned for November.
So, our target for 2008 assumes a net $2.5 million hit for increased wheat prices. If wheat prices are below our targeted cost of $7.70, we’ll take less price. If they are higher we will strive for a greater increase in order to keep the earnings impact to $.05 per share.
Now, when we cannot control the price of wheat, we can respond to it intelligently. So, our purchasing team continues to carefully monitor the market. We take some encouragement from the fact that wheat futures for late 2008 are now lower in price than for early in the year reflecting the market's belief that the prices will ease.
In an atypical year for wheat prices, we have an atypical approach to our purchasing commitment. For the time being, we are remaining open on 2008 rather than locking in for the year at what may well prove to be a higher than average price. And we will, of course, attempt to recover as much as of any additional commodity cost as possible through price increases.
Ron detailed for you our approach to pricing strategy and successful effort to build transactions year-over-year. We worked hard to test and implement the pricing structure that is strategic and not merely tactical and believe this change will serve us well in 2008.
As we approach the implementation of this price increase and as we head further into this difficult consumer environment, it is too soon to know if we will be able to continue record of building transaction while we work to cover our cost increases through pricing and work to improve our penny profit per transaction. While it will take some time to see the full outcome of this price increase, we feel that it will hold significant promise for improving our margins and Cafe-level profitability.
Having outlined some of the potential challenges in 2008 and our planned responses, I would like to take a moment to mention one initiative, which is a microcosm of our approach to the business.
As you may know, we have been testing a breakfast sandwich recently. This product began, as do all of our products, with a straightforward yet challenging objective: to create a differentiated product that customers love; that fits with and enforces our concept; and drives favorable economics for our Cafes.
Yes, there are a lot of baked sandwiches out there but not like ours. We crack fresh eggs in the Cafe and add other terrific ingredients like Vermont white cheddar cheese, Niman Ranch sausage and Applewood Smoked Bacon and then we serve it on our freshly baked ciabatta bread. Our taste tests has proven that customers love our breakfast sandwiches and our market tests have shown customers are voting at the registers with meaningful sales most of which are incremental. The sandwiches sell for about $3 to $3.50 leaving us a higher penny profit than any other breakfast item including our successful egg soufflés.
So, we think we are on to something that matters to our customers, adds Cafe volume and increases both the transactions and penny profit for transaction and supports our manufacturing operation through incremental bread sales.
We do make mistakes from time to time, but we learn from them. So, I am not going to tell you that the story of 2008 will be written by the success of the breakfast sandwiches. It is too early yet to commit to a sales forecast or even an introduction date. Although if you were interested in seeing the product, you can find it in test in our home market of St. Louis. But I mention this initiative as the kind of work we are continuing to do to achieve the triple goals of advancing our competitive position, addressing the needs of our customers, and improving our Cafe-level economics.
We’ve a wonderful phrase in our cultural values, when we speak about approaching our work with optimism and mastery. We are fortunate to be able to build on the foundation of an extremely strong concept that continues to resonate with customers and to earn and deserve their loyalty.
We have a thoughtful and thorough plan already in progress to improve our margins. And we have encouraging and very early results. And so, despite an uncertain environment, we do indeed feel optimistic as we look to 2008.
Now, before turning the call over to your questions, I would like to inform you of a small change to our reporting process that I think you will welcome. Many of our friends in the investment community--in fact many of you on this call--have observed that we are essentially alone in our industry group in reporting comp sales at the end of each period.
Some of you have noted that these very short-term, very volatile figures create unnecessary noise and do not help in forming a balanced view of the company. We agree. We believe that it is time to join our peers, who generally do not publish monthly sales releases as we do.
Accordingly, beginning in fiscal 2008, we will no longer publish a monthly report of our comp store sales. We will instead share this information at the end of each quarter. To be specific, our quarterly earnings releases will also include comp store sales by periods broken up by company, franchise and total system.
This change will take effect at the beginning of 2008. So, period 12 of 2007 will mark the end of our real time monthly comp reporting. Beginning with the first quarter of 2008, we will report comps for all three periods of the quarter along with our quarterly earnings report.
We are committed to providing transparency to our investors through meaningful reporting of the key metrics of the business, in addition to the core financial report. As such, we have thought long and hard before making this change to the frequency of our sales reporting.
We are doing so now, because we believe that the revised schedule will shed just as much light on our performance, while perhaps generating a bit less heat.
Before we go to your questions, as Neal mentioned, we do occasionally make mistakes and a couple of quick corrections for the transcript.
One is, when we cited our metrics for the fourth quarter, we gave a metric of average weekly sales for new openings of $39,700 to $40,700. That is not the metric we used, we misstated. That is, average weekly sales for every single unit in the system of $39,700 to $40,700.
Quickly, a small misspeak, a dollar of wheat impact for us next year will be $0.16 of earnings per share rather than $16. So, just to get the transcript right, I will take a little career risk and correct my boss.
So, at this time, we are open to take your questions. As is our custom, we request that you ask only one question at a time in order to give as many of those on the call as possible an opportunity to weigh in.
If you have additional questions, please return to the queue. We are happy to stay on the line with you until all the questions have been asked or until the market opens at 9:30. Operator, we are ready for the first question.
(Operator Instructions) And our first question is from Rachael Rothman with Merrill Lynch.
Rachael Rothman - Merrill Lynch
2008, does that include the impact of a 53rd week? And if it does, can you quantify for us how much you would expect that to boost the top line and the bottom line?
Fundamentally, Rachael, it does. You should know, we are giving a very wide range. Neal commented on the uncertainty and to a certain extent, we have very round divisible by 10 numbers there and it is a nice help, and we do have 53 weeks.
Our next question is from Robert Derrington with Morgan Keegan.
Robert Derrington - Morgan Keegan
Ron or Neal, I am not sure, who best to pose this question to. Looking at the development, could you give us some clarification, some color on the franchise development piece?
It looks like in the fourth quarter it will be less than what you had provided guidance on your second quarter call for. And, I’m just trying to understand, what’s going on there? Is it a similar situation with Greenfield locations? Or what color can you add?
There is no significant cutback or adjustment at a tactical level by our franchise community. I think, the only thing you may be picking up is some slippage that, these projects that we can't get control of over that are often promised to us in September and October. They announced over the summer and into the fall that, in fact, they are not going to be able to hand them over until November, December, in which case, we push them into the next year.
My guess is, if you go back in the transcripts, not just to the second quarter, but into each of the last of the prior years, you have seen a similar kind of situation. We try to build that in, but we take our franchisee what they tell us in terms of their openings and report it back to you.
So, I wouldn't make too much of it one way or the other.
Our next question is from Chris O'Cull with SunTrust.
Chris O'Cull - SunTrust
My question is regarding the guidance for the fourth quarter. When you look at the operating margin decline you saw in the third and even adjust for some of the marketing expenditures with Crispani, as well as the legal costs. It seems that, you are expecting the fourth to continue to fall maybe even at a greater rate. Especially in light of the menu initiatives that you are working on in the fourth; is this being conservative or can you give us some color as to why?
Chris, I think what I’d say is we’re not expecting things to fall more rapidly. You know, I don't have your numbers right in front of me and I don't really know what you are looking at. I think, Neal commented that we all have a lot of things in play and we don't believe they are all going to pop just right in the fourth quarter. We think they are longer-term initiatives and we think they will play out more in ‘08. So, I think that is the way I would point you.
Chris O'Cull - SunTrust
When you look at the fourth-quarter guidance, are you assuming any benefit from promoting the You Pick Two combo in the fourth in your guidance?
We assume modest seasonal improvement, which we normally see in the fourth quarter with food costs. So, we don't expect enormous impact from our initiatives in the fourth quarter.
I would add to it. Clearly a number you pick up, the width of our range for the fourth quarter, the width of our range for 2008 speaks to the extraordinary uncertainty that we see out there and I think more importantly than anything else what we’re trying to indicate to you is what we’re doing. To try to guess what week is going to have what impact is quite frankly, I think is uncertain at this point. I think we’d much rather report back what happens than tell you what is going to happen.
And our next question is from Joe Buckley with Bear Stearns.
Joe Buckley - Bear Stearns
Thank you. As you shift the expansion into more established markets versus the Greenfield markets, what is your experience been over the last year or two in average weekly sales between those two types of restaurant openings?
I wouldn't even want to use the word shift, because shift seems more dramatic. I think what we’re talking about is dropping out that one out every ten stores that potentially we think is still a good piece of real estate, but, it's in a strip mall, and it's potentially an area where there is a lot of new housing going up or expected. A mall I was looking at in San Diego last week, there was lots of new houses going up, but, it is the heart of the sub-prime meltdown.
I think we feel like we have in the last couple of years as our growth has taken off accepted some more of that maturation risk. And I think that we have less patience for that today. So, I think it is clearly less of a shift and essentially a dropping of the bottom 10% of the stores that have a longer payout cycle.
And Joe, you use the work markets and if we can just clarify that a little bit. We are not talking about cities. We are not talking about metropolitan areas. We are talking about sites, trade areas, specific locations.
So, Ron described something that might be a Greenfield where you are waiting for the suburb to move to you a little bit. It could that be five miles away from that there is something that is not a Greenfield location in that same metropolitan area that is terrific for us.
Joe Buckley - Bear Stearns
Okay. That's helpful.
The Greenfield will take longer to grow.
Joe Buckley - Bear Stearns
Thanks for the clarification, thanks.
And just to further add to what I may have said. I think the right word we would use that we use internally is ‘fine tune.’ It is fine tuning using our real estate modeling processes.
And our next question is from Steven Reese from JPMorgan.
Steven Reese - JPMorgan
Hi, thanks. I wanted to ask about the labor investments plan for 2008. We saw a lot in the second half of ‘06 with Crispani and again in ‘07 with the Expeditor. I guess, if you could just provide some color on where you see the need for additional labor and stores given traffic expectations that look to be relatively flat.
I guess it is probably fair to say that there are no significant incremental labor initiatives that can be pulled out as those have, with the singular possible exception of what we are doing around delivering to the table, which we have been testing over a number years. We continue to test that in certain stores in certain markets, and dependent on where we go with that and how we think about that question, it could have some potential impact.
But, we are not announcing the rollout of that, and it’s something a test site might want to verbalize. I think it speaks to more of a philosophical perspective, which is we are very committed to taking costs out of everything else in the P&L. But ultimately think that we have to continue to put dollars into the quality of our people, the quality of our relationships, and the quality of the way the consumer experiences it if we are going to grow transactions. And so, I think that statement is less a warning that there is more labor investment coming and more a statement of philosophy.
Our next question is from Sharon Zackfia with William Blair.
Sharon Zackfia - William Blair
Hi, good morning. I guess when we walk into the stores on November 19th, can you explain more or what the change in your price structure and strategy is? I get the price increase per say but it sounds as if we are going to see something different in the way that price increase flows and maybe the look of the menu itself.
And I know you are talking about simplifying all of that for the consumer. Just can you help us visualize that?
Sure, Sharon. First, I think it will be November 15, as opposed to the 19th.
You will walk in and you will see the menu organized into very clear categories, moving from the central register, high up you will see a picture of our soup featured. From there it will move to our Signature and then Cafe sandwiches, our Signature and Cafe salads, and then our beverages that are reorganized.
In every case, we will be reorganizing within these categories such that we feature the highest penny profit items so that your eyes will be drawn to those things that will leave us the most money. You will see greater price discrimination on the menu. One of the things that our research has shown is that Panera has less price discrimination, that is to say variance from top to bottom than concepts like Subway.
Subway has things that are less expensive and things that are more expensive. You will see Panera continue to try that discrimination, again, trying to make it available for everyday use while also taking advantage of the opportunities to charge people prices for specialty products.
So you will see that. You will see a new menu panel that features are Be a Hero program. Be a Hero in the office or home that encourages you to take home bulk products, everything from soup in a group we call the quarter soup to bulk bagels, to bulk baked goods and the like.
You will certainly experience that. You will experience in our celebrations, which is another form of really menuing our communication, you are going to see us often speaking about putting products together again in a way that leads to higher penny profit. I think it gives you I hope some taste or feeling for some of what you will experience in this November 14 re-menuing.
Ariel Sharon - William Blair
And just a follow up, have you tested this kind of menu organization at all?
We are in test on it today. We spent about a month and a half to two months really doing some very serious research and analysis. A ton of analysis trying to make sure we understood where our penny profit was and where the money was made and where it wasn't.
Second, we introduced it in what we are calling a disaster test in a group of stores a week ago. We will announce where they are, but we introduced it there in a group of stores. Our simple purpose in that was to see what the first reactions were and to see if we got certainly any negative reaction. We don't know if any negative reaction to date such that would cause us to in any way abort the launch of this new menu.
And our next question from is from Jeffrey Bernstein with Lehman Brothers.
Jeffrey Bernstein - Lehman Brothers
Great, thank you. The question is actually for Ron. I know in your opening comments, you talked about the competitive landscape and you did not think any of the slowdown of late has been due to competition.
Just wondering perhaps from your own internal studies how you assess the impact of competition and you highlighted a very sensitive consumer, the potential for trade down, just looking at some of best casual and quick-service players that are performing a little bit better in this environment.
I’m just wondering, how you think of that competition and what makes you think that Panera is not a victim of such competition. Thanks.
I would start and say who are these competitors out there? There are many ways to cut competition, okay. And so I started to say, who are the format competitors at this point? You are talking to us about Cosi? I’ll let you make your own judgments.
Who are these competitors? We don't see at this moment any huge massing of competition. Getting to the question of those we share paradigm with, people we deeply respect, the folks at Chipolte and the people at Pei Wei.
Are they competition? Our perspective is in a very indirect way, yes, but really not. Let's take lunch, which is our primary business. Let's look at decision-making process. It is 11 O’ clock; you are sitting in your office. ‘Okay, we are not going out for a celebratory lunch. It is not a business lunch. What kind of food are we in the mood for?’ That’s the first question. And in my office it may be soup, salad, sandwich. It may be Greek. It may be Mexican. It may be Italian. Once you’ve answered that question, hopefully you will say soup, salad, sandwich as we do four out of the five days here in this office.
They then say who’s the best within our price parameters and our distance parameters and that’s a multidimensional decision that gets made all at once. Who is the best at that? And if you are in the mood for soup, salad and sandwich, we want Panera to come up on you short list as number one choice for soup, salad and sandwich that day. If you want Mexican, I think go to Chipotle or Qdoba - you figure it out; if you want Asian go to Pei Wei.
So, I think that they are not in that sense direct competition. I think going forward further, I think that beyond the national operators, there is a wide range of competitors. It is a highly fragmented industry, and it extends everybody from the upscale grocery stores, the Whole Foods of the world that are doing more and more takeout in sandwiches all the way through upgraded fast food. But I don't think we see anything directly in any specific market, which is usually where you will see it first.
I think that probably Panera is now in size and a national footprint such that broad consumer currents probably have more effect on it than does any individual format or regional competitor. And that is pretty well the way we suggest and think about it. Hope that is helpful.
And our next question is from John Glass with CIBC.
John Glass - CIBC
Hi, thanks. Listening to the call, the first half was focused on the margin initiatives and particularly focused on sandwiches as well as other things and second half cited higher wheat costs.
And so, I wonder at what level you are swapping one margin crisis for another; in other words with a run-up in wheat is there a point in which sandwiches actually become less profitable to sell than salads or is that not an issue.
And maybe as a broader part of that question, what kind of flexibility are you building into your menu such that if you run into commodity spikes, etcetera, that you are able to switch celebrations rather quickly in order to help that margin initiative along?
We’re thinking about pricing. It’s a great question, John. And I am not sure I agree with you that it is about margin and then wheat, but it is a great question in terms of how we think.
And let me give you an example. I think we are increasingly trying to say if we are rolling out a specialty salad and our penny profit goal and our target for penny profit in the competitive set of products that it would cannibalize the group of products, other entrees you might choose, soup, salad or sandwich.
Let's say the marker for that was leaving us $5 in penny profit and the food costs on that was $2 and we would price that at $6.99. What we are trying to say is as we bring out new products and as things get introduced and adjusted around the menu, I think you can expect us to price products to protect their penny profit.
And so I would suggest to you that if wheat prices drive up sandwiches in such a dramatic way, and I would argue it is only about 10% of the cost of the sandwich. But As extremely difficult as it would to be to have a dramatic change driven, but if it would, then we would adjust it through the pricing and I think as much as anything we are attempting to do is to protect our margins through pricing, drive our penny price profit through pricing and menu structure all the while holding growing transactions.
And that's the core of what we are really trying to say to you as we think about this.
Next question is from David Tarantino with Robert W. Baird.
David Tarantino - Robert W. Baird
Just a follow-up question on margins. It looks like for '08, at least on the low end your guidance, you are assuming some either flat or slightly down margins even though you are taking a number of steps to reverse the negative trends you have seen in '07. So I understand the pressure from wheat, but could you provide some additional color on why you wouldn't expect any margin rebound from the low levels you are seeing this year?
I think, David, you just need to look at our comp range, and at the low end of our comps we would see deleverage against all the fixed components in our P&L.
I mean, simply put, David, our comp guidance is 1% to 4%; 2.5% price right down the middle. So, it essentially assumes 2.5% price, and flat transactions right down the middle. If it ended up in the very low end of that range and we don't know what kind of consumer headwinds we are going into. If it does, then you are going to have deleveraging offset certainly by the penny profit increases.
I think we have a range here you could drive a truck through purposely, because it speaks to the level of uncertainty and the number of moving pieces that are occurring here. And I think that that's how we think about it and that's how you should read it.
And you know we are very conscious about delivering and getting out of a posture of under delivering. And we want to be clear of what we are doing, the activities that are in place, our beliefs that many of these will have a very positive impact.
But we want to be cautious about declaring for you what, when and where, particularly in the context of whatever environmental and inflationary pressures exist.
David Tarantino - Robert W. Baird
Okay, if I could ask a follow-up. The prior question about Q4 guidance, you said you assumed that you weren't expecting a huge benefit from some of the category management initiatives in Q4. What have you assumed for '08? Have you taken a similar conservative approach in your guidance there?
Sure, the low ends of our comp range, absolutely. I mean the biggest swing is where comps come out. We have a comp range of 1% to 4%. And you can pretty well track it, the earnings guidance within that range. If the comps are at the high range you will have earnings at the higher range. If you have comps at the low end, 1%, you will have the potential of de-leveraging.
Again, I think we are trying to give you relative to both fourth quarter and next year is the same thing that every one of us understands in our gut. That there is a lot of moving forces out there, and we want to be as direct and honest with you and interested in the fact that they exist, and there is a range of outcomes that can occur here.
And our next question is from Jason West with Deutsche Bank.
Jason West - Deutsche Bank
Just wanted to follow up on the decision on the pricing. Can you just talk a bit about why you decided to wait until November 14th. You know it's been margin pressures for a few quarters now. I want to get your thinking around that.
Going forward, it sounds like you can move more quickly. Just wondering if it is related to the complexities of changing out the menu boards or sort of why this price increase was held off for so long.
That is a great question. Actually I think we really began focusing on it 10, 12 weeks ago, this summer. As we started to look under the hood and see what was going on. Again remember, we had shifted—it’s very important why I went to the history--we shifted from a focus on growing transactions, when transactions were negative going into the summer, and then we’re really shifted to a focus on penny profit when we realized we had gotten the transactions but not the penny profit growth we wanted.
So the focus began this summer. We conducted some research. We are very sensitive to something, which is not to react and then create another problem. And we often see that happening in our business. And we didn't. As we had come out of the transaction growth, we were very cautious about causing now negative transactions again and we don't want to be sitting here in three or six months as a whole bunch of people are telling you, that they are experiencing negative transactions.
We think that is a much bigger issue. And so in the context of that we spent the eight weeks to conduct the research. We spent the time to really understand where we were making our money, what were the penny profits, including all the manufacturing and the whole deal and really to come out with a position.
Having done that, and really communicated that with some of our community, the rest will be communicated over the next two weeks, and for us now 1200-plus Cafes, we don't move like the PT boat, we move more like a battle ship. And the reality is it does take us 8 to 10 weeks to actually execute a price change.
John Glass asked a question. I knew I missed something. He asked can you change the celebration? You know we can change the celebration probably on 8 to 12 weeks of notice; 8 weeks is about the shortest limit. But there is another price for them all the time, which is in the 1200 cafe system with 50,000 people and the needs to communicate with them to make sure they are clear. They just can't do it on a dime. So things take time.
And I think that we don't want to turn this organization upside down into a reactive machine to disrupt the organization. We want to do things in a logical, sensible way based on a clear understanding of research and operating in a controlled and disciplined fashion and be responsible to the thousands of people that run these Cafes and the franchise partners that we have.
And our next question is from Ashley Woodruff with Friedman, Billings and Ramsey.
Ashley Woodruff - Friedman, Billings and Ramsey
A question on the fresh dough facilities. Being able to leverage those is one of the things that I think historically has given Panera above-average margins. And clearly you can do some things with what you are promoting, but if the customer keeps going away from those products that are produced in the facility, you are likely to keep seeing that pressure.
Is there an opportunity to move more items through the manufacturing facilities like the sweet goods or maybe figure out how to make them more efficient or service more stores in order to mitigate that margin pressure long term?
It is possible there may be opportunities there. And as you can well imagine, it is not a thought that has escaped our notice. And so, just as we do with our own manufacturing operations, we look at the contract manufacturing, we look for opportunities to improve efficiencies there since we benefit from that. We ask the question, are we making the right things in the right places in the right ways? And we certainly increased the intensity of our focus on the entirety of the supply chain and manufacturing and are looking for ways to get back to the margins that we have enjoyed there in the past.
Having said that, I think it is important to realize that the consumer shift here is not some secular change in our customers’ preferences. This is not people deciding that they don't want to eat certain kind of foods, they want to eat other kinds of food. Because this completely opaque to them, where the dough is made. So, some of the shift back is going to happen naturally, not by forcing things down customers' throats, but by, we offer this terrific egg soufflé, which uses a dough piece that is manufactured by a contract manufacturer.
On the heels of that we are feeling very good about the breakfast sandwich, which uses our ciabatta bread, which we make in our own facilities. We have some of the initiatives that Ron talked about particularly bulk purchase of bagels and some of the resizing and re-merchandising and emphasis of bread. And we think that will naturally help us shift some of the sales back or add some sales back to the FDF operations.
And Ashley, if I can add something to it, I think you noted something which is very correct. Panera has benefited from leveraging its supply chain over the past couple of years. This year, we absolutely got deleveraged.
It really hurt us. It is the one thing that is the reality of our business model and brings some uncertainty to it. You had wheat up 75% at the same time you had some shifts away from our own self-manufactured product.
Having said that, we will and we are catching up on our transfer prices. It takes us some time to do that given our contracts. We will be able to essentially reflect the prices in our transfer prices, and we will take advantage of the natural leverage that exists in our supply chain, as we march forward.
And potentially that open an opportunity for shall I say a hint of releverage as we come out the back side and that’s our expectation and you can be assured, we are looking at everything there is to gain that that new leveraging, understanding that again a significant moving business that you don't change on a dime.
And our next question is from Fitzhugh Taylor with Banc of America securities.
Fitzhugh Taylor - Banc of America
I was just curious as you look back on Crispani. What was different about that you saw there in the test phase that changed in the rollout and usage phase? And we’re talking a lot about testing and stuff that you’re doing now. I am curious was the test flawed? Or did it just act differently out in public than it did early testing?
That is a great question. Thanks for asking it. I think that there are several levels of testing that we do; the first level of test something what we call preference for the item, intent to purchase.
I think those who have had Crispani, generally you had great experience with it. Our consumers certainly did. We had very, very high intents to purchase. People, who enjoy it, love the product, very, very high and sort of the non-economic testing.
We then ran it for about six or nine months, maybe a year actually, but we ran it with different configurations and marketing support because we were trying to figure out how best to, how most efficiently, that is to say, how to spend money to get people to experience it.
Because we clearly understood that Crispani as I think told you and said to ourselves was a huge and difficult thing. We were going to attempt to build another day part by bringing in families, and they were not necessarily our direct target customer, and we had to have the marketing muscle to reach them and get trial of them.
Now what we have our models that say that as we roll things out, and they get customer acceptance, they build. And we have models, going back to bagels, for example, where over years the volumes on them tripled from where they were after the first roll out of it.
So we made a decision based on a year’s playing with it, mostly around how you build consumer trial of it that was the testing. We made the model, we made the decision to roll it out on an assumption that over three years volumes would build based on the preferencing and the experience we have had with products traditionally building post celebration, post consumer trial. We have clearly not seen that.
And if anything Crispani is probably at this point certainly significantly less than what we would have expected. It’s probably negatively profitable and it’s probably not producing anything incremental.
So that the question for us is really to address and figure out can we boost the sales to cover the fixed cost and without going into details, you can imagine there is tremendous intensity around that, there are three or four different tests around that.
And with a clear mandate that either we are building the sales on it and we can feel the sense of confidence that it will cover the fixed costs in place for it or we’re going to pull it.
And our final question is from Bryan Elliott with Raymond James.
Bryan Elliott - Raymond James
Already been asked. Thanks.
With that, we thank you for listening to us and hanging in here as we tried to explain to you where we are coming from, where we are going, and as ever, Neal, I and Jeff are available in anyway to be helpful for you. Thank you and good morning.
This concludes today's conference call. We thank you for your participation. Have a wonderful day.
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