Panera Bread Q3 2007 Earnings Call Transcript

| About: Panera Bread (PNRA)

Panera Bread Co. (NASDAQ:PNRA)

Q3 2007 Earnings Call

October 24, 2007 8:30 am ET


Jeffrey Kip - Chief Financial Officer and Senior VicePresident

Ronald Shaich - Chairmanand Chief Executive Officer

Neal Yanofsky - President


Rachael Rothman - MerrillLynch

Robert Derrington -Morgan Keegan

Chris O'Cull - SunTrust

Joe Buckley - BearStearns

Steven Reese - JPMorgan

Sharon Zackfia - WilliamBlair

Jeffrey Bernstein -Lehman Brothers

John Glass - CIBC

David Tarantino - RobertW. Baird

Jason West - DeutscheBank

Ashley Woodruff -Friedman, billings and Ramsey

Fitzhugh Taylor - Banc ofAmerica


Welcome to today's Panera Bread Company ThirdQuarter 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. Goodmorning, everyone, welcome to Panera Bread’s third quarter fiscal 2007 earningscall. Let me cover a few regulatory matters. I’d like to note that during ouropening remarks and then our responses to your questions, certain items may bediscussed which are not based on historical fact. Any such items includingtargeted 2007 results should be considered forward-looking statements withinthe meaning of the Private Securities and Litigation Reform Act of 1995. Allsuch forward-looking statements are subject to risks and uncertainties thatcould cause actual results to differ materially.

I'll begin our call byreviewing the third quarter results and key metrics. Ron will then discuss theissues the company faces and our plans going forward. He will also give somebroader perspective about how we feel the company has progressed. Neal willthen conclude with our views on the fourth quarter and our initial view on2008.

With that, let's get intothe third quarter 2007 financial results. Consistent with the first and secondquarter, these results are consolidated and include the operations of ParadiseBakery Cafe.

Last night, we issued ourthird-quarter 2007 earnings release for the 13 weeks ending September 25th. Ournet income for the third quarter was $11.9 million and EPS was $0.37 per diluteshare versus a net income of $10.9 million and EPS of $0.34 per diluted sharein 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 rateof 27.8%. The $0.37 EPS and tax rate of 27.8% is directly comparable and basedon the same tax assumptions as found in our original and revised EPS guidance.

To be clear our tax ratetarget has been consistent in each guidance we’ve issued this year. Theprinciple 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 tohigher food cost salads, and secondly away from bread and bagel self-manufacturedin our fresh dough facilities.

Two, product ingredientand input prices outpacing product increase of approximately 0.6%. And three,increased labor cost from first the investment of labor in the lunch day partto improve ease of use in the form of the Expeditor, and second normal wageincreases of about 3% versus our existing price increase.

Let me now review our keymetrics for the third quarter. Our system-wide comparable Bakery Cafe salesincreased 2.6% in the quarter, with 3.4% company-owned locations and 2.1% compsin franchise-operated locations.

Our system-wide averageweekly 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 forfranchise operated Bakery Cafes.

We opened 35 Bakery Cafesin the third quarter, 19 of which were company owned and 16 of which werefranchise operated, and we closed two Bakery Cafes in the quarter, one companyowned an one franchise operated. In addition our Bakery Cafes were open a totalof 14,931 operating weeks in the quarter.

Now I would like to moveon to the key-line items of the third quarter versus the comparable period ayear 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.

Thebreakdown is as follows. Net Bakery Cafe sales increased 40.6% to $232.2million in 2007 from $165.1 million in 2006, driven primarily by sales from unitsopen in the last four quarters and in part by acquisitions over the sameperiod.

Franchise royalties andfees increased 7.9% to $16.3 million in the third quarter of 2007 from the samequarter in the prior year driven by new franchise operated Bakery-Cafes openedin the trailing four quarters, partially tempered by the acquisition offranchise operated Bakery-Cafes by the company.

Fresh dough sales tofranchisees remain consistent at $24.7 million in both 2007 and 2006. Thosesales to franchisees have not grown in pace with franchisee-operated salesbecause of a shift in Bakery-Cafe mix previously noted away from the bread andbagels we self-manufacture in our fresh dough facilities.

As a result of thesedifferential growth rates, we continue to experience a shift in total revenuemix as Bakery-Cafe sales as a percent of total revenues increased to 85% in thethird 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 salesto franchisees declined to 9.0% from 12.1%. The shift in revenue also resultedin part from the increased number of new company-owned Bakery-Cafes as apercentage of all new Bakery-Cafes open.

Moving on to marginanalysis. Restaurant margins were lower by approximately 260 basis points inthe third quarter of 2007 versus the same quarter in 2006. Let's go throughthis Bakery-Cafe expense by component now. First, cost of food and paperproducts increased by 200 basis points year-over-year. Approximately half theincrease is driven by margin de-leverage, given ingredient cost pressuresversus and year-over-year price increase of approximately 0.6%.

The other half of theyear-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 weself-manufacture and additionally our customers purchase more salads with ahigher natural food cost and fewer lower food cost soups and sandwiches,increasing the cost of food and paper products. We saw the trend stabilize inperiod nine and as we seasonally would have expected. Although it’s importantto note to weather this fall has slowed our shift into soups.

Labor as a percentage ofrestaurant sales rose 90 basis points in the third quarter versus thecomparable quarter in the prior year. Approximately half of this increase as aresult of the year-over-year addition of the Expeditor position at lunch todrive ease of use for our customers. Our bias will continue to be towardinvesting labor in the Bakery-Cafes to improve the customer experience.

The other half of theincrease is driven by our normal approximately 3% wage increase outpacing our0.6% price increase, and this factor’s partially offset by improved labormanagement versus the prior year.

Occupancy costs in thethird quarter increased 60 points versus the prior year to 8.0% of restaurantsales based upon somewhat higher average per square foot costs in immaturestores outpacing the growth-of-sales during the third quarter of 2007 ascompared to 2006.

Other operating expensesin the third quarter fell 90 basis points versus the prior year to 14.0% from14.9% of restaurant sales. Approximately 75 basis points of the decreaserelates to higher advertising costs incurred in the prior year connected withthe Crispani rollout. With significantly higher openings expected in the fourthquarter this year versus last year, we expect to leverage on this line toreverse in the fourth quarter.

Moving on from restaurantmargins, fresh dough cost of sales to franchisees as a percent of fresh doughsales to franchisees improved 60 basis points over the prior year. The improvementwas driven by the continued growth of the income we earned on the sales ofcontract manufactured baked goods, such as soufflés, scones and cookies to ourfranchisees versus prior year, which offsets the de-leverage from costincreases versus flat sales in our FDF system.

Depreciation costs in thethird quarter remained consistent at 5.5% of total revenues in both thirdquarters of 2007 and 2006. General and administrative expense as a percent oftotal revenues improved 140 basis points over the prior year in large part fromthe presence in the prior year of 40 basis points of one-time legal expensesand 50 basis points from the national brand component of the Crispani roll.

Pre-opening expenses inboth the third quarters of 2007 and 2006 remain consistent at 0.7% of totalrevenues. Now let's turn our attention to other income which declined by 30basis points to 0.1% of total revenue in the third quarter 2007. The reason forthis decline was lower interest income driven by lower cash balances in thethird quarter than in the prior year.

Let me conclude with afew other items we traditionally disclose on our earnings call.

As I noted previously theeffective tax rate for the quarter was 27.8%. Included in this tax rate is thebenefit of $1.5 million or 9% of the rate reflecting the favorable resolutionof a tax matter we previously reserved for under FIN 48.

We expect the tax ratefor the fourth quarter to be approximately 37% and for fiscal 2007 to beapproximately 34.2%. We currently expect the 2008 tax rate to be approximately37.2%. There are approximately 32.2 million fully diluted shares outstandingincluding the impact of 2.1 million stock options outstanding with an averageexercise price of $36.48.

The company finished thequarter with $17 million in cash and zero debt on its balance sheet versus $72million in cash and investments and zero debt at the end of the comparableperiod in 2006.

In the quarter, thecompany generated $27.5 million in cash from operations and employee stockoption exercises and had capital expenditures of $32.9 million.

Let me now turn it overto Ron.

Ronald Shaich

Great, thank you, Jeff. Asmany of you know our team has spent the last few months talking to investorsabout Panera. It is our sense that the real question investors want to determineis, ‘where is Panera in its life cycle as a growing company?’

People have been tryingto determine whether Panera is a former growth company with only a modestfuture ahead or if the industry-leading concept experiencing short-term marginpressure and one which can be expected to return to strong and stable earningsexpansion. Essentially, the question is, ‘is the weakness experienced in 2007going to be repeated in future years, or is 2007 an anomaly?’

In order to helpinvestors answer that question, I think it is helpful to understand what hashappened with our business over the last year and a half, and while we find ourmargins weaker today than in 2006. But first, let me tell you, what isn'timpacting Panera.

It is not the concept. Itis not any weakness on our appeal to the customer. And it is not competitiveencroachment. We know the strength of our concept given our continuedindustry-leading customer satisfaction ratings, our high and consistent unitvalues, and our strong Bakery-Cafe return on investment.

So what has been going onand how did we get in this situation? In other words, what is management beenfocused on? And how do we end off with market contraction? Let me start by statingthat it has been our long-term objective to attempt to increase our competitiveposition and industry-leading cafe volume substantially, while operating in anever more complex environment with incredible cross winds - and by that I meaninflationary pressures and a very sensitive consumer.

To understand this betterlet me take you back to Q1 2006. At that time we were running 15% two-yearcomps and we were feeling quite expansive. In fact in early 2006, we justcompleted an internal exercise exploring the question of how to take ourindustry-leading volumes from $2 million to significantly more than that.

Throughout 2005, we hadbeen testing a pita-like product called Crispani, which we believed had thepotential fuel or our next negative growth. In 2005, our market test withCrispani produced strongly positive consumer reactions but modest sales. As welooked forward into 2007 and beyond, we believed Crispani had the potential toperform as so many products at Panera have before it with strong organic growthbuilt over several years. Our experience told us product quality drovelong-term growth and expansion in sales.

In May of 2006, we madethe decision to rollout Crispani, and in the fall of 2006, we did so. In Q4 of2006, we focused on that rollout and we focused on introducing Crispani tocustomers. As Q1 of 2007 rolled around, we began to see something we had notanticipated.

Crispani was deliveringsales as we expected, but more significantly to our surprise all income in Q42006 and Q1 2007 were much weaker than we thought they would be. Yes, gasprices were up, weather was bad, and the consumer was weak.

But nonetheless, thecomps in Q4 2006 and comps in Q1 2007 were much weaker than one could expectwith the addition of Crispani. As we looked deeper and deep near the comps, webegan 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 verydisturbing. This was the first time in the recent history of our company thatwe've seen transactions fall off. In response to this problem, we prepared thestrongest transaction-building sales initiative we have ever mounted for thesummer of 2007.

In Q2 and early Q3 2007,that salad initiative was rolled out and proved to be a success beyond ourexpectation. In fact, it drove our lunch transactions strongly positive onceagain. But to our surprise, despite the growth in transactions, our retail in FDFprofitability 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 margincompression, we realized that there were four main issues that were drivingdown summer margins. Let me explain the first cause of margin degradation.

Yes, transactions wereup, average check was up and comps were up. As we looked deeper, we discoveredpenny profit per transaction--that is to say what is left over after the foodcosts is subtracted from sales--was down year-over-year.

In fact, in our desire toprotect transaction growth, we successfully driven salads, but cannibalized ourbiggest 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 foodcost is subtracted and those dollars are available to cover inflation and laborand other costs was flat. The result: margin degradation.

So why did we let thishappen? Quite frankly, we focused on the wrong metric. We should have beenfocusing on growth in total penny profit dollars, which is the product ofgrowth in transactions and year-over-year growth in penny profit pertransaction.

Instead, we were focusingin on comps, which is the product of year-over-year growth in transactions andyear-over-year growth in average check. We certainly learned a lesson. The cashthe consumer brings in the door is not the same as the cash they leave behindafter we pay for the cost of the food they purchase.

The second thing wediscovered as we looked under the hood to understand our weakened margin in summer2007 was our FDF profits were off significantly. This showed up in increasedfood cost on the P&L. Significant increases in commodity cost and a shiftby the consumer away from the products manufactured in the FDF de-leveraged ourfacilities and our P&L.

Third, Crispani, with itslarge fixed labor component was not helping us. Fourth, the largeryear-over-year mix of relatively younger stores, as a percentage of our totalstore base was negatively impacting our margins.

So, the question inrecent months at Panera has been, how do we react to this situation? How do werebuild our margins while growing transactions? And how do we once again regainyour confidence?

Here is what we are doingto improve our business, to grow our margins while growing our transactions andto regain your confidence.

First, on November 14, wewill be taking a 2.5% price increase across our menu. This includes, anapproximately 5% increase on our baked goods. The intent of our price increaseis not just to drive the average check and offset the margin pressure, but alsoto a) drive transaction growth by making the menu easier to use; b) broaden ourpricing spread to protect everyday use by more price-sensitive targetconsumers. We want to do this while offering options for customers willing tospend more and leave more in profit.c) we want to stir people toward choosingitems that drive more penny profit per transaction like, You Pick Two at lunchand higher penny profit specialty itemsl and d) we want to cover theinflationary pressures we experience.

Let me further add, weare committed to protecting our margins in these inflationary times. And as aresult, we are now planning to review our pricing every quarter in 2008.Second, as part of our plan, we introduced a category management function tohelp us strengthen our margins. This team exists to help us increase pennyprofit per transaction.

Already, the team hasbeen instrumental in helping us reorganize product placement of the new menupanels rolling out November 14. By doing so, we expect greater ease of use forour customers and we expect to be able to encourage purchases, which lead to ahigher penny profit per transaction.

Additionally, our newmenu panel labeled Be a Hero encourages consumers to take Panera back to theoffice or home via home purchases.

Finally, our categorymanagement team is working with our food development team to strengthen boththe transaction building and penny profit-building impact of upcomingcelebrations.

Together, our categorymanagement team and our food development team are increasingly focused on doingfewer products that are more differentiated in the marketplace and awardinghigher penny profit per transaction, while simplifying procedures for others.

Third, as part of ourplan, 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 andwe are concerned. Our view of Crispani is it cannot stay as it is. You shouldknow that we have a number of tests in place to determine our ability tostrengthen our sales of Crispani and to take advantage of the fixed costs thatare in place. Simply put, the answer on Crispani is either more sales or wepull the program.

Fourth, a lot of energyis focused on locking in 2008 purchasing. This includes soup, distribution,dairy and wheat.

Fifth, as part of ourplan, we’re taking a number of actions to impact our FDF margins. These havebeen hurt significantly. We will execute an FDF price increase of approximately5% which, given our contractual agreements with our franchisees, will be inplace, December 26.

We will also continue tointroduce new bakery products that appeal to customers and bring down ourcosts. We recently introduce new focaccia and ciabatta breads that arenaturally lower in fat, higher in fiber and have no trans fat or cholesteroland they are delicious.

The breads are a greatexample 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 Bread2.0 program.

Sixth, as part of ourplan, we are focusing on rebuilding margins and we are focused on doing sowhile continuing to grow transaction. This is very important to understand. Ourplan includes building both margins and transaction growth.

Our medium-term “circleof warmth” goals, as we call them, revolve around eliciting feelings of lust,trust, relationship, and ease of use from our customers. As a result, ouroperatives continue to focus on speed, accuracy and on improved customerexperience.

We evaluate ourperformance monthly to understand our success in improving our speed, accuracyand customer service; all three metrics have improved this year. We believethis translates into transaction growth in the future and we know it is a keyto differentiation.

Just as importantly,Panera continues to have a number of other initiatives in place to buildtransactions. We’ve introduced a new line of delicious artisan pastries. Andjust as we always have, you will of course see us continue with our traditionalrotations of new sandwiches, salads, paninis and soup throughout the year. We are also deep intest 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 arefocused on fewer, better products and upcoming in-cafe celebrations, you’ll seeus celebrating favorites already on the menu and bringing back some oldfavorites. You’ll see more add on and more bulk alternatives.

There is one last elementof our plan to boost margins I would like to cover with you today. We made adecision recently to tighten up our real estate decision-making process. Wethink the company is better served with fewer stores in immature trade areas orGreenfield locations. Simply put, we believe it isunnecessary to open stores of this sort at a time of margin pressure. Movingforward, it is our intention to knock out these potential locations that ourmodel indicates will be at the low end of our ROI goal in the short-term, and/orhave a long maturation cycle.

Many of you willcertainly ask, ‘what can you expect from these initiatives and when will theyhave a meaningful impact?’ To be truthful, we don't know. What we do know is there’smuch optimism in the organization and many good things happening that we expectwill make a real difference.

And we know that theunderlying strength of Panera remains robust, but we also understand it’s ourresponsibility to deliver improved margins and transactions and deliver theearning growth that you’ve grown to expect from this team. Know this. Though weare very cautious after a year of under-delivery, we feel positive our teamwill get the job done.

Neal Yanofsky

Thanks, Ron. Let's startwith our expectations for the fourth quarter and then look beyond the end ofthe year toward our targets for fiscal 2008. We are currently targetingfourth-quarter fully diluted earnings per share of $0.53 to $0.59. This targetis based on our projected performance on our key metrics, which are as follows.

Comp store sales increaseof 1% to 3.5%, 60 to 65 new Cafe openings with 21 to 24 of those franchise and39 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 driverof our short-term results is our comp performance, and we are indicating afairly broad range for the quarter. Comps are always difficult to foresee, andmore so now as we implement a price change in the middle of the quarter.

In addition, the November14th pricing move is more than a price increase, although it is a priceincrease. It is also a change in our pricing structure and strategy, aimed inpart and improving our penny profit per transaction.

So, although we aretargeting a comp range for the quarter as we always do, we will be more closelywatching the effect of our various initiatives on the penny profit pertransaction. Having said this, I can report our initial read on comps for period10, which has just ended.

We expect period comps of0.3% to 0.6%. Now, this is below the range we have set of the quarter as awhole. Why then do we believe our comp performance will improve in periods 11and 12? Do we simply think that cold weather, if it ever arrives, will help ussell more soup?

Well, it should, but morenotably in period 10 we were running over the second month in which we hadsubstantial marketing support of Crispani in 2006. In periods 11 and 12 last year, comps relaxed byabout 175 basis points. So we expect to strengthen against that easiercomparison in the latter part of this quarter. In addition, we will have ourprice increase in place and company Cafes for about half of period 11 and allof period 12, which would help support comps.

On the key metric ofdevelopment, 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 costsassociated with these Cafes, which will each average only about five weeks ofoperation in the quarter, will create some short-term drag on our earnings forthe quarter.

We also intend tocontinue to invest in labor that supports the quality of our customerexperience and therefore, supports transactions growth. And while we have anumber of margin-oriented initiatives in the works, these will just startrolling during the quarter and so, will not have a material short-term impacton earnings.

So let's now turn ourattention 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. AndCafe operating weeks of $68,000 to $68,500. These lead to an EPS target growthrate for fiscal 2008 of 10% to 20%. This is the broader range than usual forus, and it reflects the current uncertainty there is on several key variables.

First, there is thegeneral economic environment and consumer confidence. You don't need me torepeat the litany of ills we all read about daily in the paper: housing valuesdown; gas prices up; consumer confidence waning.

With more and moreeconomists beginning to invoke the "R" word, recession, we feel it isappropriate to approach 2008 with a healthy awareness of the potential for ourtransactions, our average check or both to be dampened by further deteriorationin the broad economic environment.

These are certainly nottypical economic times for many of our customers. On the other hand this is notthe first soft economy in which we have operated. And we have not found ourbusiness to be hypersensitive to economic downturns.

The second externalfactor is the severe increase in the cost of wheat. Earlier this year, wheatcrossed above $5 for only the third time in the past 30 years. But what sixmonths 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 committedforward for 2008 in our flour purchases. So, this commodity remains apotential source of earnings volatility for next year. Here is how the price ofwheat flows into our cost. We expect to use approximately 140 million pounds offlour 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 changein our cost. Wheat futures for 2008 now average about $7.70. And our 2008 targetassumes 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 ofmore $8 million hit to earnings or $16 per share. We think we’ll be able tooffset much but not all of this potential impact through further priceincreases beyond those planned for November.

So, our target for 2008assumes a net $2.5 million hit for increased wheat prices. If wheat prices arebelow our targeted cost of $7.70, we’ll take less price. If they are higher wewill strive for a greater increase in order to keep the earnings impact to $.05per share.

Now, when we cannotcontrol the price of wheat, we can respond to it intelligently. So, ourpurchasing team continues to carefully monitor the market. We take someencouragement from the fact that wheat futures for late 2008 are now lower inprice than for early in the year reflecting the market's belief that the priceswill ease.

In an atypical year forwheat prices, we have an atypical approach to our purchasing commitment. Forthe time being, we are remaining open on 2008 rather than locking in for theyear at what may well prove to be a higher than average price. And we will, ofcourse, attempt to recover as much as of any additional commodity cost aspossible through price increases.

Ron detailed for you ourapproach to pricing strategy and successful effort to build transactionsyear-over-year. We worked hard to test and implement the pricing structure thatis strategic and not merely tactical and believe this change will serve us wellin 2008.

As we approach theimplementation of this price increase and as we head further into thisdifficult consumer environment, it is too soon to know if we will be able tocontinue record of building transaction while we work to cover our costincreases 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, wefeel that it will hold significant promise for improving our margins and Cafe-levelprofitability.

Having outlined some ofthe potential challenges in 2008 and our planned responses, I would like totake a moment to mention one initiative, which is a microcosm of our approachto the business.

As you may know, we havebeen testing a breakfast sandwich recently. This product began, as do all ofour products, with a straightforward yet challenging objective: to create adifferentiated product that customers love; that fits with and enforces ourconcept; and drives favorable economics for our Cafes.

Yes, there are a lot ofbaked sandwiches out there but not like ours. We crack fresh eggs in the Cafe andadd other terrific ingredients like Vermont white cheddar cheese, Niman Ranch sausage and ApplewoodSmoked Bacon and then we serve it on our freshly baked ciabatta bread. Ourtaste tests has proven that customers love our breakfast sandwiches and ourmarket tests have shown customers are voting at the registers with meaningfulsales most of which are incremental. The sandwiches sell for about $3 to $3.50leaving us a higher penny profit than any other breakfast item including oursuccessful egg soufflés.

So, we think we are on tosomething that matters to our customers, adds Cafe volume and increases boththe transactions and penny profit for transaction and supports ourmanufacturing operation through incremental bread sales.

We do make mistakes fromtime to time, but we learn from them. So, I am not going to tell you that thestory of 2008 will be written by the success of the breakfast sandwiches. It istoo early yet to commit to a sales forecast or even an introduction date. Althoughif you were interested in seeing the product, you can find it in test in ourhome market of St. Louis. But Imention this initiative as the kind of work we are continuing to do to achievethe triple goals of advancing our competitive position, addressing the needs ofour customers, and improving our Cafe-level economics.

We’ve a wonderful phrasein our cultural values, when we speak about approaching our work with optimismand mastery. We are fortunate to be able to build on the foundation of anextremely strong concept that continues to resonate with customers and to earnand deserve their loyalty.

We have a thoughtful andthorough plan already in progress to improve our margins. And we haveencouraging and very early results. And so, despite an uncertain environment,we do indeed feel optimistic as we look to 2008.

Now, before turning thecall over to your questions, I would like to inform you of a small change toour reporting process that I think you will welcome. Many of our friends in theinvestment community--in fact many of you on this call--have observed that weare essentially alone in our industry group in reporting comp sales at the endof each period.

Some of you have notedthat these very short-term, very volatile figures create unnecessary noise anddo not help in forming a balanced view of the company. We agree. We believethat it is time to join our peers, who generally do not publish monthly salesreleases as we do.

Accordingly, beginning infiscal 2008, we will no longer publish a monthly report of our comp storesales. We will instead share this information at the end of each quarter. To bespecific, our quarterly earnings releases will also include comp store sales byperiods broken up by company, franchise and total system.

This change will takeeffect at the beginning of 2008. So, period 12 of 2007 will mark the end of ourreal time monthly comp reporting. Beginning with the first quarter of 2008, wewill report comps for all three periods of the quarter along with our quarterlyearnings report.

We are committed toproviding transparency to our investors through meaningful reporting of the keymetrics of the business, in addition to the core financial report. As such, wehave thought long and hard before making this change to the frequency of oursales reporting.

We are doing so now,because we believe that the revised schedule will shed just as much light onour performance, while perhaps generating a bit less heat.


Before we go to yourquestions, as Neal mentioned, we do occasionally make mistakes and a couple ofquick corrections for the transcript.

One is, when we cited ourmetrics for the fourth quarter, we gave a metric of average weekly sales fornew openings of $39,700 to $40,700. That is not the metric we used, wemisstated. That is, average weekly sales for every single unit in the system of$39,700 to $40,700.

Quickly, a smallmisspeak, a dollar of wheat impact for us next year will be $0.16 of earningsper share rather than $16. So, just to get the transcript right, I will take alittle career risk and correct my boss.

So, at this time, we areopen to take your questions. As is our custom, we request that you ask only onequestion at a time in order to give as many of those on the call as possible anopportunity to weigh in.

If you have additionalquestions, please return to the queue. We are happy to stay on the line withyou until all the questions have been asked or until the market opens at 9:30.Operator, we are ready for the first question.

Question-and-Answer Session


(Operator Instructions)And our first question is from Rachael Rothman with Merrill Lynch.

Rachael Rothman - Merrill Lynch

2008, does that includethe impact of a 53rd week? And if it does, can you quantify for us how much youwould expect that to boost the top line and the bottom line?

Ronald Shaich

Fundamentally, Rachael,it does. You should know, we are giving a very wide range. Neal commented onthe uncertainty and to a certain extent, we have very round divisible by 10numbers there and it is a nice help, and we do have 53 weeks.


Our next question is fromRobert Derrington with Morgan Keegan.

Robert Derrington - Morgan Keegan

Ron or Neal, I am notsure, who best to pose this question to. Looking at the development, could yougive us some clarification, some color on the franchise development piece?

It looks like in thefourth quarter it will be less than what you had provided guidance on yoursecond quarter call for. And, I’m just trying to understand, what’s going onthere? Is it a similar situation with Greenfield locations? Or what color canyou add?

Ronald Shaich

There is no significantcutback 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 thatwe can't get control of over that are often promised to us in September andOctober. They announced over the summer and into the fall that, in fact, theyare not going to be able to hand them over until November, December, in whichcase, we push them into the next year.

My guess is, if you goback in the transcripts, not just to the second quarter, but into each of thelast of the prior years, you have seen a similar kind of situation. We try tobuild that in, but we take our franchisee what they tell us in terms of theiropenings and report it back to you.

So, I wouldn't make toomuch of it one way or the other.


Our next question is fromChris O'Cull with SunTrust.

Chris O'Cull - SunTrust

My question is regarding theguidance for the fourth quarter. When you look at the operating margin declineyou saw in the third and even adjust for some of the marketing expenditures withCrispani, as well as the legal costs. It seems that, you are expecting thefourth to continue to fall maybe even at a greater rate. Especially in light ofthe menu initiatives that you are working on in the fourth; is this beingconservative or can you give us some color as to why?


Chris, I think what I’dsay is we’re not expecting things to fall more rapidly. You know, I don't haveyour numbers right in front of me and I don't really know what you are lookingat. I think, Neal commented that we all have a lot of things in play and wedon't believe they are all going to pop just right in the fourth quarter. Wethink 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 thefourth-quarter guidance, are you assuming any benefit from promoting the YouPick Two combo in the fourth in your guidance?

Jeffrey Kip

We assume modest seasonalimprovement, 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.

Ronald Shaich

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 wesee out there and I think more importantly than anything else what we’re tryingto indicate to you is what we’re doing. To try to guess what week is going tohave what impact is quite frankly, I think is uncertain at this point. I thinkwe’d much rather report back what happens than tell you what is going tohappen.


And our next question isfrom Joe Buckley with Bear Stearns.

Joe Buckley - Bear Stearns

Thank you. As you shiftthe expansion into more established markets versus the Greenfield markets, whatis your experience been over the last year or two in average weekly salesbetween those two types of restaurant openings?

Ronald Shaich

Iwouldn't even want to use the word shift, because shift seems more dramatic. Ithink what we’re talking about is dropping out that one out every ten storesthat potentially we think is still a good piece of real estate, but, it's in astrip mall, and it's potentially an area where there is a lot of new housinggoing 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 wehave in the last couple of years as our growth has taken off accepted some moreof 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 thebottom 10% of the stores that have a longer payout cycle.

Neal Yanofsky

And Joe, you use the workmarkets and if we can just clarify that a little bit. We are not talking aboutcities. We are not talking about metropolitan areas. We are talking aboutsites, trade areas, specific locations.

So, Ron describedsomething that might be a Greenfield where you are waiting for the suburb tomove to you a little bit. It could that be five miles away from that there issomething that is not a Greenfield location in that same metropolitan area thatis terrific for us.

Joe Buckley - Bear Stearns

Okay. That's helpful.

Neal Yanofsky

The Greenfield will take longer to grow.

Joe Buckley - Bear Stearns

Thanks for theclarification, thanks.

Ronald Shaich

And just to further addto what I may have said. I think the right word we would use that we useinternally is ‘fine tune.’ It is fine tuning using our real estate modelingprocesses.


And our next question isfrom Steven Reese from JPMorgan.

Steven Reese - JPMorgan

Hi, thanks. I wanted toask about the labor investments plan for 2008. We saw a lot in the second halfof ‘06 with Crispani and again in ‘07 with the Expeditor. I guess, if you couldjust provide some color on where you see the need for additional labor andstores given traffic expectations that look to be relatively flat.

Ronald Shaich

I guess it is probablyfair to say that there are no significant incremental labor initiatives thatcan be pulled out as those have, with the singular possible exception of whatwe are doing around delivering to the table, which we have been testing over anumber 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, itcould have some potential impact.

But, we are notannouncing the rollout of that, and it’s something a test site might want toverbalize. I think it speaks to more of a philosophical perspective, which iswe are very committed to taking costs out of everything else in the P&L. Butultimately think that we have to continue to put dollars into the quality ofour people, the quality of our relationships, and the quality of the way theconsumer experiences it if we are going to grow transactions. And so, I thinkthat statement is less a warning that there is more labor investment coming andmore a statement of philosophy.


Our next question is fromSharon Zackfia with William Blair.

Sharon Zackfia - William Blair

Hi, good morning. I guesswhen we walk into the stores on November 19th, can you explain moreor what the change in your price structure and strategy is? I get the priceincrease per say but it sounds as if we are going to see something different inthe way that price increase flows and maybe the look of the menu itself.

And I know you aretalking about simplifying all of that for the consumer. Just can you help usvisualize that?

Ronald Shaich

Sure, Sharon. First, I think it will be November 15, as opposed to the 19th.

You will walk in and youwill see the menu organized into very clear categories, moving from the centralregister, high up you will see a picture of our soup featured. From there itwill move to our Signature and then Cafe sandwiches, our Signature and Cafesalads, and then our beverages that are reorganized.

In every case, we will bereorganizing within these categories such that we feature the highest pennyprofit items so that your eyes will be drawn to those things that will leave usthe most money. You will see greater price discrimination on the menu. One ofthe 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 thatare less expensive and things that are more expensive. You will see Paneracontinue to try that discrimination, again, trying to make it available for everydayuse while also taking advantage of the opportunities to charge people pricesfor specialty products.

So you will see that. Youwill see a new menu panel that features are Be a Hero program. Be a Hero in theoffice or home that encourages you to take home bulk products, everything fromsoup in a group we call the quarter soup to bulk bagels, to bulk baked goodsand the like.

You will certainlyexperience that. You will experience in our celebrations, which is another formof really menuing our communication, you are going to see us often speakingabout putting products together again in a way that leads to higher pennyprofit. I think it gives you I hope some taste or feeling for some of what youwill 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?

Ronald Shaich

We are in test on ittoday. We spent about a month and a half to two months really doing some veryserious research and analysis. A ton of analysis trying to make sure weunderstood where our penny profit was and where the money was made and where itwasn't.

Second, we introduced itin what we are calling a disaster test in a group of stores a week ago. We willannounce where they are, but we introduced it there in a group of stores. Oursimple purpose in that was to see what the first reactions were and to see ifwe got certainly any negative reaction. We don't know if any negative reactionto date such that would cause us to in any way abort the launch of this newmenu.


And our next questionfrom is from Jeffrey Bernstein with Lehman Brothers.

Jeffrey Bernstein - Lehman Brothers

Great, thank you. Thequestion is actually for Ron. I know in your opening comments, you talked aboutthe competitive landscape and you did not think any of the slowdown of late hasbeen due to competition.

Just wondering perhapsfrom your own internal studies how you assess the impact of competition and youhighlighted a very sensitive consumer, the potential for trade down, justlooking at some of best casual and quick-service players that are performing alittle bit better in this environment.

I’m just wondering, howyou think of that competition and what makes you think that Panera is not avictim of such competition. Thanks.

Ronald Shaich

I would start and say whoare 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 aretalking to us about Cosi? I’ll let youmake your own judgments.

Who are thesecompetitors? We don't see at this moment any huge massing of competition.Getting to the question of those we share paradigm with, people we deeplyrespect, the folks at Chipolte and the people at Pei Wei.

Are they competition? Our perspective is in a very indirect way, yes, butreally not. Let's take lunch, which is our primary business. Let's look atdecision-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. Whatkind of food are we in the mood for?’ That’s the first question. And in myoffice it may be soup, salad, sandwich. It may be Greek. It may be Mexican. Itmay be Italian. Once you’ve answered that question, hopefully you will saysoup, salad, sandwich as we do four out of the five days here in this office.

They then say who’s thebest within our price parameters and our distance parameters and that’s amultidimensional decision that gets made all at once. Who is the best at that? Andif you are in the mood for soup, salad and sandwich, we want Panera to come up onyou short list as number one choice for soup, salad and sandwich that day. Ifyou want Mexican, I think go to Chipotle or Qdoba - you figure it out; if youwant Asian go to Pei Wei.

So, I think that they arenot in that sense direct competition. I think going forward further, I think thatbeyond the national operators, there is a wide range of competitors. It is ahighly fragmented industry, and it extends everybody from the upscale grocerystores, the Whole Foods of the world that are doing more and more takeout in sandwichesall the way through upgraded fast food. But I don't think we see anythingdirectly in any specific market, which is usually where you will see it first.

I think that probablyPanera is now in size and a national footprint such that broad consumercurrents probably have more effect on it than does any individual format orregional competitor. And that is pretty well the way we suggest and think aboutit. Hope that is helpful.


And our next question isfrom John Glass with CIBC.

John Glass - CIBC

Hi, thanks. Listening tothe call, the first half was focused on the margin initiatives and particularlyfocused on sandwiches as well as other things and second half cited higherwheat costs.

And so, I wonder at whatlevel you are swapping one margin crisis for another; in other words with a run-upin wheat is there a point in which sandwiches actually become less profitableto sell than salads or is that not an issue.

And maybe as a broaderpart of that question, what kind of flexibility are you building into your menusuch that if you run into commodity spikes, etcetera, that you are able toswitch celebrations rather quickly in order to help that margin initiativealong?

Ronald Shaich

We’re thinking aboutpricing. It’s a great question, John. And I am not sure I agree with you that itis about margin and then wheat, but it is a great question in terms of how wethink.

And let me give you anexample. I think we are increasingly trying to say if we are rolling out a specialtysalad and our penny profit goal and our target for penny profit in thecompetitive 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 forthat was leaving us $5 in penny profit and the food costs on that was $2 and wewould price that at $6.99. What we are trying to say is as we bring out newproducts and as things get introduced and adjusted around the menu, I think youcan expect us to price products to protect their penny profit.

And so I would suggest toyou that if wheat prices drive up sandwiches in such a dramatic way, and Iwould argue it is only about 10% of the cost of the sandwich. But As extremelydifficult 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 areattempting to do is to protect our margins through pricing, drive our pennyprice profit through pricing and menu structure all the while holding growingtransactions.

Andthat's the core of what we are really trying to say to you as we think about this.


Next question is fromDavid Tarantino with Robert W. Baird.

David Tarantino - Robert W. Baird

Just a follow-up questionon margins. It looks like for '08, at least on the low end your guidance, youare assuming some either flat or slightly down margins even though you aretaking 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 additionalcolor on why you wouldn't expect any margin rebound from the low levels you areseeing this year?

Neal Yanofsky

I think, David, you justneed to look at our comp range, and at the low end of our comps we would seedeleverage 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, itessentially assumes 2.5% price, and flat transactions right down the middle. Ifit ended up in the very low end of that range and we don't know what kind ofconsumer headwinds we are going into. If it does, then you are going to havedeleveraging offset certainly by the penny profit increases.

I think we have a rangehere you could drive a truck through purposely, because it speaks to the levelof uncertainty and the number of moving pieces that are occurring here. And Ithink that that's how we think about it and that's how you should read it.

And you know we are veryconscious 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 becautious about declaring for you what, when and where, particularly in thecontext of whatever environmental and inflationary pressures exist.

David Tarantino - Robert W. Baird

Okay, if I could ask afollow-up. The prior question about Q4 guidance, you said you assumed that youweren't expecting a huge benefit from some of the category management initiativesin Q4. What have you assumed for '08? Have you taken a similar conservativeapproach in your guidance there?


Sure, the low ends of ourcomp range, absolutely. I mean the biggest swing is where comps come out. Wehave a comp range of 1% to 4%. And you can pretty well track it, the earningsguidance within that range. If the comps are at the high range you will haveearnings at the higher range. If you have comps at the low end, 1%, you willhave the potential of de-leveraging.

Again, I think we aretrying to give you relative to both fourth quarter and next year is the samething that every one of us understands in our gut. That there is a lot of movingforces out there, and we want to be as direct and honest with you andinterested in the fact that they exist, and there is a range of outcomes thatcan occur here.


And our next question isfrom Jason West with Deutsche Bank.

Jason West - Deutsche Bank

Just wanted to follow upon the decision on the pricing. Can you just talk a bit about why you decidedto wait until November 14th. You know it's been margin pressures for a fewquarters now. I want to get your thinking around that.

Going forward, it soundslike you can move more quickly. Just wondering if it is related to thecomplexities of changing out the menu boards or sort of why this price increasewas held off for so long.

Ronald Shaich

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 afocus on growing transactions, when transactions were negative going into thesummer, and then we’re really shifted to a focus on penny profit when werealized we had gotten the transactions but not the penny profit growth wewanted.

So the focus began thissummer. We conducted some research. We are very sensitive to something, whichis not to react and then create another problem. And we often see thathappening in our business. And we didn't. As we had come out of the transactiongrowth, we were very cautious about causing now negative transactions again andwe don't want to be sitting here in three or six months as a whole bunch ofpeople are telling you, that they are experiencing negative transactions.

We think that is a muchbigger issue. And so in the context of that we spent the eight weeks to conductthe research. We spent the time to really understand where we were making ourmoney, what were the penny profits, including all the manufacturing and thewhole deal and really to come out with a position.

Having done that, andreally communicated that with some of our community, the rest will becommunicated over the next two weeks, and for us now 1200-plus Cafes, we don'tmove like the PT boat, we move more like a battle ship. And the reality is itdoes take us 8 to 10 weeks to actually execute a price change.

John Glass asked aquestion. 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 weeksis 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 tocommunicate with them to make sure they are clear. They just can't do it on adime. So things take time.

And I think that we don'twant to turn this organization upside down into a reactive machine to disruptthe organization. We want to do things in a logical, sensible way based on aclear understanding of research and operating in a controlled and disciplinedfashion and be responsible to the thousands of people that run these Cafes andthe franchise partners that we have.


And our next question isfrom Ashley Woodruff with Friedman, Billings and Ramsey.

Ashley Woodruff - Friedman, Billings andRamsey

A question on the fresh doughfacilities. Being able to leverage those is one of the things that I thinkhistorically has given Panera above-average margins. And clearly you can dosome things with what you are promoting, but if the customer keeps going awayfrom those products that are produced in the facility, you are likely to keep seeingthat pressure.

Is there an opportunityto move more items through the manufacturing facilities like the sweet goods ormaybe figure out how to make them more efficient or service more stores inorder to mitigate that margin pressure long term?

Neal Yanofsky

It is possible there maybe opportunities there. And as you can well imagine, it is not a thought thathas escaped our notice. And so, just as we do with our own manufacturingoperations, we look at the contract manufacturing, we look for opportunities toimprove efficiencies there since we benefit from that. We ask the question, arewe making the right things in the right places in the right ways? And wecertainly increased the intensity of our focus on the entirety of the supplychain and manufacturing and are looking for ways to get back to the marginsthat we have enjoyed there in the past.

Having said that, I thinkit is important to realize that the consumer shift here is not some secularchange in our customers’ preferences. This is not people deciding that theydon't want to eat certain kind of foods, they want to eat other kinds of food. Becausethis completely opaque to them, where the dough is made. So, some of the shiftback is going to happen naturally, not by forcing things down customers'throats, but by, we offer this terrific egg soufflé, which uses a dough piecethat is manufactured by a contract manufacturer.

On the heels of that weare feeling very good about the breakfast sandwich, which uses our ciabattabread, which we make in our own facilities. We have some of the initiativesthat Ron talked about particularly bulk purchase of bagels and some of theresizing and re-merchandising and emphasis of bread. And we think that willnaturally help us shift some of the sales back or add some sales back to the FDFoperations.


And Ashley, if I can addsomething to it, I think you noted something which is very correct. Panera hasbenefited from leveraging its supply chain over the past couple of years. Thisyear, we absolutely got deleveraged.

It really hurt us. It isthe one thing that is the reality of our business model and brings someuncertainty to it. You had wheat up 75% at the same time you had some shiftsaway from our own self-manufactured product.

Having said that, we willand we are catching up on our transfer prices. It takes us some time to do thatgiven our contracts. We will be able to essentially reflect the prices in ourtransfer prices, and we will take advantage of the natural leverage that existsin our supply chain, as we march forward.

And potentially that openan opportunity for shall I say a hint of releverage as we come out the backside and that’s our expectation and you can be assured, we are looking ateverything there is to gain that that new leveraging, understanding that againa significant moving business that you don't change on a dime.


And our next question isfrom Fitzhugh Taylor with Banc of America securities.

Fitzhugh Taylor - Banc of America

I was just curious as youlook back on Crispani. What was different about that you saw there in the testphase that changed in the rollout and usage phase? And we’re talking a lotabout testing and stuff that you’re doing now. I am curious was the testflawed? Or did it just act differently out in public than it did early testing?

Ronald Shaich

That is a great question.Thanks for asking it. I think that there are several levels of testing that wedo; the first level of test something what we call preference for the item, intentto purchase.

I think those who havehad Crispani, generally you had great experience with it. Our consumerscertainly did. We had very, very high intents to purchase. People, who enjoyit, love the product, very, very high and sort of the non-economic testing.

We then ran it for aboutsix or nine months, maybe a year actually, but we ran it with differentconfigurations and marketing support because we were trying to figure out howbest to, how most efficiently, that is to say, how to spend money to get peopleto experience it.

Because we clearlyunderstood that Crispani as I think told you and said to ourselves was a huge anddifficult thing. We were going to attempt to build another day part by bringingin families, and they were not necessarily our direct target customer, and wehad to have the marketing muscle to reach them and get trial of them.

Now what we have our modelsthat say that as we roll things out, and they get customer acceptance, theybuild. And we have models, going back to bagels, for example, where over years thevolumes on them tripled from where they were after the first roll out of it.

So we made a decisionbased on a year’s playing with it, mostly around how you build consumer trialof it that was the testing. We made the model, we made the decision to roll itout on an assumption that over three years volumes would build based on the preferencingand the experience we have had with products traditionally building postcelebration, post consumer trial. We have clearly not seen that.

And if anything Crispaniis probably at this point certainly significantly less than what we would haveexpected. It’s probably negatively profitable and it’s probably not producinganything incremental.

So that the question forus is really to address and figure out can we boost the sales to cover thefixed cost and without going into details, you can imagine there is tremendousintensity around that, there are three or four different tests around that.

And with a clear mandatethat either we are building the sales on it and we can feel the sense ofconfidence that it will cover the fixed costs in place for it or we’re going topull it.


And our final question isfrom Bryan Elliott with Raymond James.

Bryan Elliott - Raymond James

Already been asked.Thanks.

Ronald Shaich

With that, we thank youfor listening to us and hanging in here as we tried to explain to you where weare coming from, where we are going, and as ever, Neal, I and Jeff are availablein anyway to be helpful for you. Thank you and good morning.


This concludes today'sconference call. We thank you for your participation. Have a wonderful day.

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