Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Panera Bread Company (NASDAQ:PNRA)

F1Q08 Earnings Call

April 30, 2008 8:30 am ET

Executives

Ronald M. Shaich – Chairman of the Board & Chief Executive Officer

Jeffrey W. Kip – Chief Financial Officer & Senior Vice President

Analysts

Jason West – Deutsche Bank Securities

David Tarantino – Robert W. Baird & Co., Inc.

John Glass – Morgan Stanley

Jeffrey Bernstein – Lehman Brothers

Christopher O’Cull – Suntrust Robinson Humphrey

Steven Rees – JP Morgan

Sharon Zackfia – William Blair & Company, LLC.

Bryan Elliott – Raymond James

Analyst Rachel Rothman – Merrill Lynch

Robert Derrington – Morgan, Keegan & Company, Inc.

Operator

Good day everyone and welcome to today’s Panera Bread Company first quarter 2008 earnings release conference call. As a reminder today’s call is being recorded. At this time I would like to turn the call over to your Chief Financial Officer Mr. Jeff Kip.

Jeffrey W. Kip

Good morning everybody. Welcome to our first quarter earnings call. Let me cover a few regulatory matters as per usual. I’d like to note that during our opening remarks and in our responses to your questions certain items may be discussed which are not based on historical fact. Any such items including targeted 2008 results should be considered forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. All such forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially.

Ron will begin our call with a few introductory remarks.

Ronald M. Shaich

Good morning everyone and welcome to our Q1 earnings conference call. Frankly, this is a call I’ve been looking forward to for the last several weeks and that is not something I normally say about these conference calls. Let’s get right to it. This is a difficult time for our industry. We at Panera, like others have been hit hard by the rapidly costs for commodities notably in our case the hyper inflation of wheat. But, we have adjusted. We have spent the last few quarters developing and executing our plan. Our team has been and our team remains intensely focused on improving margins, intensely focused on holding or growing transactions and intensely focused on improving return on invested capital while continuing to differentiate our concept.

We’re pleased to be able to share with you today the real traction we are seeing in each element of that plan. I would like to now ask Jeff to review Q1 with you. I will then provide some perspective on our plan and our results to date on that plan. I will then ask Jeff again to provide you with our target for Q2 and our full year 2008 target and the assumptions that underline those targets. We will then open it up to your questions.

Jeffrey W. Kip

Let’s get right in to the first quarter results. Yesterday afternoon at a much more reasonably hour than last quarter we issued our first quarter earnings release for the 13 weeks ending March 25; let’s review the metrics. Our comparable Bakery Café sales increased 3.3% at company owned locations during the first quarter. Retail price was approximately 3% year-over-year. Comps increased 1.7% at franchise operated locations. Average weekly sales for company owned units opened in fiscal 2008 were $39,083 above our full year target of $36,000 to $38,000. We opened 27 Bakery Cafés in the first quarter, 14 of which were company owned, 13 of which were franchise operated.

Our net income for the first quarter was $5.4 million including a $2.7 million charge for previously capitalized development and lease expenses that was the outgrowth of the company’s decision to raise our hurdles for new café development. EPS was $0.41 per diluted share including the impact of the $0.06 development related charge. This compares to net income of $15 million and EPS of $0.47 per diluted share in the first quarter of the prior year.

Let me now take a couple of minutes and break down the pieces of the process we went through which ultimately reduced the number of company owned new units we will open this year and resulted in the $0.06 of related charges that I previously mentioned. First, with our 2000 margins under some pressure we made the decision December, 2007 to utilize our most recent run rate margin for calculating return on investment capital hurdles on new café investments. The effectiveness was to raise the sales hurdles at which we would give the green light to build a new bakery café. In order to build and open a new site we must feel confident in hitting a long term differential free cash flow return of 15% or better on our all in bakery café investment. We look at this metric on both a long term and snapshot basis. Differential free cash flow is store EBTIDA less standard overhead load, less standard cap ex net of the loss royalty we would have received by theoretically keeping the capital and franchising the location instead.

Secondly, in early 2008 Ron, myself, John McGuire our Chief Operating Officer and Mike Nolan our Chief Development Officer went through every single potential site for 2008 and eliminated any sites we were not confident would meet our revised sales hurdles. We made this judgment independent of whether or not leases had been signed. As a second pass we reduced investment for signed leases by subtracting buy out costs for signed leases from the investment to make sure we were looking at incremental return on incremental capital, i.e. with buyout costs netted out. While we normally eliminate sites as part of our process this was an entirely new level of review. The sites we eliminated were scattered through the year at various stages of development from very little time invested to leases actually signed but in no cases had ground actually been broken. Thus, the sites very widely in terms of the charges associated with elimination but in each case the site was not one that meet our revised hurdles.

The full development charge breaks down in to a few components. Approximately $0.025 of accounting charges driven by the decision to terminate leases for certain sites we decided not to develop as part of our process. Secondly, approximately $0.025 for the write off of early stage capitalized assets and overhead related to these developments of these sites. And finally, about $0.01 of severance charges for employees affected by our decision to open fewer units.

With that, let’s get in to a little more detail on the P&L and our margins for the first quarter versus the comparable period a year ago. Starting with total revenue first quarter’s revenue increased 27% to $305 million in 2008 versus $239.7 million in the comparable period of 2007. The breakdown is as follows: net bakery café sales increased 32% to $260.4 million in 2008 from $197.1 million in 2007 driven primarily by sales from units opened in the last four quarters, by acquisitions in the same period and increases in comparable bakery café sales; franchise royalties and fees increased 7% to $17.4 million in the first quarter of 2008 from $16.3 million in the same quarter in the prior year driven by new franchise operated bakery cafés opened in the trailing four quarters partially tempered by the impact of the acquisition of franchise operated bakery cafés by the company; fresh dough sales to franchisees grew 3% to $27.1 million in 2008 from $26.3 million in 2007 after two quarters of year-over-year decline. As a result of these differential growth rates we continue to experience a shift in total revenue mix as bakery café sales as a percent of total revenues increased to 85.4% in the first quarter of 2008 compared to 82.2% in 2007 while over the same period franchisee royalty and fees declined to 5.7% from 6.8% and fresh dough sales to franchisees declined to 8.9% from 11%.

The net impact of these shifts on operating margin is approximately 110 basis points of optical unfavorability on operating margin year-over-year and as the decrease in franchise revenues which are pure income follows as a percent of the bottom line margin. We’ll return to this a little later when we discuss operating margins.

Now, let’s move on to the margin analysis. Restaurant margins overall were lower by approximately 190 basis points in the first quarter 2008 versus the same quarter in 2007. Let’s go through bakery café margin by component now. First, cost of food and paper products increased by $110 basis points year-over-year to 30.5% of restaurant sales. Again, 100 basis points of this increase the $2.5 million unfavorable impact of wheat prices year-over-year. We were able to offset another approximately 100 basis points or so from unfavorability from other cost increases by taking price and successfully impacting mix through our category management initiatives.

Labor as a percentage of restaurant sales rose 80 basis points year-over-year to 32.5%. The year-over-year increase breaks down in to several components. First, while as of quarter end we’ve released that the full 100 basis point run rate benefited Crispani removal we only picked up about half of the targeted benefit in the full quarter given later timing and certain inefficiencies. Secondly, the addition of the expeditor position in the café at the end of the second quarter of 2007 has driven approximately 50 basis points of unfavorability in our labor margin year-over-year while supporting our transaction initiatives. This impact will continue through the second quarter of 2008 when we anniversary that addition. Finally, the remaining unfavorability year-over-year came from labor inefficiencies in our late 2007 new openings and somewhat higher benefits costs versus the prior year. All costs we expect to return to run rate levels.

Occupancy costs for the first quarter increased 33 basis points versus the prior year to 8.2% of restaurant sales. Based upon somewhat higher average per square foot costs in immature stores our pacing the growth in sales during the first quarter of 2008 as compared to 2007. Other operating expenses as a percent of restaurant sales in the first quarter of the year improved 30 basis points from 13.1% to 12.8% in the prior year as we’ve made some real progress in our cost control efforts in this area.

Moving on from restaurant margins. Fresh dough costs to sales to franchisees as a percent of fresh dough sales to franchisees leaped 890 basis points over the prior year. Approximately 800 basis points of this represents the margin impact of wheat. The remainder is driven by the significant increases in diesel gasoline costs year-over-year an impact we expect to grow larger in the last three quarters of the year. I’ll come back to discussing this impact later.

Just a quick comment on the reclassification we made between this line item and bakery café costs of sales. We’ve mentioned in the past that the historical decision to include in this line our sweet goods contractual income stream as a credit with no revenue associated somewhat clouded the picture of the profitability of our manufacturing business. To provide better transparency with this manufacturing business we moved this contractual income to a credit in our costs of sales in the same way we account for income from other vendors’ contracts i.e. we net it against the costs of goods from those vendors. Cost of goods sales to franchisees now more transparently reflects the profitability of our fresh dough facilities themselves and our manufacturing operations on a standalone basis.

Depreciation costs in the first quarter of the current and prior year remain fairly consistent at 5.3% and 5.6% of total revenue respectively. The positive leverage on this line is driven by sales increases catching up with investments such as the two new fresh dough facilities we built in late 2006 and early 2007 and the series of FDF expansions we undertook in 2006. General and administrative expense in the first quarter of the current and prior year remain fairly consistent at 7.2% of total revenues. However, included within the first quarter of 2008 is approximately 90 basis points related to the development slowdown charge I previously described. Pre-opening expenses in both the first quarters of 2008 and 2007 remain fairly consistent at .4% and .5% of total revenues respectively as we opened the same number of company owned new units in the same quarter as in the same period of the prior year.

Before I talk about interest and tax rate I’d like to sum up what we see as very positive progress on our margins. Bakery café margins are down 190 basis points year-over-year but we know 100 basis points of that decline is driven by the unprecedented rise in wheat costs. Net of these costs the sequential year-over-year comparison of restaurant margins show dramatic improvement. Further, as we indicated regarding the first quarter’s end run rate, we removed 100 basis points of expense from our labor line. Additionally, we’ve been able to offset all cost increases in our cost of sales through pricing and other category management initiatives outside of the aforementioned wheat increases with additional price increases coming. So, we feel pretty good about where our bakery café margins are headed.

Finally, we feel good about our operating margin as well. Of the 290 basis points year-over-year decline 90 basis points are from the $0.06 of charges related to the decision to open fewer company owned units this year. 150 to 160 basis points of unfavorability are driven by wheat of which nearly half will be eliminated by the second half of the year through dough price increases to franchisees. And, there are an addition 70 plus basis points of run rate improvement coming from Crispani removal. That analysis does not even include the 110 basis points of optical unfavorability driven by the acquisition of franchise bakery cafés at prices which deliver our long term ROI hurdle. Conditions under which I would argue, it always makes sense to acquire. On the other hand as I noted last quarter we probably have a modest pre-disposition towards selling rather than buying if given the choice because we like a strong franchise company balance. The point remains on a year-over-year operating basis we’re very pleased with the positive moment in our margin improvement momentums. I’ll comment directionally on quarters two, three and four later in the call.

Now, let’s turn our attention to interest expense which increased to $1 million of expense or three tenths of a percent of total revenue in the first quarter of 2008 as compared to a tenth of a million of expense or a tenth of a percent of total revenue in the same period of 2007. The increases is a result of the increased interest on our credit facility entered in to in the fourth quarter of 2007. In terms of taxes, the effective tax rate for the quarter was 37.5% compared to 36.8% in the comparable period of 2007. Currently, we’re projecting the possibility of zero to $0.04 of incremental discreet tax expense in the remainder of the year. Timing if these possible expenses actually hit us would likely be $0.00 to $0.02 in the second quarter, $0.00 to $0.02 in the third quarter. We currently expect the tax rate for the remainder of 2008 to fall in the range of 37.5% to 40% in the event that any adjustments actually hit us.

Moving on to the cash flow for the quarter. The company generated $27.6 million of cash from operations and employee stock option exercises and had capital expenditures of $19.4 million. In addition, we repaid $15 million of our credit facility in the first quarter of 2008.

Let’s now talk about the balance sheet. At the end of the first quarter 2008 we had $19.7 million in cash, $14.9 million of investments in the Columbia Strategic cash portfolio and a net asset value of $0.93 on the dollar and $60 million of debt. This compares to year end at which, prior to completion of our share repurchase program we had $68.2 million in cash, $23.2 million of investments in the Columbia Strategic cash portfolio and a net asset value of $0.96 on the dollar and $75 million worth of debt. To date we received redemption of more than 40% of the funds we had in the Bank of America Fund at nearly $0.99 on the dollar.

As we discussed on our fourth quarter earnings call during the first quarter of 2008 we completed the previously announced $75 million share repurchase program. We repurchased $27.1 million worth of shares at a weighted average price of $36.02 per share by the end of 2007 and completed the full repurchase in the first quarter of 2008 by taking in $48 million worth of shares for a cumulative total of approximately 2.2 million shares or $75 million at an average price of $34.62 per share, a number that looks pretty good compared to today’s share price. On average for the quarter there were approximately 30.2 million fully diluted shares outstanding including the impact of 1.9 million stock options outstanding with an average exercise price of $38.91.

Now, I’d like to hand it back to Ron to review our strategic initiatives.

Ronald M. Shaich

As you all know we are deeply focused on our plan to move the business forward. The plan is clear, it is focused on improving margins while maintaining or growing transactions and strengthening return on invested capital while driving long term concept differentiation. I’d now like to walk you through the status of each of the key pieces of that plans.

Let’s begin with margins; simply put and as Jeff indicated we’ve seen significant traction on our margin initiatives in Q1. Let’s now discuss the impact of Crispani labor on those margins. As you know we made that hard choice to remove Crispani from our menu in January 2008. Following that choice the question became can Panera get the labor out? The answer is a resounding yes. The pickup from Crispani labor was fully realized on a run rate basis by the end of Q1 and represents a 100 basis point pickup in Q2 and going forward.

The second margin improving initiative I’d like to speak to is category management. As you know we began building this function last fall. Our team has been intensely focused on changing customer behavior and driving gross profit per transaction for the effective execution of a high low pricing strategy and a redefined menu structure. The manifestation of this work has been several price and menu adjustments in the past six months. Let’s now discuss these retail price and menu adjustment initiative individually. In November, 2007 we took an approximately 2.5% increase and reorganized the products on our menu panels. The focus of the price increase was on higher priced specialty products and the focus of our remenuing was to bring greater prominence to our higher gross profit items. This initiative was rigorously tested and the testing demonstrated that we would be able to affect the changes with no noticeable degradation in transaction growth. The actual results of Q1 proved the testing to be accurate. To the best of our knowledge there was no negative impact on our transaction in Q1 from our November price increase.

Let me note we implemented another retail price increase of approximately 2.7% in late March, 2008 in company stores. This adjustment focused on raising prices on a number of entry level items. That is to say often times items different than the items we raised prices on in November. This price increase was also rigorously tested. Again, the test suggested we would have limited negative transaction impact. In fact, post roll out there has been no noticeable transaction fall off as a result of our late March price increase. In fact, company comps were up 7.3% for the first 34 days of Q2. This represents about 32 days with the new pricing. In fact, if you subtract out the 5.8% year-over-year price increase in effect Q2 to date and the approximate 1% of impact from the shift in Easter, one can assume we’re running about a half of point of real transaction mix growth in the period since the March price increase. It’s also important to note that many of our franchisees followed our lead and implemented a menu structure similar to ours in early April. Though we’re not yet sure of the all in level of price increases we’re pleased to note that their comps are up approximately 4.6% for Q2 to date.

Let me now comment on future price adjustments. We expect to implement a price increase on our bagels in mid June. This will represent an additional lift of .4%, that is to say .4% of total sales and allow us to raise our FDF prices to cover more of the hit we’re experiencing from wheat. Our confidence in our June increase is based again on two rigorous bagel pricing tests we began in February, 2008. The first test was a 10 store market where we raised the price of all bagels from $0.99 to $1.15. The second test was in a 12 store market where we utilized a high low tiered pricing structure. Let me explain. In our tier pricing structure signature bagels, things like cinnamon crunch, asiago, or dutch apple were priced at $1.25. Non signature bagels like our plan, everything, sesame and whole grain bagels remained at $0.99. We tested both pricing structures because we wanted to gage customer reaction, mix shifts and the impact on the bakery café profitability. We were particularly concerned about any change that would impact transactions negatively. After analyzing the data and observing the price test in the field we have decided in favor of the two tiered bagel pricing system. Beginning June 18th all company owned bakery cafés will sell bagels at two price points $0.99 for non signature bagels and $1.25 for signature bagels.

Before I conclude my comments on margin, let me note that we are testing other category management initiatives for later in the year. One such test is a combo program for our breakfast products. We are also testing the removal of chips to allow us to further improve margins without value degradation for the 50% of the people who we believe are not eating the free chips side choice we now offer. Let me also note that we’ve made real progress on other costs initiatives. We’ve been very focused on controllables, all those little nickel and dime things like electric rates and newspapers that really add up when you’re a $2.5 billion brand. Our goal is to have these costs all below the gross profit line grow to a rate significantly less than the growth of our gross profit.

Now, let me turn our attention to the second plank in our plan, maintaining or growing transactions. This is clearly a tough task when one considers the consumer environment and the constant drum beat of media attention focused on our weakened economy. It’s also a tough mission when one is committed to improving margins which is certainly the case for Panera. Also, tough in the face of the removal of our Crispani sales.

I’m very pleased to be able to report to you that to date Panera has been able to maintain transaction growth despite all the headwinds we have faced. As Jeff indicated to you Q1 company comps were up 3.3% and Q1 transaction growth was positive, about half a point net of the impact of Easter. And, as I’ve already indicated to you Q2 company comps to date were up 7.3% and Q2 company transactions to date were also up about a half a point net of the Easter shift. A number of you continue to ask us how transactions are doing in various markets. Let me update you on that now. Our experiences are similar to many other companies. We are seeing weakness in markets like Southern California, Arizona, Las Vegas, Florida and Detroit. However, we are pleased that transaction degradation in those markets has been more than offset by transaction growth in other markets.

Let me now focus on why we think we’ve been able to produce this solid transaction growth. First, we’re pleased to report that our breakfast sandwiches have been rolled out to almost all of Panera. Breakfast sandwiches are performing exactly as we expected. They are giving us a lift in the morning, they are giving us new transactions in the morning and they are giving us higher gross profit per transaction in the morning and we’re doing it all without any fixed labor. Bottom line, breakfast sandwiches are off to a very good start. Breakfast sandwiches are working because they fit naturally in to our product line. Clearly, these sandwiches belong in Panera, they’re all natural and made by bakers not microwaves. We invite you to visit your neighborhood Panera and experience them. We know you’ll be pleased.

Let me also talk about the role of operation. As ever, we have been intensely focused on quality of operations to build transactions. In particular that has been our key driving force since spring of last year. For Panera quality of operations means speed, accuracy and a further improved customer experience to increase differentiation. This is certainly not a sexy program but is one that really matters, maybe more than anything else. The good news is our scores on our internal operating metrics continue to rise and we are confident that this too is helping to build transaction growth.

Let me now discuss the role of Via Panera. Our Via Panera catering program is building comps in 2008. In late March we rolled out a new catering pricing strategy to all company owned bakery cafés. Our Via team refocused on driving transaction growth by making the take out catering menu easier to use and steering people towards choosing items that drive more penny profit per transaction. We have a full Via menu redesign on the docket for 2008. Stay tuned for details on that initiative in future earnings calls.

Let me now turn our attention to media. We expect to maintain solid transaction growth in 08 by increasing our media expenditures. What this means is that our billboard and radio advertisements will increase significantly in 2008. As you know, Panera is one of the least advertising intensive companies in our industry. We have traditionally believed in using only local store marketing to build our sales and the in store experience. Yet, the fact that we are today a $2.5 billion brand with significant scale and low unaided awareness makes media a potentially attractive option. Our focus over the last two years has been in learning about the use of media in such a way that we can prove to ourselves that it provides a real return on investment and not simply a short term hit. In 2006 we conducted significant research on our target customers and we tested a wide range of media alternatives. Based on that work we’ve focused on billboards and radio as the key media and further based on that work we ran media trials utilizing billboards and radio in five markets in 2007. The media we tested paid for itself in less than 12 months. More importantly, by comparing our results to controlled markets we were able to determine that the lift generated sustained itself up through the end of our test period. That is to say that it was real and solid and not simply short in its impact.

Based on our 2007 testing our 2008 plan called for us to initiate a more intense media effort in those markets we have identified as being suitably efficient for such media initiatives and that represents about half of our markets. Though the 2008 media programs begin just this month it is too early to understand the impact and testing tells us it will take two to four months before we see real gains from it. So, simply put I want you to know about this initiative being out there but it’s way too early to read the results of it and quite frankly to pull out of our data what is working and what is not. But, we will update you.

As you well know, none of these individual initiatives I’ve mentioned so far has single handily improved our transactions but taken together they have proven strong enough to withstand the consumer headwinds and loss of Crispani we’ve experienced. Obviously, we couldn’t be more pleased and we’re hopeful we’ll continue to have this kind of success as we move in to the remainder of the year. But, one note of question, we are generally concerned in projecting future transaction growth for the remainder of 2008. Keep in mind what we’re running up against. Q1 2007 transactions were -2.1% but Q2 2007 transactions were .5% and most important Q3 2007 transactions were extraordinarily strong as we delivered 2.7% transaction growth in that quarter. Recall that in Q3 2007 we executed a hugely successful summer salad celebration with a relatively low price point. We truly believe it’s going to be hard to outdo those results in Q3 2008 despite the fact that we’ll rerun that salad celebration. Oh, and by the way, you can count on the fact that we will be more aggressive on pricing those salads this summer.

Let me sum up our view on transaction growth for the remainder of 2008. We would suggest that if we can deliver slightly negative to flat transaction growth in the face of the strength of 2007 transaction growth and the negative winds of 2008 and also improve our margins, we would be doing very well.

Now, let me turn your attention to our key tactic for driving return on invested capital new store productivity. As margin compressed across all bakery cafés in 2007 our return on invested capital obviously went down. In December, 2007 we made the decision to utilize our actual run rate margin to evaluate new cafés going forward. As Jeff discussed, this in turn led us in 2008 to cancel a number of projected 2008 locations. We are quite pleased that in Q1 our new stores produced average weekly sales of $39,083. Let me caution you though that we had several strong openings in Q1 and frankly don’t expect our Q1 results to maintain themselves throughout the year. As a result we are targeting new café average weekly sales of $36,000 to $38,000 and we’d be quite pleased to deliver those kinds of numbers for the full year.

Let me now turn it back to Jeff who will take you through our target for Q2 and our target for the second half of the year. I’ll then return for a brief closing comment. And, since we’re running a bit long here I want to give you everything up front, we will stay on for 30 minutes of questions if you so wish.

Jeffrey W. Kip

I’d like to now offer you our financial outlook and target starting with the key assumptions underlying our second quarter, second half of the year and full year targets. Let’s begin with our second quarter 2008 financial targets. Given the results we’ve seen to date in the second quarter we’ve raised and narrowed our second quarter EPS target from $0.37 to $0.43 per share to $0.40 to $0.44 per share. As Ron discussed earlier the key metric driving our raised second quarter target is transaction growth. We’re now targeting 5% to 6% company owned comp store sales growth in Q2 up from our previous target of 2.5% to 4.5%.

Moving on to second quarter margins. As Ron and I both discussed, we’re really pleased with the progress we’ve made on our margin initiatives. On a run rate basis we’ve already realized 100 basis points on the labor line from Crispani removal we anticipated and we’ll see this in the second quarter in full. However, the headwind we face on rising wheat costs is [inaudible] second quarter. All in costs on wheat for us in the second quarter is going to be $17.25 per bushel versus $5.80 in the prior year implying a dough transfer price needed to break even on our dough sale to franchisees of 22%. Our actual weighted average dough price increase will be about 13% in the quarter so our total net weight impact all the way through the P&L will be $6.5 million, about $4 million of those dollars are going to hit our cost of sales and about $2.5 million will hit the cost of dough sales to franchisees. That’s obviously net of the price increase.

Further, we face new additional headwinds. Gasoline prices moved up significantly during the first quarter and will be up $0.50 to $0.75 per gallon we believe over the first quarter and the second quarter. To put the gasoline rise in context, each $0.25 rise in the cost of diesel fuel per gallon for the full year adds approximately $750,000 of costs to our manufacturing distribution expense on an annualized basis. $0.50 to $0.75 in a quarter thus means about $500,000 of expense in that quarter or $0.01 of negative EPS impact and we currently believe we could see up to an additional $0.03 of negative impact in the third and fourth quarters together on top of that $0.01 in the second quarter. And, it gets worse, this actually excludes other pressures in the P&L from the price of gasoline such as fuel surcharge and packaging costs. Additionally, many of you are aware of the class action lawsuits we are facing. While we view these cases as totally unfounded and intend to defend the company vigorously we currently believe we will incur approximately $0.01 impact in litigation expense per quarter in the second, third and fourth quarters of the year in our G&A expense line.

To sum on margin for Q2 the company is targeting bakery café margins flat to slightly down versus the prior year despite our increased pricing because of the impact of $4 million or 160 to 170 basis points on the bakery café margin line from those costs. Operating margin we believe will be similar to slightly down from the prior year inclusive through the whole P&L of approximately 225 basis points of impact on that line from the cost of wheat year-over-year.

Finally, as I’ve already discussed we have possible tax exposures between $0.00 and $0.04 for the remainder of the year. The facts on these exposures do not support a FIN 48 reserve, they’re possible they’re not probably. Our concern there is a possibility some such expense could hit us. Our best guess to timing if the possible exposures actually hit us at all would be tax expense of $0.00 to $0.02 in the second quarter and $0.00 to $0.02 in the third quarter.

Let’s now discuss our second half 2008 targets. For the third and fourth quarters we’re revising our targets downwards to $1.17 to $1.28 per share based on the cost impacts I’ve just reviewed totaling $0.06 to $0.07 offset somewhat by an increased comparable store sales target of 3.5% to 5.5%. This comp target is up from 2.5% to 4.5% and includes 5.5% of weighted average retail price increases for both quarters implying a transaction growth for the back half of the year in the range of -2% to 0%. Key metrics on margins remain the same. Our all in cost of wheat locked for the year as mentioned before for the third and fourth quarters is going to be approximately $13 versus $5.80 in the prior year with dough transfer prices on the portion of those sales to franchisees actually breakeven. So, wheat impact will only hit retail costs of sales for approximately $2.5 million per quarter with no additional impact at the operating margin line. Further, as mentioned before we will get 100 basis points of impact favorable on labor margin from Crispani removal in the back two quarters.

Based on these assumptions we’re now targeting both bakery café and operating margin improvement of approximately 75 to 100 basis points in the third quarter and approximately 125 to 150 basis points in fourth quarter because we’ve got these additional expenses from gasoline and litigation weighing in more than previously expected.

Finally, for fiscal 2008 we’re reaffirming our overall guidance of $2.00 to $2.11 for earnings growth of 12 to 18% over the $1.79 we earned in 2007. Just to recap the key assumptions for full year 2008 we’re planning on a weighted average price increase of approximately 5% and overall comps of 45%. Wheat is locked for the year at an all in costs of $14 per bushel versus $5.80. Net of price, the total hit to our P&L throughout the year is about $17 million year-over-year from wheat or 130 basis points at the operating line. And finally, as mentioned before, we expect 100 basis points of improvement from Crispani throughout quarters two, three and four. Given all the impacts we’ve reviewed we’re now targeting both bakery café and operating margins of roughly flat plus or minus the 2007 at the middle of our range including the aforementioned 130 basis points of unfavorable margin impact on both lines from wheat year-over-year. The additional impact of other charges and approximately 50 basis points total for the year on operating margin impact from the shift in company franchise mix which we discussed earlier as an optical impact.

In terms of 2009 we continue to hold a 150 to 200 basis point improvement at the operating margin line over 2007 as our target. While it may be an aggressive target we are seeing the progress on our key initiatives and metrics that leads us to believe we can approach and reach that goal.

With that, I’d like to turn it back to Ron for closing remarks.

Ronald M. Shaich

I’d just like to say again that we couldn’t be more pleased that our plan in every sense seems to be working. Despite the skittish consumer, despite the uncertain economy and despite the removal of Crispani we see our continued ability to improve margins while growing transactions and improving return on invested capital as a positive indicator of consumer acceptance of our concept and the strength of our initiatives. All of us at Panera look forward to watching our plan play out through 2008 and 2009 and I personally look forward to again being excited to host the conference call. It’s certainly a lot more fun this way.

At this time we’re 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 an opportunity to weigh in. If you have additional questions please return to the queue. We’re happy to stay on the line with you until all questions have been asked or until 9:45 given room for the half hour I committed to.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Jason West – Deutsche Bank Securities.

Jason West – Deutsche Bank Securities

I was wondering if you could talk about how wide spread the media program is? Is that now in all major markets or is that still rolling out market by market? And, if you can talk a bit about what the cost is there?

Ronald M. Shaich

It’s in about half the markets. The criteria for us is frankly cost per café and as long as it meets certain standards in cost per café we put it in to those markets. Obviously, as growth continues we get more and more efficient and more and more markets. Secondly, in terms of cost I think that roughly across all of Panera we’re talking about somewhere in the range of about 1.2% of sales, $30 million. Is that a fair number to you Jeff?

Jeffrey W. Kip

It’s spread across.

Ronald M. Shaich

I think that most, if not all the markets that are part of the program will run for five months. It will be on for three weeks, off for a week then it will be running I think for four of the five months. It has begun, it’s begun the last couple of weeks, the billboards may or may not be up in a given market, the radio may or may not be running but presumably it is. Our experience shows that initially there’s modest impact, our testing has shown that it will pick up generally around the eight week mark and start to kick in. But, it’s not going to be dramatic, none of this is promotional, it’s all rooted in brand and explaining the Panera point of difference. It’s basically about reminding people of what Panera’s point of difference is and building on unaided awareness and it ultimately shows up as frequency.

Operator

Your next question is from the line of David Tarantino – Robert W. Baird & Co., Inc.

David Tarantino – Robert W. Baird & Co., Inc.

A question on pricing, can you talk about what your research or data has indicated related to the impact of pricing over a prolonged period? So in other words, what do you think the risks of your consumer getting fatigued by the higher prices over the course of the year?

Ronald M. Shaich

Let’s talk about it two ways. First, we have traditionally run some fairly serious research relative to pricing. We last ran that research prior to the November pricing increases. We concluded based on that research that we had a relatively strong price value relationship and some opportunities for price selectively. That led to our November increase and our March increase. We are in the field as we speak rerunning a version of that price increase research and we’ll know better how we view our price value proposition at this time but I cannot give you any information on that. I would suspect given that we have had no negative impact of the pricing either in the data reported to you or even anecdotally it’s been very well received by our customers. I don’t think that our price value relationship, it’s probably been diminished some in the context of the increases but I don’t think we’re at the edge of a problem. I will tell you that if I perceive us as ever being at the edge of a problem we would not create that problem. That’s our key commitment which is growing transaction medium term.

I would further note that some people have asked me, “You had a price increase in November, another one in March, now you’re doing it in June and you’re talking about something in November. Are these too frequent?” The important thing to remember is they’re not necessarily on the same items. We’re taking different pieces of the menu and we’re moving around the menu. For example, the June 18th increase on bagels will affect nobody other than bagel consumers which is a small percentage. I lastly would comment on pricing, I think in some ways we have benefited from all the media exposure of wheat. I think customers have heard so much about inflation in these products on the nightly news and they’ve seen it in the grocery stores that they’re giving folks like us permission because they fully understand the necessity here. They don’t like it but they at least understand it and don’t feel resent full of it.

Operator

Your next question comes from the line of John Glass – Morgan Stanley.

John Glass – Morgan Stanley

My question is on longer term margin goals. Jeff, if I do my quick math correctly you think maybe in 09 operating margins can get back to roughly 10%. In 05 and 06 I think they were closer to 12% or 13%. You think about the changes you made in your business model one in slowing growth and two in operating more company stores versus franchise stores, is that a goal that is a longer term goal is still obtainable? How do you think the changes in your business model ultimately change the margin potential in the business? If I could just sneak in also a margin related question is now do you think about contracting wheat in 09? Is it too early to start thinking about that and getting that question out of the way early?

Jeffrey W. Kip

Let me comment quickly on the wheat question and let me talk a little bit about your operating margin issues. First of all, we are thinking about wheat in 09. Our intent is to get [inaudible] and lock it up. There’s two times a year to buy it, December/January June/July, we are looking at what we are going to do in June/July and we’ll be making a decision on that. Secondly, let’s talk a little bit about operating margin. I think operating margin is a little bit of a misleading line because of what you deal with in terms of your franchise company mix. As I said earlier we think that the acquisitions we’ve done have all been great acquisitions from a shareholder value return point of view because we’re in the business of owning Paneras and running them and when you can buy your own business at five to six times we think that’s a great thing to do with your capital. We’re doing it at 50% plus long term returns and on a theoretical level, we should do it all day long.

However, we do believe in a strong franchise company mix. Like I said we’d be more biased against taking it down a little then taking it up but we’re not that focused on reclaiming operating margin, it’s changed through that shift. What we are focused on is our bakery café margin and getting appropriate leverage in our supply chain and against our G&A. So, are we going to get 100% of it back? Probably doubtful given the optic switch, just kind of the way we account for it externally, they’re not true business margin issues if we’re using our capital well. But, we’re definitely targeting, we’ve laid out targeting getting something like half of it back and sure we’d love to get more of it back if we can do it intelligently while still maintaining the medium term and long term differentiation of our concept.

Operator

Your next question comes from the line of Jeffery Bernstein – Lehman Brothers.

Jeffrey Bernstein – Lehman Brothers

Actually just kind of a bigger picture question to follow on that, historically you were viewed as a very [inaudible] 25% plus earnings grower, after you’ve gone through a couple of challenging years and then as you look through your 08 openings and slow down unit growth in 08 I’m just wondering if you can look out a year and look at your company more broadly whether you think you can see unit growth ramping up again for 09 from where you shift from more mature [inaudible] growth companies with greater focus on cash flow perhaps, further boost of leverage, great focus on share repurchase and just keep the unit growth down at 100 units or below perhaps?

Ronald M. Shaich

I think rather than projecting out the future I think the objective for this team is to focus in delivering the results and delivering on its plan. Relative to that it will give us the ability to look forward and make certain judgments about what we’re capable of doing. I think obviously we would rather do more good stores then less good stores. The criteria for us is being confident that they will be good stores, that they will produce the kinds of returns that we want to produce and that we’ll be able to grow transactions. I think that what I’m really trying to say to you Jeff is that we are hesitant to speak to one to four year kind of time frames. I think it all depends on what actually plays out and how this company is able to perform. You’re clear that as Jeff has indicated, the key driver for us is the proper use of our capital.

Operator

Your next question comes from the line of Christopher O’Cull – Suntrust Robinson Humphrey.

Christopher O’Cull – Suntrust Robinson Humphrey

Ron, how should we think about pricing to franchisees, if wheat prices are lower in 2009 compared to this year?

Ronald M. Shaich

I mean we have a contractual relationship with our franchisees in which the price that they pay is tied to the retail prices that we sell in our stores. That is, as I think you all understand, what has made it so difficult for us this year in a time of hyper inflation to recapture the increase in wheat cost that have hit or FDFs and gasoline frankly now because we have to take that retail price first. We won’t do that unless we’ve tested it and that takes some time then we have to give them a 45 day notice, that takes some time. We have to give them time to change their menu board. So, in times of hyper inflation it’s quite problematic. I think we have not locked in wheat for next year so we don’t know where that’s going to go but one of the things we are very focused on doing is trying to stay ahead of it now so that we can take the proper prices at a retail level and be able to adjust our retail prices and therefore our transfer prices to keep it in proportion. I think beyond that we’ll continue to operate within the context of our contractual relationships. I think that is what our community has asked us to do at the beginning of this year during hyper inflation and we’ll continue to do that always being sensitive to the context in which we operate.

Jeffrey W. Kip

The one thing I would add Chris is that I wouldn’t think totally linearly about wheat end pricing. There’s a lot of other costs, gasoline has gone up significantly in the context of very low price increases, etc. so it’s not a linear calculation. We’ve tried to lay it out that way for you to understand the impact of wheat.

Operator

Your next question comes from the line of Steven Rees – JP Morgan.

Steven Rees – JP Morgan

Ron, it sounds like the high low menu strategy is working very well for you all and given that your traffic is now improving and you don’t appear to be having much trade down if at all on the lower ticket items. What do you see as the greatest opportunity longer term to build average check? Is it more on the value side through lower price add ons or do you see again an opportunity to have it on the higher end?

Ronald M. Shaich

I guess I would say it to you this way, we are focused on two things and we have made significant change in the internal metrics we’re using. We are focused on transactions and gross profit per transaction. From that kind of thinking we would argue there are significant opportunities coming through category management and menu development on gross profit per transaction. That is to say there is specialty item, higher priced items, that is to say items that have innately a higher gross profit per transaction. I would say on the transaction front or the transaction side of it we continue to try to protect the entry level customer because the metric that we look at is frequency and we’re very cautious about doing anything with our entry level pricing or you would call it our low end pricing. Not discounting it, not cheap, it’s just making it available for everyday use because we are deeply concerned about maintaining frequency among those consumers.

Operator

Our next question comes from the line of Sharon Zackfia – William Blair & Company, LLC.

Sharon Zackfia – William Blair & Company, LLC

I was hoping you could talk a little bit about the franchisees. We didn’t get system wide sales so I’m just curious you saw a nice tick up in the unit productivity on company locations, are you seeing that in franchise locations as well? And, what’s the enthusiasm out there? What’s the development pipeline look like?

Ronald M. Shaich

I think people are feeling generally pretty good right now. I think as we indicated to you the franchise comps we up strongly in Q2 to date at 4.6% for the first 34 days of the quarter. I think that there’s that sense of enthusiasm that exists. I think that our franchisees generally mimic our company stores. The advantage and disadvantage of operating 500 or so company stores is that we experience what they experience and if we experience something they experience it possibly with the exception of the wheat which we’ve experienced to an inordinate degree this year because of the FDF structure. I think that all of us in Panera generally feel very fortunate to be blessed with this brand that is able to withstand and to generate both higher margins, higher gross profit per transactions while continue to grow transactions. I don’t know how many concepts out there growing transactions right now. I think we are pretty blessed with a concept that can deliver. It ain’t us, it’s this concept and that’s what we all share and we own and I think we are very fortunate and I think that’s probably generally felt across our community.

Operator

Your next question comes from the line of Bryan Elliott – Raymond James.

Bryan Elliott – Raymond James

I wanted to ask about Ron kind of your strategic thinking on the franchise company mix. You kind of held that territory for a while, proved you could grow a lot of company stores, have gotten buy in from the franchisees on the sort of new relationship that you wanted to. Should we expect over time to see a bit of a reacceleration in the signing of new deals? And, therefore expansion within the franchise community itself?

Ronald M. Shaich

It think at this point most of the territory, just to update you, that we can reach with our fresh dough systems today are essentially called for in one way or another. I don’t think you’re going to see a significant acceleration or increases in the number of new markets being sold. We’re in most markets in the country. I think you heard Jeff speak to this point, the criteria for us in all these discussions is not a line in the cement philosophy, we’ve got to be more company or more franchise. I think the criteria for us is return on capital and to the degree that there are attractive ways to use our capital either through company stores or through selling markets or buying markets, we’re going to look at that. And, having said that, we believe deeply in a strong franchise system, it’s a great system. Our franchisees are in this and we want them not for their capital, we want them quite frankly for their very strong local operating skills, their strong real estate skills and as much as anything they make the system better. So, you will continue to see us operating essentially in a headset that says decisions are driven by capital allocation. We’re relatively agnostic which way it goes. So, I’d probably tell you as Jeff indicated we’d rather be a little less of the system then more of the system.

Operator

Your next question comes from the line of Rachel Rothman – Merrill Lynch.

Analyst Rachel Rothman – Merrill Lynch

On the G&A line it looks like ex the development related charge it would have been better about 90 bips year-over-year. Could you talk about what drove the favorability and how we should think about a run rate for the balance of the year?

Jeffrey W. Kip

I think it’s pretty simple, we’re doing a better job leveraging our G&A and we’re probably a little light on program expense and national media expense in the first quarter versus the rest of the year and our run rate won’t be as favorable year-over-year going forward. In fact, I think what we said on the call last time is that we expect flat to very modest leverage at this line in the year. Now, you’ve got additional expenses hitting it in terms of the litigation.

Operator

Your next question comes from the line of Robert Derrington – Morgan, Keegan & Company, Inc.

Robert Derrington – Morgan, Keegan & Company, Inc.

Ron, how should we think about the company has established a pretty sizeable credit facility and you haven’t drawn much on it. I’m just trying to think about your use of that whether in share repurchases ongoing, franchise acquisitions, can you give us some color there?

Ronald M. Shaich

Sure. Just simply put it’s nice to have that credit facility. When we use it you’ll be the first to know. Beyond that I think it would be inappropriate to comment as to what that money might be used for until a decision is made to use it.

Operator

Your next question comes from the line of Bryan Elliott – Raymond James.

Bryan Elliott – Raymond James

Just as you guys are getting a lot smarter why did we reduce the disclosure? Why didn’t we get restaurant weeks and the normal sales disclosure that we use to get?

Jeffrey W. Kip

Bryan, let me address it. It think using the words reduced disclosure is a fairly negative way of saying it. It wasn’t our intent to reduce disclosure. I think our view that operating weeks is a pretty consistent number if you look back over time when we get stores open within a quarter they’re opened five of the 13 weeks. When we get stores opened within the weeks they’re open 20 of the 52 weeks. What we’re trying to do is simplify disclosure, focus on the key stuff and make it easier. It wasn’t any attempt to reduce disclosure, simply and attempt to un-clutter the release with some of the less material and more consistent stuff that we normally do. And, we also made the decision that we want to focus people on the company versus the franchise business rather than the system wide numbers for a couple reasons. One is we actually get comments from the SEC system wide sales aren’t a GAAP number, they’d prefer that we not use it so that’s one issue. The I think secondly, we think it’s appropriate to look at the businesses differently as the system wide number is more of a merged number. So, we’re really just trying to go with the appropriate level of detail to focus people on the right stuff to understand the business.

Ronald M. Shaich

I also would add Bryan there’s a lot of energy that a number of companies are involved in, in trying to move to the right data to get people focused on the right stuff and that’s resulted in a lot of people pulling back on a lot of data particularly some of the companies have been the leaders in disclosure. I hope the fact that we’ve been on this conference call for 45 minutes of prepared comments and almost a half hour of questions and that the detail in which we are prepared to go through at the risk of having it hung around our necks later is supportive of the highest levels of disclosure and our commitment to try to give you as great a perspective as we can conscious of the competitive impact of anything that we say on these calls.

Jeffrey W. Kip

We’d argue that we have raised the level of information that we’re giving on the business this year to unprecedented levels for us and really trying to ramp up the disclosure on the stuff that matters.

Operator

That is all the time we have for questions today. With that I’d like to turn things back over to you Mr. Kip.

Jeffrey W. Kip

Thanks to everybody for joining. We look forward to talking to you over the rest of the year and we think it’s going to be a good one.

Ronald M. Shaich

Thank you.

Operator

This does conclude today’s Panera Bread conference call. We thank you for your participation and ask that you have a wonderful day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Panera Bread Company F1Q08 (Quarter End 03/25/2008) Earnings Call Transcript
This Transcript
All Transcripts