Ronald M. Shaich - Chief Executive Officer
Jeffrey W. Kip - Chief Financial Officer
Nicole Miller – Piper Jaffray
David Tarantino – Robert W. Baird & Co. Inc.
Steve West – Stifel Nicolaus & Company
John Glass – Morgan Stanley
Sharon Zachfia – William Blair & Company
Jason West – Deutsche Bank Securities
Steven Rees – J.P. Morgan
Bryan Elliott – Raymond James
Jeffrey Bernstein – Lehman Brothers
Rachel Rothman – Merrill Lynch
Chris O’Cull – Suntrust Robinson Humphrey
Panera Bread Company (PNRA) Q2 2008 Earnings Call July 23, 2008 8:30 AM ET
Welcome to today’s Panera Bread Company second quarter 2008 earnings release conference call. (Operator Instructions) At this time, I would like to turn things over to the Chief Financial Officer, Jeff Kip.
Welcome to Panera Bread’s second quarter earnings call. With me this morning is Ron Shaich, our Chairman and Chief Executive Officer. I’d also like to introduce everyone to Michelle Harrison who is our new Vice President of Investor Relations. We are very excited to have her on board, and she is looking forward to hearing from all of you.
Let me cover a few regulatory matters first. I’d like to note that during our opening remarks and then our responses to your questions, certain items may be discussed which are not based on historical fact. Any such items including targeted 2008 results or conditions and details relating to 2009 performance should be considered forward-looking statements within the meaning of the Private Securities and Litigation Reform Act of 1995. All such forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially. Ron will begin our call with a few introductory remarks.
Welcome to our Q2 earning conference call. Frankly, I’ve been looking forward to this call for some time. Simply put, we had a great Q2. EPS was up 33%, and the future again looks bright. This is particularly so when one considers the hyperinflation in wheat we are presently absorbing and the extraordinary weakness in our economy that we in this industry confront. So rarely have I felt so good about a quarter. The hardest thing about being a CEO is when you don’t deliver for the people who believe in you, and that is how we felt late last year. What makes this quarter so gratifying is that it’s a small way a repaying those of you who believed in us and our company when it didn’t seem so clear that one should do so last year. I particularly want to thank those investors who stuck with us when our results were weaker last fall. Frankly, Q2 is for you. Okay, let’s get right to it.
Our plan to improve margins while holding or growing transactions and improving return on invested capital is working, and it’s working well, and we are pleased to be able to share that success with you today. I’d now like to ask Jeff to review Q2 with you. I’ll then provide some color commentary on our plan to move the business forward. Jeff will then provide you our targets for Q3 and Q4 2008 as well as assumptions that underlie them. I will then conclude.
Thanks Ron. Let's get right into the second quarter results. Last night, we issued our second quarter earnings release for the thirteen weeks ending June 24, 2008. Let’s first review the metrics. Our comparable bakery cafe sales increased 6.5% in company-owned locations during the second quarter. We estimate that this number benefited approximately 30 to 40 basis points from the shift of Easter from the second quarter last year to the first quarter year. Retail price was approximately 5.5% year over year. Net of the Easter shift, transaction and mix growth amounted to approximately +0.6 to +0.7% year over year, with mix impact modest. Comps increase 4.8% at franchise operated locations.
Average weekly sales for company-owned units opened in fiscal 2008 were $35,776 in the second quarter. Year to date, that number is $36,640, in line with our full year target of $36,000 to $38,000. We opened 19 bakery cafes in the second quarter, 6 of which were company owned and 13 of which were franchise operated.
Our net income for the second quarter was $15.7 million after charges of $0.02 per diluted share, resulting from unfavorable tax adjustment, and $0.01 per diluted share from the further writedown of the company’s investment in the Columbia’s Strategic Cash Portfolio. Including the impact of these charges, earnings per share were $0.52 per diluted share. This compares the net income of $12.6 million and EPS of $0.39 per diluted share in the second quarter of the prior year.
Let’s get into a little more detail on the P&L and our margins for the second quarter versus the comparable period a year ago. Starting with total revenue, second quarter revenues increased 27% to $320.9 million in 2008 versus $253 million in the comparable period of 2007. The breakdown is as follows: Net bakery cafe sales increased 31% to $274.4 million in 2008 from $209.6 million in 2007, driven primarily by sales from units opened in the last four quarters, by acquisitions over the same period, and increases in comparable bakery cafe sales.
Franchise royalties and fees increased 6% to $18.1 million in the second quarter of 2008, from $17 million in the same quarter in the prior year, driven by new franchise-operated bakery cafes opened in the trailing four quarters, partially tempered by the impact of the acquisition of franchise-operated bakery cafes by the company. Fresh dough sales to franchisees grew 8% to $28.4 million in 2008 from $26.3 million in 2007. As a result of these differential growth rates, we continue to experience a ship in total revenue mix as bakery cafe sales as a percent of total revenues increased to 85.5% in the second quarter of 2008, compared to 82.9% in 2007, while over the same period, franchise royalties and fees declined to 5.6% from 6.7%. The net impact of the shift on operating margin is approximately 110 basis points of optical unfavorability on margin year over year. Fresh dough sales to franchisees declined as a percent of total sales to 8.8% from 10.4%. We will return to this a little later when we discuss operating margins.
Now, let’s move on to P&L margin analysis. Restaurant margins overall were higher by about 170 basis points in the second quarter of 2008 versus the same quarter of 2007. Let’s go through the bakery cafe margin by component now. First, cost of food and paper products improved by 30 basis points year over year to 30.3% of restaurant sales. Together, our category management initiatives and operational focus drove 190 basis points of favorability year over year, while the impact of wheat and other cost inflation drove an offsetting 160 basis points of unfavorability, netting to our 30 basis points of pick-up year over year.
Going forward, we don’t expect to retain all of that 190 basis point of favorability each quarter as September marks the anniversary of our kickoff of category management and the fourth quarter anniversaries our menu reorganization and November 2007 price increase.
Labor as a percentage of restaurant sales improved 100 basis points year over year to 31.1% of restaurant sales. Higher than anticipated sales and sound execution versus some inefficiency in Q2 2007 added to the 100 basis points margin benefit we got by removing Crispani in the beginning of this year. That benefit, you will recall, was partially offset by the addition of the expedited position which added an additional 50 basis points of labor. In the third and fourth quarters, we continue to target 100 basis points of labor margin improvement from Crispani removal without the offset from the expeditor as we anniversary the edition of that position in July.
Occupancy costs in the second quarter increased 30 basis points versus the prior year to 8.1% of restaurant sales, based upon somewhat higher average per square foot costs in immature stores outpacing the growth in sales during the second quarter of 2008 as compared to 2007. Other operating expenses as a percent of restaurant sales in the second quarter of the year improved 70 basis points to 13.4% from 14.1% in the prior year, as we benefited from higher than expected sales and continue to make progress in our cost control efforts in this area. In the back half of 2008, we don’t expect the same level of favorable gains and other operating expenses given the timing of certain field marketing expenses.
In total, bakery cafe margins are again up 170 basis points year over year, primarily as the result of our ability to take price to offset inflation, category management initiatives driving a more profitable mix of business, and favorable labor costs given the removal Crispani which have more than offset the rise of wheat and fuel costs.
Moving on from restaurant margins, fresh dough cost of sales to franchisees as a percent of fresh dough sales to franchisees left 720 basis points over the year unfavorable. Approximately 780 basis points of this unfavorability was driven by the $2.2 million impact of wheat cost increases, net of our price increases, with the all-in cost of the wheat at its high point in the second quarter for the whole year at $17.25 a bushel versus $5.80 per bushel last year. Again, the number we quote is wheat futures plus cost of basis per bushel.
Increases in diesel costs per gallon year over year drove another additional 40 basis points of unfavorability in this margin line. Our revised guidance for the remainder of the year assumes a diesel cost per gallon of approximately $5 for the each of the third and fourth quarters versus approximately $3 and $3.30 respectively in the prior year. In the second quarter, diesel was around $4.50 per gallon versus approximately $3 in the same period of the prior year.
Operating leverage in our manufacturing facilities yielded 100 basis points offsetting favorability, netting us to the total 720 basis points of unfavorability. Depreciation costs in the second quarter improved 50 basis points to 5.1% of total revenues versus the prior year at 5.6%. The positive leverage on this line is driven by sales leverage and our investments.
General and administrative expense in the second quarter improved 20 basis points year over year to 6.7% from 6.9% in the prior year. This improvement, driven by strong G&A disciple, came even though we accrued 80 basis points more of incentive compensation program expense versus the prior year. This significant increase was driven by the fact that these programs were substantially under water last year, and we are accruing higher than our target year to date given our exceptionally strong performance. We expect an additional 40 basis points per quarter of bonus accrual in each of the quarters in the second half of the year given our expected performance driving an unfavorable G&A margin versus the prior year.
Pre-opening expenses in the quarter improved 30 basis points to 0.3% of total revenues versus 0.6% in the second quarter of 2007 as we opened 11 fewer company-owned units in the second quarter than we did in the same period last year. The slowdown in new openings reflects the more rigorous investment criteria we discussed on our first quarter earning call. We’d expect this year-over-year comparison to continue to be positive in the second half of 2008. We feel very good about our overall improvement in operating margin. A hundred basis point year-over-year increase is a very strong marker towards our internal goal of 150 to 200 basis points’ improvement in the 2009 operating margin versus our 2007 margin. Overall, we actually generated more than 400 basis points of favorability through margin improvement initiatives and strong execution to offset more than 300 basis points of margin headwind in the quarter. This headwind I refer to is created by a full 190 basis points of unfavorability, net of price increases based on the cost increase per bushel in wheat and an another additional 110 basis points margin headwind created by the optical margin shift driven by the acquisition of our franchise bakery cafes.
As you know, we believe it when we buy a franchise bakery cafe at 5 to 5-1/2 times differential cash flow, and that’s EBITDA net of royalties, we earn an outstanding return on capital, but it drives an unfavorability in our operating margin simply because franchise revenues are 100% income and acquired stores have a high teens margin. Thus, we call this shift optical rather than economic. Based on our ability to drive favorability over and above the challenges we face, we now anticipate finishing the year with favorable year-over-year operating and bakery cafe margins versus 2007.
Moving on to taxes. The effective tax rate for the quarter was 39.6% compared to 32.5% in the comparable period of 2007. Prior year was lower than average driven by favorable unwinding of a FIN 48 tax exposure reserve, whereas in the second quarter of 2008, we experienced the unfavorability of the previously mentioned $0.02 FIN 48 reserve expense. Currently, we are projecting the possibility of an additional up to $0.02 of incremental discreet tax in the third quarter of 2008. The tax rate would be approximately 40% in the third quarter and 30% fourth quarter under that scenario. Going forward, we expect our tax rate to move in the range between 38% and 40%.
Moving on to cash flow for the quarter. The company generated $62.7 million of cash from operations and employee stock option exercises and had capital expenditures of $15.9 million. In addition, we repaid $42 million of our credit facility in the second quarter of 2008. At the end of the second quarter, the balance on our credit facility was $18 million. Continued strong cash flow has allowed us to further reduce the credit facility to its current level of $10 million, meaning that our performance this year has allowed us to pay down $65 million of the $75 million we borrowed to fund our $75 million share purchase completed in the first quarter of this year. As a side note on that transaction, given the way our business has performed year to date, we continue to be extremely pleased with the level, an average share price of $34.62, at which we repurchased the $2.1 million shares in the fourth quarter of 2007 and the first quarter of 2008.
Now, let me give you an update on our position in the Bank of America’s Columbia Strategic Cash Portfolio. During the second quarter, we adjusted our net asset value from $0.93 on the dollar to $0.89 on the dollar which resulted in approximately $0.01 hit per diluted share to earnings. The current credit environment and the deterioration of many asset classes beyond just mortgage-backed securities have led us to believe that a net asset value of $0.89 on the dollar more accurately reflects the risk in the remaining investment portfolio. Including the adjustment and a 3% cash redemption we received in the quarter, we ended the second quarter with $13.5 million of investments in Columbia Strategic Cash Portfolio which compares to the year-end balance of $23.2 million. To date, we have received redemption of more than 43% of the funds we had in the Bank of America fund at nearly 98.5 cents on the dollar. Our current expectation based on what Bank of America has told us is that the fund will continue to liquidate into 2009.
We ended the second quarter with $22.1 million in cash, excluding the $13.5 million of NAV in the Columbia Fund, and $18 million of debt. This compares to year end when prior to completion of our share repurchase program, we had about $68 million in cash and $75 million of debt. On average for the quarter, there were approximately 30.3 million fully diluted shares outstanding including the impact of 1.7 million stock options outstanding with an average exercise price of $39.56 per share. Now, I’d like to hand it back to Ron to review our strategic initiatives.
As you all know, we’ve been deeply focused on our plan to move the business forward. We bet on a plan of action to improve margins while maintaining or growing transactions and strengthening return on invested capital, all the while driving long-term concept differentiation. Along the way, we learned a great deal. First, we learned that the inflationary cost pressures of 2008 would be far worse than we ever could have expected. Second, we learned that the economy would be far weaker than we could have imagined, and third, we’ve learned that our plan is working better than we ever would have hoped for. With that in mind, let’s walk through the three prongs of our plan.
Let’s begin with margins. As Jeff indicated, we saw significant traction on our margin initiatives in Q2. Simply put, we are exceeding our goals from margin improvement. How? Most importantly, we’ve been using our category management function to drive improved gross profit per transaction. Indeed, our category management team has been very effective in helping us to effect disciplined price adjustments. To that end, we've been intensively focused on executing the pricing philosophy we laid out for you several quarters ago. Our objective in that philosophy has been to drive gross profit per transaction by changing consumer behavior and by effectively executing a high/low pricing strategy. As you know, the manifestation of this work has been several carefully tested price and menu adjustments in the past 9 months.
Let’s now discuss these pricing initiatives individually. In November 2007, we took an approximately 2.5% increase and reorganized the products on our menu panels. The focus of this increase was a higher priced specialty products. The focus of our re-menuing was on bringing greater prominence to our higher gross profit items. This initiative was rigorously tested, and the testing demonstrated that we would be able to effect the changes with no noticeable degradation in transaction growth. As you know, this is exactly what happened.
In late March 2008, we implemented another retail price adjustment of approximately 2.7% in company stores. This adjustment focused on raising prices at a number of entry level items. This price increase was also rigorously tested, and again the test and actual results proved there was limited, if any, negative transaction impact. In addition, many of our franchisees followed our lead and implemented a menu structure similar to ours in early April. On June 18, 2008, we implemented a price increase on many of our bagels at our company-owned bakery cafes. To do so, we executed our high/low strategy, pricing signature bagels at $1.25 and our non-signature bagels at $0.99. This represents an additional lift of approximately 1% of total sales. It also allowed us to raise our go-transfer prices to franchisees to cover more of the hit from wheat. We’re pleased to report that actual results performed consistently with our testing. More importantly, we continue to see little or no negative consumer blow-back from this adjustment.
In addition, we just completed our testing of an additional 1% across-the-menu increase. Based on those successful tests, I’m pleased to be able to report to you today we plan to roll out an additional 1% increase in September. In sum, the net result of these price adjustments is a year-over-year price increase of 5.5% for Q2, a projected year-over-year price increase of approximately 6.5% for Q3, and a projected year-over-year price increase of approximately 6% in Q4, and most importantly, research that we recently conducted shows that Panera’s value score remains as strong as strong as ever despite the pricing adjustments we executed at the end of 2007 and in 2008.
In addition, our category management team has been successful in effectively pricing new products, such as our new grilled breakfast sandwiches and the reintroduction of our strawberry poppy seed salad such that each of these products drives up gross profit per transaction.
Before I conclude my comments on category management, let me note that we are hard at work on the other category management initiatives for 2009. One such test is a combo program for our breakfast products. We’re also testing a menu restructuring to offer more size and more price alternatives on our soup. In addition, we will also begin testing a new pricing initiative in the fourth quarter with hopes of implementing those adjustments at the beginning of Q2 2009. Expect to get updated on these initiatives as we go forward. Let me also note that we made real progress on other cost initiatives, particularly controllables. As I’ve shared with you before, our goal is to have those costs below the gross profit line grow at a rate significantly less than the growth of our gross profit, and our team has done a great job of doing just that.
Let’s now turn our attention to transactions, the second prong in our plan. The truth is we’ve been very surprised to see transaction strength. In fact, transactions were up half a point in Q2. So, here’s the question. Does this mean that Panera is recession resistant? No. What it means is that we’ve been able to take control of our destiny. We’ve been able to build transactions to offset recessionary pressures. Is it possible that we may be less affected by recession than other brands? The answer is yes, given the higher average income of our customers and the fact that we’re a breakfast and lunch spot for working people rather than a casual dining establishment for dinner. But despite all that, the economic doldrums are certain to hit Panera customers as well. So what’s going on, and how then were we able to grow transactions despite our price increases and our category management initiatives in Q2? Think of it like a cup. Transaction loss is metaphorically like holes in the bottom of that cup. Think of those holes as small leaks if you wish. We have been able to offset the leakage in our metaphorical cup by pouring into the top of that cup, increase transactions from our new breakfast sandwiches and from the strength of our media as well as our continued operational focus, and we estimate that taken together, these positive transaction builders offset the transaction losses we would experience coming about as a result of the uncertain economic environment and its effect on certain of our customers.
As you read in our release, we are today pre-releasing comparable company-owned bakery cafe sales for the first 27 days of Q3. Company comps in those first 27 days were 3.6% and franchise comps were about 4%. Truth be told, these comps are down sequentially, so what’s going on? As ever, we don’t fully understand the more modest comps of Q3. Simply put, it’s too early to read the results coming in as we march forward with just 3 weeks of results. But here’s what we do know. We know that the way the July Fourth holiday fell this year negatively impacted comps. More importantly, we know that in the first three weeks of Q3 2008, we’ve been running against some of the most powerful comp weeks of 2007. As you may recall, in Q2 2007, company-owned comps were 1.7%. In the first period of Q3 2007, that is to say period 7, the one we’re in right now, comps in 2007 were 4.4%. This was where our very successful summer celebration rooted in our strong summer salads really took off. In the second period of Q3 2007, that is to say period 8, comps were 4.1%, and in the third period of Q3 2007, that is to say period 9, comps were down to only +1.5% as our summer celebration and its success in building the business began to recede.
Think of it this way. In Q2 2008, we ran 2-year company-owned comps of 8.2%. For the first 3 weeks of Q3, company stores ran 2-year comps again of 8.2%. In Q3, with comps targeted at 4% to 5%, we are assuming 2-year comps of 6.9% to 7.9%. In Q4 2008, with comps targeted at 3.5% to 4.5%, we are assuming 2-year comps of 6.1% to 7.1% which we think makes sense for our use in our target given the weakening economic picture. The point is we’re going up against some of the stronger comps from 2007 at the same time that the economy continues to weaken. So in the context of that, discretion is better than valor, and expectations for weaker transaction growth in Q3 and Q4 makes sense.
Now, let me turn our attention to our progress on ROIC. We know that driving our ROIC, that is to say or return on invested capital, from good back to great involves two things. First, it involves our core margins. Second, it involves the average weekly sales of our new cafes. Obviously our core margins have improved significantly. In fact, when we look at our company store business as a standalone business, utilizing the same transfer prices as our franchisees as we frankly do internally, our average bakery cafe, including our new openings year over year have seen profit growth of 16% in Q2. This is the result of our margin improvement efforts and the leveraging of our fixed costs.
In addition, our average weekly sales on new cafes in the class of 2008 continues to be significantly stronger than the prior year. We are currently looking at average weekly sales of $35,776 for new company bakery cafes for Q2. It is true that our Q2 openings were weaker than the extraordinary numbers we produced in Q1. Having said that, year to date, they are up $36,640 which is 15% higher than the new unit AWS at this time last year, but just as we told you in Q1 not to get excited about the numbers, I’d say the same thing about the Q2 numbers. I feel very comfortable in telling you this because we’ve actually had a couple of very strong openings recently. In fact, to my amazement, we just opened a store in North Carolina doing over $80,000 a week. So, here’s the bottomline on average weekly sales. We remain confident that despite the ups and downs, we’ll finish the year with our class of 2008 producing AWS in our target range of $36,000 to $38,000 and well ahead of what the class of 2007 produced last year.
One final note before I turn it back to Jeff for a review of our Q3 and Q4 targets. Sometime last year, I had the opportunity to travel with one of our sell side analysts. I’d like to recall for you his comments. He noted that one of the great risks for companies like Panera, in fact one of the great risks for almost every company in the food service industry was the day and their management teams had never before operated in an inflationary environment. As a result, he lamented, none of the companies had systems or procedures in place, nor management attuned to operating in inflationary times.
I spent a great deal of time last fall thinking about that comment, and I realized how absolutely correct this analyst was. As a result, our senior team spent a fair amount of time last fall reviewing all of our practices and procedures in an effort to prepare the organization to operate in an environment with far greater inflation. That thinking led us to build out the category management function and create a true strategic pricing discipline focused on understanding where customers perceive value. Both of these changes have proven beneficial to our margins in 2008. It also led us to change our thinking and focus far more on gross profit per transaction as opposed to average check or sales per transaction. As we did so, we shifted our key internal metrics to gross profit dollars from comp dollars. In essence, in the past we had been focused on the dollars consumers brought into the cafe, but for the last 9 months and going forward, we have been and will be focused on the dollars consumers leave when they walk out of the cafe.
Finally, this thinking has led us to restructures our purchasing processes such that to the greatest extent possible, we are committed to purchasing six months ahead, at least 6 months ahead, with relatively short purchase commitments. In fact, our general practice today is to purchase 6 months ago for a 6-month contracted period. This enables us to project out our underlying inflation and to make sure we are strategically pricing to cover that inflation. In addition, such a strategy allows us to moderate the impact of cost gyrations. The bottomline? Panera has been rebuilding itself to operate in an inflationary environment, and I believe that those skills along with our plan to improve margins, grow transactions, and improve ROIC while increasing long-term concept differentiation will pay dividends over the next couple of year.
Now, let me turn it back to Jeff who will take you through our target for Q3 and our targets for the second half of the year. I’ll then return for a very brief closing comment.
I’d like to now lay out for you our financial outlook and targets for the remainder of 2008 and offer a few initial comments on 2009. As part of this earnings release, we have not broken out the third and fourth quarters of 2008 separately in our targets. Our combined EPS target previously was $1.14 to $1.26 per share. We revised our second half target upward for 2008 to $1.24 to $1.30 share, or 33% to 40% growth versus the prior year. This breaks down to $0.42 to $0.44 per share for the third quarter, or 14-19% growth, and $0.82 to $0.86 per share for the fourth quarter, or 46 to 54% growth.
Let’s get into a little more detail by quarter, starting with our third quarter financial targets. As I just noted, the third quarter EPS is now targeted at $0.42 to $0.44 per share. Our guidance on key metrics is as follows. We moved our transaction guidance to a target range of -1.5% to -2.55%, based on our concerns for the economic environment. Consistent with that and the 6.5% pricing in the quarter, Ron discussed, we are targeting 4-5% company-owned comp store sales growth in Q3.
Moving on to third quarter margins, as Ron and I both discussed, we’re pleased with the progress we’ve made on our margin initiatives. We expect continued favorability on our cost to sales line, although perhaps not at the level we saw in Q2 as we started to anniversary couple of management rollout pricing and improved executions in the second half of 2007, and wheat costs continue to present a significant headwind. We now expect wheat costs of $15 per bushel in the third quarter versus $5.80 in the prior year, driving $3 million plus in cost of sales expenses in bakery cafes year over year.
In terms of cost of dough sales to franchises, while we have taken pricing on our dough sales to neutralize the negative dollar impact, margin will continue to be materially unfavorable versus the prior year because expense and sales will increase by the same dollar amounts and fuel cost increases will offset in part the operating leverage in that business. As previously mentioned, we are now expecting gasoline costs of about $5 per gallon for Q3 and Q4. At the very beginning of the year, we had actually anticipated $3.50 per gallon for the year.
In terms of labor margin, as we previously mentioned, we are targeting 100 basis points of improvement n the labor line in both third and fourth quarters from Crispani now. Finally, as also previously discussed, we have possible tax exposures of between zero and $0.02 for the third quarter. The facts don’t yet support a FIN 48 Reserve, but we’re concerned there’s possibility that some expense could hit us. Our best guess as to timing of if the possible exposures actually hit us at all would be tax expense of $0.02 in the third quarter, over and above our average tax rate.
Let’s now discuss our fourth quarter 2008 targets. We’re guiding to an EPS target range of $0.82 to $0.86 per share. The EPS target is built on the following sales metrics. Transaction growth of negative 1.5% to negative 2.5%, a year-over-year price increase of 6%, a comparable store sales growth in a target range of 3.5% to 4.5%. Key metrics for margin are all-in cost of wheat for the fourth quarter at $12 per bushel, versus $5.80 in the prior year, driving $2.5 million of incremental bakery cafe cost of sales of expense. In terms of dough sales to franchisees, we expect dough prices at breakeven to wheat costs. Again in the fourth quarter, we expect continued improvement in our cost of sales from our initiatives, and we expect to continue to enjoy 100 basis points from improvement in the labor line from the removal of the fixed labor associated with Crispani.
Based on all these assumptions, we are now targeting approximately 200 basis points of favorability year over year in both our restaurant and our operating margins in the fourth quarter, despite significant unfavorability driven by both wheat and gasoline inflation. I’d like to conclude by commenting on full-year 2008 guidance and add a couple of points on expectations for 2009. For fiscal 2008, we’re raising our EPS guidance from $2.03 to $2.17 to $2.17 to $2.23, for an overall earnings growth of 21-25% over $1.79 we earned in 2007. To avoid confusion, this target is net of all charges. In other words, all charges that we’ve expensed in the first and second quarter are in that number. Thus, we assume $0.41 and $0.52 for the second quarter, in addition to the $1.24 to $1.30 we are now targeting for the second half of the year. I want to remind you that this full-year growth is still net of approximately $0.34 year-over-year negative impact resulting from the rising cost of wheat net of price increases. So had wheat costs remained the same as last year, a truly phenomenal year we would be having. Now, as I mentioned before, in 2009 we continue to hold 150 to 200 basis points of improvement in the operating margin line over 2007 operating margin as our internal target. We are seeing the progress on our key initiatives and metrics that builds our confidence that we can reach that goal.
In terms of 2009 EPS targets, analysts’ consensus estimates currently have our 2009 EPS at a 17% to 21% growth rate versus our revised 2008 full-year target of $2.17 to $2.23. We believe that these kinds of numbers are at the high end of prudent. The end of the current hyperinflationary environment and broader economic recession do not appear to be near end. We currently believe that core cost of sales inflation in our retail business will run 5-6% for 2009, and while we are committed to take pricing to offset this cost inflation, we are very cognizant of the toll this can take on our transaction counts in a tough economy.
In terms of wheat costs, we have locked in wheat for the first half of 2009 at approximately $10 per bushel, and will walk the second half of the year and the fourth quarter through a disciplined purchasing process. However, there are significant offsets to the benefit that price will yield year over year driven by first fuel inflation and second other commodity cost increases and one of the big ones right now is dairy and broad 4-5% inflation across all the other costs in our fresh dough facilities, without any incremental price in that business expected. With the high likelihood of a lingering recession through 2009 and its potential corollary impact of negative transactions, we feel it would not be wise to estimate 2009 growth any higher than 20%.
With that, I’d like to turn it turn it back to Ron for closing remarks.
Let me conclude as I began. We could not be more pleased with our second quarter results, and we could not be more pleased with our prospects for the future. To deliver 33% EPS growth in the second quarter despite a weak consumer environment and despite the hyper-inflation we are experiencing in wheat and gasoline is quite gratifying. To be able to raise our second half 2008 targets to reflect a 33-40% increase over the prior year is a reflection of the strength of our concept, it’s a reflection of the power of our plan, and it’s a reflection of the confidence we have in our support center team, our operators, and our franchisees. That ends our prepared comments.
At this time, we are open to take your questions. As is our custom, we request that you ask only one question at a time, and you do so in order as it allows us to give as many of you on the call as possible an opportunity to weigh in. If you have additional question, we would request that you return to the queue. We’re happy to stand online until all your questions have been asked or until the market opens at 9:30. We’ll certainly give you 15 minutes, so we’ll stay on the line till 9:35. Operator, we’re ready for that first question.
(Operator Instructions) Our first question comes from the line of Nicole Miller with Piper Jaffray.
Nicole Miller – Piper Jaffray
One quick housekeeping thing. What would the tax rate have been excluding that 2-cent charge and that penny, and then my non-housekeeping question is, looking at the unpredictable environment, looking into ’09, how do you guys feel about development? I think you had maybe previously talked about 100 to 120. Does it still stand, or what are you thinking today?
In terms of housekeeping, Nicole, tax rate is about 37.5% excluding the FIN 48 expense, and then secondly, the other charge goes in other income and expense. Relative to openings for next year, Nicole, I think it’s way too early to project or target anything. We will when we release guidance for 2009, which we’re not attempting to do today, we’re just attempting to voice the concerns we have, but when we give guidance for 2009, you can be sure we’ll give you guidance on openings.
We’ll take our next question from David Tarantino with Robert W. Baird.
David Tarantino – Robert W. Baird & Co. Inc.
Clarification question on recent traffic trends. Can you provide some color on the impact of the July Fourth timing and if the flooding in the Midwest might have had any impact on the recent numbers, and separate from those issues, would traffic be running inside your guided range for Q3?
July Fourth, as you know, this year it basically knocked out the second weekend much more strongly than the prior year where it was spread between two weekends and it wasn’t as much intense. We could literally see it because we receive comps every single day and you could see the way it actually built up and then melted. Clearly, the weather in the Midwest hurt us and the flooding as well. We had some stores that were actually closed as a result of it, but I would stay away from that. To be honest with you, we tried very hard not to pull apart regions against regions, weather against weather, week against week. I think what matters here is that if you hold apart those first three comps, if you had 6% price in there, that basically you had negative mix in traffic or transactions of roughly 2.4%. There are a lot of factors in there. We try to look at it on a quarterly basis, and on a quarterly basis, it’s highly stable. What has surprised us immensely and which we are totally pleased by is that we went into the year with guidance of a target of somewhere between zero and negative 2% traffic growth/transaction growth, and you saw that in the second quarter, we were up half a percent. We’ve been very gratified by the success. Having said that, nobody knows what the future brings, and we think it’s wise to target based on continued economic weakness, and that’s why you hear the targets that we’re talking about, but I guess the important point to note is that as ever Panera will do everything in its power to drive those transactions and continue to move forward, and we’ll see how the world plays out quarter by quarter.
Let me just add a little bit of clarification to what people looking at in terms of trends. We’ve given pricing as weighted average for the quarter. As you know, our price increases tend to move within the quarter, and just so people understand, our pricing so far this quarter is at 6 plus. We’re going to get to 6.5 for the quarter because we’re going take a point or so at the beginning of September and average up to about 6.5. So, in the three weeks, we had, as Ron said, about 6% pricing, about 3.6% comps, and essentially minus 2.4% traffic within the range. If you go back to June, June essentially had about 5% pricing in it as the extra point of bagel pricing came at the end of the month, and so with 5% pricing, that month was essentially flat on transactions and mix, so the pricing moves a little differently, and the transactions don’t move precisely if you go with a full quarter price average, if that’s helpful.
We’ll take our next question from Steve West with Stifel Nicolaus & Company.
Steve West – Stifel Nicolaus & Company
Really quick, maybe a little more color on the same store sales growth. We talked about the breakfast sandwiches doing well, and from what I’m seeing, they are selling well. You guys used to tell what 4731. Do you have any color on that that you can give us, and also could you let me know currently where is growth coming from, which day part is it? More breakfast or is it rest of the QSR or is it maybe more lunch? Is there anything you can tell us on that?
We’ll take that as one question. As ever, I’m all finesse to try to separate out all these different pieces, and in tests, we’re always able to separate out any individual initiative because we have a very specific control, but once we roll it into the system, it’s very hard because there is no overt control, and I can’t isolate the impact of one element. The result is there’s sort of a stew of things that are driving the transaction growth that we see and offsetting the recessionary pressures that we like everybody else are experiencing, so we’re got a stew in there, and we’re got breakfast sandwiches which is certainly good for a couple of hundred basis points of transaction growth. You’re got the impact of the media. That’s certainly a positive impact. I don’t know how to separate out our operational focus. It’s been key to us. And I’m sure we have underlying undertone that these are matching up against relative to consumer weakness. Having said that, when we look at it by day part, clearly given the strength of what we’re doing, our breakfast day part is our strongest day part. It’s up not just in terms of transaction growth. It’s up in terms of gross profit per transaction even more significantly because these products are bringing not just growth in transactions, but gross profit per transaction. Our weakest day part is evening and dinner, partially in the context of the removal of Crispani , but I think as importantly, that’s where you feel the most discretionary behavior. I hope that gives you the perspective you’re looking for.
Steve West – Stifel Nicolaus & Company
Thank you, and just to let you know, I have noticed a big improvement on your execution at the stores, so it is working.
Steve, thank you. I know our St. Louis operators would appreciate your perspective, but you know, as ever, that’s the hardest one to share with you because that’s not the sexy stuff. It’s not isolatable into an individual program, but let me tell you, when we cut almost a minute off the speed of service and we improve the accuracy scores, it directly translates into what we’re all about.
We’ll take our next question from John Glass with Morgan Stanley.
John Glass – Morgan Stanley
Housekeeping and then a question. What is the extra week impact on the fourth quarter in your guidance, and the question is I understand you don’t believe that your pricing has impacted traffic, but what metrics can you look at on a real-time basis to prove that to yourself that it is just part of the comparisons or something broader? Are there mix shifts that you look at or are there specific product velocities? What gives you comfort that pricing is not driving traffic down?
I’ll start with the second question first, and then Jeff will take your first housekeeping matter relative to the 53rd week. Let me tell you what gives us comfort relative to pricing. You know that discussion you and I’ve had for the last 6 months, and that is we run quarterly very deep value studies. We’re out in the market with 3000-4000 people in the sample base, and I’m talking about looking at it by target customers and non-target customers, and I think as you may know, last November, we had value scores that were better than most of the companies that you cover or most of you cover, without getting specifics. Literally based on surveys done and completed as recently as a couple of weeks ago, and the results that we analyzed, those value scores are indicating that essentially the same relative value or strength of value that Panera had last November still exists today, so I have to look at the underlying consumer sentiment, and I have to look at what they think and how they come across to me in this survey work to try and understand what is going on in their minds. It’s certainly been something we’ve been concerned about and aware of, but we see nothing from the survey data to indicate any value degradation in their view of Panera. Having said that, to try to pull all this out and say how much is the reaction to price and how much is the economic environment, it’s very simple. A recession is a depression for some people, but as far as most of our customers, their behavior hasn’t changed, but if 1 out of 33 of our customers, if they lost their home or if they have a problem or their husband’s lost his job or their life has change or they’ve been laid off and they’re not working in that office anymore, well, that’s traffic. That’s 3%, so I don’t know what is what. I only can tell you that it’s all in there together in the stew. It’s the initiatives we’ve driven to drive transaction growth. It’s the economic uncertainly that affects some customers, and you have to throw in pricing. Again, to repeat myself, we see nothing on a survey basis that indicates pricing is a concern.
In terms of your other question, John, that’s not something we put a sharp pencil to to figure out exactly in our guidance what that week is worth, and so the best help I can give you is to say I think it’s basically 4 cents. It’s worth a little more than 1/53 of our year. It’s worth a little more because there’s certain but not a ton of fixed items which don’t get spread weekly. They’re spread on a fiscal basis, but too many, so it’s the best way to think about it.
We’ll take our next question from Sharon Zachfia with William Blair & Company.
Sharon Zachfia – William Blair & Company
I’m slightly confused on your initial [inaudible]. It sounded like on the one hand, you still are targeting 150 to 200 basis point margin improvement from last year. On the other hand, you’re saying that 20% gross margin growth might be too aggressive. Those obviously are a little contradictory statements, so maybe if you can connect the dots for us and if you can’t get to the 150 to 200 basis point for ’09, it that something we would expect to get to that improvement by 2010?
Let me cut is pretty simply for you. The 150 to 200 basis points, as stated, it’s our internal target. It’s what managerially we’re holding ourselves to shoot for. What we’re saying about 2009 and what I’m not saying by that, Sharon, is I’m not saying, ‘Hey Sharon, put 150 to 200 basis points of margin improvement into your model, spin the dial, and see what EPS you get. That’s not the direction we’re saying. We’re saying that’s what we’re driving towards and we feel great about our progress towards it. We feel like we’re on track. What we’re saying with our comments on 2009 is that we don’t think it’s prudent to put the kinds of numbers out there that are over that 20% number right now because we don’t know enough about 2009 to say anything like that, and so we doubt other people out there know more than we do internally, and we don’t mean that in a rude way. We just mean it in a fairly simple way, and the headwinds we’re sailing into right now in terms of commodities inflation, you’re heard us say it’s probably 5-6% average in the P&L all in. In terms of commodities inflation, it’s huge, and then the recessionary overhang here and the potential it has to continue to slow transactions if it moves through the economy is tremendous, and so we think it unwise to get higher.
We’ll take our next question from Jason West with Deutsche Bank Securities.
Jason West – Deutsche Bank Securities
I was wondering if you could talk a little bit more about the decision to take more pricing in September, if that was a tough call given the recent traffic trends, or why take the pricing now if the comps are already going to be pretty… I mean the pricing is already pretty significant even without that?
We’re looked at pricing every quarter, and what we try to do is do the pricing that makes sense for the business and where we’re going with the business, and so this was a targeted fourth quarter adjustment. It’s basically our fourth adjustment of the year from where we started out. I think we’ve probably gotten a little more skin on each of the adjustments, which is why it may be slightly more than you might have originally projected, but I don’t think there’s any real change in the philosophy or any change in the execution of that philosophy. I just think it basically gave us a little more margin than we might have originally expected before we knew what we really were going to pricing.
We’ll take our next question from Steven Rees with J.P. Morgan.
Steven Rees – J.P. Morgan
With the better new store volumes this year, can you just talk a little bit about the margin performance of the new units that you’ve opened so far this year versus the prior years? Maybe if you could look at the numbers and come back and maybe quantify just the overall impact from the lower margin units that you’ve opened in the last couple of years and the impact that that will have on the margin erosion?
Steve, it’s pretty straight forward. All our stores perform about the same within volume bands, so if you get higher volumes, you get better margins. We don’t get into disclosure on all the levels of sales, but on a level, more sales treats you better against your fixed costs, so there stores are doing better on margin than previous classes which opened lower. I would also add, Steve, that you go to our supplemental sales and bakery cafe information which breaks out comps or change in company-owned average weekly sales and comp sales by class. You see that the class of ’07 and the class of ’06 are essentially running in terms of average weekly sales growth 500 basis points better than the average, which is to say ’07 is up 8.4, ’06 is up 8.1, and ’05 and prior is up 3.8, so as we have said for so many years, what happens is stores open and they then grow at a rate more rapidly than the underlying base of the remainder of the stores, and ultimately all get to pretty much the same price.
Steven Rees – J.P. Morgan
Right, but just in terms of the 400-500 basis point decline we’ve seen since ’05, how much of that would you say was due to the [inaudible] versus just other factors.
We haven’t broken it out that way, so…
The system-wide AWS as you see at the top of that page is continuing to grow certainly when compared to what it was in ’02, ’03, and ’04, and has been pretty stable in ’05, ’06, and ’07.
We’ll take our next question from Bryan Elliott with Raymond James.
Bryan Elliott – Raymond James
Jeff, the guidance line by line and specific commentary guidance, I assume is against restated prior year for third and fourth quarter? We’ve moved some COGS between commissary and stores, and so we don’t have Q3 and Q4 from which to sort of rectify your comments. Any chance that we might get that, at least just the dollar amount or the shift in Q3 and Q4, so that we will be on the same page with you?
No. I think you can probably make your best estimate based on trends.
We’ll take our next question from Jeffrey Bernstein with Lehman Brothers.
Jeffrey Bernstein – Lehman Brothers
Just a followup on your ’09 thoughts. I know you mentioned, Ron, earlier that you want to look at 6 months and lock in 6 months in advance. In terms of commodity cost visibility and perhaps your suppliers’ willingness to lock in for set terms at fixed prices, just wondering if you can give some color on items other than wheat perhaps how far out you see that being locked? How do you come up with that 5 to 6 blended? And just as a followup, I think earlier someone had asked a question about unit growth in ’09. I’m just wondering how far in advance you have to lock in that pipeline, or whether at this point in ’08, you already have an idea as to how many openings you might see in ’09? Thanks.
Jeff, on your question, we are currently working on locking up everything we’re going to lock for ’09. As already commented, you know that at least half the wheat we won’t be locked till the fourth quarter. I think that in general we’re in the same kind of process on all our commodities. As Ron commented, we try and do about 6 months at a time six months ahead so the implication is that right now we’re about half done. That’s a good way to think about it, and the range is built on based on everything we currently know, just like any other estimate, it’s the range of outcomes we think might occur with that other half and how it averages, so that’s how we’re doing the current outlook, so it could change with volatility, and it’s one of the concerns we have about 2009, to be very frank with you. The answer to your second question, yes, we have some visibility on ’09 right now in terms of real estate, but it’s not very fully baked, and we will guidance on that roughly perhaps on our next call if we think it’s prudent.
I will add to that and say most of the commodities that we’ve been able to box in half are things like wheat. The proteins are moving quickly into that place. Here’s where much of the uncertainty remains, and I think it’s what you know. It’s gasoline. Gasoline is a primary driver of so many costs. Think about packaging. There are also a few escalation clauses in our distribution contracts and as well inbound freight and outbound freight, so we’re very conscious and control the things that we can control. On this one that has had such gyrations, which is gasoline, we really aren’t, which is what gives us a comfort level in saying you should expect cost inflation for Panera next year of somewhere in the range of 5-6% based on both, what’s locked in and the uncertainties around a number of commodities that trade at a spot basis for us like gasoline.
We’ll take our next question from Rachel Rothman with Merrill Lynch.
Rachel Rothman – Merrill Lynch
Can I just ask a followup on the traffic? I know you guys just commented that you haven’t seen any deterioration or shift in the traffic as a result of the pricing, but it kind of looks like you either had a negative mix shift or declining traffic and you’re projecting further increases in the back half of the year. Can you talk about whether people are trading down on the menu, and I think you maybe mentioned earlier that that’s been impacting you as well. Can you talk about what you’re seeing if that’s a recent phenomenon and how we should think about that for the back half of the year as well?
I thought I gave perspective to it, but I’ll try to give a little more, Rachel. Let me clarify. I at no point want to indicate we don’t think price has an effect. What I think I said is I don’t know. It’s all part of the stew. There’s a stew of things that are going on from economic uncertainly to pricing to a whole bunch of initiatives we had that run the gamut from operations to product development. Taken together, as you think about the first half of the year, we projected essentially down transaction growth, and in fact for the second quarter had positive transaction growth. I don’t think anybody knows what the third or fourth quarters are going to bring. We know we’re running against much stronger comps or transaction growth last year. We are running against a third quarter in which we were as hot as we were at any time in 2007, in which we had a very successful summer celebration, and in the context of all of that uncertainty, we think it’s appropriate to build our targets on the range of about 1.5 to 2.5% negative transaction growth. We’ll all see what happens. What I did say, I think, to John and I want to indicate to you is the only way I can look at the impact of price because it’s all in the stew is to look at survey data that we run on value, and relative to that survey data on value, I am seeing nothing at all that indicates that our value and our value strength relative to competitive alternatives is any weaker than it was a year ago.
We’ll take our final question from Chris O’Cull with Suntrust Robinson Humphrey.
Chris O’Cull – Suntrust Robinson Humphrey
Ron, this question may have been asked; I drop off for a few minutes. Ron, we’ve seen a lot of retail development people slow openings or at delay the build-outs for obvious reasons. Do you think this could have an impact on store performance or development plans?
If anything, I think it could have a positive impact. As you see any number of retailers pull back and folks like Starbucks closing 600 or 700 cafes or stores, I think you have a commercial real estate market that is frankly much less bullish in their attitude towards retailers and much more willing to make deals, and I think in the context of that, smart operators that have very high ROI concepts like we do, we have a strong very strong system with literally no weakness in it and we continue to deliver strong ROI with the improved margins that we’re seeing this year, it makes things that much more attractive, and our direction to our development people is go out there and do stronger deals, do tougher deals. This is the time to do that, so I think it’s a good time for development, not a bad time.
Thanks very much to everybody. I think this concludes our second quarter 2008 earnings call and Q&A session. We look forward to talking to everybody again in a few months.