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P.F. Chang's China Bistro, Inc. (NASDAQ:PFCB)

Q2 2008 Earnings Call Transcript

July 23, 2008 1:00 pm ET

Executives

Mark Mumford – CFO

Rick Federico – Chairman and CEO

Bert Vivian – President, P.F. Chang's China Bistro

Russell Owens – EVP, P.F. Chang's China Bistro & President, Pei Wei Asian Diner

Analysts

Steven Barlow – Banc of America Securities

Jeff Farmer – Jefferies & Co.

Brad Livington [ph] – Keybanc Capital Markets

David Tarantino – Robert W. Baird

Destin Tompkins – Morgan Keegan

Sharon Zackfia – William Blair

Bryan Elliott – Raymond James

Matthew Difrisco – Oppenheimer

Nicole Miller – Piper Jaffray

Keith Siegner – Credit Suisse

Rob Wilson [ph] – Garp Research [ph]

Greg Ruedy – Stephens Inc

Operator

Welcome to the second quarter P.F. Chang's China Bistro, Inc. earnings conference call. (Operator instructions) I will pass the call over to Mr. Mark Mumford, Chief Financial Officer of P.F. Chang's China Bistro. Sir, you may go ahead.

Mark Mumford

Thank you and welcome to P.F. Chang's Second Quarter 2008 Earnings Call. During our management comments and our responses to your questions certain items may be discussed which are not based entirely on historical facts. Any such items should be considered forward looking statements within the meaning of the Private Securities Litigations Reform Act of 1995. All such statements are subject to risk and uncertainties which could cause actual results to differ from those anticipated. Such risks and uncertainties include factors more completely described in this morning's press release and the company's filings with the SEC. With that, I will turn the call over to Rick to begin.

Rick Federico

Good morning everyone and welcome to the second quarter conference call. Joining me today are Bert Vivian, President of P.F. Chang's, Russell G. Owens, President of Pei Wei Asian Diner, Mike Welborn, our Chief Administrative Officer, and as you know Mark Mumford our CFO. In general , I will have some very brief opening remarks followed by Bert's update and the Bistro Russell's update on Pei Wei and Mark's financial review and then we will close with a question and answer period.

Again it is nice to start the call by saying our second quarter results were better than we had internally forecasted. However we did arrive there a bit differently than we did in the first quarter. In Q1 we combined favorable sales, cost control and G&A leverage into a better-than-forecasted quarter. In the second quarter we saw a continuation of our operations team focused on enhancing profitability as well as Chang's [ph] bonus expense, favorable trends in G&A. However we did not see greater topline pressure than we expected in both of our brands.

The two questions we consistently get asked are answered by, it is not good and I don't know. The questions are how is the operating environment and when will it change. The first quarter we have seen pressure on the consumer increase and so I am not going to waste any more of your time stating the obvious.

We continue to work on our ongoing operating initiatives, we are encouraged by our early marketing results and continue to focus on gaining leverage from our shared services believing that there is more consumer pressure in front of us. Bert, Russell and Mark will provide more detail in their reports. Our Pei Wei evolution test continues to produce positive results. Pei Wei has made great strides enhancing the role and impact of our management teams. The net result is we are seeing significant reduction in turnover rates for the first half of the year. In our test stores evolution has had the desire to impact on labor and cost of sales. We continue to be cautious regarding the impact of evolution that evolution might have on guest traffic and we'll watch it carefully as we introduce these initiatives to our system. Again Russell will add more color in his report.

Our Bistro operations team continues to make great strides ensuring best practices across their system. We continue to see positive improvements in both labor and cost of sales the obvious challenges returning to growing traffic. The Bistro has implemented a wide variety of initiatives designed to enhance our guest experience that we have discussed over the last couple of quarters. As we start to market against these enhancements, we will look for guest feedback validating our efforts.

At this point we think a more conservative approach to allocation of capital is warranted. At the Bistro we have revisited all locations in our development pipeline, the typical real estate development pipeline runs about 18 to 24 months. As we looked at each location we evaluated it using the most current information and internal expectations. In certain cases the site had not developed as we had expected and we have chosen to delay or abandon those projects. The net result is we will open 12 to 14 new Bistros in 2009. This is not a permanent reduction in our development plans and we will continue to be opportunistic in the future.

At Pei Wei we use the same (inaudible) to evaluate our pipeline but also included how each type [ph] complemented our revised strategic development strategy. If it did not enhance our current strategy it was shot leaving 6 to 10 Pei Wei in 2009. We fully expect that project evaluation and our sales building efforts will produce concept return that make it attractive to increase our development in the future.

Finally, a final update on Taneko. At our last call, we have signed a definitive agreement to transfer the assets and lease [ph] to a local Arizona restaurant operator. We officially closed Taneko on July 20th and expect the transaction to be completed during the first week of August. I do want to thank the Taneko (inaudible) during the first week of August. I do want to thank the Taneko team for all they have done and for aiding in the transition of all of our employees. I am happy to say that most of our unit level teammates have accepted positions in other local P.F. Chang's or Pei Wei restaurants.

With that I will pass it to Bert.

Bert Vivian

Good morning everyone, thanks for joining us today. From a revenue perspective the second quarter was a bit disappointing for us. Overall, Bistro revenues increased 11.4% year over year, however after making a positive move in the first quarter our comps took a step backwards posting a decline of 2.3%. Viewing our comp system by state, the positive trend exhibited in Q1 which was 23 states positive 13 down completely flipped in Q2, we have 13 up and 23 down.

On a weighted basis, Arizona, California, Florida and Nevada accounted for 84% of our total comp decline and all four states showed a sequential decline in their first quarter results taking a different cut at the data this time by day part we would be able to see the same reversal and trend in the second quarter. As a point of reference, in the first quarter we had positive day part activity during the week at both lunch and dinner and positive dinner comps on the weekend. In other words, weekend lunch was the only negative day part we experienced in the first quarter. In the second quarter our weekend business directionally remained the same, however both weekday and (inaudible) parts slipped into negative territory leaving us with weekend dinner as the only positive day part during the week in the second quarter.

Total revenue for the Bistro came in 0.2% less than our internal expectations. Our team did a terrific job of managing their business during the quarter. Cost of sales was roughly a push with last year as initiatives focused on managing our rice and wharf [ph] oil usage helped to offset some higher commodity costs. In addition, labor declined 70 basis points year over year driven primarily by improved efficiency and scheduling in the back of the house. Offsetting some of these gains was a 50 basis point increase in our utility bills which caused our direct operating expenses to increase 30 basis points over last year. All in all, our cash margins at the Bistro increased about 80 basis points year over year to 18.6%.

Let me highlight a few things which you are going to expect to see from us in the second half of the year. We will be rolling out a new menu next week across the country featuring four new items from our grill as well as a new shrimp appetizer. Our enhanced grill offerings will be featured in radio, online, direct mail and billboard advertisements in ten cities during the third quarter. In addition we will be highlighting our lunch bowl offerings in the Phoenix markets. Our marketing spend for the year has been targeted at roughly 1% of sales. Through the first two quarters we are slightly behind trends. This is a pattern that will reverse itself in the third quarter.

We have opened ten new restaurants so far this year and we intend to open seven more restaurants in 2008 all of which will open in the fourth quarter. In addition we have temporarily closed one restaurant in Miami in order to assimilate some additional square footage that became available adjacent to our existing space. This restaurant will reopen at the beginning of the fourth quarter, thus we will lose roughly 13 weeks of revenue and incur approximately $500,000 in operating and pre-opening expenses during the third quarter with respect to that unit.

If we put the final touches to our 2009 development plan, we expect to open 12 to 14 new Bistros next year. This is a reduction from the pace of the past two years and is a direct reflection of two factors. First of all, we are or were a perspective tenant and a handful of properties that have been delayed, postponed or altogether cancelled for next year. Secondly our performance over the past couple of years particularly in the western half of the United States has led us to reduce the amount of new capital that we are deploying. We are hopeful that this cycle will pass. However, until it does, we expect our capital expenditures will moderate from the recent past. With that I will turn it over to Russell.

Russell Owens

Thanks Bert, good morning everyone. For the quarter our comp sales were negative 3.2% worse than expected as we continued to see weakness out west, specifically Phoenix, Las Vegas, Southern California and to a lesser extent Dallas. Those four markets make up 41% of our comp units and were more than 7% for the quarter versus negative 6% in the first quarter this year. The balance of our system had positive comp sales in Q1 and Q2. For the quarter our expected price increase was approximately 2% but our average transaction was flat with prior year as guests continued to order fewer appetizers and more lower price bowls versus entrees. Looking at the day part information indicates that we are wait-listed [ph] dinner versus lunch and weekends versus weekdays consistent with our previous trends.

We opened four new restaurants this quarter, two in Florida, one in Dallas, and our third location in Columbus, Ohio. Average weekly sales were just over $35,000 for the quarter. We remain on track to open 25 locations this year, six during the current quarter and the remaining four in the fourth quarter. Overall revenues for Q2 were below our expectations due to the worse than anticipated average weekly sales rates for our comp and non-comp restaurants. Simply put this is the toughest environment I have ever experienced. Considering this I am pleased with many aspects of our business and the performance of our team this quarter. There are some positive improvements in key areas that are being overshadowed by the difficult environment but they are there.

Looking at the P&L, cost of sales increased 20 basis points from the first quarter and last year due to increases in wharf oil, chicken and rice prices offset by the Q1 price increase. Labor cost improved 20 basis points from the first quarter and 30 basis points from last year. As productivity gains more than offset the 3% year-over-year increase in average rates. Operating expenses increased 150 basis points from Q1 and 140 basis points from last year driven mostly by an additional $900,000 in marketing expenses.

I will talk about the marketing in more detail in a moment. In addition, we saw a 50 basis point increase in utility costs versus prior year entirely due to rate increases ranging from 11 to 16% across our system. Occupancy costs, depreciation and amortization were all on target in terms of dollars but higher as a percent of revenues due to our lower than expected average weekly sales.

Now an update on the marketing initiatives. Beginning mid-May through early June we started various combinations of online, radio and outdoor media in our more penetrating markets of Dallas, Phoenix, San Antonio and Austin plus four newer markets. This was followed by direct mails to selected locations in those markets in June through mid-July. We incurred about $1.1 million in costs for the second quarter and will spend a similar amount this quarter, in total $2.3 of our annual $3 million projected spend in Q2 and Q3. The early results are encouraging but it is too soon to determine the ultimate return and the impact of these programs. We are very excited about the creative work and the consumer feedback thus far. Our fourth quarter spend would be light as we take a pause to evaluate results. On the basis of what we have seen to date I would expect a more robust ongoing media plan as part of the long term Pei Wei strategy.

The other major initiative we have been working on is to improve the overall profitability model for Pei Wei. As you recall, we were addressing three major issues management retention, complexity of executing our menu and as a result inadequate profitability levels at our current sales volume. Our first objective was to improve management job quality and job satisfaction by improved scheduling and changing duties to more leading and managing and less doing of hourly functions. We also wanted to increase the flow of internal promotions from hourly to management. The test results have been very positive and well received. Our restaurant management teams are excited about the new work schedules, duty changes and enhanced key employee position and training support as well potentially improve the restaurant's bottom line.

We will ultimately be able to effectively run a typical Pei Wei restaurant with one less manager while improving job satisfaction and increasing bottom line results. We are pleased with our trends in management retention as Rick mentioned as a result of improved developmental programs and the emphasis on job satisfaction over the last six programs and the emphasis on job satisfaction over the last six to nine months. Our turnover rates for 2008 thus far have improved significantly and are currently in the mid-30% range.

To address the menu complexity issue we originally started to test with extreme menu cutbacks. We have looked into our guests and tried to do all we can to minimize the impact on them adding back items twice during the test periods. The current menu strikes the appropriate balance between protecting our guests and gaining the efficiencies we need to simplify execution and improve costs. This menu will eliminate the body and the prep area and add a couple of hours per day to other positions in our kitchen. It also removes a few high cost and low selling items and reduces inventory and recipe complexity.

At the end of the day, the resulting changes made from last year's menu is the deletion of two protein choices, one less bowl dish and one less soup along reformulating four recipes. The new menus are in all of Texas, Arizona, and California as of this week and will be system wide by the end of August. The management and staffing changes will follow the menu roll out but will take longer to complete. They begin in Texas and will continue market by market through October. During the test we saw improvements in cost and productivity generally in about sixty days. So, we expect to begin seeing overall margin gains beginning fourth quarter.

Our third quarter will see some cost pressures associated with the menu installations, product obsolescence, management relocations and hourly training costs. In addition we have been evaluating an enhanced labor scheduling productivity tracking tool developed with the help of outside experts in this field. This new tool has worked very well and we anticipate finalizing the test this quarter making the necessary adjustments and implementing across our system during the fourth quarter. In the test locations labor costs have improved on average by 100 basis points. This tool's impact should gain traction by year end and further improve our results as we enter 2009.

I am excited about the positive impact these changes will have on our business. We believe they will give us a 200 to 250 basis point improvement in profit margins compared to our trends at the end of 2007. Unfortunately some of our improvements will likely be offset by rising costs in the current consumer environment which we expect to continue to 2009.

On the subject of 2009, our current plan is to open 6 to 10 new diners next year all in existing markets. The decision to slow our pace of development is based on several factors, the current macro environment combined with our intentional pause while addressing our internal initiatives as well as seeing controls like projects were co-tenancy concerns arose or the entire project has been delayed or cancelled. I am confident that the changes we have talked about this morning has positioned Pei Wei to be ready for increasing our rate of growth when the macro economic environment makes us prudent to do so.

With that I will turn it over to Mark.

Mark Mumford

Thanks Russell. I want to take a minute and recap and consolidate the numbers that you heard Bert and Russell talk about.

Consolidated revenues for the quarter were $304 million, a 14% increase over Q2 of 2007. Bistro revenues grew 11% primarily driven by 15% increase in sales week for the quarter partially offset by a negative comp of 2.3%. In Q2 of 2007 we have added 25 new Bistros five of which opened in Q2 of 2008. Pei Wei sales increased 23% primarily as a result of new store openings. Since Q2 of 2007 we have opened 33 new locations a 26% increase. Comp sales for the quarter were down 3.2%.

As we discussed last quarter we expect to see minimal cost to sales pressure this year probably somewhere in the 20 to 30 basis point range as a majority of our proteins which collectively represent approximately one half of our cost of sales spend our contract is due for the reminder of this year. So we begin to have some uncertainty and concern regarding the impact of raising grain cost and global protein demand will have on our 2009 contract pricing.

To that end we have been proactive and negotiate and exploring alternatives to mitigate the rising cost pressure. We have blocked in about 80% of our anticipated 2009 (inaudible) usage at our current pricing level. We have also walked in all off 2009 which will add about 35 to 40 basis points to pressure the concepts and rice is locked into Q1 of 2009. We will continue to look for advantageous point to enter the market and lock in cost they need to look for advantageous points to enter the market and lock in costs where appropriate.

Q2 2008 consolidated G&A expenses increased 40 basis points over the prior year. We had a tough comparison this quarter as Q2 2007 reflected the reversal of over $700,000 in corporate bonus expenses billed in Q1 of 2007 compared to corporate bonus accruals recorded in the current year of $1.5 million. Excluding the impact of corporate bonus in both of the years G&A expenses actually declined by almost 40 basis points as a percentage of sales. Depreciation expense at both concepts increased 30% [ph] of sales. The Bistro is 70 basis points higher primarily due to depreciation of the grill, decreased leverage on the topline, the impact of 2007 (inaudible) rollout and greater intangible amortization due to partnership buyouts.

The Pei Wei is 70 basis points higher primarily due to (inaudible) on the topline in spite of higher depreciation expense from new locations due to opening more expensive markets i.e. a higher percentage in California and the Northeast versus less expensive markets like Arizona and Texas. Interest expense for the quarter was $949,000 which compares to interest income in Q2 of 2007 of $179,000. The end of the quarter with $80 million borrowed under the (inaudible) credit versus $10 million in Q2 of 2007.

During the quarter we entered into an interest rate swap agreement that locked our interest rate on $40 million of variable debt at around 4% through May 10, 2010. We lost the interest rate for the remaining $40 million borrowed under alliance for one year under the existing debt agreement.

Our tax rate came in at 26.4% versus 26.1% in the prior year as our tip [ph] credits continued to keep our tax rate low. So in total EPS from continuing operations for the quarter was $0.40 up $0.03 from the $0.37 earned in Q2 of 2007. For the year that puts us at $0.79 versus $0.78 of EPS in the first half of 2007. Although we continued to feel pressure in out topline we continued to focus on controlling costs to the extent that you are not a fact to gas experience.

Overall we are pleased with the results for the quarter and year to date but we believe there is still quite a bit of pressure ahead. (inaudible) $119 today it is around $130 and the average price of gas at the pump has climbed over $4 a gallon. This is causing inflationary pricing in grocery and hard goods and we are not certain that we have seen the bottom of the economic pressure plaguing the consumer all of which makes predicting our topline very difficult. At the end of the day sales driver business give us the flexibility to manage our cost structure. Until we see consistent enough (inaudible) traffic we are going to remain cautious about the near term. Consequently, we are only modestly increasing the earnings expectations for the year from $1.34 to $1.40 up to $1.36 to $1.42.

Now, turning to the balance sheet, we ended the quarter with $20 million in cash versus $24 million at the end of fiscal year 2007. Borrowings in our credit line remained at $80 million versus $85 million at the end of last year. Net cash provided by operating activities for the first six months of the year was $70 million compared to $57 million for the first half of 2007, a 24% increase. On the investing and financing side for the first six months of OE, we spent $5.4 million and the repurchase of minority interest and that is down to $9.5 million in 2007.

We purchased 10 million of stock during Q2 with an average repurchase price of $25.38 and that leaves us 40 million of remaining authorization. Repaid $10 million of carton related debt and we have used $45.8 million in CapEx which is down from $64.4 million for the first six months of 2007. If we dive into our CapEx number in more detail, we see that that $46 million is a growth number. We collected about $15 million in TI allowances given in the net number of about $31 million.

We are bringing down our 2008 CapEx projections to between $100 and $110 million which we equate to between $80 and $90 million net of TI allowances. A reduction from our previous expectation of $125 to $135 million growth and $105, $115 net. This is primarily due to our updated 2009 development plans. We are still projecting cash from operations for 2008 of between $140 and $145 million which means we should generate somewhere between $30 and $40 million of free cash flow for the year. Our fully diluted share count for the quarter was 24,247,000 [ph] which is down 7.2% from the Q2 2000 number of 26, 129,000.

Lastly, our next earnings call will be on October 22 when we will discuss the results of our third quarter and with that I am going to open up the – turn the call back over to the operator to open up the questions. Operator?

Question-and-Answer Session

Operator

(Operator instructions) Our first question comes from Joe Buckley from Banc of America Securities.

Steven Barlow – Banc of America Securities

Hi it is actually Steven Barlow for Joe. I guess with lower ‘09 unit growth and more free cash flow generation how do you guys think of using that?

Mark Mumford

Right. So, we are going to obviously have a reduction and it is not the CapEx that we are going to send next year. The free cash flow should be slightly increasing because of operating results. I can tell you I don't mind having a little bit of cash sitting on the balance sheet right now specially during these turbulent times. We are not interested to repay the $80 million in debt, obviously 4% interest that is pretty cheap money. So we will continue to be opportunistic and looking at share repurchases and having a little cash on the balance sheet.

Steven Barlow – Banc of America Securities

Then your targeted CapEx spend for '09, have you guys given that?

Mark Mumford

No, we have not given you guys that number yet but it is pretty easy to walk through the math. Each of the Bistros on a gross basis we will spend about $4 million, so yes we are opening three (inaudible) should generate $12 million in incremental cash there on the Pei Wei side from a cash perspective. On a gross basis, it is about $1 million along with that obviously comes pre-opening expenses and partner investment expenses, Pei Wei, opening down to 8 new Pei Weis and total number of Bistros should give us $0.11 and $0.12 incremental EPS in 2009 as well.

Steven Barlow – Banc of America Securities

And then lastly of the '09 Bistros, the 12 to 14, how will this split among new and existing markets, thanks?

Rick Federico

It is split roughly about 50/50.

Operator

Thank you. Our next question comes from Jeff Farmer from Jefferies & Co.

Jeff Farmer – Jefferies & Co.

Good afternoon guys. Considering that you will be cutting your absolute unit openings in half in '09, what does that mean for your growth infrastructure cost moving forward?

Mark Mumford

For shared services, is that the question?

Jeff Farmer – Jefferies & Co.

Yes, in terms of the unit opening teams and any type of potential or regional management that might be a little redundant at this point, so just in terms of again cutting your unit growth in half, what does your unit or your growth infrastructure cost potentially move next year in terms of cost savings?

Russell Owens

To a large degree – I am sorry, this is Greg – to a large degree we are internally evaluating the amount of support required to get us through 2009 but our expectation is that this is kind of a temporary reduction in new unit growth and so we want to be cautious and not to be making any real dramatic changes and so we get more clarity around our project evolution working around our sales building initiatives around both brands.

Jeff Farmer – Jefferies & Co.

Then just a bigger picture earnings question for me, recognizing that you no longer break out the allocated corporate overhead between the (inaudible) does look like Pei Wei. If you get close to maybe the $0.89 per share cruising in '08 and with the unit development guidance being low next year it can potentially double, just wanted to see if I am roughly in the ball park in that one, in your view?

Mark Mumford

Could you ask that again, please?

Jeff Farmer – Jefferies & Co.

Sure. Again more of a bigger picture earnings question. Just to recognize that you are no longer breaking up the allocated corporate overhead between these concepts gets more difficult for us to understand the concept level accretion for Pei Wei and Bistro. My own model looks like it could approach $0.08 to $0.09 this year. I am considering that you are going to cut Pei Wei development meaningfully next year. Looks like that number could easily more than double. I am just going to say a ballpark on that one.

Mark Mumford

Yes. Especially given that we are pre-opening the partner expenses that go along with those new openings at Pei Wei it is 200,000 per store. We can easily see that EPS related to Pei Wei double next year.

Okay. Thanks guys.

Operator

Thank you. Our next question comes from Brad Livington [ph] with Keybanc Capital Markets.

Brad Livington – Keybanc Capital Markets

Good afternoon. Thank you. I had a question on the depreciation line. There was a lot of deleverage in the first half due in big part to the depreciation on the growth at Bistro but as we start lapping that rollout of that in the second half of '08 should we start expect similar improvement on that. I mean probably higher as a percentage of sale still. May be not 60 basis points year over year?

Mark Mumford

Depreciation expense for the remaining year on a targeted basis is kind of probably be about what we saw for the first two quarters. I mean you are right we are seeing quite a bit of deleverage in both concepts and the Bistro 10 basis point and the year-over year is coming from sell deleverage. And the rest of it is coming from some of the things you can mention incremental investments we have made in the restaurants from the switch of the platewares. We had acceleration going on that is going to end in the back half of the year to the grill to the small wares that we need to reserve all those things added on to the pressure. But Pei Wei majority of the increases come in from the top line deleverage 35 basis point, roughly 50 basis points of total deleverage is coming from sales.

Brad Livington – Keybanc Capital Markets

Okay. And then looking at the partner investment expense line we were expecting the little bit of a charge for that and it would have been a benefit this quarter. Is there any guidance that we can get on what to expect in the back half – follow a similar trend or –?

Mark Mumford

Our internal forecast and the credit 500,000 of the credit was at the Bistro. We bought out 12 additional partnerships in Q2 and those were early buyouts and we are not anticipating or forecasting credits for Q3 and Q4 related to Bistro.

Brad Livington – Keybanc Capital Markets

And then just a couple of more quick ones. Sorry to hold you up. The interest rate swap at about 4% of that 40 million, is there any kind of spread that could possibly go up on that depending on ratios or is that the lock in 4%?

Mark Mumford

The 4% for the two years is locked. Obviously we have swings during that two year period. It will all be on the balance sheet between equity and liability account that will equal out at the end of two years and the 4% of the remains under the existing credit agreement. There is no derivative associated with that. That is a lock in. So, the 4% is we don't have any exposure on that. Those are lock in numbers.

Brad Livington – Keybanc Capital Markets

Okay. I just wanted to make sure I heard this right. New walk over contract will result in 35 to 40 basis points of cost of goods pressure in '09.

Mark Mumford

Right. Right

Operator

Thank you our next question comes from David Tarantino of Robert W. Baird.

David Tarantino – Robert W. Baird

Hi good afternoon. Further question on Bistro labor which looked very well managed in the second quarter. What specifically are you doing there and would you expect that kind of performance to continue in the second half as traffic remains low?

Bert Vivian

David you are cutting in and out a little bit. I am guessing you are asking about labor?

David Tarantino – Robert W. Baird

Can you hear me okay. The question is what specifically you are doing to drive the impressive leverage that you have got in the quarter and to drive the impressive leverage that you have got in the second quarter and how sustainable do you think that is going forward as traffic remains at the Q2 level?

Bert Vivian

I wish I could tell you it is a lot of hard work on the operators' parts. Really trying to be efficient as possible with the back of the house labor as well from both the man hour basis as well from a scheduling standpoint and mostly we saw back of ht house and a very, very modest amount was in the front of the house. Whether or not that is sustainable I don't think you as we look on a year-over-year basis, I don't think we will continue to be able to post those kinds of year-over-year numbers. However, the good news is that to the extent that we are implementing the systems and procedures in our thought process today I think that will continue to pay dividends for us as we move forward. We can every get the sales meter moving in the right direction and I think it will allow us to be pretty efficient in terms of turning marginal sales dollars into profitable model.

David Tarantino – Robert W. Baird

Okay thanks. And Mark on the guidance for the year what kind of comps are embedded in the second half?

Mark Mumford

We don't give you guys a comp guidance going forward. What we have considered the current trends that we saw in Q2 on both of the concepts and considered the marketing spend that we are going to be applying in Q3 and we incorporated all of those into our guidance numbers that we have given you.

David Tarantino – Robert W. Baird

Okay and then a last question. The outlook for '09 commodities, it sounds like you are going to see some pressure on both concepts. What are the current thoughts on your ability to take more pricing in this kind of environment at the Bistro and Pei Wei?

Bert Vivian

David, this is Bert. At the Bistro I will tell you that we are not thinking too much about taking any price certainly over the next six to 12 to 18 months. I still don't think the environment is going to allow us to do that. So, we simply have to get better at our game. In terms of taking care of our guests they walk through the doors, do everything we possibly can to make sure they have a great dining experience. And we are hopeful that they will bring some friends on their next visit. A little bit of sales momentum which will help us offset some of those cost pressures that we are going to see in and on. The same holds true for Pei Wei.

David Tarantino – Robert W. Baird

Thank you.

Operator

Your next question comes from Destin Tompkins from Morgan Keegan.

Destin Tompkins – Morgan Keegan

My first question is a follow up to the previous question. The slower development in 2009 and what that convenient potential savings that you mentioned pre-opening in partner investment extent being a little bit lower but what about inefficiencies from new stores. Is that a meaningful number that we could look to as far as 2009?

Bert Vivian

I mean it is certainly going to be a meaningful number. New stores particularly Pei Wei it takes a while to get the efficiencies up to speak. So I am not having those new stores as a drag we would expect to have operating margins in both of the concepts up. We will certainly incorporate that when we give you guys the 2009 guidance.

Destin Tompkins – Morgan Keegan

Would that be most evident in labor and cost of sales?

Mark Mumford

Yes. Predominantly in labor and cost of sales, more in labor than in cost of sales.

Destin Tompkins – Morgan Keegan

The next question was for Bert on the average check at the Bistro. It seems like the average check benefit has been coming down the last couple of quarters and assuming mini pricing has been about the same. Can you give us an idea what has been driving that mix benefit that may be lessening over the last couple of quarters?

Mark Mumford

I think the trends that we are seeing with out product mix certainly we have introduced the grill on those items priced at the higher end of our menu. It is driven a little bit increases on check. No question about that. Actually it has been offset a little bit with the introduction of lunch bowls this Spring. I think that we are going to see a bit of an equilibrium when it comes to our average check. We have seen an increase over the past couple of years as we have lost our lower paying guests, those individual who are paying the least amount for their dining experience at the Bistro, as I have said in previous quarters, those are the customers that we have lost. So, simply by losing those guests we have seen some creep in average check for the past few years but it certainly has been impacted slightly by the grill and offset a little bit by the (inaudible).

Destin Tompkins – Morgan Keegan

And then one last question if I may for Rick. Looking at Pei Wei like you are seeing the margin improvement that you are hoping to see with the test stores but I guess given the increased operating risks around Pei Wei – have you guys ever considered franchising Pei Wei and would you consider may be adding the franchise program to hedge some of that operating risk?

Mark Mumford

I guess the simple answer is two fold. One, never say never, and secondly and may be more specifically really a strategy that we contemplated, really put a whole lot of brain power behind. I think it is sitting here and thinking about it around the question given the age of the Pei Wei system and our belief that ultimately brew marketing and operating initiatives that we are going to be able to drive some top line results and as evolution start to take hold the kind of the getting all of that coming together in given concepts and time in order to determine what those impacts are. I think it will be premature to be going down the path of any type of franchise.

Destin Tompkins – Morgan Keegan

Sure. Makes sense. Thanks guys.

Operator

Thank you. Our next question comes from Sharon Zackfia from William Blair.

Sharon Zackfia – William Blair

Hi good afternoon. Couple of questions on marketing spend I guess for both Pei Wei and Bistro. Firstly, do you run that through your cost of G&A and then secondarily is your embarking on this more ambitious program, how are you assessing whether or not they are generating upward turn? What is the kind of sales to spend you are looking for to justify them?

Mark Mumford

The majority of the expenses run through the operating expense line. If there is any type of (inaudible) that kind of is going to flow through cost of sales will hit us in the P&L line items. As far as looking at the returns we look at the spend that we have on the marketing programs and then we look at the list that we are getting in the test stores versus the control stores and then we monitor that during the test as well and the period after the test to see what type of sale that we are getting and then evaluate that over that period of test to see if we have got enough incremental revenues to drive margin to offset the incremental expenses.

Sharon Zackfia – William Blair

Okay. I guess another question. Russell kind of talked about some one time cost related to the implementation of I think you are calling it the project evolution, the labor and the menu changes. I thought they are going to be included in the third quarter. Is there any kind of ballpark you can give us on kind of what we are going to see dollar wise and one time transitional charges for Pei Wei?

Mark Mumford

We'll spend roughly a quarter million dollars with the menu itself, product will be pretty minimal. The training costs are going to vary a lot by store and spread out over a long period of time. But it is not a huge number

Sharon Zackfia – William Blair

Okay thank you.

Operator

Thank you. Our next question comes from the line of Bryan Elliott of Raymond James.

Bryan Elliott – Raymond James

Good afternoon. Couple of questions. First, Miami closure and thirteen week of sales you said about half a mil of pre-opening costs, was that the message there?

Bert Vivian

That's correct Bryan.

Bryan Elliott – Raymond James

Okay and then but we will also be running rent and other things won't we or will that get capitalized somehow.

Bert Vivian

That is included in the half a million dollars.

Bryan Elliott – Raymond James

From accounting standpoint, they get pulled out and all goes into pre-opening?

Bert Vivian

The $500,000 includes ongoing operating expenses.

Bryan Elliott – Raymond James

I will get with Mark on that. Also wanted to clarify, someone asked about the inefficiencies and the impact of that on concept margins. I thought I heard, I think Mark answered that given the reduction of the waiting of new stores that we should see rising margins in both brands next year, and thinking about pricing plans and the amount of inflation that is out there. Just wanted to make sure I heard that correctly.

Mark Mumford

Let me clarify. What I intended to say was that by having those fewer new stores in there it should give us a little bit of a tail wind in our operating margin. Those definitely have a drag on operating margin. And so we should have – so everything else remains the same. We have some cost of sales, same labor and so forth, operating margin should improve. But we know we are going to have a pressure.

Bryan Elliott – Raymond James

Thank you.

Operator

Thank you. Our next question comes from Matthew Difrisco of Oppenheimer.

Matthew Difrisco – Oppenheimer

I don't know if this was answered already or not but with respect to the marketing dollars. If you open up less stores next year and sort of sluggish type top line environment were we are flat to slightly down would you spend more in dollar terms in marketing or could that be a source of leverage also. If it is not yielding an upside on topline would you look to pull that on both brands?

Bert Vivian

I think if we are seeing the returns we are able to quantify the return on incremental dollar of marketing leverage spending we would definitely spend more. If we are not comfortable seeing those returns we will not spend any more.

Matthew Difrisco – Oppenheimer

Are you seeing what you had classified as returns of that now?

Bert Vivian

Right now we see a mix back. In some of the tests that we run we can definitely see the returns and some of them it is too early to tell and some of them always still have some refinement to do in the initiatives that we are rolling out to the customers.

Matthew Difrisco – Oppenheimer

Okay and then looking – I guess what I am wondering is are you looking at it sort of like you look at it as contribution per store or is it a contribution per brand since you are opening more stores or should we expect dollar growth in that as a corporation or is it going to be flat number?

Bert Vivian

I think still it is yet to be determined. This year we spend about 1% of sales, next year we have not determined what we are going to spend yet. I think in it is still all dependant upon what type of returns we are seeing in those marketing expense.

The best way to think about it is we are just coming through the first wave of marketing initiatives in both brands. As Mark said if we see the kind of results that we would anticipate and we felt that it was prudent to invest greater dollars to get better results we would do it. I think given that it is first half if we are seeing less than desirable results we will refigure our marketing strategies and continue to apply some balance there but without – may not necessarily spend the same amount through that exercise.

Matthew Difrisco – Oppenheimer

Could you talk a little bit about customer trend of late, I guess we probably I was a little bit surprised, some of the others might be surprised also that you didn't see any sort of pick up in May or June after the rebate checks? Is it more a function of what we see miles driven less by the average American or demand destruction people are driving less that – are your locations seeing less traffic or it is just an aggregate problem in the economy and consumer or did you – or were you not expecting any sort of listed on the rebate checks. I am just wondering if gas is offsetting any sort of benefit that you would have expected from rebate checks.

Bert Vivian

I can tell you that we were anticipating a lift from the rebate check, so were not disappointed. To answer all these other questions. We will be lot smarter in out ability to forecast and run our business better. But there is whole list of variables that are associated with each one of those questions and frankly we don't know the answers to it.

Matthew Difrisco – Oppenheimer

Okay, and then lastly even though you are pulling back in '09 are you going to be opening up in existing markets, any other troubled markets, you mentioned about four or five markets that are negative comp. Can we pull back markets that are negative comping now? Can we pull back growth in those store in those markets or we are going to backfill some of those markets further?

Bert Vivian

I think that as we looked at the '09 development and I think as I mentioned in my comments we are going to deploy a little less capital at the Bistro and clearly because of our performance over the last couple of years west of the Mississippi, it is harder and harder for us to approve deals out West. So I think you can make the general assumption that our development will be more East Coast than West Coast and clearly I think it is going to be roughly a 50/50 split in terms of new markets, existing markets but again as the Bistro grows it gets more and more difficult to be a new monk.

Matthew Difrisco – Oppenheimer

Then my last question Bert, with respect to a couple of days ago I think you did a really good presentation on the circles with the five miles and a couple of those '06 stores that opened up and were somewhat cannibalistic for the Bistro in the '07, are you seeing those stores, these specific stores that you highlighted, the original ones there that were the victims of the cannibalization, are they back to when we rebuilding the volumes? I am trying to go through and look at the store class comps, a little hard to figure out but can you help us with that?

Bert Vivian

Unfortunately you have a better memory than probably the rest of the audience with respect to that presentation and it probably would not be fair to start speaking about it without anyone having seen it, not everyone having seen it, so I will say that generally speaking with respect to those particular markets that are highlighted our general traffic in those markets has improved as we expected that it might but again at this point it is hard to talk about improved traffic rather than system when the overall system is running negative. There are glimmers of hope out there and again I think that if you look at our system in toto, it is a tale of two cities. As I mentioned in my comments we have roughly four states that are providing this is significant amount of brag to us. We also have some areas of the county where we have outstanding results in traffic growth. We are struggling through this, it continues to be our belief that if we focus on our guests, our employees that we will get through this cycle. I think that our team has done a great job in terms of managing their business. I would say that they all are working very, very hard in order to try and increase our sales and increase our traffic and you do that day by day. I would love to be able to tell you that when you start (inaudible) to those results or does not seeing it but we remain vigilant in that regard and I am hopeful that it has been moved to the back of the year in '09 that w can actually start pulling two successive success in the overall system.

Matthew Difrisco – Oppenheimer

Okay, thank you.

Operator

Thank you. Our next question comes from Nicole Miller from Piper Jaffray.

Nicole Miller – Piper Jaffray

Good afternoon, I just wanted to also ask about development first in terms of the performance for new units this year, is it anything different than plan or what you have seen historically, and then second looking into '09 as you sort of moderate developments for both concepts, how could they benefit for example from not channelizing as it is just a more moderate piece of development over all for which you also perhaps be taking three opening teams from some of your best stores to open these stores and is there a potential that they could open at higher volume?

Bert Vivian

Hi Nicole, this is Bert. With respect to the units that we have opened in 2008 I think we are very pleased with their performance thus far, you can see the volumes in our press release, I would say that from an operational standpoint I think our teams are doing a very good job you know with respect to those new restaurants in performing in a manner that is actually a little bit better than we have done in prior years. To reflect '09 and really in general, we don't have opening unit teams per se. We don't have a group that sits here in our home office and travels to restaurants and our new units. Our opening unit teams are cold from our existing restaurants. We find our best folks who happen to have the driver initiative to be great trainers and we will pull them from existing restaurants. So to the extent that we are reducing our development there is not going to be necessarily a group of people that will suddenly say we don't need you anymore. That group does not exist at the (inaudible).

Nicole Miller – Piper Jaffray

Okay with this fact, you are saying about 15 that you are getting – I guess what you are seeing 15 that you are getting I guess with certain stores. But will continue to be those teams in those regions I guess then?

Bert Vivian

Absolutely. For example we open up a Bistro in Minneapolis area we will clearly pull our training team from up in that section of the United States. And again that is no different than what we have done in the past.

Nicole Miller – Piper Jaffray

And will that be the same for Hei Wei as well?

Bert Vivian

That is correct.

Nicole Miller – Piper Jaffray

Okay thanks.

Operator

Our next question comes from Keith Siegner of Credit Suisse.

Keith Siegner – Credit Suisse

Thanks just a couple of questions. Given the sales level for example 50,000 [ph], it could have made sense – the real estate process need not have been robust as in the past and it could have been now. Could it make sense to me to close some of the Hei Wei units may be take a chare write off and have immediate margin and free cash flow estimate?

Bert Vivian

Short Answer is we have been working over the last several months with a new database sort of fiscal validation and evaluate our trade areas in existing sites. We were early in that process with that product. So step one for us is to look at all those existing restaurants. In many cases new restaurants in new markets, we don't go after brand awareness when the potential of the site is not being met. But as we go through that process as we look historically we have the potential to getting were we want to get. We would certainly consider closing our restaurant but we don't have any of that going on at this time. We believe that those restaurants in markets were we are continuing to fill out those markets hopefully having some great marketing tools to help drive top line and that we become popular restaurants down the road.

Keith Siegner – Credit Suisse

If some of the newer restaurants that are in newer markets some of these are running at lower average liquid sales. With the development plans being focused more on the existing or kind of adjacent markets without going and adding the markets, how do you get the market share to get them on to the targeted levels?

Bert Vivian

This year's development and next year's development are targeting those markets and we have not gone into new markets, contemplate new markets. The development is in those early low level entry market that we just started going into late '06 and early '07. We continue to develop in those markets to get brand awareness. We are not in the mode of building a lot more restaurants in our fully developed markets at the risk of cannibalization. So, we are going where strategically we think building brand awareness is going to help us in the existing restaurants in our new openings. Couple of markets where we are pretty like and it doesn't look like it is going to be anything in '09 added to those markets and we will contemplate that as we go through the year.

Keith Siegner – Credit Suisse

And then last question, just wanted to get a little bit detail about the 2008 cost at Pei Wei in first quarter generated 41000 in average liquid sales. That is obviously just like the quarter. The ones that you opened in second quarter did they open just as strong as in first quarter or did they also open closer to the 2Q average?

Mark Mumford

The four that we opened in the second quarter at running about the total group is running in the second quarter, the drop from the first quarter to second quarter is driven by the first quarter openings we set going in to the second quarter primarily by two or three locations in our small to mid-size towns like Norman, Oklahoma, Arkansas which both opened up in the mid to high 50s normalized down to 40s as we expected them to.

Keith Siegner – Credit Suisse

Okay, thanks.

Operator

Our next question comes from Rob Wilson [ph] from Garp Research [ph].

Rob Wilson – Garp Research

Thanks for taking my call. Bert, a little while ago you talked about not wanting to take price increases for may be the next 12 to 18 months. And I am sure confused I have listened to a lot of restaurant conference calls and it seems like everybody is taking price increases, they are taking price increases. So, I am just curios why are you guys so adamant in seemingly taking price increases in this environment?

Rick Federico

It is not smart as everybody else. When faced with declining traffic in our system I don't think that I guess really care whether or not oil or rice is more expensive or frankly labor costs are up. I think what they do hear about is the prices they pay and the value they receive at our restaurants our team is trying to do everything possible to put out best foot forward and present a great value proposition for our guests. And frankly rising prices in this environment cuts against that manner, so perhaps we are stupid in that regard. Again as Rick said earlier never say never. But we are going to try and understand as much pain as much we can to the benefit of our guests.

Rob Wilson – Garp Research

Then may be one other question. Given that Pei Wei may break even at what point you guys may be say it is time to shutter that division?

Rick Federico

I don't think we have gone through that exercise yet.

Rob Wilson – Garp Research

Do you have plans on doing that?

Rick Federico

Certainly. I would think that would be reasonable assumption but it is not something that we are kicking around amongst ourselves as we enter into that.

Rob Wilson – Garp Research

Do you believe that Pei Wei can make money next year or year after that?

Rick Federico

I believe that the things that we are working on Pei Wei are designed to produce the kind of results that we would want to put some money behind.

Rob Wilson – Garp Research

Okay. Fair enough. Thanks for taking my call.

Operator

Thank you our next question comes from Brad Livington with Keybanc Capital Markets.

Brad Livington – Keybanc Capital Markets

I will make it quick. This call kind of gone long. I will just ask again about cost to sales. Just looking at gas at $4 more a gallon, is there a potential for suppliers to up fuel surcharges and may be impact cost to sales by 10 to 20 basis points in the second half.

Mark Mumford

Absolutely we are seeing surcharges right now is baked into our guidance. Rise in fuel affects everything in getting produce and commodities to our restaurants is certainly affected by rising fuel costs.

Brad Livington – Keybanc Capital Markets

Okay. Perfect. Thank you very much.

Operator

Thank you. Our last question comes from Greg Ruedy of Stephens Inc.

Greg Ruedy – Stephens Inc

Good afternoon. Question for Bert, on cost of sales on at the Bistro. You have done a nice job holding that line level. Is there anything that you can point to besides the walk and the rise in the process or operating initiatives that are giving that a boost or maintaining that line?

Bert Vivian

I mentioned in my comments that our team is working on initiatives on walk around usages as well as ice usage and I think we are seeing nice results from that. Our menu mix and the things that we have done with our menu for the past year I think it had helped us in terms of how our guests use our restaurants. We certainly brought a grill on board which has a higher cost of sales associated with those items. We also have been able to balance that with other items with regard to the menu. So, net-net I think that our team has done a good job of picking up pennies where they can not at the expense of guest experience and we have also been able to manage a little bit through our menu mix and that is kind of the short answer to it. I don't see that changing dramatically to the back half of the year.

Greg Ruedy – Stephens Inc

Okay. Question for the both concept leaders. Roughly you mentioned that you have some reformulated menu items, to what extend do you both have an opportunity to source or switch ingredients on menu updates and or may be also plate presentations to offset the commodity pressures?

Russell Owens

We are not looking at changing ingredients on our products. We certainly are changing the ingredients on our products, we certainly have never been in the mood of diminishing the quality of the product or in the fashion we deliver to the guests. We have no thoughts right now of changing portions.

Greg Ruedy – Stephens Inc

And then lastly, Bert, as you introduced the boat [ph] as the years progressed, how does that mix flow so far this year?

Bert Vivian

The boat [ph] is popular. Again despite the fact that our lunch day part traffic has declined, you know that fact that our guests have embraced that product. It offered the guests a great opportunity to get in and out of the Bistro for something less than $10 and I think that again as we push forward and over time it will become is a staple and will become a staple of our guests during that month period.

Greg Ruedy – Stephens Inc

Great. Thanks for taking the questions.

Bert Vivian

Absolutely. Thank you. Looks like that is our last question and I want to thank everyone for joining us here today and we will talk to you again on our October 22, to go over quarter results. Thank you for joining us.

Operator

This concludes today's conference call. Thank you for joining us. All parties may disconnect at this time.

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