Q2 2023 Potbelly Corp Earnings Call
Participants
Robert D. Wright; President, CEO & Director; Potbelly Corporation
Steven W. Cirulis; Senior VP, CFO & Chief Strategy Officer; Potbelly Corporation
William C. Atkins; VP & Controller; Potbelly Corporation
Jeff Priester
Sharon Zackfia; Partner & Group Head of Consumer; William Blair & Company L.L.C., Research Division
Presentation
Operator
Good afternoon, everyone, and welcome to Potbelly Corporation's Second Quarter 2023 Earnings Conference Call. Today's call is being recorded. At this time, all participants have been placed in a listen-only mode. The lines will be open for your questions following the prepared remarks. On today's call, we have Bob Wright, President and Chief Executive Officer; Steve Cirulis, Senior Vice President and Chief Financial Officer; and Will Atkins, Vice President, Controller of Potbelly Corporation. At this time, I'll turn the floor over to Mr. Atkins. Sir, you may begin.
William C. Atkins
Good afternoon, everyone, and welcome to our second quarter 2023 earnings call. By now, everyone should have access to our earnings release and accompanying investor presentation. If not, they can be found on the Investor Relations section of our website. Before we begin our formal remarks, I need to remind everyone certain comments made on this call will contain forward-looking statements regarding future events or the future financial performance of the company. Any such statements, including our outlook for 2023 or any other future periods should be considered forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.
These forward-looking statements are not guarantees of future performance nor should they be relied upon as representing management's views as of any subsequent date. Forward-looking statements involve significant risks and uncertainties, and events or results could differ materially from those presented due to a number of risks and uncertainties. Additional detailed information concerning these risks regarding our business and the factors that could cause actual results to differ materially from the forward-looking statements and other information that will be given today can be found in our Form 10-K under the headings Risk Factors and MD&A and in our subsequent filings with the Securities and Exchange Commission, which are available at sec.gov.
During the call, there will also be a discussion of some items that do not conform to U.S. generally accepted accounting principles or GAAP. Reconciliations of these non-GAAP measures to their most directly comparable GAAP measures are included in the appendix to the press release and investor presentation issued this afternoon, both of which are available in the Investors tab of our website. With that out of the way, I would like to turn the call over to Potbelly's President and CEO, Bob Wright.
Robert D. Wright
Thank you, Will. Good afternoon, and thank you for joining our call today. I'm extremely proud of what we have achieved this quarter. At a high level, we grew same-store sales by 12.9%, driven mainly by traffic growth, continued to take traffic share from the fast casual category each week through the quarter, grew shop level margins by 300 basis points, including leverage across food, labor and occupancy and sign incremental development deals, bringing our total shop development commitments to 106 shops to date under our franchise growth acceleration initiative. We continue to make excellent progress executing our 5-pillar strategic plan, and we're excited about what we can achieve in 2023 and beyond.
Diving into more specifics, let's start with the Potbelly digital experience. We enjoyed another outstanding quarter of performance in our digital business, achieving our seventh consecutive quarter of record digital sales driven primarily by strong performance in our [Perks] loyalty program. For the quarter, our digital business represented approximately 38% of our total shop sales. While the growth in this channel has been tremendous, we believe we are still in the early innings of our digital journey and are excited about the major opportunities ahead to further grow our perks penetration with our guests. Our operations and customer experience improvements continue to drive traffic and sales as well. We've seen year-over-year improvements in staffing, management and associate turnover and peak hour throughput yielding improved customer experience scores, not only overall, but in the areas of speed, accuracy, food quality and friendliness. Our associates and managers are participating in their business success through our tips and shop-level bonus and incentive programs driving engagement and a strong sense of ownership.
We also continue to be encouraged by the benefits we're seeing from Potbelly Digital Kitchen, or PDK, which are clearly showcased through the ongoing growth of our digital business and our ability to handle the incremental throughput, particularly during peak periods. Moreover, the improvements in the customer experience are equally important, evidenced by orders ready on time, accuracy and food quality scores. We continue to expand Potbelly digital kitchen installations in existing shops, and we're excited to announce that PDK will be standard in all new franchise locations, further amplifying the rollout across the system.
Strategic marketing continues to support our traffic-driven foundation to sales growth and is a large part of the success we've seen in the Potbelly digital experience in recent quarters. We're excited to announce the return of the underground menu only available in our app. During the second quarter, we added our fourth underground menu item with the reintroduction of the Clubby, featuring roasted turkey breast, hickory smoked ham, crispy Applewood smoked bacon and Provolone cheese dressed with lettuce, tomato and buttermilk ranch. The customer reception has been amazing with the Clubby reaching our #1 sandwich in the first few days despite only being available in the app. All in all, our marketing and LTOs and digital-only promotions continue to drive traffic, value and excitement for our customers while also serving as a continued growth driver for the Perks loyalty program and our digital channels. We remain keenly focused on food and marketing innovation to further expand these promotional efforts in the coming quarters.
Moving to our franchise Growth Acceleration initiative, or FGA. Our new shop development pipeline continues to build as we further emphasize our franchise focus and build the organization's capability to support growth. We have a highly active and fluid pipeline of qualified Potbelly franchisee candidates from initial leads all the way to our regularly scheduled discovery days. We were excited to share earlier this week the summary of one of our more active markets in the state of Florida. As part of our ongoing investment in our organization's capabilities, in June, we announced the appointment of Lynette McKee as Senior Vice President of Franchising to oversee all aspects of franchisee market planning, franchise recruitment and sales. We're excited for Lynette to build upon the progress that we've already made as we continue to build towards 2,000 units in the U.S. over the next decade. Already in her first few weeks, Lynette has begun to refine our targeted recruiting efforts, fine-tune our franchisee selection criteria, and she has advanced deals soon to be announced.
Furthermore, subsequent to the end of the quarter, we welcomed Bryant Kyle, our company founder, back to the Potbelly family through the announcement of a 27-unit deal that includes 12 re-franchise shops and a 15 shop development agreement in Maryland. Bryant has a keen understanding of the Potbelly vision and deep appreciation for the brand and what sets us apart. We look forward to his leadership in the franchise system and to him accelerating our growth momentum in Maryland as we continue to execute our strategic franchise and growth strategy across the U.S.
Potbelly's unique brand, combined with proven business fundamentals and an experienced team is the foundation of our ability to drive growth for the next decade. As we look ahead, there's still work to be done, but I'm incredibly pleased with our progress on all things franchising from lead generation and franchisee selection to real estate and construction support. We're building a best-in-class franchising organization, and we remain committed to our long-term unit growth goals. We're highly encouraged by our progress thus far and look forward to sharing more updates this year as more SDAAs or Shop Development Area Agreements are finalized.
Turning to our 2024 growth targets. Our strong brand value, strategic marketing efforts and continued execution of our 5-pillar strategy has built upon the momentum we've created in recent years. Achieving $25,950 per week during the second quarter or over $1.3 million on an annualized basis gives us increased confidence in achieving average unit volumes in excess of $1.3 million across the full year of 2024. Our shop level margin target remains at 16%, which will be driven by continued portfolio-wide top line leverage, operational efficiencies and cost discipline, and we remain committed to our target of 10% unit growth in 2024. Overall, we're very happy with where we stand relative to our 2024 targets, and we're focused on continuing to execute to achieve our near-term goals and build the foundation to achieve our 2,000 unit potential.
Finally, I'd like to thank our Potbelly team for their hard work and commitment to our unique brand and the growth trajectory we're on. Potbelly employees are instrumental in providing a distinct and differentiated fast casual experience for each of our customers and ensuring they're satisfied and delighted from their first moment to their last bite. I'm so proud of our team from our frontline associates to our support center employees. It is the continued efforts of our people that drove our success in the quarter. With that, I'll now turn the call over to Steve to detail our financial performance for the second quarter.
Steven W. Cirulis
Thank you, Bob, and good afternoon, everyone. Stock revenues in the second quarter increased 8.4% to $124.7 million, driven by same-store sales growth of 12.9%, resulting in average weekly sales of $25,950. Traffic continues to be a major contributor to same-store sales growth as we continue driving demand through compelling marketing, providing our customers value for what they pay and implementing price increases primarily to mitigate increases in input costs. As Bob mentioned, this has allowed us to continue to take traffic share from the broader fast-casual category on a weekly basis. The top line strength we saw in the quarter was broad-based with each period achieving same-store sales growth of at least 10% and each real estate type achieving same-store sales growth of at least high single digits. Our digital business continues to grow and now represents approximately 38% of revenue, an increase of 170 basis points versus last year, predominantly through our owned channels. Our on-premise business also grew on a dollar basis. Continued strength in our digital channels is a direct result of the overall Potbelly digital experience, including improved app and web interfaces, dedicated efforts to increase Perks loyalty program member acquisition and activation and engagement through targeted digital promotions and advertisements.
Turning to expenses. Food, beverage and packaging costs were 28.0% of shop sales, a 50 basis point improvement versus the prior year period. Overall Q2 commodity inflation was up 3.4% versus last year. Our grocery category, which includes produce, soup, condiments and chips, saw the largest input cost increases with meat, primarily chicken retreating year-over-year. Labor expenses were 30.4% of sales, a 100 basis point improvement versus the prior year period. This improvement is attributed to top line leverage, along with continued optimization of our hours-based labor guidance. We continue to see wage rates moderate and expect this to continue to normalize as we move through the year.
Occupancy was 10.5% of sales, a 150 basis point improvement versus the prior year period. The improvement was driven by top line leverage. Other operating expenses were 16.8% of sales, roughly in line with the year ago period. This was due to variable expenses, such as increased brand fund spend and third-party delivery and credit card fees, which were offset by sales leverage on fixed expenses. These margin improvements should not be understated. 50 basis points improvement on food 100 basis point improvement on labor and 150 basis point improvement on occupancy. We're proud of these results as they showcase the potential of the Potbelly economic model with sustainable top line growth fueled by the effectiveness of our marketing efforts, including our Perks loyalty program, focus on customer experience, prudent cost control and normalization of inflationary pressures.
Importantly, we are well on our way to achieving our 2024 shop level margin target of 16%. The Overall, shop level margins in the second quarter were 14.4%, an increase of 300 basis points versus the year ago period. General and administrative expenses were 9.2% of revenue. Going forward, we believe general and administrative expenses as a percentage of system-wide sales is a more applicable way to view our business as we become more franchise-based over time. For the second quarter, general and administrative expenses were approximately 8.2% of system-wide sales. The increase in G&A was driven primarily by higher bonus accruals as we outperformed our targets in the quarter as well as digital maintenance costs. We are encouraged by these results as we continue to leverage sales, control costs and build the development infrastructure ahead of our increasing pace of unit growth.
We reported net income of $2.2 million for the quarter, a $1.6 million improvement versus the prior year period. Adjusted net income was $2.0 million compared to $1.5 million in the prior year period. Second quarter adjusted EBITDA was $8.0 million or 6.4% of total revenue. This was a $2.2 million increase year-over-year and a 140 basis point improvement on the margin.
Turning to our outlook. For the third quarter of 2023, we are currently forecasting the following: average unit volume between $25,000 and $25,500 same-store sales growth between 7% and 9%, stock level margin between 12% and 14% and adjusted EBITDA between $5 million and $6 million. For the full year 2023, our outlook includes record-level AUVs, same-store sales growth in the high single digits to low double digits and shop level margins of at least the low teens. With that, I'll turn the call back over to Bob.
Robert D. Wright
Thanks, Steve. We're thrilled with our second quarter results, but we're only getting started. Our top line strength has continued into the third quarter, and we continue to take traffic share from the fast casual industry on a weekly basis. We have line of sight on achieving our 2024 growth targets, and we have a strong pipeline of additional shop development area agreements that we look forward to sharing in the coming months and quarters. With that, we're happy to answer any questions. Operator, please open the line for questions.
Question and Answer Session
Operator
Ladies and gentlemen, at this time, we'll begin the question-and-answer session. (Operator Instructions) Ladies and gentlemen, with that, I'd like to hand the call over to Jeff Priester, Managing Director, ICR, for a few additional questions. Please go ahead.
Jeff Priester
Thank you, Jamie. As Potbelly's done previously, we have offered investors the opportunity to send in additional questions or topics in advance of the earnings call. The first question is on unit growth. Bob, you mentioned you're committed to your 2024 unit growth targets. What gives you the confidence in achieving 10% unit growth next year?
Robert D. Wright
Yes. Thanks, Jeff. First of all, we are excited to celebrate the number of shop commitments that we have since we started our franchise growth acceleration initiative. And at 106, we feel like the pace is in our favor. And as with development in any brand, it's all about building momentum. And so what we're looking forward to is building on the momentum we have and developing more of that as we finish this year and all through next year. The view into the pipeline itself is part of the reason that we have that confidence. I mentioned it a few times in our prepared remarks about looking forward to further announcements as we continue to sign and close those additional SDAAs that we're working on. I'm excited about Lynette's leadership already as we continue to invest in our team and their ability to manage more of that pipeline, recruit more targeted and be able to further vet our franchise candidates in a more quick manner. So there's a lot of excitement in the pipeline itself. We will continue to invest in that team and ensure that we're able to keep pace with the ongoing needs and growth for it. But we continue to believe that this momentum that we're building will be with us for a while.
Jeff Priester
Great. The next question is on G&A. Steve, you introduced system-wide sales of the metric for the first time this quarter and noted it's a more apical way to view the business. Can you explain why that's the case?
Steven W. Cirulis
Sure. Thanks, Jeff. It really relates to what Bob was just discussing in terms of our transition to a more franchise-based organization. And with that, we feel it's important to reflect the relationship between the sales that all of our units drive and the investment needed to support the investment in those sales, notably on the development side. For companies like ours that are moving towards franchising are already there, it's a conventional way to report your G&A is against system sales. And as we continue to build the development infrastructure and enable our unit growth aspirations for 2024 and beyond, we feel that reflecting the investment in franchise development against only our company revenue paints an incomplete picture of our G&A management. And so as we continue to open more franchise units in the upcoming years. Our percent -- our G&A as a percent of system sales could go down as happens with many other companies like ours. And in the end, we want to be able to provide that kind of transparency for everyone.
Jeff Priester
Great. And then Bob, the next question is on nontraditional units. You've previously spoken about growing through both traditional and nontraditional units. How big of an opportunity are nontraditional units? And how do they fit into your 2024 unit growth goals?
Robert D. Wright
Yes. Look, I think nontraditional is a big opportunity for us long term. I mean, if you look at the -- look at our success across shop types as a brand, you would believe that we have the ability to continue to grow and develop the brand in all kinds of locations. But I'd like to be clear on the balance there. Our emphasis is on SDA development and SDAA agreements with multiunit franchisees that will build out a certain territory. It's the best way to penetrate the market. It provides the most predictable pattern of growth for us because those are multiunit deals, and we've shared publicly before every one of our multiunit deals has lease control dates and open dates that are responsible for those franchisees to hit those numbers and hit those time lines. So when we sell one of those traditional packages and which is primarily for traditional units, then we know that we build more and more sustainability and predictability into that growth trajectory.
But we also have incoming inquiries on nontraditional, and we do have a person on staff to help us with that. They're unique to take down. You've got RFPs and certain locations have different requirements. So we wanted to make sure we had the resources to respond to that incoming with those nontraditional sites, and we're going to take advantage of them, especially as I said a moment ago, how well we do in the nontraditional sites. But I would not want anybody to misread where our focus is. It really is all about new development through shop development area agreements were multiunit deals that set up our franchisees to be able to build their business in the market where they want to do business.
Jeff Priester
Great. That was the last submitted question. I'll turn the call back to Jamie for any additional questions in the queue.
Operator
And at this time, we have a question from Sharon Zackfia from William Blair.
Sharon Zackfia
I have a (inaudible) of questions here. I guess, first on the 2024 AUV target of $1.3 million. I mean, it seems like that's something you're going to hit this year. Is there something I'm missing in kind of the math here?
Robert D. Wright
No. Sharon, look, I mean, as I said in my remarks, too, when you annualize this most recent quarter, we would be above that $1.3 million. But the reality is if the trailing 12 is just not quite there. And we haven't really pushed those 2024 AUV targets yet until we get one more quarter really, 2 more quarters of settling of what our trajectory is on volume.
Sharon Zackfia
Okay. I guess I'm also curious, I mean you keep -- you're talking about taking share. I mean who do you think the donors are here? Are you getting share from independents? Is there kind of a material larger chain that you think Potbelly is getting more than their fair share from?
Robert D. Wright
Yes, it's difficult to say by chain, but we are using data sources that would be sourcing their data from the chains. So if you look at the chain restaurants in the fast casual segment, we've got a couple of different data sources that we acquire that data from. And we're pleased to see the common trends across both sources that our pace of growth, particularly with traffic, is outpacing the fast-casual segment. And we've been doing it week-on-week and month-on-month for a while. So look, I think the efforts that we talk about with our 5-pillar strategy is the reason we also feel confident those numbers are accurate. We've talked quite a bit about the operations emphasis we've had staffing training, the throughput and the unlocking of that throughput capacity during our peak periods, not only with Potbelly Digital Kitchen, but in those that don't have Potbelly Digital Kitchen, we're applying some of that learning on that front line throughput there, too, until we install it, of course.
Add to that, all of our marketing efforts, the digital that we've leaned into so heavily the success of our Perks program. And we see the reasons in our strategy and execution that would make those numbers make sense to us. And we also believe that we've got more gas in the tank if it comes to what we own in ops and marketing and execution.
Sharon Zackfia
Perfect. I also wanted to touch on, I guess, the composition of traffic and ticket because I heard that on the 13 comp, the majority was traffic driven. I think you were running kind of 7% of price, which would imply some negative mix. Is that a function of more kind of on-premises or walk-in versus delivery? I know deliveries generally been softer than walk-in or take out across the industry. So I'm wondering if there's a channel dynamic happening in the mix.
Steven W. Cirulis
Thanks, Sharon. Look, the real news is the traffic is strong. We're happy to see that we're gaining share there, as Bob described. And our same-store sales are largely built off of that traffic base. We have -- we actually were lapping about an 8.8% price from last year, which for us shows up and the same-store sales show up both in traffic and check. We don't -- when we do raise price, we don't typically bank on all of it flowing through. We marked some of it down for a level of stickiness that we have consistently kind of seen.
So what we saw in terms of flow-through within quarter 2 was about right on target with what we expected. In terms of the behavior of customers, what we've seen a lot of is that folks aren't really managing their check so much as we've brought probably no new customers to the brand, and we've got our existing customers coming more often. There is more movement into our original and skinny sizes. And our big size is, while a smaller part of the mix on a unit basis are basically the same as they were last year. So that's strength across the board in terms of the menu. And we continue to watch if there's any real mix shifting or if we see any changes in customer behavior as they try to manage their check. But we're right on where we thought we'd be in terms of the stickiness of that price flow through and really excited about the traffic. And what that just tells us is, I think, the way that we've managed price over the last year in terms of sticking to our strategy of just trying to price enough to kind of outrun some of those input costs gives us some confidence that we're on the right track there.
Sharon Zackfia
And then last question. I mean, clearly, your digital as a percent of your overall sales has been very healthy and then really hanging in there. Are you seeing -- I guess, when I look at that, kind of how would you break that out between kind of new Perks members versus just a frequency being maintained or even increasing across existing Perks numbers. I don't know if you kind of disclose average active users for Perks, but I'm just trying to figure out kind of how that digital flywheel is playing out for you?
Robert D. Wright
Yes. We don't disclose the breakdown on Perks, either penetration or member acquisition. But what I can tell you is we're incredibly pleased with the Perks contribution to that digital business in Q2. And it continues to grow and it grows at a rate that we see some continued acceleration in. What that means for us is, again, we haven't spoken publicly about the specifics, but those are more frequent users and their average check is a little bit higher as well. They also are very easy to activate with the various promotions that we have. They pay attention to the things like the underground [mint], the promotional activity like we had our Tax Day BOGO and the first day of summer BOGO and those things, even just the LTOs and the cookie promotions that we have, we get a great reaction from our Perks consumers because they're becoming more and more affiliated with and have a higher affinity for the brand and they like the way that they're brought into that sort of friendly ecosystem.
So we think that's very favorable for us over time. We also think we've got a lot of room to run with growing Perks because clearly, once they're in our channels, we get all that data, we get to speak to them directly. We get more of a one-on-one relationship with them, and we have different nurturing channels depending on their behavior. The other thing is, as we all know, with some of the other third-party digital business, our margins when we have a direct relationship with our customer are always more favorable to us. So we see all kinds of reasons to keep pressing on that. And frankly, we think we've got a lot more in the future that we can lean on with Perks.
Operator
And with that, we have reached the end of our question-and-answer session. I'll now turn the call back over to Mr. Wright for closing comments.
Robert D. Wright
Thank you, and thank you all again for your time this evening. We look forward to speaking with you again soon. And until then, I hope you have a great night.
Operator
Ladies and gentlemen, with that, we'll conclude today's conference call and presentation. We thank you for joining. You may now disconnect your lines.
