Potbelly Corporation (PBPB) Earnings Call Transcript & Summary

[indiscernible] Benchmark. Joining us from Potbelly are the company's CEO, Bob Wright; and the company's CFO, Steve Cirulis. Bob, Steve and the entire team have executed a brand transition at Potbelly that's allowed the brand to compete effectively in a macro environment that's certainly been challenging, to say the least, and has seen some of those more occasional nondigitally connected customers move to a focus on more overt value, which you've done a good job delivering. With the continuing solid operating performance, including stronger-than-expected same-store sales and adjusted EBITDA results for the fourth quarter and strong and improving unit level economics, there's a building delivery of new unit opening momentum for the brand that we'll explore as part of this discussion by franchisees, which should allow Potbelly to further accelerate unit growth for fiscal '25. I want to thank you both for joining us today.

Bob, I'd love to kick it off by asking you to take a couple of minutes to level set where the Potbelly brand is leaving 2024, where we feel as far as the positioning to really lean into the growth of the brand over time and really just how the brand is increasingly positioned with some of the work that you did to meet the needs of financially strapped consumers in this environment.

Yes, thanks, and thanks for those nice comments. First and foremost, it's our birthday today. So happy 48th birthday to Potbelly to be part of how we're positioned. This is a storied decade seasoned brand that really is, I think, in its best season ever. In the last 4 years, Steve and I and the rest of the senior leadership team have been diligently focused on our 5-pillar strategy that answers those concerns, questions. And the consumer is going to experience these times of pressure, but are we prepared to ring the bell and answer the call for the things that they're looking for, that our franchisees are looking for and of course, that the investors are looking for, and that's the beauty of the business. I think we're positioned really well. I mean we came through fourth quarter with positive sales significantly beating expectations. We've got -- we've previously announced it's a 2,000-unit brand, and we already have 727 of those units either open or under an agreement to be developed by our franchisees. We added another 30 to that number in the fourth quarter. We've got nearly 100 franchise units open. When we started a few years ago, it was just around 40. And gosh, we already announced -- preannounced yesterday that while we're not guiding towards 2025 unit development, 38 of our units that are already in development, we can see those already here at the beginning of January, and we've got time to add to that. So we're very excited about the position. Look, '24 was a very challenging time for the consumer. We all know that. They simply had more inflation to deal with than they had wage growth to support that life. And they were making decisions. I think all of us are consumers, so all of us understand this really well. But the goal that is the Potbelly brand is at the root of how we think about our relationship with the consumer. This is a very special brand. And they say, "Wait a minute, are you with Potbelly?" The very next phrase they say, and I'm telling you 5 years in almost for me, I've never heard anything else, oh, I love Potbelly and then they begin to tell you why. To have a brand that was struggling the way it was in the pandemic, that had some opportunities operationally, had some challenges with growth, hadn't even started franchising. But when you start there with the consumer that truly loves the brand, you've got a pot of gold, and you just need to go mine. We have focused on value. We focused on food quality. We continue to invest in our digital strategy. We continue to invest in our operations and see the best operation success that we've had in years delivering on that promise every day. And our franchise strategy clearly is no longer a strategy. It's a plan that we're executing on. We're excited about the growth that we have ahead.

That's great. Thanks, Bob. Coming into the fourth quarter, when we talked about how you were framing up the guidance and the original guidance was down 50 basis points to down 250. When we spoke about that, the high end of that in your mind was going to be unlocked by some key new product introductions that you saw during the quarter. You obviously outstripped the high end of your guidance. Can you talk to us about product newness that was introduced during the quarter, how it's resonating with your consumers? And what kind of tailwind this gives the brand going into '25?

Yes. First of all, it's always fun to beat our own expectations, let alone you all. And that was -- it really was kind of that range of guidance, it was just as you described. We saw some things that we thought could make a positive difference and pull us up to the top end of that guidance. That was the work that we've done, the testing that we had. And if you're not familiar with those adjustments, we added a whole muscle protein to our menu that's now in 2 different sandwiches. It's a slow-cooked pulled pork. It goes on our Cubano sandwich that's now permanently on the menu. Our Sweet Heat barbecue sandwich, which is on the menu, carries with it a new sauce with 2 ingredients, we brought an entire new line to the menu. And we did make news last quarter when we talked about an extension to our dispensed beverage products with our Potbelly refreshers. Those are made with our partner in Tractor Beverage. They're amazing lemonades. And both of those, I think, line extensions helped us with some adjacent potential that we had really warmly accepted by our customers. Some of it have been tested in LTOs in the past and some have been market-tested. So that's where we thought there was real potential. But the outperformance, I think I'd add 2 areas of focus. This continued focus on value. We did not take a price increase in the fourth quarter, which we have in the last few years. We haven't had a price increase since July, in fact, now. So that's just an indicator of how we were focused on maintaining value for the customer. Our $7.99 promotion continues to work. Operations are always critical. I'd tell you, I couldn't be more proud of Adam Noyes and our operations team, both company and franchise, setting year-on-year records for our op scores with our customers, whether it's overall satisfaction, likelihood to return, those food scores, taste of food, ready on time, all the things that we all care about when we're customers. Those are huge for us. And then David Daniels, our CMO, we reallocated some of our advertising spend. If you've been following our story, we currently invest about 3% of our system-wide sales through collections from both company and franchise restaurants into our advertising, our national advertising fund. And in the fourth quarter, David saw some opportunities to make some adjustments in that allocation of funding. And through those adjustments, we discovered that we could accelerate some growth in certain areas of our business. We'll talk more about how that showed up both in digital and other areas as we get to the reporting cycle. But you put all that together, and it came together very, very nicely for a nice sales quarter.

Yes. That was great. You spoke to value and the challenge around value, how you're tackling it with the $7.99 platform. If you look at the sandwich space and the broader QSR space and coming off the results that you just posted this quarter, how do you feel about the value positioning for the brand? Do you feel like it's enough for now for where the consumer is? And again, there's 3 tranches of customers. So the value matters for that walk-in customer. But can you also talk a little bit to that digitally connected and perks customers and how they are still accessing the brand even in this environment?

I'd tell you, this is -- for me anyway, this is my 37th year in the business. And we've been thinking about value in good times and bad times in every industry. Because for all of us, it's -- when you walk away and you finish that last bite of whatever that meal is and you finish paying the bill or you've already paid the bill, it's that notion that, you know what, that's great, I'm coming back for that. And we had that focus on value that's in our first pillar, great food at a good value. That's in our first pillar, it has been for almost 5 years when we reengineered the menu. So there's an intrinsic value that must be in the menu. It has to make sense to the customer. We pay very close attention to pricing ever since we re-engineered that menu so that we don't destroy the value at its core and then have to figure out how to buy it back with promotions. So that's the first stage. The second one, of course, is what we've done with all our digital efforts, both in the loyalty program and in the digital promotions that we've done, I just mentioned one. We don't do it very often, but for special occasions, we'll do things like a celebration for a birthday and that sort of stuff. And our customers really respond well to that in those digital channels. What we shared last year was those non-digital or less digital, less frequent consumers who were under all that pressure last year were kind of pulling back. Lunch is one of the easiest dayparts to pull back a visit from. And our research and David did the research has said that at $9, you start to hit a limit of where someone says, "You know what, I'm going to go ahead and bring my own lunch today," so we created the $7.99 additional layer. We already had pick your pair, sandwich soup, sandwich salad, salad soup, that sort of thing. We already had value meal deals where you can add chips and a drink. But this $7.99 combo, it's just 3 sandwiches, skinny chicken, skinny ham, skinny turkey plus chips, and a drink for $7.99. The value scores for customers that order that and eat that food, when they walk away, there's a significantly higher value score, significantly higher likelihood to return score, and elevated quality scores. And that's what we really want. Our franchisees love it because those happen to be our 3 most efficient in terms of cost perspective proteins. So we've got wide adoption of it. And we believe it's probably a layer for a while to come. The value that we build into digital, though, that's the fun part and super exciting, too, because while we bring in -- give those non-digital customers a reason to come back, they're hard to reach. We don't have a digital relationship with them. We just want that to be every day. You might go into our shops and go, gosh, they're a little merchandise heavy on the $7.99. That's our only chance to talk to the customer that's going to use that promotion. And we don't see trade down as a result of it. With our digital customers, however, once we get you into the digital channels, we actually watch those customers in various segments of frequency. We got broken down into 5 different frequency bands. All 5 of them have increased in frequency. So once we get you in, we find different ways to speak to you about what our relationship is with you. And we're still learning. Let me be clear. There's a lot more ahead of us in that area, but things like segmented offers. If you're a Perks member at Potbelly by any chance and you're one of our medium frequency Perks members, I can tell you, I know the message you got last year when we had our back-to-school promotion if you didn't use the back-to-school promotion. You actually got a custom message from us that had such impressive results. We keep learning about those combinations of behaviors. And that brings value, too. And of course, the internal Perks program as well.

I think it's always difficult to thread the needle with trying to support traffic, trying to create value for the customer while preserving margin, right? It's easy to kind of deal back and give away margin that $7.99 deal, that's -- those are some of our lowest food cost products, but they're also some of the most popular products. Turkey sandwich is incredibly popular. And when you're able to do things like we did with our menu expansion in the fall, adding something simple like new sauces creates the ability for folks to engage in the brand even at that level in a way that creates, I think, builds this affinity. The hard part about all of that, which we demonstrated in the quarter was even though we were discounting more than we would normally do in a year that wasn't as challenging from a consumer standpoint, we still managed to expand margins. We'll unpack that a little bit more when we get into our earnings season, but it's -- it was helpful for us to think through all of those moving pieces and end up with a great result we did, which is positive same-store sales comp and expanding margins, not just at the shop level, but also at the company level.

Yes. Drilling down a little more on Perks and Perks is a driver of the business. And I know that we can talk to it qualitatively. There's not always a ton of metrics that you want to give it because it's such a weapon for Potbelly...

Absolutely...

But you did rework the program and you set up reward tiers at different points. And earlier discussions we've had is that stimulate frequency as people are redeeming more often at lower point tiers. Does that continue? Is there any more rework to the program? And just how is the program building as far as membership coming into it? Because it's a great asset for the brand...

Yes. Thank you. We are very pleased with our Perks program. It is just about to reach its 1-year anniversary of the rework where we have coins. We now have 12 different menu items that you could redeem your coins for. The previous program was basically an entree sandwich. And it really is interesting to watch the different behaviors. Some of our most frequent customers never get a free sandwich. And that's what they were roped into before. And many of them are like, well, I'm going to come back and get a sandwich on a weekly basis anyway, but I sure do like that free cookie every time I come in. So they use it differently. We are learning how to communicate to different segments of our consumer set. And I'll tell you, we're going to make some additional investments this year in our digital platform and our Perks program. We think there's more to do. And there's more that we want it to do for us that we've got to do some under-the-hood work to be able to unlock that. We'll share that more as we unlock it. But I think that the more you learn that you can do with this, the more you want to do with it. And the fact of the matter is it's been very successful. The redemption rate on all those different products that people can get, whether it's a pickle or a bag of chips or the cookies or the shakes or the full-size entrees, you can get a big sandwich, you name it, they're hitting just about exactly what we projected. And they are being used differently by many. I think there's some additional learning we can get out of to lean on it even more, which tells us we think we've got more in it.

And it sounds like you were hinting out there's an opportunity to take the program to more segmented groups of customers eventually on that journey to personalization...

Absolutely. It will take a next -- it will take another gear of technology to be able to do that because you get into a place where there's only so many manual segments that we can build and develop, and we need to automate some of that. We need to unlock the ability to be able to break that down, maybe not all the way to 1:1, but a number of segments that we would no longer want to try to count.

That's great. Given the overall macro environment and what we saw in the industry, in 2024, that's occurring in the backdrop of franchisees really leaning into growing with the brand. And we saw that acceleration, especially as you got to the back half of the year with franchisee openings really starting to kick in. Can you walk through some of the unit-level economics that franchisees are looking at, especially with the new 1,800-square-foot prototype that you rolled out this year? And then if we look at Potbelly as a choice for potential franchisees versus other sandwich competitors or other potential competitors, what's drawing them? I know there's a lot of company-specific things that are bringing people to the brand.

Well, I'll tell you what, I'd start with Steve's comments a moment ago. Everything that we're talking about, whether it's marketing perks, new promotions, new products, geez -- when we started working together, we literally reengineered the P&L so that it looked like a franchise P&L. Everything we're doing is focused on what that unit level economic model looks and feels like to a franchisee. So it's a big deal with us if we're thinking about a promotion that the franchisees are resistant to because that should be a warning sign there's something going on in the economics. But those unit-level economics are pretty -- they've been consistently similar for years. The investment economics need to make sense for our franchisees and the operating economics need to make sense. You add to that the attraction of the brand itself, which is -- that is an absolute veto vote for franchisees. They simply don't love the idea of getting involved in brands. They don't love the brand itself. And then the operations, I don't know a better way to say, they're still blasted. As a guy who grew up in operations, this is a fun space. It's a fun business. You get to work shoulder to shoulder with people that you like working with. And so franchisees are evaluating all of that. But to your question, let's be honest, if the financials aren't exciting and the returns aren't outsized compared to the other options that they have, they're not going to talk to us. I think we're signing new deals when a lot of other brands are struggling to sign new deals for a lot of that reason. I don't know Steve will want to build on my comments, but basics, like 2:1 sales-to-investment ratio, high margins, great occupancy numbers and really healthy returns.

Yes. It's a compelling proposition for someone who wants to create wealth if you're a franchisee. Really kind of quick math, if you want to follow along. We do about 1.3 million AUVs. I mentioned that we expanded margin. We were at 15.7% last fourth quarter. We got higher than that. I won't say exactly what it is, but let's just say it's 16%. We have a royalty rate of 6%. So 10% is kind of what you end up with. Our 16% minus the royalties, if you're a franchisee, it's 10%. The franchisees typically do better than we do with things like occupancy. We have short of 20% of our units are in central business district locations, which are higher rent typically. So a franchisee after royalties would do close to 12%, maybe even better than that. And part of that occupancy is helped by this 1,800 square foot prototype that we talked about, which is it's not a fixed box that is a template that then gets planted everywhere. It's a concept which allows for the operations of a Potbelly to drive the same kind of sales at a bigger box. Our average box is 2,300 square feet. And so it gives the franchisee the ability to get access to different spaces, but it also allows them to, frankly, have a better rent profile, which is a bit of an annuity going forward. And if it's about $55 a square foot, it's kind of the savings that you'll see on every square foot you save, that's a compelling thing for a franchisee. But back to the returns, if we're sitting at a franchisee has 12% to 14% margins, 2:1 sales investment ratio on a $650,000 investment in one of our shops, that's mid- to high 20s cash-on-cash return, unlevered. So that compares favorably to many of the brands that others are looking at.

Especially if you filter brands that have white space for development. There's a lot of talk about brands and their margins, their returns for franchisees, but they don't have any territory to sell. And we hold our head very high among all of our competitors with the economics Steve talked about. And we're not done. We're not done. I mean we've built a few of those 1,800 square foot buildings. We're going to build a couple more -- a few more maybe this year ourselves because we think there are ways to get even more efficient with the construction to pull some costs out to extract some operations efficiency. And the beauty of having our company operations still in place is we can learn even more.

Absolutely. Steve, I want to spend a couple of minutes here just on the balance sheet and cash flow that the business generates. It's largely debt-free balance sheet, a little over $8 million in cash at the end of the third quarter. A lot of the company-specific investment that needed to be made is either underway or largely completed when you look at technology, you look at Potbelly Digital Kitchen. When you get to the investment, which is all helping to drive that accelerating franchisee growth, what are the claims on increasing cash flow as that franchise model starts to really accrue that for Potbelly?

Sure. Well, look, we're in the game of creating value, right, and putting that cash to work in the places where we see the highest returns. And I would say we've got 3, 4 areas where we are focused on investing because that's where we see the returns, right? We do a lot of work to understand where we think we might get outsized returns, and then we'll pour the money into that in a judicious way. So the first is our facilities, right? And we have 340-plus company units that we will continue to operate. And so we didn't spend a lot of money in terms of capital in those restaurants during COVID, and there's opportunity now for us to invest back in them. We did a lot of work on this 1,800-square-foot prototype that we learned from. And some of those components, we want to put back into the -- our company shops, our existing shops because our experience in this industry is if you do a thoughtful investment in remodels in your shops, you can see some sustained lift in sales. And we've thought about it in a way that allows us to -- and our team did some clever thinking around -- we've got small -- a snack size kind of remodel. We've got a skinny size, an original size or a big size because we know sometimes it's just signage, right? A small investment in signage might provide an outsized benefit in terms of visibility, traffic and those kinds of things. So there's the existing facilities. Then new restaurants, we will invest in new restaurants, company restaurants where we think it's -- where we think we can get that real estate and have a great opportunity like Texas Medical Center in Houston, that's an existing company market that we want to further penetrate. And you get these opportunities to do it with a company shop, we'll take those opportunities. As well, we'll continue to push that prototype, learn a little bit more so that we can benefit our franchisees and keep the costs down while enhancing the customer experience because it's really important. Bob mentioned the unique brand that we have. We love our in-shop experience. We think it's a big differentiator. And so we want to continue to make sure that we are staying relevant and we're staying compelling for consumers. And then digital, Bob talked about digital, roughly 40% of our business is digital. It's important to continue to spend in that area so that we are continuing to provide the functionality, not just for the customer, but also on the back end, like Bob described, the capability to provide more compelling and more specific segmentation around the marketing. So you'll see we'll spend in that area. And then finally, share buybacks. We'll continue to invest in our own brand, right, where we think the value is disconnected from where the market is, we'll do that as well. So high return, value-creating opportunities is where the money goes.

That's great. That's great. Well, we just clicked down to 0 there. So we're running out of time. The management team will be hosting a breakout session at 9:30 at Table J6 in the [ Cochina ] room. I want to thank you both for spending the time, doing this today, and thanks, everybody, for joining us.

Thanks, everyone.