POTBELLY CORP - Quarter Report: 2015 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For the Quarterly Period Ended September 27, 2015

OR

For the Transition Period from                      to                     

Commission File Number: 001-36104

Potbelly Corporation

(Exact name of registrant as specified in its charter)

111 N. Canal Street, Suite 850

Chicago, Illinois 60606

(Address, including Zip Code, of Principal Executive Offices)

Registrant’s telephone number, including area code: (312) 951-0600

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  o    No  x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

Common stock, $0.01 Par Value – 30,297,871 shares as of October 30, 2015

POTBELLY CORPORATION

QUARTERLY REPORT ON FORM 10-Q

TABLE OF CONTENTS

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POTBELLY CORPORATION AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

(amounts in thousands, except share and par value data, unaudited)

See accompanying notes to the unaudited condensed consolidated financial statements.

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POTBELLY CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Operations

(amounts in thousands, except share and per share data, unaudited)

See accompanying notes to the unaudited condensed consolidated financial statements.

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POTBELLY CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statement of Equity

(amounts in thousands, except share data, unaudited)

See accompanying notes to the unaudited condensed consolidated financial statements.

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POTBELLY CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows

(amounts in thousands, unaudited)

See accompanying notes to the unaudited condensed consolidated financial statements

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POTBELLY CORPORATION AND SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements

(1) Organization and Other Matters

Business

Potbelly Corporation (the “Company” or “Potbelly”), through its wholly-owned subsidiaries, operates Potbelly Sandwich Works sandwich shops in 28 states and the District of Columbia. The Company also sells and administers franchises of Potbelly Sandwich Works sandwich shops. The first domestic and international franchise locations administered by the Company opened during February 2011, and in July 2015, the Company opened its first franchise shop in the United Kingdom. Additionally, during July 2015, the Company transitioned a franchise shop to a company-operated shop at a cost of $0.3 million. The Company did not record any goodwill related to the transaction.

The table below sets forth a rollforward of company-operated and franchise-operated activities:

_______________

⁽¹⁾  Shop closure during the 39 weeks ended September 28, 2014 was driven by an underperforming shop.

⁽²⁾  Shop closures during the 39 weeks ended September 27, 2015 were related to planned shop closures in airport terminal locations as well as planned closures for underperforming shops with expiring leases.

Basis of Presentation

The unaudited condensed consolidated financial statements and notes herein should be read in conjunction with the audited consolidated financial statements of Potbelly Corporation and its subsidiaries and the notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 28, 2014. The unaudited condensed consolidated financial statements included herein have been prepared by the Company without audit, pursuant to the rules and regulations of the SEC regarding interim financial reporting. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) have been condensed or omitted pursuant to the SEC’s rules and regulations. In the opinion of management, all adjustments, which are of a normal and recurring nature (except as otherwise noted), that are necessary to present fairly the Company’s financial position as of September 27, 2015 and December 28, 2014, its statement of operations for the 13 and 39 weeks ended September 27, 2015 and September 28, 2014 and its statement of cash flows for the 39 weeks ended September 27, 2015 and September 28, 2014 have been included. The consolidated statements of operations for the interim periods presented herein are not necessarily indicative of the results to be expected for the full year.

The Company does not have any components of other comprehensive income (loss) recorded within its consolidated financial statements, and, therefore, does not separately present a statement of comprehensive income (loss) in its consolidated financial statements.

Principles of Consolidation

The unaudited condensed consolidated financial statements include the accounts of Potbelly Corporation; its wholly owned subsidiary, Potbelly Illinois, Inc. (“PII”); PII’s wholly owned subsidiaries, Potbelly Franchising, LLC and Potbelly Sandwich Works LLC (“LLC”) and 17 of LLC’s wholly owned subsidiaries and the LLC’s 4 joint ventures, collectively, the “Company.” All significant intercompany balances and transactions have been eliminated in consolidation. For consolidated joint ventures, non-controlling interest represents a non-controlling partner’s share of the assets, liabilities and operations related to the 4 joint venture investments. The Company has ownership interests ranging from 65-80% in these consolidated joint ventures.

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POTBELLY CORPORATION AND SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements

Fiscal Year

The Company uses a 52/53-week fiscal year that ends on the last Sunday of the calendar period. Approximately every five or six years a 53rd week is added. Fiscal years 2015 and 2014 each consist of 52 weeks. The fiscal quarters ended September 27, 2015 and September 28, 2014 each consisted of 13 weeks.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions, primarily related to long-lived assets and income taxes, that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

New and Revised Financial Accounting Standards

We qualify as an “emerging growth company” pursuant to the provisions of the Jumpstart Our Business Startups Act of 2012, or the JOBS Act, enacted on April 5, 2012. Section 102 of the JOBS Act provides that an “emerging growth company” can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. However, we have chosen to “opt out” of such extended transition period, and as a result, we will comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. Our decision to opt out of the extended transition period is irrevocable.

In April 2014, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2014-08, “Presentation of Financial Statements (Topic 205) and Property, Plant and Equipment (Topic 360): Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity.” The pronouncement changes the criteria for reporting discontinued operations while enhancing disclosures in this area. Pursuant to ASU 2014-08, only disposals representing a strategic shift, such as a major line of business, a major geographical area or a major equity investment, which were not expected to have continuing cash flows should be presented as a discontinued operation. If the disposal does qualify as a discontinued operation under ASU 2014-08, the entity will be required to provide expanded disclosures. ASU 2014-08 is effective for fiscal and interim periods beginning on or after December 15, 2014. Early adoption is permitted. The adoption of ASU 2014-08 is not expected to have a significant impact on our consolidated financial statements or disclosures.

In May 2014, the FASB issued ASU No. 2014-09, “Revenue from Contracts with Customers.” The pronouncement was issued to clarify the principles for recognizing revenue and to develop a common revenue standard and disclosure requirements for U.S. GAAP and IFRS. The FASB has approved a one-year deferral of the effective date of ASU 2014-09, such that it will become effective for the annual period ending after December 15, 2017. We are evaluating the expected adoption method of ASU 2014-09 and the adoption is not expected to have a significant impact on our consolidated balance sheet or consolidated statement of operations.

In August 2014, the FASB issued ASU No. 2014-15, “Presentation of Financial Statements – Going Concern (Subtopic 205-40) – Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern.” The pronouncement requires our management to evaluate whether there is substantial doubt about our ability to continue as a going concern. The pronouncement is effective for the annual period ending after December 15, 2016, and for annual periods and interim periods thereafter. Early adoption is permitted. The adoption of ASU 2014-15 is not expected to have a material effect on our consolidated balance sheet or consolidated statement of operations.

In July 2015, the FASB issued ASU No. 2015-11, “Inventory (Topic 330)”. The pronouncement was issued to simplify the measurement of inventory and changes the measurement from lower of cost or market to lower of cost and net realizable value. This pronouncement is effective for reporting periods beginning after December 15, 2016. The adoption of ASU 2015-11 is not expected to have a significant impact on our consolidated balance sheet or consolidated statement of operations.

(2) Fair Value Measurement

The carrying amounts of cash and cash equivalents, accounts receivable, accounts payable and all other current liabilities approximate fair values due to the short maturities of these balances.

The Company assesses potential impairments to its long-lived assets, which includes property and equipment, whenever events or circumstances indicate that the carrying amount of an asset may not be recoverable. Shop-level assets are grouped at the individual

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POTBELLY CORPORATION AND SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements

shop-level for the purpose of the impairment assessment. Recoverability of an asset is measured by a comparison of the carrying amount of an asset to its estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of the asset group exceeds its estimated undiscounted future cash flows, an impairment charge is recognized as the amount by which the carrying amount of the asset exceeds the fair value of the asset. After performing a periodic review of our shops during each quarter of 2015, it was determined that indicators of impairment were present for certain shops as a result of continued underperformance of shop profitability. We performed an impairment analysis related to these shops and recorded impairment charges of $1.0 million and $1.6 million for the 13 and 39 weeks ended September 27, 2015, respectively, related to the excess of the carrying amounts recorded on our balance sheet over the identified shops’ estimated fair values. The fair value of the shop assets was determined using the discounted future cash flow method of anticipated cash flows through the shop’s lease-end date using fair value measurement inputs classified as Level 3. Level 3 inputs are derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable.

In fiscal 2014, the Company established a non-qualified deferred compensation plan, “Potbelly Non-Qualified Deferred Compensation Plan,” which allows highly compensated employees to defer a portion of their base salary and variable compensation each plan year. The Company maintains a rabbi trust to fund obligations under the deferred compensation plan. Amounts in the rabbi trust are invested in mutual funds. The investments in the rabbi trust are designated as trading securities and carried at fair value. Fair market value of investments in the rabbi trust is measured using Level 1 inputs (quoted prices for identical assets in active markets). As of September 27, 2015, the fair value of the investments in the rabbi trust was $97 thousand, which is included in other assets in the condensed consolidated balance sheet. The associated liability is recorded within other long-term liabilities in the condensed consolidated balance sheet. The Company records trading gains and losses in general and administrative expenses in the condensed consolidated statement of operations, along with the offsetting amount related to the increase or decrease in deferred compensation to reflect its exposure to liabilities for payment under the deferred plan. For the three months ended September 27, 2015, the Company recorded an immaterial amount of unrealized losses on investments held in the rabbi trust.

(3) Earnings per share

Basic and diluted income per share are calculated using the weighted average number of shares outstanding for the period as follows:

(4) Income Taxes

The Company recognized income tax expense of $2.8 million on pre-tax income of $7.2 million, or an effective tax rate of 38.4%, for the 39 weeks ended September 27, 2015, compared to income tax expense of $2.5 million on pre-tax income of $6.1 million, or an effective tax rate of 40.3%, for the 39 weeks ended September 28, 2014. The difference between the statutory rate and the effective tax rate is primarily attributable to state income taxes offset by certain federal and state tax credits.

(5) Capital Stock

On September 8, 2015, the Company’s Board of Directors authorized a share repurchase program of up to $35.0 million of the Company’s common stock.  This program replaces the previously authorized share repurchase program, which was completed in the third quarter of 2015. Under the current program, the Company may, from time to time, purchase shares in the open market (including

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POTBELLY CORPORATION AND SUBSIDIARIES

Notes to Unaudited Condensed Consolidated Financial Statements

in pre-arranged stock trading plans in accordance with the guidelines specified in Rule 10b5-1 under the Securities Exchange Act of 1934, as amended) or in privately negotiated transactions. During the 39 weeks ended September 27, 2015, the Company repurchased 2,094,721 shares of its common stock for approximately $27.0 million in open market transactions, which includes shares purchased under both the new plan and the completed plan. As of September 27, 2015, the remaining dollar value of authorization under the new share repurchase program was $32.7 million. Repurchased shares are included as treasury stock in the condensed consolidated balance sheets and the condensed consolidated statement of equity.

(6) Stock-Based Compensation

Throughout the 39 weeks ended September 27, 2015, the Company issued 558,479 stock options under the 2013 Long-Term Incentive Plan to eligible employees and key executives. The fair value of the options was determined using the Black-Scholes option pricing model. The weighted average fair value of options granted during the 39 weeks ended September 27, 2015 was $6.45 per share, as estimated using the following weighted average assumptions: expected life of options –seven years; volatility –45.25%; risk-free interest rate –1.90%; and dividend yield –0.00%. The Company used the simplified method for determining the expected life of the options. Due to the lack of historical data as a newly public company, the Company calculated the specific stock price volatility using a blended volatility rate based on comparable publicly traded companies.

A summary of activity for the 39 weeks ended September 27, 2015 is as follows:

In accordance with ASC Topic 718, Compensation—Stock Compensation, stock-based compensation is measured at the grant date, based on the calculated fair value of the award, and is recognized as an expense over the requisite employee service period, which is generally the vesting period of the grant, with a corresponding increase to additional paid-in-capital. For the 13 and 39 weeks ended September 27, 2015, the Company recognized $0.7 million and $1.8 million, respectively. For the 13 and 39 weeks ended September 28, 2014, the Company recognized $0.6 million and $2.0 million, respectively, which includes $32 thousand and $0.4 million related to the May 2014 unrestricted common stock grants, respectively. As of September 27, 2015, the unrecognized stock-based compensation expense was $6.8 million, which will be recognized through fiscal year 2019. The Company records stock-based compensation expense within general and administrative expenses in the consolidated statements of operations.

In May 2015, the Company issued 30,856 shares of restricted stock units (“RSUs”) to certain non-employee members of its Board of Directors. The RSUs had a grant-date fair value of $14.26 upon issuance and have a vesting schedule of 50% on the first anniversary of the grant date and 50% on the second anniversary of the grant date. In August 2015, the Company issued 5,221 shares of RSUs to the new non-employee member of its Board of Directors. The RSUs had a grant-date fair value of $11.88 upon issuance and have a vesting schedule of 50% on the first anniversary of the grant date and 50% on the second anniversary of the grant date. The Company recorded an immaterial amount of stock-based compensation expense related to the issuance of all of these RSUs.    

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

Forward-Looking Statements

The following discussion of our financial condition and results of operations should be read in conjunction with the unaudited condensed consolidated financial statements and the notes thereto included elsewhere in this Quarterly Report on Form 10-Q and with our audited consolidated financial statements included in our Annual Report on Form 10-K for the fiscal year ended December 28, 2014. This discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and involves numerous risks and uncertainties. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts and generally contain words such as “believes,” “expects,” “may,” “will,” “should,” “seeks,” “intends,” “plans,” “strives,” “goal,” “estimates,” “forecasts,” “projects” or “anticipates” or similar expressions. Our forward-looking statements are subject to risks and uncertainties, which may cause actual results to differ materially from those projected or implied by the forward-looking statement. Forward-looking statements are based on current expectations and assumptions and currently available data and are neither predictions nor guarantees of future events or performance. You should not place undue reliance on forward-looking statements, which speak only as of the date hereof. See “Risk Factors” and “Cautionary Note Regarding Forward-Looking Statements” included in our Annual Report on Form 10-K for the fiscal year ended December 28, 2014, for a discussion of factors that could cause our actual results to differ from those expressed or implied by forward-looking statements.

Overview

Potbelly is a fast-growing neighborhood sandwich concept offering toasty warm sandwiches, signature salads and other fresh menu items served by engaging people in an environment that reflects the Potbelly brand. Our combination of product, people and place is how we deliver on our passion to be “The Best Place for Lunch.” Our sandwiches, salads and hand-dipped milkshakes are all made fresh to order and our cookies are baked fresh each day. Our employees are trained to engage with our customers in a genuine way to provide a personalized experience. Our shops feature vintage design elements and locally-themed décor inspired by the neighborhood that we believe create a lively atmosphere. Through this combination, we believe we are creating a devoted base of Potbelly fans that return again and again and that we are expanding one sandwich shop at a time.

We believe that a key to our past and future success is our culture. It is embodied in The Potbelly Advantage, which is an expression of our Vision, Mission, Passion and Values, and the foundation of everything we do. Our Vision is for our customers to feel that we are their “Neighborhood Sandwich Shop” and to tell others about their great experience. Our Mission is to make people really happy, to make more money and to improve every day. Our Passion is to be “The Best Place for Lunch.” Our Values embody both how we lead and how we behave, and form the cornerstone of our culture. We use simple language that resonates from the frontline associate to the most senior levels of the organization, creating shared expectations and accountabilities in how we approach our day-to-day activities. We strive to be a fun, friendly and hardworking group of people who enjoy taking care of our customers, while at the same time taking care of each other.

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13 Weeks Ended September 27, 2015 Compared to 13 Weeks Ended September 28, 2014

The following table presents information comparing the components of net income for the periods indicated (dollars in thousands):

_______________

Revenues

Total revenues increased by $11.4 million, or 13.4%, to $96.0 million during the 13 weeks ended September 27, 2015, from $84.7 million during the 13 weeks ended September 28, 2014. The increase in revenues primarily consisted of an increase of $8.3 million in sales from shops not yet in our company-operated comparable store sales base, $0.1 million increase in franchise revenues and a $3.0 million, or 3.7%, increase in company-operated comparable store sales. The increase in company-operated comparable store sales resulted from increases in average check from certain menu price increases and menu mix, as well as traffic.

Cost of Goods Sold

Cost of goods sold increased by $3.2 million, or 13.4%, to $27.3 million during the 13 weeks ended September 27, 2015, compared to $24.0 million during the 13 weeks ended September 28, 2014, primarily due to the increase in revenues. As a percentage of revenues, cost of goods sold remained consistent at 28.4% during the 13 weeks ended September 27, 2015 and the 13 weeks ended September 28, 2014.

Labor and Related Expenses

Labor and related expenses increased by $3.9 million, or 16.4%, to $27.7 million during the 13 weeks ended September 27, 2015, from $23.8 million during the 13 weeks ended September 28, 2014, primarily due to new shop openings, wage inflation in certain states as a result of statutory minimum wage increases, as well as an increase in an existing incentive program and an additional incentive program to reward employees for tenure and development which began in fiscal year 2015. As a percentage of

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revenues, labor and related expenses increased to 28.8% during the 13 weeks ended September 27, 2015, from 28.1% during the 13 weeks ended September 28, 2014, primarily driven by higher labor costs, wage inflation in certain states as a result of statutory minimum wage increases, as well as an increase in an existing incentive program and an additional incentive program to reward employees for tenure and development, which began in fiscal year 2015.

Occupancy Expenses

Occupancy expenses increased by $1.4 million, or 13.3%, to $11.9 million during the 13 weeks ended September 27, 2015, from $10.5 million during the 13 weeks ended September 28, 2014, primarily due to new shop openings. As a percentage of revenues, occupancy expenses decreased to 12.3% during the 13 weeks ended September 27, 2015, from 12.4% during the 13 weeks ended September 28, 2014, primarily due to sales leverage (i.e., the ability to spread certain expenses over a higher revenue base) partially offset by increases in certain occupancy related costs.

Other Operating Expenses

Other operating expenses increased by $1.7 million, or 18.7%, to $10.5 million during the 13 weeks ended September 27, 2015, from $8.8 million during the 13 weeks ended September 28, 2014. The increase is attributable to new shop openings, as well as increased fees associated with credit card usage in our shops, and other operating expense increases in line with revenue growth. As a percentage of revenues, other operating expenses increased to 10.9% during the 13 weeks ended September 27, 2015, from 10.4% during the 13 weeks ended September 28, 2014, primarily driven by increased fees associated with credit card usage in our shops, various increases in other operating expenses as well as the $0.2 million cumulative adjustment recorded during the 13 weeks ended September 28, 2014, for the change in accounting estimate related to gift card breakage.

General and Administrative Expenses

General and administrative expenses increased by $1.6 million, or 21.1%, to $9.2 million during the 13 weeks ended September 27, 2015, from $7.6 million during the 13 weeks ended September 28, 2014. The increase is driven primarily by increases in performance-based incentives, stock-based compensation as well as rent associated with our new office and costs associated with improving our technological infrastructure. As a percentage of revenues, general and administrative expenses increased to 9.6% during the 13 weeks ended September 27, 2015, from 9.0% during the 13 weeks ended September 28, 2014, driven by items referenced above, partially offset by sales leverage (i.e., the ability to spread certain costs over a higher revenue base).

Depreciation Expense

Depreciation expense increased by $0.5 million, or 9.3%, to $5.5 million during the 13 weeks ended September 27, 2015, from $5.0 million during the 13 weeks ended September 28, 2014, primarily due to a higher depreciable base related to new shops and existing shop capital investments. As a percentage of revenues, depreciation decreased to 5.7% during the 13 weeks ended September 27, 2015, from 6.0% during the 13 weeks ended September 28, 2014, driven by lower depreciation associated with new shops with lower build-out costs and longer expected useful lives for leasehold improvements, as well as leasehold improvements at legacy shops with higher build-out costs and shorter expected useful lives being fully depreciated.

Pre-Opening Costs

Pre-opening costs increased by $0.2 million, or 62.4%, to $0.5 million during the 13 weeks ended September 27, 2015, from $0.3 million during the 13 weeks ended September 28, 2014, primarily due to timing of new shop openings during the 13 weeks ended September 27, 2015 compared to the 13 weeks ended September 28, 2014.

Impairment and Loss on Disposal of Property and Equipment

Impairment and loss on disposal of property and equipment decreased to $1.1 million during the 13 weeks ended September 27, 2015, from $1.3 million during the 13 weeks ended September 28, 2014. After performing a periodic review of our shops during the third quarter of 2015, it was determined that indicators of impairment were present for certain shops as a result of continued underperformance of shop profitability. We performed an impairment analysis related to these shops and recorded an impairment charge of $1.0 million related to the excess of the carrying amounts recorded on our balance sheet over the identified shops’ estimated fair values.

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Interest Expense, net

Interest expense increased by $14 thousand, or 33.3%, to $56 thousand during the 13 weeks ended September 27, 2015, from $42 thousand during the 13 weeks ended September 28, 2014, primarily due to the accretion of certain occupancy-related interest costs. Interest expense for the 13 weeks ended September 27, 2015 is attributable to interest on the note payable, unused commitment fees, occupancy-related interest costs and deferred financing fees, partially offset by interest income related to money market funds.

Income Tax Expense

Income tax expense decreased by $0.4 million to $0.9 million for the 13 weeks ended September 27, 2015, from $1.3 million for the 13 weeks ended September 28, 2014. For the 13 weeks ended September 27, 2015, our effective tax rate was 37.3%, compared to 39.2% for the 13 weeks ended September 28, 2014. The decrease in the effective tax rate primarily relates to the Company recognizing certain federal tax credits, which were not recognized in the comparable prior period.

39 weeks ended September 27, 2015 Compared to 39 weeks ended September 28, 2014

The following table presents information comparing the components of net income for the periods indicated (dollars in thousands):