Noodles & Company

Good afternoon, and welcome to today's Noodles & Company Third Quarter 2020 Earnings Conference Call. All participants are now in a listen-only mode. After the presenters' remarks, there will be a question-and-answer session. As a reminder, this call is being recorded. I will now introduce Noodles & Company's Executive Vice President and General Counsel, Melissa Heidman. You may begin.

Thank you, and good afternoon, everyone. Welcome to our third quarter 2020 earnings call. Here with me this afternoon is Dave Benninghausen, our Chief Executive Officer. I'd like to start by going over a few regulatory matters. During our opening remarks and in response to your questions, we may make forward-looking statements regarding future events or the future financial performance of the company. Any such items, including details relating to our future performance, should be considered forward-looking statements within the meaning of the Private Securities Litigation Reform Act. Such statements are only projections and actual events or results could differ materially from those projections due to a number of risks and uncertainties. The safe harbor statement in this afternoon's news release and the cautionary statement in the company's annual report on Form 10-K for its 2019 fiscal year and subsequent filings with the SEC are considered a part of this conference call. including the portions of each that set forth the risks and uncertainties related to the company's forward-looking statements. I refer you to the documents the company files from time to time with the Securities and Exchange Commission, specifically the company's annual report on Form 10-K for its 2019 fiscal year and subsequent filings that we have made. These documents contain and identify important factors that could cause actual results to differ materially from those contained in our projections or forward-looking statements. During the call, we will discuss non-GAAP measures, which we believe can be useful in evaluating the company's operating performance. These measures should not be considered in isolation or as a substitute for our financial results prepared in accordance with GAAP. A reconciliation of these measures to the most directly comparable GAAP measures is available in our third quarter 2020 earnings release and our supplemental information. Now I would like to turn it over to Dave Benninghausen, our Chief Executive Officer.

Thanks, Mel, and good afternoon, everyone. I look forward to sharing with you today the continued progress the meals and company has made since the onset of the COVID pandemic and our excitement with the opportunities that lie ahead. Before I discuss that, though, I would like to share how incredibly proud I am of our team members and partners for their continued commitment to providing delicious meals prepared safely, quickly, and consistently at our restaurants across the country. Our team has never been stronger, and their dedication has allowed us to navigate through these challenging times and given us confidence in our ability to take advantage of the opportunities ahead. Of course, the health and well-being of our team members and guests remains our company's top priority. We continue to actively monitor and follow local and federal mandates related to COVID-19 and are committed to remaining a leader in the past casual space in our health and safety protocols. We believe that our approach has increased trust and brand equity with our consumers, which is evidenced by our sales recovery, as well as improvements in guest sentiment that have occurred during the past several months. Although there remains uncertainty around the duration and severity of COVID-19, I have never had greater confidence in our opportunity to thrive and accelerate growth in the years to come. Today, I would like to focus on three key areas of our strategy to take advantage of this opportunity. First, continued differentiation of our concept to appeal to a broad range of lifestyle, convenience and dietary needs. Second, activating our brand, particularly through our digital assets and marketing strategy. And third, accelerating unit growth to take advantage of an operating model we feel is perfectly suited for a post-COVID world. I'll start with how we intend to capitalize on the unique strengths of the brand. As you know, we are the only national chain delivering world flavors through a core menu focused on noodles and pasta. The variety inherent in our menu has been and will continue to be a meaningful strength of the brand, as we offer favorites from kids to adults, healthy to indulgent, and flavors both familiar and new. Aside from the great variety in our menu, unlike many of our competitors, our food travels extremely well, and given our relatively low price point and strong speed of service, Noodles is particularly well suited to take advantage of the increased need for convenience from today's consumer. As we've discussed in the past, 60% of our sales were off-premise even prior to the COVID pandemic. Clear evidence of how well our concept and menu meet that need for convenience. While during the initial stages of the COVID pandemic, we focused on amplifying our core menu, we have since returned to our standard discipline process for menu innovation. We believe there remains significant opportunity for us to broaden reach and frequency through menu innovation, while at the same time simplifying our existing menu and reducing unnecessary execution hurdles for our operations teams. The item currently in test that we are most excited about is our cauliflower gnocchi, which we expect to roll out nationally during the first quarter of 2021. For years, our guests have requested a gnocchi offering, and what we particularly love about the item we are testing is that it meets all of the flavor and texture expectations the guests have come to expect from Noodles & Company, but also offers an additional plant-based alternative on our menu, which is low-carb, low-calorie, gluten-free, and contains a full serving of vegetables in each regular portion. The gnocchi will be well-suited for many of our classic pasta sauces and will be featured with our roasted garlic sauce, which has the highest taste of food score of all sauces on our menu. We are confident that the cauliflower gnocchi will broaden the appeal of our brand, particularly with our attractive target market. Noodles & Company's core audience is comprised of individuals who seek great flavors delivered fast and easy. The brand over-indexes with both millennials and Generation Z, with notable strength with young families. This overall variety of our menu, the ease and quality with which our food travels, and our natural appeal to families have been evident during the pandemic, especially as it relates to our dinner sales. As we reported on October 1st, our company-comparable restaurant sales in September returned positive with a 1.1 percent increase. Despite continued limitations on our dine-in capacity, our afternoon and dinner day parts have been especially strong, with growth of 4.8 percent and 7.3 percent respectively in September. Our dinner strength gives us increased confidence that we will be well positioned for outside sales growth as consumer patterns ultimately normalize in a post-COVID world. While we do expect that there will remain a work-from-home trend that continues after the pandemic, resulting in continued industry pressure at lunch, we're actively working on a refresh of our salad category to position us to capitalize on increased lunch demand for those who do return for more traditional lunch patterns. While we did not anticipate our salad category refresh to be launched until late spring of 2021, in the meantime, we're utilizing the launch of group ordering as well as other digital enhancements to meet the increased needs of those working from home or doing online learning with their children. As we continue to further differentiate the brand for today's environment, I'd now like to move to our second strategy surrounding activating the brand, particularly through our digital capabilities. Digital sales during the third quarter increased 151% versus the prior year and accounted for 61% of total sales. We continued to elevate our digital properties during the third quarter, including the aforementioned launch of Group Ordering. Our digital assets have allowed us to improve the effectiveness of our marketing strategy as we better target our guests and more effectively engage with them through our rewards program. Despite a cluttered social media environment, we have seen a meaningful increase in the open rates of our email communications, a decrease in the cost per acquisition of our media spend, and improved engagement with our social media content. While our rewards program has grown to over 3.2 million members, we still feel we are in the very early stages of utilizing the program to understand and engage with guests at a more personal and targeted level. We expect the program will be an important catalyst for sales growth over the next few years, as we elevate our engagement and form deeper, more personalized relationships with our guests. During the third quarter, about half of our digital sales came through delivery, with the remainder coming from order-ahead quick pickup and curbside channels. We continued to optimize all of our digital channels and anticipate technological enhancements to our curbside pickup, as well as continued optimization of our digital marketing mix during the fourth quarter. Importantly, digital momentum remained strong thus far in October with digital mix at 58% of sales. With our increase in delivery sales, there of course comes increased pressure to the P&L through delivery fees. During the third quarter, delivery fee cost was 5.5% of sales, an increase of 390 basis points versus the prior year. Currently, we maintain an approximate 10% price premium for guests that are ordering through third parties that was launched in Q4 of last year. We've not seen resistance to that price premium and are currently testing an additional 5% price premium that we expect to expand nationally by the end of 2020. As a reminder, we do not currently incorporate a price premium for delivery orders that are made directly through our own digital properties, and we continue to optimize to move delivery orders into our own channels, which bring with it improved guest engagement as well as lower costs. Although delivery has definitely placed some pressure on our margin, We remain pleased with how delivery and digital in general have accelerated brand awareness throughout the country, particularly in markets where we have less saturation. New customers are being attracted to the brand as this access has increased. As an example, our Northern California and Arizona markets, which have nine and five restaurants only, respectively, recorded comparable sales of 35% and 32% during September. The ability to use technology to activate the brand and increase awareness in newer trade areas or less saturated markets gives us even more confidence in our third strategy, which is to accelerate our unit growth. We continue to believe that there will be meaningful disruption in the real estate environment for restaurants in coming years. And we're excited about the opportunity for us to take advantage of that disruption with a more efficient off-premise oriented footprint. Our new restaurants continue to be our best-performing class in the history of the company, bolstered by two restaurants opened thus far in October that have performed strongly, including one restaurant in Wisconsin that has set new records for sales during their first 7, 14, and 21 days of operations. Like many of our new restaurants, this particular restaurant includes our order-ahead drive-thru pickup window, which has proven very beneficial in meeting the increased need for speed and convenience from today's consumers. 78% of digital orders for this location have been processed through the drive-thru window, and average time has been an impressive 62 seconds despite their tremendous volume. We continue to target at least 70% of new restaurants to include the order ahead drive-thru window in their construction. These types of numbers give us greater confidence not just in a reduced square footage in general, but additionally in the potential to test materially cost-effective build-outs that only incorporate off-premise and or digital sales. We are also exploring virtual restaurant or ghost kitchen alternatives, which could provide certain high-density or infill opportunities that we did not feel were viable even a few months ago. We are aggressively building a robust development pipeline, and we've recently bolstered our team with three new hires to advance both our company and franchise development strategy. We continue to target at least 10 to 15 restaurants open system-wide during 2021, with a target of at least 7% annual unit growth beginning in 2022. In the current environment, while it's difficult to reliably anticipate exactly how the recent disruption will influence timing and availability of real estate, we do feel well-positioned to take advantage of additional growth opportunities as they arise. This opportunity is supported by our strong balance sheet. During the third quarter, we paid down a significant amount of our borrowings, and as of September 29th, the company held $8.6 million of cash on hand and had borrowings of $44 million. The company currently has $52.3 million available for borrowing under our revolving credit facility. Our net debt of $35.4 million at the end of Q3 was a small increase relative to the end of Q2, but did incorporate catch-up on rent and other obligations after the completion of generally favorable negotiations with our landlords and vendors. Just as importantly, our growth opportunity is supported by our strong team. For the past few years, we've invested in building our pipeline and culture as a competitive strength. We continue to see significant improvements in our turnover trends and have built a dedicated, robust pipeline of future leaders with great tenure and knowledge of the noodles brand. We've continued this investment in our team through targeted, relevant, and industry-leading benefits. To that end, we recently announced several benefit enhancements, including the availability of free in-person and virtual counseling to support mental health, supporting team members growing families by offering six weeks of paid maternity and paternity leave, as well as providing assistance for surrogacy and adoption. Our strategies around further differentiation of the concept, activation of the brand, and accelerated unit growth would not be possible without our tremendous team members, and I'm extremely humbled at the opportunity to work alongside them to meet our collective tremendous potential. Now I'd like to turn to some detail on our third quarter results and expectations for the balance of 2020. As we pre-announced on October 1st, we reported revenue of $106 million, a 10% decline over the prior year. Comparable sales declined 3.8% system-wide for the quarter, comprised of a 3.6 percent decline of company-owned restaurants and a 5 percent decline of franchise locations. Our company comparable sales decline included a 150 basis point negative impact due to closing for the 4th of July weekend. As noted in our earnings release, comparable sales improved throughout the quarter, culminating in a 1.1 percent comparable sales increase and a 2.4 percent increase in average unit volumes over prior year in September. I'm happy to report that in over half of our markets, we continue to see sequential improvements in trends from September through to October, despite increasing COVID trends throughout the country. Comberville sales are roughly flat quarter to date, and we continue to see average unit volume growth versus prior year. Currently, just over 85% of our restaurants are open for limited in-restaurant dining, and while we expect there may be more restrictions in coming weeks and months, we remain very confident in our ability to navigate those restrictions and be positioned for outside sales growth in a post-COVID environment. Third quarter restaurant level margin was 15.4%, a decline of 170 basis points versus prior year. Like comparable restaurant sales, margins did improve throughout the quarter, with restaurant level margin flat year over year at 16.5% in September. We are proud of the efforts of our teams to improve efficiencies throughout the operating model, as that has allowed us to overcome much of the impact of the increased delivery fees associated with digital sales, which, as I noted earlier, increased 390 basis points versus prior year to 5.5% of sales in the third quarter. In the third quarter, the company recorded adjusted EBITDA of $7.7 million, and adjusted earnings per diluted share were one cent. Looking to the balance of 2020, of course, there remains uncertainty in the current environment, and we remain focused on building sales volumes and optimizing our model while making the appropriate adjustments for COVID-related restrictions and capacity constraints. While we are pleased with our continued momentum, we do feel the uncertainty surrounding COVID makes it difficult to provide comparable sales guidance for the remainder of 2020. As a reminder, During the fourth quarter, total revenue year over year will continue to be impacted by nine locations that were re-franchised earlier in 2020, as well as six restaurants that have closed since the beginning of Q4 of 2019. Primarily sites that were at or approaching their lease end and were not well situated to meet the changing needs of the consumer trends. Two additional locations that are located in areas that have been particularly impacted by the restrictions in place remain closed. Finally, we continue to experience temporary restaurant closures related to the restrictions and the COVID pandemic, typically only for a day or two, as we ensure the ongoing safety of our team members and guests. Collectively, we expect these circumstances to negatively impact revenue year over year by approximately $6 to $7 million during the fourth quarter. Of course, as we lack closure and re-franchising activity, and ultimately exit the pandemic, these temporary impacts will abate and position the brand for meaningful revenue growth. As a reminder, averaging volumes, which normalize for these impacts, were roughly flat year over year during Q3, and our AUVs are growing versus prior year thus far in October. From a margin perspective, assuming no meaningful change in restrictions related to the current pandemic, we expect our margins in the fourth quarter to be modestly below prior year. with significant improvements in labor and our overall model being offset by the impact of increased delivery fees. We do feel that we remain well-positioned as we optimize our operating model, particularly regarding the delivery channel, to have a more efficient and profitable economic model in a post-COVID world than we did entering the pandemic. Before we open the call to questions, I would like to reiterate my thanks to our teams throughout the country and my confidence in the future of Needles & Company. We have a differentiated concept particularly well-suited for short and long-term consumer trends, the digital strength to further activate the brand, and a tremendous growth opportunity ahead of us. While 2020 has certainly been a remarkably challenging year for the country, I do feel that Needles & Company has risen to the challenge cemented our brand with our team members and our guests, and positioned ourselves to be a clear winner for the years to come. With that, Tawanda, please open the lines for Q&A.