El Pollo Loco Holdings, Inc. (LOCO) Q2 2016 Earnings Report, Transcript and Summary

Greetings and welcome to the El Pollo LoCo second quarter 2016 earnings conference call. At this time, all participants have are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions]. As a reminders, this conference is being recorded. I would now like to turn the conference over to Larry Roberts, Chief Financial Officer. Thank you. You may begin.

Thank you operator and good afternoon. By now everyone should have access to our second quarter 2016 earnings release. If not, it can be found at www.elpolloloco.com in the Investor Relations section. Before we begin our formal remarks, I need to remind everyone that our discussions today will include forward-looking statements. These forward-looking statements are not guarantees of future performance and therefore you should not put undue reliance on them. These statements are also subject to numerous risks and uncertainties that could cause actual results to differ materially from what we expect. We refer all of you to our recent SEC filings for a more detailed discussion of the risks that could impact our future operating results and financial condition. We expect to file our 10-Q for the second quarter of 2016 tomorrow and we encourage you to review that document at your earliest convenience. During today's call, we will discuss non-GAAP measures, which we believe can be useful in evaluating our performance. The presentation of this additional information should not be considered in isolation or as a substitute for results prepared in accordance with GAAP and reconciliations to comparable GAAP measures are available in our earnings release. With that, I would like to turn the call over to Steve Sather.

Thanks Larry. Good afternoon everyone. And thank you all for joining us on the call today. We are pleased to report 2016 second quarter results that included our 20th consecutive quarter of system-wide comparable store sales growth and pro forma net income of $0.19 per share. More importantly, we believe our second quarter results displayed continued progress as a result of the value, operational and service initiatives that we have implemented during the past year. System-wide comparable store sales increased 2.4%, including a 2.7% increase at franchise restaurants and a 2.0% increase at company operated restaurants. We are particularly pleased that transactions at company operated restaurants increased 2.7% during the quarter and believe this is an indicator that we are making headway with our more value focused guests and heavy users. Restaurant contribution margin for the quarter was a healthy 22%, which was 40 basis points better than the second quarter of 2015. The primary driver of margin performance was lower food costs, driven by commodity deflation and a favorable marketing calendar which more than offset higher labor costs. As we discussed last quarter, sales continued to run below our expectations in Houston. While the soft Houston economy is likely a headwind, we are focused on building a deeper relationship with consumers to drive repeat purchases and build frequency. To that end, we are enhancing our local store marketing initiatives including focusing our efforts on our core menu offerings. On the operation side, we are adding employee training resources to improve our customer service and better educate customers about our food. We believe that as we continue to attract new customers in our restaurants and they experience the taste and the quality of our food, we can turn them into repeat customers. It's also important to note that the things we have learned with regard to our entry into Houston will be valuable as we enter new markets in the future. Switching now out to development. During the second quarter we opened two new company operated restaurants. Additionally, franchisees opened three new restaurants including our 12th El Pollo LoCo in Houston. For the full year 2016, we continue to expect to open 17 to 20 new company operated restaurants and expect our franchisees to open between 10 and 15 new restaurants. We remain pleased with the progress of our development plan in Dallas where, together with our franchise partner, we expect to open approximately seven restaurants this year, including two that are scheduled to open this month. With regard to franchise restaurant growth, we remained focused on accelerating development and continue to seek new franchise candidates with the resources and capability to develop in new markets. During the second quarter, we announced to signing of a development agreement with a new franchise partner, PLM Restaurants, who will open six new restaurants in the Tucson, Arizona area by August 2019. In addition to opening new restaurants, PLM Restaurants completed the acquisition of two existing El Pollo LoCo restaurants in the Tucson market, one of which was a company operated restaurant and the other a franchised unit. PLM Restaurants currently operates over 80 Burger King restaurants and we are very excited to have them join the El Pollo LoCo system. Finally I would like to provide a quick update on our new Vision prototype, a design that we feel better reflects the quality of our food and QSR-plus positioning. We continue to receive favorable consumer feedback from our initial remodel in Fullerton, California and plan to complete more remodels with the new design by early next year. In addition, all new Dallas restaurants, both company and franchise, will open with a new design as well as will new company operated restaurants outside of Dallas, which have not already begun the permitting process. We expect to have a total of between eight and 12 restaurants operating with the Vision design by the end of the year, including new builds and remodels. With that, I would like to turn the call over to Larry for a detailed discussion of our second quarter results and 2016 guidance. Larry?

Thanks Steve. For the second quarter ended June 29, 2015, total revenue increased 9% to $97.5 million from $89.5 million in the second quarter of 2015. The growth was largely the result of the increase in company operated restaurant sales which rose 8.7% in the second quarter to $90.9 million. This increase in company operated restaurant sales was largely driven by the contribution from the 18 new restaurants opened during and subsequent to second quarter of 2015 combined with a 2% increase in comparable restaurant sales. The increase in company operated comparable restaurant sales was comprised of a 2.7% increase in transactions offset by a 0.7% decline in average check. The decline in average check was a result of a 1.4% increase in pricing offset by a 2.1% unfavorable mix which was largely anticipated as we left last year at the higher priced Carne Asada promotion and remain focused on delivering great value to our customers. Franchise revenue increased 12.2% in the quarter to$6.6 million from $5.9 million in the second quarter of 2015. This increase was driven largely by the contribution from nine new restaurants opened during and subsequent to the second quarter of 2015, comparable restaurant sales growth of 2.7% and higher revenue related to our point of sales system. Turning to expenses. Food and paper cost as a percentage of company restaurant sales decreased 270 basis points year-over-year to 29.7%. The improvement was predominantly due to lower commodity costs, particularly lower contracted chicken prices and favorability in our promotional calendar. As a reminder, for the remainder of the year prices for all of our chicken needs are locked in and we expect commodity deflation of around 4% for the year. Labor and related expenses, as a percentage of company restaurant sales, increased 160 basis points year-over-year to 26.8%. The increase in labor expenses was primarily driven by increases in California minimum wage and incremental labor required at 11 restaurants opened in the fourth quarter of 2015 and five restaurants opened during the first half of 2016. Occupancy and other operating expenses, as a percentage of company restaurant sales, increased 70 basis point compared to the prior year's second quarter to 21.5%. The increase was primarily due to rent expense on new and renewed restaurant leases and the incremental cost related to opening new restaurants in the fourth quarter 2015 and the first quarter of 2016. General and administrative expenses increased by approximately $1.9 million year-over-year in the second quarter to $8.3 million. As a percentage of total revenue, G&A expenses increased 130 basis points to 8.5%. The increase included $340,000 of legal cost related to the securities class action litigation. Excluding cost associated with the securities litigation, G&A expenses in the second quarter of 2016 would have increased approximately $1.5 million or 100 basis point as a percentage of total revenue. This increase resulted primarily from increases in headcount, a higher accrual for the company's annual bonus program, restaurant pre-opening expenses, travel expenses and dead site cost associated with new restaurant location that company chose not to continue pursuing. Depreciation and amortization expense increased to $4 million from $3.2 million in the second quarter of last year. As a percentage of total revenue, depreciation and amortization increased 50 basis point year-over-year. The increase was primarily driven by our new store development as well as by our remodeling program. Prior to our IPO, we entered into a tax receivable agreement that calls for us to pay our pre-IPO shareholders 85% of the tax savings realized as a result of utilizing our pre-IPO net operating losses and other attributes. We recorded a provision for income taxes of $5.3 million in the second quarter of 2016 reflecting an estimated effective tax rate of 42.4%. This compares to a provision for income taxes of $5.1 million in the prior year second quarter. We reported GAAP net income of $7.3 million or $0.19 per diluted share in the second quarter compared to a net income of $7.2 million or $0.18 per diluted share in the year ago period. In addition to our GAAP net income, we have calculated pro forma results adjusting for one-time or unusual items. To arrive at pro forma net income, we have made adjustments for expenses and gains on recovery and insurance proceeds related to a fire at one of our restaurants in 2015, expenses associated with the tax receivable agreement, gains or losses on disposable assets, asset impairments, closed store costs, gain on disposition of restaurants, professional fees incurred as a result of a block trade of 5.96 million common shares in second quarter of 2015 and legal expenses associated with a securities class action lawsuit. We have added back provision for income taxes and have applied 40% income tax rate. Included in our earnings release is a reconciliation of our GAAP results to our pro forma results. We believe that the pro forma results provide a useful view of our business and cost structures. Accordingly pro forma net income for the quarter was $7.6 million as compared to $7.4 million in the second quarter of last year. Pro forma diluted earnings per share were $0.19 for the second quarter of 2015 compared to $0.19 in the prior year period. In terms of our liquidity and balance sheet, we had $9.5 million in cash and equivalents as of June 29, 2016 and $117.1 million in debt outstanding. For the foreseeable future, we expect to finance our operations including new restaurant development and maintenance capital through cash from operations and borrowings under our credit facility. We continue to expect our capital expenditures to total $35 million to $39 million for the full year of 2016. Turning to our 2016 guidance. Based on current information, we are updating our guidance for fiscal 2016. We now expect pro forma diluted net income per share of $0.58 to $0.72. This compares to pro forma diluted net income per share of $0.71 in 2015. Our pro forma net income guidance for 2016 is based in part on the following annual assumptions. We expect system-wide comparable restaurant sales growth to be in the low single-digits. We expect to open 17 to 20 new company-owned restaurants and expect our franchisees to open 10 to 15 new restaurants. We expect restaurant contribution margin of between 20.8% and 21.2%. We expect G&A expenses of between 8% and 8.2% of total revenue excluding legal expenses related to securities class action litigation. We expect adjusted EBITDA of between $67 million and $69 million and we are using a pro forma income tax rate of 40%. With that, I will turn the call back over to Steve for closing remarks.

Thank you Larry. Let me close by saying that we continue to focus on delivering against our four brand pillars, great food, excellent service, a warm and inviting atmosphere and a good price. We believe this will strengthen the foundation of our business and drive results over the long-term. Along these lines, despite a challenging external environment, we continue to see improvement in our core business, driven by the value, service and operations initiatives that we have put in place during last year. In Houston, we are very focused on driving trial and continuing to educate consumers about our great food, as we look to steadily grow our user base and increase frequency. Lastly, our development remains on track and we continue to make progress attracting new franchisees with the skill, resources and capability to partner with us in our future development. Thank you for joining us today. We appreciate your continued interest in El Pollo LoCo and we would be happy to answer any questions that you might have. Operator?

[Operator Instructions]. Our first question comes from line of David Tarantino with Robert W Baird. Please proceed with your question.

Hi. Good afternoon. Larry, could you talk about the factors that are driving the change in the earnings outlook for the year? Because I guess it's not clear what's driving the change versus what you provided last time.

Yes. David, so versus last time, we had a pretty solid second quarter, but as I look out the balance of year, we still expect that we will be making quite greater incremental investments in Houston and Dallas. They are probably the biggest drivers of why we dropped both, the margin and the EPS estimates. As we look and as we have highlighted, the Houston restaurant sales are still below our target, but we have made a decision here that the one thing we are not going to do is cut back on labor and some of the other expense items. So we are going to continue investing and making investments in labor and even on the food cost line. As we look to bring customers into our restaurant in Houston, we have decided we are going to be a little more aggressive in how we do that. So that's an investment on the food cost lime. So when we look at that and then the idea that will probably translate that into some of that also in Dallas as we enter Dallas. Those are really the biggest drivers of why we dropped our full-year EPS and margin percentage.

Got it. And was there any change in your expected revenue outlook related to those new units? I know the comp guidance doesn't change, but does the outlook for the revenue for the new unit change?

From the Q1 forecast, not really, no.

Okay. Great. That's helpful. And then, Steve, could you maybe elaborate on what you are doing in the Houston market from a marketing and operations standpoint to drive better momentum in those locations? I think you mentioned that you are going to be more focused on the core menu. But that any color you could offer on exactly what your plans are to get those sales volumes moving higher?

Yes. Sure, David. Recently we had implemented a number of actions really to drive trial and have deeper relationships with the consumer, driving repeat purchases and build awareness. To that end, first is, we have focused on switching our direct mail. The creative we have increased the circulation to help build awareness. We are sending out to a larger area around the restaurants. And also we have focused on the menu comprehension and inducing trial. We shifted our media spend to a highly targeted social media advertising and we think that's the future. We have also added upgrading our field marketing position and as well as our calendar, as now we are focusing on the core menu items in Houston versus focusing on the LTOs. So those are just a few, David, of the things we have done. But as Larry mentioned, we are continuing to give Houston that support on labor to when people come in and the trial is there, we are doing sampling programs .So they have a great experience. We are continuing to support a little bit longer out after the store is open from their initial increased labor for training. So we see that as a positive and will also include that into Dallas where we feel very good about the Dallas, which we think the economy there is stronger probably open and as we mentioned in the beginning of the call, seven units this year along with our franchise partner, The Harper Group. So we think that will be stronger there.

Great. That's helpful. Thank you.

Thank you. Our next question comes from line of Andy Barish with Jefferies. Please proceed with your question.

Hi guys. On the commodity, sorry about that. On the chicken outlook, I know it's a little bit early but given the amount of chicken production out there and the amount of proceed, do you have an early look at 2017 that it may again be either flat or down year?

Yes. Andy, obviously as you said, it's early, but certainly we are feeling pretty good about the situation. I think corn actually hit a certainly year overlap lower to last year and I think even lower than last two years. So with corn prices at a very low point at this point and certainly we are seeing chicken supply looks to be pretty good, I think we feel good about entering 2017 that will see, I mean I am cautiously optimistic that will be flat on the chicken, plus or minus 1%. But we certainly feel pretty good about where we are right now on chicken cost heading into next year.

Okay. And then can you give us some areas or what you are seeing in terms of improvements in key operating metrics or guest satisfaction scores from some of the labor investment you have made last year at peak?

Yes. This is Steve, Andy. As you know, we use our market force and monitor that very closely. We are seeing continued strong scores, both Q1 and through Q2. Also our NPD metrics for Q1, we haven't gotten our Q2 metrics yet, were very strong as well. So we continue to focus on all of those including the last visit excellence we monitor. Some of initiatives that we did last year to improve speed of service on the inside, those seem to be resonating with consumers, monitoring drive-through speed, which are improving our LV, last visit excellence.

Okay. Thanks guys.

Thank you. Our next question comes from line of John Glass with Morgan Stanley. Please proceed with your question.

Thanks very much. Just for Steve, when I look at your mix decline this quarter, you commented it was versus higher check averages in the year ago period. How much of that is just due to do that versus an uptick in your own promotional activity? When I look at your mix last year, it kind bounced around. But it didn't seem like last year's mix got a disproportionate benefit relative to other quarters last year. Is there also just an increase in discounting your business to drive some of that traffic?

Well, mix is basically flat right now, given our promotional calendar now. Our transactions as we mentioned are positive and continue positive in the first part of the third quarter. And then of course the pricing that we took.

Hi John. In terms of mix, what really drove the mix differential year-on-year, was the fact that last year, remember we were promoting steak with an underlay of shrimp, both of which were at significantly higher prices. And so when we launched that, that was a mix impact of this year. As I look out at the next couple of quarters, I expect to be flat to slightly negative. So you are not going to see another Q2 in terms of mix in Q3 and Q4, because again our promotional items are pretty much more similar versus this year, we had will be promoted versus steak and shrink last year, which of course were very high check items. And as Steve just highlighted one of the things we want to bring out was, we talked about transactions and the fact that we feel great about the 2.7% transaction growth and what we are seeing so far in Q3 is we are again positive to-date on transaction and expect to be positive for the quarter in transactions.

Just to add to that on price, John, we are currently at 1.5%. So we took 70 basis points in April and that was on top of an 0.8% increase in the last November. And we will look at that again in this November and determine what's proper.

Okay. And then just, you mentioned there was a new store design and you are going to start to use the new construction in maybe couple of conversions. I thought that maybe just, Steve, at the time of the IPO you were talking about a remodel program, the Hacienda design. So is this just for new stores? You still remodeling under the old program? Or did you find the old program wasn't doing what you wanted to do, so you switched this new design?

No, we are very happy with the initial Hacienda program that we started years ago. In fact, 70%-plus of the system is now either new in the Hacienda or the Hacienda remodel. We did what we call our Vision design, a prototype in our Fullerton store here in California and that was really the next phase of the design development. It's really more reflects a guide QSR-plus, our positioning. It's really the inside matches what Ed and I talked about as the food, it now matches the quality of the food and we are getting and we have done some research on it. And we are getting very good customer feedback from the research that we have done. We are going to have between eight and 12 of those done either in new stores this year or remodel into the Vision design. And we are kind of actually at a low in our Hacienda, of the timing of our Hacienda remodeled. So this is really a perfect time for that. All of the Dallas stores, both company and franchise, will be in the Vision design as well as many new company stores right now that is beyond, that's not in permitting right now. So we look forward to that for the balance of this year and giving me your input on that the initial feedback from the consumers is, it's resonating very well.

That's great. And then just one more. You mention your reduction in your restaurant operating margin assumptions. I think you have to lower your G&A, though. So somewhat of an offset to the lower margin, is that right, in what's driven that?

Yes. That is correct. And the biggest driver of that is a basically lower balance.

Okay. I am sorry about that. All right.

Thank you. [Operator Instructions]. Our next question comes from the line of Sharon Zackfia with William Blair. Please proceed with your question.

Hi. Good afternoon. It sounds like this probably isn't the case for you, but a couple of other concepts have talked about slowing in California in June and July. I am just curious if you are seeing that as well?

Hi Sharon. This is Steve. We think the California market seems to be holdings well for us. We have heard some talk that you are referring to, but if you look at the burger chains, so you have got a lot of discounting going on in the burger chains and very competitive there. But we think our con strategy is right on. We believe that this really is what's delivering our results now and we believe over the long-term, because we think it really differentiates us. And a lot of the initiatives that we put in place last year, focusing on speed of service, throughput, improvements in service aspect, we have always our food quality there, but really also being very cautious on price increases, we think with the kind of the hard work we did last year is resonating and holding very well for us this year. So we think the strategy is right. And we think we are fortunate and Larry, I will let you add anything on top of that of the California consumer.

No. We are not seeing. As we highlighted, a good Q2 on transactions, Q3 continues at this point to be positive, we expect to be positive. So maybe there is a headwind there, but I can't say as we can point to it as seeing it having a big impact on our transaction or sales. So I guess we are a little different from some of the other concepts.

Okay. And then maybe you are taking all the sales, which is fine. A question on the food cost. You talked about reinvesting some on the food cost line as well in Dallas and Houston. Can you flush that out and tell us order of magnitude, what kind of impact that is?

Yes. As Steve highlighted, one of things we are really focused on Houston, is driving trial. And so we are doing some, I will call it, aggressive discounting and things to get people in the restaurant to try our food. Obviously when they try our food, we believe they will become permanent customers. So if I look at Houston in terms of magnitude of what we expect to run on food cost, I am going to say, it's going to be probably a five percentage point difference versus say our base business, that kind of magnitude.

Okay. Thank you.

Thank you. Ladies and gentlemen, there are no further questions at the time. I would like to turn the floor hack to management for closing comments.

Thank you operator and thank you everybody for joining us today. We appreciate your following El Pollo LoCo and have a good evening.

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.