El Pollo Loco Holdings, Inc. (LOCO) Q3 2018 Earnings Report, Transcript and Summary

Greeting. And welcome to the El Pollo Loco Third Quarter 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the presentation. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host today, Mr. Larry Roberts, Chief Financial Officer. Please proceed, sir.

Thank you, Operator, and good afternoon. By now everyone should have access to our third quarter 2018 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 discussion 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 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 third quarter of 2018 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 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. I'd now like to turn the call over to President and Chief Executive Officer, Bernard Acoca.

Thanks, Larry. Good afternoon, everyone, and thank you all for joining us today. I'm very pleased to report our results for the third quarter which we believe are evident that our transformation agenda is sound and is beginning to gain traction. System-wide comparable restaurant sales increased 2.6% in the quarter, while lapping 1.7% growth in the third quarter of last year for solid two-year comparable growth of 4.3%. Our best two-year comparable sales trend in over a year. System-wide comparable restaurant transactions were flat for the quarter and in terms of cadence, we experienced an uptick in both comparable sales and transactions in September. I'm also pleased to add that this momentum has carried into the fourth quarter with both system comparable sales and transactions currently positive. A strong marketing calendar in the quarter, which included our Overstuffed Quesadillas in $5, craveable combos promotion helped to drive our sales momentum. We believe that these promotions demonstrate our ability to drive sales without heavy discounting. During the quarter, we also reintroduced chips in our handmade guacamole as an option for our guest, which our operators did an excellent job using to drive add-on sale as evidenced by our favorable mix. We are proud of these results and the strategic progress we made in the quarter, but we believe this is only the beginning of our journey to take El Pollo Loco brands to new heights. Now let's talk about the progress we've made against the three key strategies that underpin our transformation agenda. Our first strategy is creating a people first culture. As I discussed previously, culture is the foundation for all great companies and as part of this it is critical that we continue to invest in and develop our talent. All of our support centre teams, field leaders and franchisees have completed training on heart centred leadership, which focuses on leading with authenticity, humility and transparency and is about motivating and inspiring people in the right way. In addition, all of our company area leaders have now been trained on high impact coaching, one of the four essential roles of leadership designed to build the business acumen of our leaders. The balance of company managers will complete the training in the next few months. We also continue to drive utilization of workplace by Facebook in all our company-owned restaurants to increase employee engagement, and foster our recognition culture of celebrating employee achievement. It's incredibly exciting to see how our restaurant teams have embraced this dynamic social media platform to publicize their results, share best practices and deepen their relationships with one another. Lastly, with regard to our people first agenda, we recently brought on Board a new and our first Chief People Officer, Jennifer Jaffe. Jennifer comes to El Pollo Loco from Estée Lauder where she led the human resources function for two phased cosmetics and was involved with the company's acquisition by Estée Lauder in 2016. Prior to Estée Lauder, Ms. Jaffe was Vice President of human resources at AT&T, where she served on HR leadership team to support more than 13,000 employees. It's Jen's top priority to further refine and embed our culture focusing on employee engagement, recognition, talent selection and development, and revamping our people management processes. Overall, we’ve made a lot of progress on feeding our culture in a fairly short period of time and it’s exciting to think about how much opportunity lays in front of us. Our second strategy consists of differentiating the El Pollo Loco brand in everything we do. It's time now for us to focus on those brand equities that we believe not only accentuate our strengths, but also deepens the strong emotional connections we have with our customers. We just recently completed codifying our brand architecture in a comprehensive brand book. This is the first time that El Pollo Loco has had such a clear articulation of who we want to be. The book has already started to influence our strategic brand decisions and how we communicate the El Pollo Loco brand to consumers. Starting in 2019, it will shape everything we do from advertising and marketing communications, to product development and store design. Now that the brand book is being completed, we are planning to make our new brand come to life through a significant brand relaunch that will take place at the start of next year. Informing the development of our brand work is an expansive customer segmentation study that has just been completed. The study has been instrumental in helping us identify our core customers, how they view and use us, and what our biggest opportunities are with them. As discussed in our previous call, while we appeal to a broad variety of consumers, preliminary studies tell us that our customers at almost 50% of our customer base continue to be both a large source of strength, as well as a big opportunity for us. In addition, the opportunity for El Pollo Loco to own families is immense. Given the fact we offer high quality, better for you food, freshly prepared in our restaurants at great prices and the fact that almost 30% of what we sell every day our family meals, we believe that families and group occasions are right in our sweet spot. Guided by this segmentation work, we took near-term actions to increase our mix of Hispanic advertising. We also included more 30 second TV ads to allow us to better tell our story and communicate our brand attributes, and we adjusted our marketing calendar to include more relevant and compelling promotions. Along with an operation own sales mindset at the restaurant level, we believe that these actions are producing improved financial results. There's still a lot of work to do but the exciting news is that we are just getting started and the full execution of these and other initiatives won't be implemented until next year. Our third strategy, expanding our business profitably and responsibly over the long-term is predicated on the first two. In a moment, Larry will talk about growth in a more traditional sense or unit growth, but first I wanted to talk about initiatives we're working on, which should help us focus our growth strategy thus enhancing its future success In September we began menu simplification test in Houston, Dallas and Los Angeles to remove a significant number of low mixing, high complexity menu item. Not only does this initiative help to highlight what we do best our fire grilled chicken on the bone, but it also reduces operational complexity allowing our restaurant teams to further focus on food quality and customer service. We are pleased with the initial results and if they continue to be favorable, we will look to remove additional products in order to free up time for employees to focus on our customers. The other key initiative to sharpen our growth strategy revolves around providing frictionless convenience to our customers, which means providing easy access to our brand by increasing the number of channels through which they can engage with an order from us. As you know, consumers are demanding convenience in the form of mobile ordering, mobile payments and delivery. To address these demands we continue to add functionality to our mobile app. During the third quarter, we added the ability for customers to pay with their mobile phones using a stored value component built into our app, as well as the capability to e-gift El Pollo Loco to a friend or family member. We’re also addressing demands for convenience through delivery, which is available through our partnership with DoorDash. All of our restaurants are now served by DoorDash and we are working to determine the exact delivery fee, which will drive maximum incremental sales. We continue to believe that success and delivery will be driven by our loyalty program, which currently has over 1.1 million members and accounts for approximately 7.5% of our sales. While we will continue to invest in bringing in new members, we have started to reduce the level of discounting required to acquire them. As with delivery, we are now focusing on optimizing our program, which in this case means determining how to translate the robust purchase history data into personalized communication and incremental sales. In summary, we are very proud of our third quarter results, which demonstrate increasing business momentum and indicate that our transformation agenda is working. Driven by our strategy of investing in and growing our talent, accentuating our brand strength and building upon them, as well as responsibly and profitably growing our business for the long-term, we believe our momentum will continue to accelerate. I look forward to sharing the progress we are making on future calls as we continue to grow and elevate the El Pollo Loco brand. And now, I’ll hand the call over to Larry to review our third quarter results in detail.

Thanks, Bernard. Before we get into our third quarter results, I’d first like to touch on our store base. During the third quarter, we opened three new company-operated restaurants, two in Southern California and one in Phoenix. Additionally, franchisee opened three new restaurants during the quarter, one each in Northern California, Salt Lake City and Dallas. For the year, we expect to open eight company-operated restaurants along with nine to 10 franchised restaurants. As remodels, the company completed one digital remodel in the third quarter and franchisees completed an additional three. We now plan to complete 15 company remodels in 2018 with franchise partners expected to complete 25 to 30, which concentrates some slippage in the early 2019. Now on to our financial results, for the third quarter ended September 26, 2018, total revenue increased 10.9% to $112.2 million from $101.2 million in the third quarter of 2017. Total revenue in the quarter includes a $5.5 million of advertising revenue related franchisee advertising fund contributions required as part of new accounting guidance implementation. Excluding the advertising fund revenue, total revenue would have increased 5.5%, driven by an increase in company-operated restaurant sales. Company-operated restaurant sales rose 5.3% in the quarter to $100 million from $95 million in the third quarter of last year. This increase in company-operated restaurant sales was driven by the contribution from the 13 new restaurants open during and subsequent to the third quarter of 2017, as well as by a 2% increase in company-operated comparable restaurant sales, partially offset by seven restaurant closures during the last year. The increase in company-operated comparable restaurant sales was comprised of a 2.7% increase in average check, partially offset by a 0.7% decrease in transaction. Franchise revenue increased 8% in the third quarter to $6.7 million, compared to $6.2 million in the prior year period. The increase was primarily driven by a 3% increase in franchise comparable restaurant sales, which included transaction growth of 0.6%, as well as nine new franchise restaurants opened during and subsequent to the third quarter of 2017. Turning to expenses, food and paper costs as a percentage of company restaurant sales decreased 100 basis points year-over-year to 28.3%. The improvement was predominant due to price increases, a favorable sales mix and lower commodity costs related to avocados, partially offset by higher packaging costs. During the fourth quarter, we set a continuation of favorable commodities trends, but expect the benefit to be offset by higher cost menu promotions. Overall, we now expect our commodity basket to be slightly deflationary for the full year. Looking ahead, we've completed our chicken negotiations and anticipate commodity inflation of 1% to 2% in 2019. As a reminder, chicken makes up approximately 36% of our commodity basket. Labor and related expenses as a percentage of company restaurant sales, increased 20 basis points year-over-year to 29.2%. The increase in labor expenses was due primarily to higher wages in California, especially in Los Angeles, the impact of incremental labor required for six restaurants opened during or after the first quarter of 2018 and higher workers compensation expense as a result of higher claims activity. These are partially offset by increased menu prices. We continue to expect labor inflation of about 5% for the full year 2018, accelerating to 5.5% to 6% in 2019. Occupancy and other operating expenses as a percentage of company restaurant sales increased 80 basis points year-over-year to 24.2%. The increase was primarily due to rent expense, relative to revenue volume generated and other incremental costs related to restaurants built in 2017 and the first 39 weeks of 2018. In addition, we incurred an unexpected increase in natural gas prices due to supply shortages resulting from fire damage to a key natural gas processing plant servicing Southern California. We expect continued cost pressures within occupancy and operating expenses through the fourth quarter. General and administrative expenses increased by $3.9 million year-over-year to $12.2 million. G&A expense in third quarter of 2018 included $3.7 million in legal costs related to the securities class action litigation, as compared to $933,000 in securities litigation cost in the third quarter of 2017. Excluding the costs associated with the securities litigation and executive transition in both periods, adjusting for the impact of franchise advertising revenues on our 2018 revenues, G&A expenses in the third quarter of 2018 increased approximately $1.1 million year-over-year to 8% of total revenue, a 78 basis point increase versus the prior year. This increase resulted primarily from adjustments to our bonus accrual. Depreciation and amortization expense decreased to $4.5 million from $4.7 million in the third quarter of last year. As a percentage of company revenue, depreciation and amortization decreased 60 basis points year-over-year. The decrease was primarily driven by lower asset values resulting from the impairment charges taken in 2017 and 2018. We recorded a provision for income taxes of $2.4 million in the third quarter 2018 for an effective tax rate of 25.9%. This compares to an income tax benefit of $2.5 million and an effective tax rate of 37.8% in the prior year third quarter. We reported GAAP net income of $6.8 million or $0.17 per diluted share in the third quarter compared to a net loss of $4 million or $0.11 per diluted share in the prior year period. Pro forma net income for the quarter was $7.6 million, as compared to $6 million in the third quarter of last year. Pro forma diluted earnings per share were $0.19 for the third quarter of 2018, compared to $0.15 in the prior year period. For reconciliation of pro forma net income and earnings per share to the comparable GAAP figures, please refer to our earnings release. In terms of our liquidity and balance sheet, we had $8.1 million in cash and equivalents as of September 26, 2018 and $31.2 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. For the full year, we now expect our capital expenditures to total $25 million to $27 million. As previously announced, our $20 million share repurchase program, which expires on June 26, 2019 will commence on November 6th. Turning to our outlook for 2018, we are updating our guidance for full year as follows. Excluding the impact of potential share repurchases, we now expect pro forma diluted net income per share of $0.70 to $0.73, which includes an estimated $0.14 benefit from the lower tax rate. This compares to pro forma diluted net income per share of $0.63 in 2017. Our revised pro forma net income per share guidance for 2018 is based in part on the following annual assumptions. We expect system wide comparable restaurant sales growth to be flat to 1%. As I noted, we expect to open eight new company-owned restaurants and expect our franchisees to open nine to 10 new restaurants. We expect the restaurant contribution margin of between 18.7% and 19%. We expect G&A expenses of between 8% and 8.2% of total revenue, excluding CEO transition costs and legal fees related to securities class action litigation and reflecting our change in accounting for franchise advertising fees. We expect adjusted EBITDA of between $51.5 million and $53 million, and we're using a pro forma income tax rate of 26.5%. This concludes our prepared remarks. I'd like to thank you again for joining us on the call today and we're now happy to answer any questions that you may have.

Thank you [Operator Instructions] Our first question comes from Mary McNellis with Robert W. Baird. Please proceed with your question.

Good afternoon. Thanks for taking the question. I first just want to ask for an update on Texas. I think your commentary on the last call suggested that the improvement that you had been making in that market may have stalled a bit, but then in this quarter you introduced the streamline menu. So I was just wondering if you could comment a little bit on how the performance went in those non-core markets during Q3 and maybe the impact that the menu simplification it had on either operations or guest satisfaction in those markets?

Sure. This is Bernard. I’ll take that question. I -- so with our performance in Texas, again it was really in the middle of that quarter that we implemented our menu simplification test. And what we’re seeing right now looks promising, still too early to tell you need a little bit of a longer read when you conduct a menu change of that sort, where we've eliminated 12 to 15 SKUs off of the menu. We’re encouraged by what we’re seeing. We’re not seeing any negativity associated with this test at this juncture, but in regard to the – overall sales trends in Texas. We’re continuing to see more of just the plateau effect if not a little bit of a softening in the business there. So, honestly, I'm not quite sure it's something we could measure within a quarter. We’re still looking to play the long game in Texas and what we've implemented to affect change there we feel hasn’t really fully taken hold. So, again, more of a longer-term focused and looking for any meaningful improvement within a given quarter.

Understood. Thank you. And just one more question on the quarter-to-date and I was wondering if you will be willing comment directionally in whether the improvement that you saw exiting Q3 I know in Q4 was more so a reflection of the year ago comparison softening or if you’re seeing some evidence that some of these newer initiatives are moving the needle on the underlying trend?

Well, I mean, you can see in the numbers, and I think, we talk about the fact that our comps last year in the back half relative to the first half had softened. But I think what you are seeing in our business we’re encouraged by certainly based on the positive transaction trends that I mentioned in my prepared remarks relative to the rest of the industry, but that seems to be somewhat more elusive for many brands and so we are encouraged by the increasing momentum we are seeing in our business.

Great. Thanks for taking the question.

Our next question comes from Matthew DiFrisco with Guggenheim. Please proceed with your question.

Hey. This is actually Matt Grosjean for Matt. Thanks for the questions. I just want to start by first just discussing the gap between the company stores and franchise stores. Anything change there, I see the Delta was about 100 basis points this quarter and it's been roughly that pace going back the last few quarters, is that mainly pricing or how should we think about that Delta going forward?

Yeah. Matt, actually, I would say, the Delta is actually tightened a little bit, I mean, yeah, 100 basis points, but they are constantly growing higher than that in the past. And what we are really seeing right now is a little bit of reverse in where we been is the fact we’re actually running higher check on company restaurants I think part of that because of the way we really been driving the quarterly chip promotion in our restaurant and where the franchisees right now are outperforming is on transaction. And so, in fact, one other thing we are doing in the fourth quarter is, we are running a test in a, call a test is actually across a large number of restaurants in which we are deploying extra labor at dinner in the drive through to see if that is one of the driver was causing that transaction gap and so we just started that test as one of the investments w are making in the fourth quarter, looking to read that. But so right now what we seen is shift where the gap is really around transactions and we do have a test in place to see further close that gap on transactions in the fourth quarter with this incremental labor.

And that test would only be at the company locations?

That test is only company located right now, yeah.

Okay. I had noted that you could be rolling out a new store design in late September in Dallas, any key findings or learnings that we should take since that new store launch?

Well, I think, you’re referring to Vision restaurants, which is all the restaurants in Dallas are the Vision design. And in fact, what we’re doing right now, I can’t remember, but I talked about on the previous call a little bit is, yeah, we’re relooking at that design and some of the element of design. I mean they are beautiful looking buildings. They are fantastic. They work extremely well in California when we build them, because California they know El Pollo Loco. The thing were questioning is putting them in a new market as great as they look to people where they understand what El Pollo Loco stands for as a brand by looking at those assets and do we need to make some tweaks to them or changing to them on the outside and the inside to better convey what El Pollo stands for and what you should expect when you go into El Pollo Loco restaurant. But just begin, I mean, all of our Dallas restaurants are that Vision design.

Understood. And the last question, you’re opening stores and having impairments and store closures. I mean what's the, how should we think about the net benefit of opening a store versus maybe closing or offsetting store or underperforming store?

Well, I guess, I look at as we, I mean, I’ll say, in the past few calls, I think, we highlight the fact that, our development is going to be increasingly focused on core markets. Core being Southern California, Los Vegas and we’ll also be building restaurants up in Sacramento. And we're focus on those, because we know when we build restaurants in those markets we get very good returns on those. So those are going to be certainly accretive to EBITDA, earnings per share, and of course, as we look around and assess our assets then if we determine that we want it, we should close more restaurants, those will also be added, because we don't because we know that they were negative EBITDA and negative EPS. So I hope that answers your question. Again, so everything we're going to be building next year, we’re very confident in the performance given that the non-core markets and any closure I think we did would definitely be accretive to earnings and EBITDA.

Understood. Thanks for the time.

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

Hi. Thanks. This is Alex on for Andy. I just wanted to follow-up on Mary’s other question about Texas and get a sense what the drag was on comps and restaurant on margins this quarter. I think, Larry, last quarter you had shared that it was about 50 basis points to the comp, is that coming down, where is that trending right now?

Yeah. So the comp impact in the third quarter was about 30 basis points, so a little better versus Q2.

And is the impact on restaurant level margin still at 150 basis points or so or is that coming about…

That also improved, yeah, actually that also improved a little bit in Q3. It was about 130 basis points, 135 basis points versus 150 basis points, 160 basis points, we're spinning at that.

Got it. And then just going back to the comments on the fourth quarter and momentum to-date, I think, in your commentary on cost of goods you mentioned that there were some higher costs promotions coming in the fourth quarter and are those going to be discounting or is that a reflection of the efforts to bring down the higher company check and close the traffic gap versus franchisees?

No. What it really reflects is the actual limit time offer that we have going in our last module, which will run from roughly Thanksgiving to the end of the year. It's not discounting, it's just a fairly high food cost item. I don't want to disclose what it is. But we feel like it's going to be a very strong promotion for us but it does have a higher food costs associated with it.

Got it. And then just, I guess, one last question staying on same-store sales, where is sort of the delivery mix trending right now? I guess are you open to sharing sort of what percentage of that mix is coming through the El Pollo Loco app versus DoorDash's, I know that was a later add to their marketplace, I mean, recently.

Yeah. So we've been steadily growing digital sales. Digital by -- by digital I mean mobile, e-commerce and delivery. So right now it represents 2.6% of our sales in totality. I think what you're really going to see is put a lot more momentum behind delivery is in 2019. Our focus historically as a company, when I say historically, I mean, maybe the past couple years, few years, has really been around lunch. Where we're going to really pivot in 2019 is put far more effort behind dinner. I think, Larry talked about the investment we're making in the quarter, the fourth quarter certainly, around additional labor at the drive through particularly at dinner, so that we improve our speed of service times during that day part. But what -- that will also be coupled by is a real focus on family meals, advertising, targeting dinner, as well as in 2019 a greater effort and messaging behind delivery. So I think we've been happy with the steady progress we've been making against delivery in 2018, but we're going to be more ambitious about the growth we're expecting to see from delivery in 2019.

Yeah. Thanks, Bernard. And I guess, well, most of that come in the form of the rewards app and pushing that messaging through the mobile app of reward.

We think that's the catalyst, the primary catalyst for delivery growth for us, yes. And so you'll see again couple, the unlock for delivery for us is a continued growing of our membership base with local rewards, our loyalty program and we're very pleased with our membership acquisition rates there, growing membership to the tune of, let's call, it 10,000 to 12,000 members a week. And so as we continue to grow that program we see that as being a major catalyst to growing delivery over the long-term.

Right. Thank you.

[Operator Instructions] Our next question comes from Jake Bartlett with SunTrust Robinson. Please proceed with your question.

Thanks for taking the question. This is Kevin Robinson on for Jake. And my question focuses on primarily like the family meal mix and also the loyalty. If you could give me a sense of what was like the quarter-over-quarter change in terms of the discounting -- the loyalty discounting? Just to get a sense of how that has changed and also what was the family meal mix percent of sales this quarter?

So, the discounting associated with the loyalty program, if anything has slowly started to ramp downward, we're holding it at about 1%. We've done a few things that have actually helped kind of hop or I should say keep the discounting steady if anything there, which is reducing the discounting associated with acquiring a new member, which doesn't seem to have hurt us too significantly quite honestly. In regards to the mix around family dinner, family meals, that has historically been anywhere between 28% to 30% of our business, and what we are trying to do certainly in 2019 is meaningfully grow that as we start to pivot and put more of our attention and focus around dinner as I mentioned just a moment ago.

Thanks for taking my question. You answered the ones I had.

Thank you. There are no further questions in queue at this time. I would like to turn the call back over to Mr. Bernard Acoca for closing comments.

Well, I just want to thank everyone for attending this evening's call and we look forward to touching base with all of you in our next quarter. Thank you for attending today.

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