Fiesta Restaurant Group, Inc.
Q3 2016 Earnings Call Transcript

Published: 8 Nov 2016

[Operator:]

Greetings, and welcome to the Fiesta Restaurant Group Third Quarter 2016 Earnings Conference Call. I would now like to turn the call over to Raphael Gross, Managing Director at ICR. Please go ahead.

[Raphael Gross:]

Thank you, operator. The company's third quarter 2016 earnings release was issued after the market closed today. If you have not already accessed it, it can be found on the company's website, www.frgi.com, under the Investor Relations section. Before we begin, I must remind everyone that during the call today, the company will include statements that are not based on historical information. These forward-looking statements include, without limitation, statements regarding the company's future financial position and results of operations, business strategy, budget, projected costs and plans, and objectives of management for future operations. Actual outcomes and results may differ materially from what is expressed or forecasted in such forward-looking statements and the company can give no assurance that such forward-looking statements will prove to be correct. Important factors that could cause actual results to differ materially from those expressed or implied by the forward-looking statements can be found in the company's SEC filings. Please note that during today's conference call, certain non-GAAP financial measures will be discussed, which the company believe can be useful in evaluating its performance. Any discussion of such information should not be considered in isolation or as a substitute for results prepared in accordance with GAAP and a reconciliation to comparable GAAP measures is available in the company's earnings release. Now, I would like to turn the call over to Danny Meisenheimer, interim President and Chief Executive Officer.

[Danny K. Meisenheimer:]

Thank you, Raph, and good afternoon, everyone. Leading Fiesta during this transitional period carries a great deal of responsibility, which I take very seriously. For those of you who don't know me, I've been with the company since 2012 and prior to taking on the role of Interim CEO, I was the Chief Operating Officer for Pollo. So I'm no stranger to FRGI and its two great brands. In my current role, I am working closely with both the board and our management team in evaluating our strategic plan and taking definitive steps to stimulate improved performance and advance our initiatives. We are dedicated to ongoing engagement with all of our shareholders and value their constructive input towards the mutual goal of enhancing long-term shareholder value. As we previously communicated, a committee of independent board directors with the assistance of Heidrick & Struggles, an international recruiting firm, has initiated searches for a permanent CEO and for an experienced restaurant executive to serve as a non-executive director to fill our open board seat. We will announce the results of these searches as soon as the right individuals have been identified. On a related note, we have suspended the search for a Taco Cabana brand CEO, as the board has now concluded that continued brand ownership of Taco Cabana is in our shareholders' best interest. I'm pleased that Mark Phillips is now serving as interim Chief Operating Officer for Taco Cabana. Mark has been with the brand for over 20 years, serving in various leadership positions including as Vice President of Operations at Taco Cabana since 2012. I'd like to take a moment to reflect on where we have been and to share where we're headed. First, we operate two unique and special brands that generate leading four wall economics in the competitive fast casual segment of the restaurant industry. Our brands continue to operate at very high levels in the respective core markets. However, over the past three years we have seen rapid expansion of our Pollo Tropical concept, nearly doubling the size of the chain during this time. In Texas alone, we opened 38 new Pollo restaurants, while introducing the brand to new guest across the state. The brand expansion was not isolated to Texas. It also included the Nashville and Atlanta markets where we opened more than 20 resultants combined. Unfortunately, despite the loyalty of valued guests and the efforts of our dedicated teams, some of those locations have struggled due to increasingly challenging market conditions, restaurant concentration and lack of brand awareness. In addition, our rapid expansion has to some degree caused us in these new markets to take our focus off of what is most important, providing our guest an exceptional Pollo Tropical experience. As a result of the restaurant portfolio overview, we've recently closed 10 Pollo Tropical restaurants in the expansion markets. Of these 10 locations, three restaurants in Texas may be converted to Taco Cabana restaurants. Team members from the closed restaurants were offered positions in either a nearby Pollo Tropical or Taco Cabana restaurant, where possible. These closures come on the heels of our announcement that we have for the time being suspended additional development in Texas. In addition to evaluating our restaurant portfolio in our emerging markets, we were planning and addressing long-term opportunities, which exist. We will focus on building an exceptional guest experience while expanding brand awareness in Texas, Tennessee and Georgia. Through the use of radio, direct mail, local store marketing and off-premise programs, we believe we can build frequency and reach to better balance consumer demand with restaurant supply. We have implemented a new operational structure with decreased spans of control and great leaders in place to focus our teams on operating excellence. We are also in the process of exploring how to regionalize our product promotions and menus to improve appeal and profitability in each of our Pollo Tropical markets. New product innovation has been an area of key focus at both brands balanced with minimizing related operational complexity. Starting in late August, at Pollo Tropical we promoted a new churrasco steak offering across the system, which contributed to generating positive transactions in September. In October, we began promoting a Chipotle Shredded Chicken Taco meal deal priced at $4.99 at Taco Cabana. More product innovation is underway in the fourth quarter and throughout 2017 at both brands. We expect to open a total of 31 new company-owned Pollo restaurants and four new company-owned Taco restaurants in 2016. As of the end of the third quarter, we had opened 26 Pollo Tropical and two Taco Cabana restaurants. In addition, by year-end, we will have reimaged 14 Pollo restaurants, five in Atlanta and nine in South Florida. To date, we have seen sustained sales lifts at restaurants we have remodeled, with trends meeting or exceeding our five-year after-tax cash payback target. Let me now touch on capital allocation in 2017. During the coming fiscal year, we are planning to open 12 to 13 Pollo Tropical restaurants throughout Florida where all of our markets generate AUVs of at least $1.9 million. We are also planning to reimage 22 restaurants in South Florida, primarily in Miami-Dade County where we operate our busiest and most profitable restaurants with AUVs of approximately $3.5 million. At Taco Cabana, we will focus on entering smaller Texas markets as well as adding restaurants in existing markets with a total of eight to 10 openings. We also expect to reimage one restaurant in San Antonio. In smaller markets we will utilize a smaller scalable building prototype that we believe can produce target investment returns, while still delivering the full menu and brand experience. Lastly, turning to our focus on off-premise business, we are now system-wide at both brands with online ordering and mobile app platforms. The mobile app platform is crucial to the success of our loyalty program for both brands. We have been piloting our Pollo Tropical loyalty program in Orlando since April. Given the results of this pilot, we recently rolled out the program to our North Florida and emerging markets to build frequency of visits within our current user base. In Orlando, we found that more than 80% of those guests that opted into the Pollo loyalty program were not previous rewards E-club members, providing evidence that we are engaging incremental guests to our new frequency platform. Leveraging our experience at Pollo, we are planning to begin piloting our Taco Cabana loyalty program in November beginning with our Austin market. We also continue to make progress on third party delivery at Pollo with a few restaurants in each of the following markets

[Lynn S. Schweinfurth:]

Thank you, Danny. For the third quarter, we grew total revenues by 5.9% to $182.3 million through sales contributions from the net new 33 company-owned restaurant openings over the past year, which offset declines in comparable restaurant sales at both brands. And while both brands had negative comp sales, they performed above industry benchmarks in Florida for Pollo, and Texas for Taco. Pollo comparable restaurant sales decreased to 1%, which included a 2.5% decrease in comparable guest traffic, and a 1.5% increase in average check. Sales cannibalization from new restaurants on existing restaurants negatively impacted comparable restaurant transaction growth by approximately 1%. Average check was primarily driven by menu price increases that positively impacted restaurant sales by 1.9%. On a two-year basis, Pollo quarterly comparable restaurant sales grew 3.2%. Comp restaurant sales at Pollo in the first four weeks of fiscal October were down 4.7% due primarily to the negative impact of Hurricane Matthew included related temporary store closures. Excluding the estimated impact of the hurricane, comp store sales declined 0.5%. The good news is that we did not sustain any material property damage from the storm. In the prior year October period, we generated a comp sales increase of 1%. Turning to Taco Cabana, comparable restaurant sales in the third quarter decreased 4.1% as a result of a 3.5% decrease in comparable guest traffic and 0.6% decrease in average check, while menu price increases positively impacted restaurant sales by 1.3%. On a two year basis, comparable restaurant sales grew 0.7%. Through the first four weeks of fiscal October, comp restaurant sales at Taco decreased 0.3%. This compares to the prior year period, when we generated a comp sales increase of 1.3%. In terms of quarterly restaurant expensing cost drivers, please refer to our earnings press release, which provides explanations for each P&L line item on a consolidated basis. Unfortunately, with negative comparable sales at both brands this quarter, sales deleverage negatively impacted profitability at both brands across fixed and semi-fixed operating costs. G&A increased $0.3 million to $14.5 million in the third quarter 2016. As the percentage of total revenues, G&A decreased to 8% in the third quarter this year, compared with 8.3% in the prior year period. During the current year quarter, we recognized $0.8 million charge for estimated costs, including legal fees and other costs related to a class action settlement and $0.6 million write-off related to costs incurred for locations we decided not to develop. These costs were partially offset by lower incentive-based compensation. In the third quarter of 2015, we incurred a charge for estimated costs including legal fees and other costs related to a class action settlement totaling $0.9 million. In the third quarter of 2016, we recognized an $18.5 million impairment charge, related to the 10 closed restaurants and six other Pollo restaurants and one Taco restaurant that we continue to operate. We will recognize lease and other charges related to the closed restaurants, which we anticipate will be between $2 million and $4 million in the fourth quarter of 2016. And as previously disclosed, the 10 closed restaurants contributed about $4.8 million of pre-tax operating losses to results in fiscal 2016 through the end of the third quarter. In the third quarter of 2016, we generated a net loss of $4.5 million or $0.17 per diluted share, compared to a net income of $7.9 million or $0.30 per diluted share in the prior year period. Third quarter adjusted net income was $8 million or $0.30 per diluted share with the bulk of the pre-tax adjustments related to impairment and other lease charges. This compares to an adjusted net income of $8.8 million or $0.33 per diluted share in the prior year period. Our consolidated restaurant level adjusted EBITDA margin, a non-GAAP measure decreased in the third quarter by 90 basis points compared with the prior year period, primarily due to margin contraction at Pollo. Pollo's restaurant level adjusted EBITDA margin decreased by 180 basis points in the third quarter versus the prior year period, as favorable commodity costs were not sufficient to offset higher labor, rent, advertising and other restaurant operating expenses as a percentage of sales. Taco's restaurant level adjusted EBITDA margin decreased 10 basis points compared with a prior year period, as favorable commodity costs were offset by higher labor, rent, advertising, and other restaurant operating expenses as a percentage of sales. At quarter end, we had a cash balance of $4.9 million and after reserving $5.2 million for letters of credit. We had $78.9 million of borrowing capacity under our senior credit facility. We continue to be in compliance with all related covenants. As a reminder, we disclosed a great deal of brand specific financial and operating performance in our quarterly earnings release, tables and in our SEC filings. This information brings brand-specific comp and non-comp restaurant average unit volumes and income statement line item details and variance explanations. We plan to file our 10-Q document today similar to what we have done in the past to give investors as much information as possible as quickly as possible. We have also provided an update of our expected operating results in 2016 in our earnings release issued today. As Danny mentioned, we're planning to open 12 to 13 new Pollo restaurants in Florida and eight to 10 new Taco restaurants in Texas in 2017. We anticipate that up to three of the Taco restaurant openings may be conversions of closed Pollo restaurants. Total capital expenditures for 2017 are expected to be $57 million to $68 million. This includes $35 million to $43 million for new restaurants, $14 million to $16 million for remodeling and capital maintenance and $8 million to $9 million related to other technology and operating equipment projects. To conclude, the company has focused on improving the trajectory of the business and actively working on building the strategy that will drive profitable growth and shareholder value in the years ahead. With that let's open the line for questions please.

[Operator:]

Thank you. The first question today comes from Alex Slagle of Jefferies. Please, go ahead.

[Alexander Russell Slagle:]

Thank you. I had a question on the plans to accelerate growth at Taco Cabana and I just wonder if you could kind of talk through the thought process behind that. Maybe what are the new store economics? And what's different versus a couple years ago? Obviously, we've seen success with the reimaging of the system, improved operations, but it's been many years of little or no growth. So just wanted to figure out what's different now and what gives you confidence to ramp that growth after all those years?

[Lynn S. Schweinfurth:]

Hi Alex. Yeah, I think just a few comments on that. The first is if you'd looked at the trending of Taco Cabana over the last several years, you have seen an improvement of overall results and the brand has been operating at peak performance through the end of last year. Of our 10 stores we're developing in 2017, four are conversions including up to three of the Pollo closures that we recently announced. So the returns around those investments are certainly very, very strong. And in addition to those, we have six other openings we're projecting. Of those openings, about two of the six are using our smaller prototype and what the smaller prototype provides for is an investment cost of less than $1.6 million where if we can get to a $1.7 million AUV in the second or even the third year, we can see returns of 20% or more. So essentially the increase in development at Taco is a combination of improved performance along with reducing the risk profile associated with the investment.

[Alexander Russell Slagle:]

Great. And then on Pollo, question on the new store volumes for the fourth quarter and previously you talked about expecting that year-over-year decline that we had seen in the first half continuing through the second half. Is that still the case for the fourth quarter as we're now lapping over some more significant new volume declines from last year in the fourth quarter?

[Lynn S. Schweinfurth:]

Yeah, well I mean as you saw in the third quarter, we did see continued declines. I think the good news is some of the cannibalization we've been experiencing has been mitigated. So we were previously reporting I think about 2% cannibalization in the first half of the year and that number has gone down to about 1% in the current quarter or the third quarter. So you do see some benefits associated with that trend in addition to easier year comparisons year-over-year.

[Alexander Russell Slagle:]

Great. Do you expect that the 1% cannibalization going forward in the near-term?

[Lynn S. Schweinfurth:]

Yes. We do.

[Alexander Russell Slagle:]

Great. That's it for me. Thank you.

[Operator:]

The next question comes from Nicole Miller of Piper Jaffray. Please go ahead.

[Nicole Miller Regan:]

Thank you, good afternoon. Would you talk a little bit about the Pollo mix kind of go up and down each quarter, and then what drove down the Taco mix further this quarter, please?

[Lynn S. Schweinfurth:]

A lot of it, Nicole, has to do with what we're promoting and some promotions and discounts that we're experiencing, especially on the Taco side I think we saw sales mix impact, same-store sales for the third quarter about 60 basis points in terms of a downward movement year-over-year. And that had to do with the promotional environment that we've been experiencing and the fact that we chose to offer a variety of meal deals as opposed to a singular meal deal which we have in the recent past and that has resulted in higher discounts and promotions.

[Danny K. Meisenheimer:]

And one additional note from a product promotion standpoint, at Pollo, the Churrasco steak promotion began in late August and really carry through September where we saw a definite improvement in transaction and sales trends versus previous year where we were actually positive to that same period from the 2015. And then the same for Taco in terms of trend improvement although is still down and a definite improvement over July and August with the $4.99 meal deals as we entered into the October period.

[Nicole Miller Regan:]

Okay. That's very helpful. And then, Lynn, I'm really sorry, I missed the CapEx breakout, you gave it some like fast enough and I assume that was first 2016, not 2017, is that right?

[Lynn S. Schweinfurth:]

No, actually the CapEx breakout was for 2017.

[Nicole Miller Regan:]

Okay.

[Lynn S. Schweinfurth:]

And the range, $57 million to $68 million in total.

[Nicole Miller Regan:]

Can you give the breakout again?

[Lynn S. Schweinfurth:]

New restaurants $35 million to $43 million, remodeling and capital maintenance $14 million to $16 million, and technology and other operating equipment projects $8 million to $9 million.

[Nicole Miller Regan:]

Thank you. Appreciate it

[Operator:]

The next question comes from Will Slabaugh of Stephens, Inc. Please go ahead.

[Will Slabaugh:]

Yeah. Thank you. I had another question on CapEx, was that number coming down? Can you talk about plans for capital deployment with a free cash that you have available. I know you're ramping up some development there at Taco, but it seems like there's still should be some free cash, so curious if that might be used towards share repurchases given where the stock is?

[Lynn S. Schweinfurth:]

Yeah. We are expecting free cash flow, and it continues to be a matter of discussions between the board and the management team as we move forward.

[Will Slabaugh:]

Okay. And on, Pollo trends, just to clarify the quarter-to-date commentary. When we take out the hurricane hit, I believe you said, you would've been down negative 0.5%. So that implies a modest improvement from what we saw last quarter. So I'm curious if you're saying continued improvement there if you feel like that as an improving trend, and if you expect negative comps to continue or if there is a possibility for us to see a positive comp out of Pollo in the fourth quarter?

[Danny K. Meisenheimer:]

Well, that's going to be very close. The trends continue to be as they were stated in October, and we look at our product promotions for the balance of the quarter and our core markets of Florida were continuing the Churrasco steak promotion. But in the emerging markets Atlanta, Texas and in Nashville, we are introducing a new spicy chicken product that began on October 31. So it's still very early, trends continue to be right around that 0.5% that we saw in October, so it will be very close.

[Will Slabaugh:]

Got it. And one more quick one if I could. On the portfolio review of Pollo Tropical in new markets, do you consider this to be a final review or could there be additional closures announced down the road?

[Danny K. Meisenheimer:]

The discussion right now in terms of the Texas market is, we're looking at the four markets Austin, San Antonio, Houston and Dallas/Fort Worth as continuing to evolve over the next 18 months. And so when we went about the closure process, we took a really hard look at these sites in terms of creating the space around them, so that we could negate the sales transfer, so that we could improve our operating team, so that we could generate trade area and market-wide awareness. And so, we felt comfortable when we went through this process that we had addressed those stores to give us the best opportunity to really build brand awareness and sales and transactions in the 30 remaining restaurants in the four Texas markets, and the same for Nashville as well as Atlanta, but primarily Texas.

[Will Slabaugh:]

Got it. Thank you.

[Operator:]

The next question is from Brian Vaccaro of Raymond James. Please go ahead.

[Brian M. Vaccaro:]

Thanks, and good evening. Just had a couple questions on the 10 Pollo Tropical units that were closed. I know you've, Lynn, you've disclosed the Pollo Tropical operating loss in those units, the $4.8 million. Can you provide what the year-to-date sales and store level profitability were on those units?

[Lynn S. Schweinfurth:]

Actually I don't have the sales number off the top of my head, but the overall profitability contribution to the loss was about $4.7 million to $4.9 million.

[Brian M. Vaccaro:]

Okay. And I guess, maybe we can get that offline from you. But in terms of how the operating loss is defined, is there a G&A cost allocation that you've included in that figure? And also are there any pre-opening costs that are included in that $4.8 million operating loss?

[Lynn S. Schweinfurth:]

Yeah. There was a minor amount of pre-opening costs, and it was really restaurant-level EBITDA. So it did not include any G&A expense.

[Brian M. Vaccaro:]

Okay. All right. That's helpful. And thinking about cannibalization a little bit, obviously been a headwind at Pollo for several years, but how should we think about the magnitude of cannibalization into 2017, sort of trying to balance the impact of continued unit growth in the core Florida markets, but maybe offset a little bit by the 10 unit closures?

[Lynn S. Schweinfurth:]

Yeah, we certainly hope to see a positive sales transfer related to the closed stores in some cases. And I think we're trying to keep our cannibalization in 2017 at or below 1%.

[Brian M. Vaccaro:]

Okay. That's helpful. And then, just on capital deployment, maybe ask it from a different angle. Is there a comfort range on your leverage ratio that you're thinking about either from a net debt-to-EBITDA or lease adjusted basis?

[Lynn S. Schweinfurth:]

Yeah, I think obviously as we think about our leverage, we want to balance leverage with risk in the current environment and it continues to be an ongoing discussion.

[Brian M. Vaccaro:]

Fair enough. Thank you.

[Operator:]

Our next question is from Jeff Farmer of Wells Fargo. Please go ahead.

[Jeff D. Farmer:]

Thank you. The advertising expenses as a percent of sales at Pollo was up pretty significantly in the 3Q and year-to-date. So I'm just curious how we should be thinking about that expense not only heading into the Q4 but also 2017.

[Danny K. Meisenheimer:]

From a timing standpoint, I believe in fourth quarter we should see an improvement in terms of cost of sales as a percentage. Going into 2017, what we'll be talking about is not only the core markets where we'll continue to invest and fund and throughout Florida, from Tampa all the way to Dade and Broward Counties from a television and traditional media standpoint. In San Antonio and Atlanta, we'll continue that march with our traditional TV and radio support where we continue to see improvement in sales as a result of the additional awareness. In the remaining markets, primarily Houston and Dallas, we'll be more trade area focused, more market focused. In terms of our catering support, we will actually have specialists in the market, selling our catering programs. Our new loyalty program, our online program will be promoted throughout the markets and throughout the stores. And then we will be taking a very hard look at the Dallas/Fort Worth market in terms of what we do with the possibility of going on air in that particular area sometime in second or third quarter. It's still under discussion, but one of the things that we're definitely taking a look at for 2017.

[Lynn S. Schweinfurth:]

And so, I would say as we look at 2017 right now, I think we're trending to about 3.8% in terms of restaurant sales as a percent of advertising expense. And we would expect to be at that level, maybe a little bit lower next year.

[Jeff D. Farmer:]

Okay. And then two labor questions. So it looks like the labor cost pressure at Pollo did narrow pretty significantly in the 3Q. I mean, I know you guys have been working on a handful of labor cost initiatives. So I'm just curious if you think you've essentially hit the run rate in terms of your labor cost efforts or if there's more to come again in the fourth quarter and into 2017?

[Lynn S. Schweinfurth:]

I think we are trending better and we expect a continuation of an improved trend versus what we've seen earlier in the year. Obviously, there is some additional pressures that we're looking at as we look into 2017 with wage inflation, over time rules and things of that nature. So we do think from a margin standpoint, from a percent of revenues or percent of restaurant sales as it compares to labor expense that we'll see some pressure next year compared to 2016.

[Jeff D. Farmer:]

Okay. And then you just sort of led right into the follow-up question now, which was wage rate inflation. So for 2016, what does it look like you're going to see? I thought at one point you guys were pointing to 3%. So I'm curious again a little bit further into 2016, what you think it's going to be for 2016, and again, same question for 2017? It sounds like you think it's going to be modestly above whatever you or at least above whatever you've seen in 2016?

[Lynn S. Schweinfurth:]

Yeah, it's been trending up. So we've been at 3%, 3%-plus and now we're starting to see the see the numbers starting to approach 4%. So right now in 2017, we're expecting roughly 3% to 5% inflation.

[Jeff D. Farmer:]

Okay. Thank you.

[Operator:]

The next question is from the Nick Setyan of Wedbush Securities. Please go ahead.

[Colin Radke:]

Hi, this is Colin Radke on for Nick. My question was just on the store level economics of the stores and the newer geographies that you are not closing. Is it fair to assume that those units are all profitable or are some of those – you had losing money at the store level, but maybe you see a path and return to profitability in 2017?

[Lynn S. Schweinfurth:]

Yeah, I think we are not profitable across the board in our emerging markets, in the restaurants we operate in the emerging markets, but we do see a path to becoming profitable as part of that cluster by 2018.

[Colin Radke:]

Okay. And just in terms of the units that you are closing, I was just wondering if you could comment. Are there any similar or unifying characteristics across those units, whether other type of trade area or the specific size that they were in or anything along those lines?

[Danny K. Meisenheimer:]

Yeah, this can be summed up best by saying the following that in some cases it could be site specific. In some cases it could be execution challenges that we had at the store level. In some cases it's simply a little bit closer as we were trying to build brand awareness little bit closer to the next available Pollo. So we were sharing guests before the awareness, had a chance to pickup and build to a point that we could do that. So it's a variety of those things that you see that sort of contribute to those 10 stores no longer being part of the Pollo chain.

[Colin Radke:]

Okay. Thanks. And then just last one from me. Just in terms of cannibalization on the Taco side, obviously, ramping up more units, some of those are going to be in existing markets. What's the right way to think about cannibalization for Taco Cabana going forward?

[Lynn S. Schweinfurth:]

Yeah, we think there could be a little bit. It would be somewhere at or below 0.5% in 2017 based on our current projection.

[Colin Radke:]

Okay. Thank you.

[Operator:]

There are no further questions. So this will conclude today's teleconference. You may now disconnect your lines at this time. Thank you for your participation.