Del Taco Restaurants, Inc.
Q3 2017 Earnings Call Transcript

Published: 20 Oct 2017

[Operator:]

Good afternoon. Thank you for standing by and welcome to the Fiscal Third Quarter 2017 Conference Call and Webcast for Del Taco Restaurants Incorporated. I would now like to turn the call over to Mr. Raphael Gross to begin. Please go ahead, sir.

[Raphael Gross:]

Thank you, operator and thank you all for joining us today. On the call are John Cappasola, President and Chief Executive Officer and Steve Brake, Executive Vice President and Chief Financial Officer. After John and Steve deliver their prepared remarks, we will open the lines for your questions. Before we begin, I would like to remind everyone that part of our discussion today will include some forward-looking statements. These statements are not guarantees of future performance and therefore undue reliance should not be placed upon them. We do not undertake to update these forward-looking statements at a later date and refer you to today’s earnings press release and the SEC filings filed by Del Taco Restaurants Incorporated for more detailed discussion of the risks that could impact future operating results and financial condition. Today’s earnings press release also includes non-GAAP financial measures such as adjusted EBITDA and restaurant contribution. Non-GAAP financial measures should not be considered as alternatives to GAAP measures such as net income, operating income, net cash flows provided by operating activities or any other GAAP measure of liquidity or financial performance. We refer you to today’s earnings press release which includes the reconciliations of the non-GAAP measures to the nearest GAAP measures. I would now like to turn the call over to John Cappasola, Chief Executive Officer.

[John Cappasola:]

Thanks, Raphael. Good afternoon, everyone and thank you for joining the call today. Let me begin by complementing our team members and thanking our guests for enabling us to extend our track record of positive company same-store sales to 21 consecutive quarters and positive system same-store sales to 16 consecutive quarters. We believe this track record places us within very select company in the limited service restaurant segment and is directly attributable to the following factors. We have enhanced brand perceptions through dramatic improvements to the guest experience. We have made great strides establishing our unique value-oriented QSR+ position with great tasting fresh food, combined with compelling value and speed. And lastly, we continue to innovate, launching new products and platforms that resonate with our guests. This in turn has enabled us to consistently grow check average beyond menu price and often with positive transactions as well. So, our guest experience focus, QSR+ brand position and menu innovation provide us solid foundation for long-term success and will continue to be at the forefront of our plans. We will be further fortifying our foundation through our focus on enhancing our approach to developing our people and our leadership and providing more efficient tools to maximize performance in our restaurants. We launched those efforts by providing targeted training and a new business intelligence tool to our general managers above store leaders and franchise partners at our recent national leadership conference. Last quarter, I talked about key leadership changes and our dynamic executive team who is leading the charge in building our brand both in terms of AUV and units and also ensuring that we execute at the highest level. However, I was not able to mention Barry Westrum by name who formally joined us as Chief Marketing Officer in August. Barry brings more than 25 years of marketing experience to Del Taco with nationally recognized brands, including Taco Bell, KFC USA, Long John Silver’s, A&W Restaurants, and most recently Dairy Queen. Barry is an established brand leader who has deep experience in strengthening brands, enhancing marketing and innovation and creating strong partnerships with operators and franchisees to build sales and profits. Barry has hit the ground running and I am excited about the future under his brand and marketing leadership. As you know, our mid-term goals are to reach 1.5 million AUV by next year and to achieve mid single-digit new system restaurant growth during 2017 and 2018. These objectives are well within reach and are only the beginning of what we expect to accomplish over time. In order to truly unlock all of our potential, we will continue to evolve our strategy to achieve our next phase of AUV and system unit growth. The leadership team is actively engaged in strategic planning and we look forward to sharing our plans to further elevate performance on future calls. Now, let’s take a look at Q3 highlights. System-wide comparable restaurant sales grew 4.1%. Company-operated comparable restaurant sales grew 3.7%, which included menu mix of approximately 1.5%. Note that system, company and franchise same-store sales all grew 10.8% on a 2-year stacked basis. Restaurant contribution margin of 19.2% and by extension adjusted EBITDA of $16.6 million were both a little short of what we had expected due to higher food costs, particularly avocados and higher cost trends within our operating expenses. However, as you will hear, we still expect to deliver on our annual guidance across revenues, diluted earnings per share, adjusted EBITDA and new system-wide restaurant openings. From a development standpoint, we opened a total of 4 restaurants during the quarter, 2 company and 2 franchise restaurants. So far in Q4, we have opened another 3 company restaurants and have 11 additional restaurants under construction comprised of 2 franchise and 9 company-operated locations. We expect to open 23 to 24 system units this year with up to 15 being company restaurants. This expected outcome will reach our goal of mid single-digit new system unit growth in 2017. Our growth model leverages both new and existing franchisees as well as strategic company development in core Western markets where our brand has strong consumer recognition and the discipline creation of a regional hub in the Southeast. This strategy has us well positioned to drive system growth in 2018 and beyond. Looking ahead, we see franchise growth as an important lever with high potential in the long run. From new franchisees looking to broaden their portfolios to existing franchisees eager to expand their relationship and investment in our brand, last month, we signed a development agreement with a multiunit restaurant operator to open 5 Del Tacos in the Greater Athens, Georgia area over the next 6 years marking our fourth development agreement signed in the Southeast during 2017 as we look to build on this momentum. We will soon finalize our 2018 new restaurant opening plans and currently expect to achieve a similar outcome to 2017 in terms of growth rate and company versus franchise mix. 2018 will also have a back half of the year opening cadence and skewed toward infill growth in the Western third. Ultimately, our disciplined approach aimed at quality openings to maximize returns including our assessment of investment cost dynamics in this inflationary environment will determine our development guidance range for 2018 when we report our fourth quarter. On the marketing and product front, recall that we employed a threefold strategy to lap our accelerated same-store sales performance in Q3 last year as we rolled over the most successful product launch in our history, the Del Taco. This strategy was predicated on driving comprehensive improvement across the brand. First, we operated at a higher level as evidenced by year-over-year improvements in both overall guest satisfaction and speed of service. Second, we continue doing better awareness and usage of the Del Taco and Platos, which each reflect ongoing opportunities to drive check and transaction growth. Platos was a key contributor driving our dinner daypart as the number one same-store sales contributor in Q3. Third, we launched a very successful Carnitas LTO to start Q3. There was a lot of pent-up demand for this product, which have not been featured on our menu for 3 years and it makes it over 5% during the promotion and peaked it over 6%. The Carnitas product lineup helped deliver strong menu mix and aided transactions driving 2-year stacked transaction growth of positive 2% for the quarter. Overall, Carnitas was a huge success that helped drive our strong third quarter same-store sales performance. And also I wanted to provide some color on several dynamics as we enter our fourth quarter. First, we have observed and then intensified QSR focused on value with many compelling value bundles and deeply discounted beverages in the marketplace. Second, our fourth quarter same-store sales comparisons remain very strong, including lapping 2% transaction growth last year. And lastly, we are exiting the Carnitas LTO which drove very high demand and featured very high check averages as it skewed towards premium price points as compared to our most recent launch of Queso, which while also driving high demand is broadly priced across all tiers of our menu. Against this fourth quarter backdrop, we will continue to use our combined solutions model to drive same-store sales and set ourselves up for 2018 and beyond starting with innovation. Toward the end of our third quarter, we launched our newest QSR+ ingredient, Queso Blanco, which is made with real cheese, real milk, jalapenos and heavy cream and contains no artificial colors, flavors or preservatives. Queso was featured in a number of products and reflects Del Taco’s continued innovation within the premium ingredient space to further embed our QSR+ position. Guest acceptance and feedback has been strong as evidenced by Queso mixing at approximately 7% in each of the first 6 weeks since its launch compared to the approximate 2% mix from our legacy nacho cheese product. Queso has also been a win for operations allowing us to eliminate a legacy piece of equipment, simplifying execution. As Q4 progresses, we will leverage Queso across our barbell menu strategy, starting with new Buck & Under product innovation, with our new dollar Queso Chicken Roller, which recently launched along with our annual fall price increase. Given the value environment, we will keep Buck & Under top of mind throughout the fourth quarter to manage value perceptions and drive core QSR user visits. As we move into November, we will pay our Buck & Under news with new Epic Burritos starting at $5 designed to drive trade-up and traffic opportunities. The new Epic Queso chicken burrito is highly craveable with a compelling $5 price point and will launch with a new Epic grilled chicken and avocado burrito at a premium price. Lastly, as always, our operators are highly focused on driving same-store sales through execution with an emphasis on peak periods, outlier performance management, optimal staffing and speed to maximize our throughput opportunities. In summary, we are set up well with many levers to pull within our combined solutions model to continue to drive same-store sales growth. We are accelerating to an expected mid single-digit new restaurant growth rate in 2017 and building momentum on our long-term franchise restaurant growth opportunity. Lastly, the leadership team is set and focused on evolving our plans to further elevate our performance. With that, I will turn the call over to Steve Brake to review our quarterly results.

[Steve Brake:]

Thanks, John. Third quarter company restaurant sales increased 6.1% year-over-year to $106.3 million from $100.2 million in the year ago period. The increase was driven by company-operated comparable restaurant sales growth of 3.7%, along with contributions from additional company-operated stores as compared to the third quarter last year. Third quarter company-operated comparable restaurant sales growth represents the 21st consecutive quarter of gains and was comprised of 4.0% in check growth, including approximately 1.5% of menu mix growth offset by a 0.3% decline in transactions. Franchise revenue increased 7.9% year-over-year to $4.0 million from $3.7 million last year. The increase was driven by franchise comparable restaurant sales growth of 4.6%, an increase in initial fees and additional franchise restaurants operating during the quarter as compared to the third quarter of last year. System-wide comparable restaurant sales increased 4.1% and lapped system-wide comparable restaurant sales of 6.7% during the third quarter of 2016 resulting in a strong 10.8% 2-year trend. The Del Taco system has now generated 16 consecutive quarters of positive same-store sales. Total third quarter revenue was $111.0 million, an increase of 6.3% over the $104.4 million in the year ago third quarter. Moving to expenses, food and paper cost as a percentage of company restaurant sales increased approximately 40 basis points year-over-year to 27.9% from 27.5%. This increase was driven by food inflation as well as impacts from our Platos and Carnitas products, which each drove a strong margin dollar contribution, but with a slightly lower than typical margin percentage partially offset by the impact of menu price increases in the mid 2% area. Food inflation was primarily driven by increases in avocados, French Fries and cheese. Based on continued increases in avocado prices which only peaked last month and additional food contracting, our annual 2017 food basket inflation is now estimated at approximately 2%, which principally arose during our second half of the year. Labor and related expenses as a percentage of company restaurant sales increased approximately 90 basis points to 31.6% from 30.7%. This was primarily driven by the California minimum wage increase to $10.50 an hour and Los Angeles County and Pasadena escalations to $12 an hour on July 1, 2017 which impacted 27 company restaurants partially offset by the impact of menu price increases. Our experience managing higher wages remains consistent with our guidance which included these minimum wage increases. Our Q3 result was favorable to the 100 basis points of de-leverage in our first quarter when company same-store sales were 4% and our recent second quarter featured only 40 basis points of labor de-leverage due to very strong company same-store sales of 6.9%. Occupancy and other operating expenses, as a percentage of company restaurants, sales increased by approximately 40 basis points year-over-year to 21.3% from 20.9% last year. This increase includes higher advertising expense as a percent of restaurant sales based on the timing of advertising as well as increased repair, maintenance, supplies, insurance and credit card fee expense as a percent of restaurant sales. Within this category, many items are fully or partially variable with sales and others with fixed attributes are subject to inflation. Over time, we expect same-store sales growth to drive leverage in this category. However, such leverage is not automatic in any given quarter or year and is ultimately dependent upon underlying expense trends across numerous categories. Based on this performance, restaurant contribution decreased 2.5% to $20.4 million from $20.9 million in the prior year. Restaurant contribution margin decreased approximately 170 basis points year-over-year to 19.2% from 20.9%. General and administrative expenses were $8.8 million, up from $8.6 million last year, but as a percentage of total revenue decreased by approximately 30 basis points year-over-year to 7.9%. This decrease was driven primarily by lower performance based management incentive compensation and lower legal expenses compared to last year. Adjusted EBITDA decreased 2.2% to $16.6 million versus $17.0 million earned last year. As a percentage of total revenues, adjusted EBITDA was 15.0%, down approximately 120 basis points from 16.2% in the prior year. Depreciation and amortization expense in the third quarter was $5.5 million, an increase of 7.1% over $5.2 million last year and as a percentage of total revenues was up slightly to 5.0% from 4.9% last year. Interest expense was $1.6 million versus $1.4 million in the prior year third quarter. The increase was due to an increase to one-month LIBOR rate partially offset by a lower average outstanding revolver balance compared to the third quarter of 2016. At the end of the third quarter, $148 million was outstanding under our all revolver credit facility, while our applicable margin for LIBOR loans remained at 1.75%. Income tax expense was $2.8 million during the third quarter for an effective tax rate of 35.5% as compared to a $4.1 million expense during the same period last year. The fiscal third quarter effective tax rate was benefited by favorable permanent difference for stock-based compensation expense from restricted stock awards that vested during the fiscal third quarter. Net income was $5.1 million for the third quarter or $0.13 per diluted share compared to $4.9 million or $0.13 per diluted share during the prior year period. Turning now to our repurchase program covering common stock and warrants, we repurchased 96,122 shares of common stock at an average price of $12.35 and 1,186 warrants at an average price of $3.97 per warrant. At the end of fiscal third quarter, approximately $24.1 million remained under our $50 million repurchase authorization. Lastly, as John touched on our ability to leverage our QSR+ positioning to provide everyday value and variety to our guests, coupled with ongoing innovation has us well positioned against the recent intensified QSR focused on value, our continued challenging same-store sales comparisons and our transition off of a very high check average Carnitas LTO promotion. Through the first 5 weeks of our fourth quarter, our same-store sales are trending up in the low single-digit area or high single-digits on a 2-year stacked basis. These fourth quarter dynamics coupled with higher-than-expected food inflation and operating expense trends have led us to revise our fiscal 2017 guidance. Please refer to today’s earnings release for the details on our outlook and be mindful that fiscal 2017 contains 52 weeks and will compare to a 53-week period in fiscal 2016. In conclusion, we are pleased to extend our long track record of positive same-store sales to 21 quarters for company-operated restaurants and 16 quarters system-wide as we very successfully lapped our strongest product launch ever in the Del Taco. As we maintain our current focus on a strong finish to 2017, we are also evaluating various strategies to accelerate restaurant contribution performance, including optimal levels of future menu price and cost saving initiatives both within our restaurants and across our supply chain. Thank you for your interest in Del Taco and we are happy to answer any questions you may have. Operator, please open the lines.

[Operator:]

[Operator Instructions] Our first question is from Alex Slagle of Jefferies. Please proceed with your question.

[Alex Slagle:]

Hey, guys. Thanks for the question. I want to see if you could offer a little bit more commentary on what you are seeing on the competitive environment and the top line cadence you saw through September and into October. I am just wondering if there is any ships you are seeing in terms of how your customers are using the brand, possibly seeing in daypart trends or the balance between the premium and Buck & Under mix?

[John Cappasola:]

Yes. Alex, it’s John. We are definitely as we said we are seeing an intensified QSR focused on value right now with particular emphasis on these compelling value bundles that are out there in the marketplace at that $5 price point as well as some of that discounted beverage activity that’s going on, which in the short run can have an impact to improve traffic on the brands that are deploying those tactics, but that pressure that is being put on us a little bit right now from a traffic perspective is just causing the trend, the traffic trend to run below what we experienced in Q3, but we are only 5 weeks into a 16-week quarters. So, it’s premature to really quantify where traffic may land for the quarter, but overall what we would say is we expect same-store sales to continue to be positive and we expect to continue to drive strong momentum from a 2-year stack same-store sales perspective in Q4. And we are in a good position as a brand to continue to drive same-store sales in this kind of environment, because of the fact that we have great everyday value and that’s been our strategy for the last several years. So, it’s earned us category leading value, affordability and variety marks in our core markets that in large part is due to our ultimate barbell approach that we keep top of mind. We have always said we don’t want to ever be in a position to pivot the value. We just want to be known for it and that’s why we taken the strategy that we have and of course we have led over the years with Buck & Under. So, our approach in this environment is going to be to continue to highlight our great value, but also to continue our path with innovation and not starting right now with Buck & Under keeping that platform top of mind to really maintain those strong value perception this period. We put some innovation out in the marketplace recently to just further highlight that for the consumer and then we are pivoting into another strong value program, but more premium with the $5 Epic Burritos. We have got a couple of new Epic Burritos hitting the menu here later this month that can provide us some trade-up opportunities. So again, we are leveraging innovation to drive interest, visits and sales definitely leading into our value strengths and we feel good about where we are position to continue to work through this environment with positive same-store sales trends.

[Alex Slagle:]

Thanks. That’s helpful. And then with the recent hiring of Barry Westrum in the CMO role, just interested in getting any early thoughts about what you guys could do to take the brand to the next level in terms of brand awareness and perceptions perhaps on new ideas on building out the data insights work or other ways to build the brand presence on social digital?

[John Cappasola:]

Yes. I think all of the above really is being assessed. And I am excited to have Barry in the business. I mentioned the type of experience that he brings to the table in my comments and then I just can’t emphasize enough how valuable it is to have a proven CMO that understands the limited service restaurant category and brand building within that category to continue our progression in that QSR+ pace. And really Barry, his work is underway. His analysis and assessment is underway. He is knee-deep in it right now. And I think that he is using that lens of being a QSR+, taking a QSR+ leadership position as a brand, which I think the great lens to take, which is going to yield that elevation that you are talking about and that idea of taking it to the next level. So, it’s too early to completely talk about what is yet to come, but I will say that he is actively involved in the business working with research and marketing and agencies right now to develop the next phase of brand development. And I do expect some exciting enhancements as we enter into 2018 and beyond.

[Alex Slagle:]

Great. Thanks for the color.

[John Cappasola:]

You got it.

[Operator:]

Our next question is from Craig Bibb, CJS Securities. Please state your question.

[Craig Bibb:]

Hi, guys. Great quarter right down the middle. And just I want to make sure I understood your response in the last question, relative to Q3, it sounds like same-store sales are pretty much about where they were, the traffic is down and mix is up with Queso, was that?

[John Cappasola:]

So, Craig, obviously we are really 5 weeks into a long 16-week quarter. So, obviously premature to part of paying where things like traffic and mix are headed for the quarter, but thus far 5 weeks and we have seen a sequential deceleration in both traffic and mix thus far Q4 compared to how they each performed during the third quarter.

[Craig Bibb:]

Okay. And then obviously looking at the 7% Queso in the mix realizing that only 5% of that incremental is that replacing other things like avocados or nachos or?

[John Cappasola:]

Craig, it’s mixed right now in regards to where that’s coming from. But I will say that even the fact is even with Queso coming into the business, we are expecting to deliver positive mix. It’s just not as pronounced or robust as it was with Carnitas and there is deftly some reasons for that. When you think about Carnitas provided higher check averages compared to Queso and really that’s due to the way that we use that protein, it was more premiumly used, because our existing guests were familiar with it. And we have that pent-up demand that it carries. So, we were able to consent to really leverage that mid-tier and premium pricing. In contrast, Queso is a new ingredient. So, from a consumer perspective, our goals were to and it continue to be to drive trial and crave for the ingredient, which we believe in turn will drive the long-term opportunities that we see with that more premium, Queso ingredient. So, we are pleased that it’s been well received. It’s carrying that strong and consistent 7% mix so far. And we think that trial is turning to frequency. Part of that – part of what we have accomplished here has happened because of the way that we have positioned it to be more broadly used on the menu and accessible to guests, because we wanted to drive that trial and achieve those objectives. So, at the same time, there are some premium items on the Queso menu like the Queso loaded nachos and we are soon going to debut just in the next several weeks we are going to debut the Queso ingredient in an Epic Burritos. And Epic’s as you might recall are priced similarly where we – priced similarly to where we are price Carnitas, so they are more premium. So, I think we are in great shape with Queso overall. The guests love that, which is that point number one that you need to accomplish. So, now we can take advantage of that and really leverage it more broadly on our menu depending on the needs of the business and we have said it can be used for traffic driving reasons, it can be used for check driving reasons and we intend to use it in both ways.

[Craig Bibb:]

Okay. And then it looks like you continue to make progress signing franchise agreement, but in the near-term, the actual franchise openings are lagging what the company is doing, we are going to be a catch up in 2018 or maybe just more color around that?

[John Cappasola:]

Yes. I think the franchise piece is building momentum and that’s the point we really want to make. We view that as a long-term opportunity for the brand and we have focused in taking that very disciplined approach to start out in the Southeast with that Southeastern hub that we have talked about. And so we are excited that we have got 4 deals signed down in the Southeast, which were highly qualified quality franchisees that we think can help to build the brand. Overall, as we said, we thank 2018 is going to feature a growth rate that’s similar to 2017 in that mid single-digit area, which will reflect that continued acceleration that we achieved in 2017 over 2016. Remember that, we approximately doubled this year what we opened in each of previous 3 years prior to 2017. So, that acceleration has occurred and we hope to maintain acceleration as we think about 2018 and beyond. We feel – we certainly feel good about our future pipeline right now and how that’s building, but as we stated as we think about 2018, we have got to consider the construction costs and we have observed recent inflationary pressure across labor and materials this year, which is impacted by that tight labor market that’s out there in that lower unemployment and rising wages environment. So, the extent of the inflation we know varies across markets. So, it’s not going to have a demonstrable impact on our growth rate, but we are going to take the appropriate responsible approach to reassess the pipeline and make sure that we proceed with projects that are still expected to drive strong returns. So, some portion of our pipeline is going to be fluid as deals come in enough and that’s a normal activity to happen as you evaluate these deals, but the good news is that we believe that we can still continue that acceleration in mid single-digit territory. We will get some of these guys down in the Southeast to start opening restaurants. And I think we will see some of that in 2018 and we hope that, that accelerates beyond that with them and others that we plan to bring into the fray in 2018.

[Steve Brake:]

And Craig, as far as the mix itself, I think what we have said before, it definitely remains true this year and next year, it will tilt towards more company openings versus franchise. Beginning in ‘19 we see a good chance of that beginning to even out longer term beyond ‘19 what we absolutely believe there is a long-term potential for the franchise growth to really accelerate beyond company openings. We will still go corporately. We are motivated. We like the returns, but longer term we do see that inflection playing out in ‘19 or beyond.

[Craig Bibb:]

Okay. Thanks a lot guys.

[John Cappasola:]

Got it.

[Operator:]

Our next question is from Peter Saleh of BTIG. Please proceed with your question.

[Peter Saleh:]

Yes. I wanted to ask about the labor line. I know you have been seeing pretty meaningful inflation on the labor side. Are there – aside from taking price is there anything else you guys are doing within the four walls of the restaurants, reduce the overall labor hours or the pressure on the labor line and how should we be thinking about that for next year given the continued inflation on wages?

[Steve Brake:]

Hi, Peter. It’s Steve. Good question. Certainly, labor it’s going to be a holistic approach just not a silver bullet. As you mentioned, menu price certainly has and will continue to play a role in addition traffic and mix. We are now the last 4 years positive traffic, this year through 36-week traffic is up 50 bps. We are now 3.5 years 14 quarters consecutively into having meaningful menu mix. It’s actually averaged 1.3%, the last 14 quarters. So, all those levers are really driving that ongoing AUV story. That itself is our highest priority to help overcome cost risk generally labor being one of them. At the same time, we are very open-minded in various levels of testing or even deployment. A lot of solutions that well over time help with the labor hour side of the equation we call it targeted discretionary investment on capital. There is a lot of various equipment ideas, some has been rolled like that being mix certainly may have talked about in the past, others are in test or are about to roll. So, whether it’s food processors, other things we are doing in the back of the house in terms of equipments as well as some of our older kitchens is doing some retrofits that enhance productivity. So those are things we are absolutely trying to put what I call smart capital forward to improve our play in terms of managing hours. And in technology as well, we are being very open-minded there as you know we are in test and learn in terms of technology initiatives. Can some of these be a mobile device or kiosks or other ways for consumers to order over time gain traction and take labor hour pressure off the front counter. We think that’s very possible and we are in a good position to further understand that. Then all of the above will be deployed when and if we see a nice accretive path. So, it’s a good question and it’s definitely something we have been and will remain focused on indefinitely.

[Peter Saleh:]

Got it. And then just any updates on your mobile order and pay strategy and the tests you have been doing there?

[John Cappasola:]

Yes. Our online ordering and mobile app pilot, it’s available in more than 50 restaurants now. We like what we are seeing from an ops execution and average check standpoint, but we are still working to perfect the model for usage in what’s already a very fast and convenient dining experience environment. So, there are marketing opportunities, including things like push notifications and loyalty live tech programming that we want to better understand that the team is looking out right now. But the push lately for us just evolving from that has been the launch into a couple of delivery tests that we have got out in market. Now it really help us understand the demand around delivery in our space and what that could look like in the future. I think we have talked about using all those dispatched platform in our mobile app test and we have been able to add delivery to that as an option to the del app and online ordering for the assessed stores is coming together with that delivery piece. And then we have also partnered with GrubHub recently and that is actually active and out in test environment right now. So that we can try to operationalize that program and really understand what that third-party delivery option looks like and we are also looking at another one or two partners to bring in to get some additional earnings. So I think we are making good progress just to continue to try to figure out what the right model looks like for quick service restaurants for the drive-through. I think we are in a good position to be able to do some deployment on a wider scale as we think about 2018 and beyond as long as we continue to make good momentum and progress on some of the consumer demand dynamics.

[Peter Saleh:]

Got it. And then just lastly on your menu pricing going forward maybe into 2018, how are you thinking about that given the overall inflationary environment plus coupled with continuing to hear more on the value side, more value promotion. So, is your pricing going to be different than what we saw this year higher or lower how should we be thinking about that?

[John Cappasola:]

We’ll guide that explicitly down the road, but it is touched on in my prepared remarks, we are currently evaluating strategies to improve restaurant contribution performance really on two fronts. First, potential cost savings, opportunities across our supply chain and at the restaurant level. And then second, we are working to optimize our menu pricing as we move forward. In terms of that future menu price, we definitely believe we’re very well positioned to successfully flow through our future menu price increases in an accretive manner that has limited impacts on traffic and/or menu mix performance. So the magnitude is something we’ll discuss down the road in any event it was again in the next year it’s all about working that barbell. We will always have that compelling low-end, today obviously it’s Buck & Under, which is compelling value and variety play within our category and then a lot of optionality in the mid tier in premium areas. Over the last year, you saw the huge mid-tier when with the Del Taco and we’ve had a lot of long-term success at the premium areas. So through that balance menu strategy, we can be nimble and when there is a intensely competitive environment like we have today much like the early half of ‘16 we can lead into Buck & Under that much more and do very well. In other environments, we can lien in on premium or mid-tier. So we love the strategy, is very versatile, coupled with the right amount of menu price, innovation all the things you’re used to see from us it’s going to – it’s up for another good year ahead.

[Peter Saleh:]

Great. Thank you very much.

[Operator:]

Our next question is from Jeremy Hamblin of Dougherty & Company. Please proceed with your question.

[Jeremy Hamblin:]

Thanks guys and congrats on another solid quarter in a tough environment. I want to come back to margins and food costs for a second. And just if we can get a little bit more color, you mentioned that Platos and Carnitas, they were negative for margins although they were positive for overall contribution to margin dollars. Can you give me a little color on Queso as it relates to margins is that a margin accretive product in general or is it more similar to Platos and Carnitos where it is margin negative?

[Steve Brake:]

Today, we have used it on the menu, it’s just very slightly margin negative. As John touched on, we love the versatility of Queso ability to use it from really the top to bottom of our menu as you use it in different builds or products that margin profile can vary. So, to-date this was a very small minimal margin drag as we move forward that could probably neutralize or maybe told the other way, but not as noticeable is what we have talked about in the past with like a Del Taco or Platos or Carnitas, those were more of a gap from our normalized margin.

[Jeremy Hamblin:]

Okay. And then following up, you mentioned that avocado costs probably were the biggest surprise in the quarter and can you call out the basis point drag that that caused in Q3 and kind of what you are expecting in Q4 from the higher than expected avocado costs?

[John Cappasola:]

The avocados, they only peaked, we have peaked and began to ease their way down yet still elevated. They take kind of the latter half of last month, which was already squarely in our fiscal fourth quarter. As far as the impact on Q3 itself, couple of times in terms of year-over-year pressure. A little bit of that I think was anticipated in our early plans, but certainly, it did remain elevated and still is elevated in the fourth quarter. While we have seen some relief, the extent of that relief and duration of that relief is still a bit hard to call. So, avocados, it’s a 1.5% of our food basket item that doesn’t sound big, but when it’s priced essentially, right about double that moment in time from a normalized historical price, it certainly can end up having a significant dollar impact on the year at hand.

[Jeremy Hamblin:]

So, you are thinking as of now about another 20 basis points for Q4 impact?

[John Cappasola:]

On a year-over-year basis, I would not expect it to be worse than that. To what extent it can improve meaningfully inside that, time will tell, we are still early days in this long fourth quarter.

[Jeremy Hamblin:]

Okay. And then on the marketing costs, it sounds like I think maybe the biggest prize that we saw was your occupancy and other operating expenses de-leveraging by 40 basis points. You guys really haven’t seen something like that in quite a few years. Can you just give us a sense for was that kind of planned marketing cost growth, what was the change year-over-year on either advertising spend or marketing spend in total that caused that 40 basis points of de-leverage or seem to be the primary cause?

[John Cappasola:]

So, advertising for every given fiscal year well run 4.0%. During the third quarter, it ran a tenth higher than last year year-to-date now through 36 weeks. It’s two-tenths higher than last year, because this year well run the same 4.0% that we ran a year ago that means fourth quarter, it will finally reverse in turn. So, fourth quarter ad expense will be priced up 30 bps higher year-over-year for Q4. So, when you segregate the tenth high run-rate in the third quarter on advertising, it was left you with 30 bps with what I would call real year-over-year OpEx pressure. So, OpEx, it’s a variety of things. As I touched on OpEx, every quick single thing in there is subject to inflationary pressure, some things like the property tax and rent field fix than they are, but rents have CPI bumps every 5 years. And every now and then, they renew for instance. Other areas are purely variable like your credit card fees and by the way, usage on credit fees continues to grow at a higher rate year-over-year and then a lot of things were semi-variable. So, utility is a good example when throughput and consumption is no, utilities are up. So, in general items in OpEx do have year-over-year dollar inflationary pressure even with a unit base that hasn’t grown much yet. At the same time, the couple of areas that did run higher than expected occurred within supplied services, repairs, maintenance, those broad categories, you are going to have good quarters and good years and this has been a tougher year. We have had some things unexpectedly inflate on us across those categories. So, when you put it altogether, some things that feel fixed still grow over timeline dollars. There are a couple of lines within that we are getting really small amounts of leverage on, but others have had inflation this year that outpaced the overall revenue growth. So, the net of it as you saw in Q3 is that 30 bps of real pressure year-over-year. The other maybe data point I would take you back to 2014 and 2015, both those years we comped 5% and 6% respectively, both those years OpEx we had a modest 20 bps of leverage. 2016, we had 80 bps. That was a better year. That was a year where things went our way probably 2014, 2015, a bit more normalized. We think long-term we should and expect to have leverage with good comps on that line item, but it will generally look more modest than robust, because a lot what’s in there is partly or fully variable.

[Jeremy Hamblin:]

Okay. Thanks for taking my questions. Good luck, guys.

[John Cappasola:]

Thank you.

[Operator:]

Our next question is from Nick Setyan, Wedbush Securities. Please proceed with your question.

[Nick Setyan:]

Thank you. As those years have gone on, obviously we have seen the food cost inflation expectation go up. As we are kind of looking at early 2018 and I am sure you are already contracting etcetera. What are you seeing out there, what’s your early expectation for what food cost inflation could be for 2018 or at least for the first half of 2018?

[John Cappasola:]

Yes, we are certainly beginning to work on calendar 2018 or into 2018 buys, but really at this juncture in mid-October, it’s a bit too early to provide any real guidance or clarity on what we think the 2018 food basket will do whether it’s front half or the full year. So it’s a big focus as well they touched on also the Canadian areas across the supply chain, and in restaurants where we can try to have cost savings initiatives play out here in the near term without at all impacting the guest experience or operational effectiveness. So we are trying to attack it from a contracting front certainly like we always do and also just trying to be creative on making sure we can kind of optimize our cost structure both in supply and within the restaurants.

[Nick Setyan:]

And then just kind of revisiting that price increase question from earlier, for example, Q4 ‘15 first half of ‘16, we saw 33.5% type of a price increases. Is that off the table in terms of that kind of magnitude of price increases given the environment?

[Steve Brake:]

I would not say that’s off the table. Next year, we have a continued path of wage inflation with the heavy California footprint. Next year is another $0.50, the several years after that or $1 each year. So, certainly the extent of cost headwinds is be them labor or food or a combination thereof. It tends to have some impact on the price set that we look to seek. As you recall, it was about a year ago, we made the very conscious decision to step away from that 3% plus pricing that we did carry in each of fiscal ‘15 and fiscal ‘16 for those full years, it was Q4 of ‘16 that we consciously brought it down to 2.5%. That’s what we will continue to carry this year through the fourth quarter and that was really based on what’s been a very tough challenging environment for restaurants, highly competitive, marked with a lot of aggressive discounting by many of our peers as well as that CPI gap of food away from home versus at home that widened considerably. So, all of that definitely informed our view to have the more modest for us 2.5% this year over the last say five quarters was as we move forward as I mentioned, but we are absolutely looking to optimize that. Our goal is to make sure that traffic and mix disruption if any is limited. And there is definitely a balance taking too much price, there is elasticity at the consumer level that could cause more long-term damage to a brand. So, while we take actions quarter-to-quarter, year-to-year, it’s really that long-term vision that we have in mind making sure that we are appropriately driving check through hopefully a healthy balance of price and mix like we have done for 3.5 years now and also doing what’s right to preserve and hopefully drive at least on a relative basis that traffic based into the future. So, it’s a balancing act. We are absolutely challenging ourselves to optimize that for the year ahead. I would say there is no number off the table. That said, I would probably think in practice that the amount we carry this year is probably to Florida think about, maybe not every quarter in the future, but at least for the near-term knowing that we have a lot of wage to overcome the food basket as we touched on, it’s hard to call year-to-year, that can swing either way quickly. We have seen that be a bit volatile in the last 24 months going from deflationary to inflationary. So, the nice thing about price is we can be nimble wherever you are carrying right now within 3, 6 or 9 months you can bring it up or bring it down based on what’s warranted. So, we are just trying to be thoughtful, disciplined and eventually drive accretion.

[John Cappasola:]

Yes, it’s John. I mean, we have set ourselves up here with being able to watch the competitive and watch the environment the consumer very closely. As we think about it, we equally know that in our wage inflationary environment, it really is going to be a level playing field for restaurants in retail. And that’s what we are going to be dealing with in California for the next several years, but the key pieces for us are to continue to maintain that value advantage. The good news is we have got a significant value advantage against the limited service restaurants. So, others are going to be taking pricing. And as Steve said, price will be part of our path as well as other things that will be doing and we have got a great econometric modeling that we are using as well as a consumer research team that’s in-house. So, I think we have got the right insights coming through to help us to make those decisions as Steve said very nimbly.

[Nick Setyan:]

That’s very helpful. And then just last question I know in the past you have talked about the new units as you kind of accelerate the growth, because they are mainly in mature markets, you expect them to kind of have off the bat some type of volumes and margins? Is that kind of what you are seeing in practice if you open up sort of 9, potentially 9 units here. How should we think about the near-term impact at least in terms of new unit inefficiencies etcetera on the unit level margins?

[John Cappasola:]

Yes. Mature markets tend to have a relatively normal volume. Occasionally in the emerging markets, we will have what we call honeymoon, just an elevated sales volume given the new game in town is a lot of excitement over time that will temper down to something more realistic. As far as on the margin side, new units in mature markets, it’s certainly not out of the gate, but definitely within that first year, the teams quickly worked away towards normalized margin environment, lots of team members are often barred from other stores things like that. So, we get efficient quickly. It’s new markets where our [indiscernible] have talked about really being a 3-year target. It takes a few years to get to that area of having efficient margins and flow-throughs in emerging. We want to keep feet on the floor really do what’s right to make sure those units are set up for long-term success. So, those are the couple of distinctions I think you were asking about.

[Nick Setyan:]

Thank you very much.

[Operator:]

Our next question is from Stephen Anderson, Maxim Group. Please proceed with your question.

[Stephen Anderson:]

Yes, good afternoon. You answered most of my questions, but I do have a follow-up question regarding the delivery test as well as the mobile payment. And I also wanted to ask if you are prepared to announce any additional markets for test, I know you had said previously looking at Denver for delivery, also the arrangement with GrubHub in San Diego, I believe was Detroit as well?

[John Cappasola:]

Yes, Stephen. I mean, what we have said is that we are testing in our mobile app environment right now through the Olo platform and that’s in Las Vegas. And we are also now testing in Southern California in select stores at this point with GrubHub. So, we haven’t expanded that beyond those geographies just yet, but more to come on future calls.

[Stephen Anderson:]

Alright, thank you.

[Operator:]

Our next question is from Joshua Long, Piper Jaffray. Please proceed with your question.

[Joshua Long:]

Great, thank you for taking my questions. Wanted to circle back to the improved satisfaction scores, curious what the guests were calling out specifically that you might be able to share with us? And then also as we think about this improvement, is there a bit of a lag you have been continually improving and putting in new procedures and products and so is the idea that this is more or less real-time or should we expect this to continue to drift higher as guests get a little bit more time and frequency with some of the new products and operational procedures that you have there at the store level?

[John Cappasola:]

Yes, Josh, just to clarify are you talking about overall guest satisfaction that we are referencing our scores.

[JoshuaLong:]

Yes, that’s what I am talking about, in terms of just really that being a nice tailwind driver to a lot of the work you are doing. Just curious how real-time you see those satisfaction scores move around whether it’s new products or this has really been a slow build from just the longer term combined fresh solutions and just continued execution in the store level?

[John Cappasola:]

Yes, I mean I think it’s really the latter there. We have seen a nice steady improvement through our combined solutions efforts over the last several years. We typically have seen as we move forward 400 to 500 basis point improving – improvements year-to-year on top box overall guest satisfaction a lot of that is due to the products that we’re bringing in, that are creating better experiences for the guests, but it’s also because our operations focused in the big part of our combined solutions model has obviously complementing those brand promises with real material improvements at the restaurant that come into life in regards to how they think about our service and how they rate us on service, how they think about our product execution and how they rate us on product as well as speed and we’ve made nice improvements across the set which is really driven the overall satisfaction improvement. So our goal would be to continue that improvement year in, year out and it might not be to the tune of 400 or 500 basis points every single year, but I think at the level that we’re at now nice steady improvements are meaningful to the guests and as we look at pieces of equipment that can simplify operations or improve guest experience through quality or as we look at some of the employee and leadership training that we’re doing at the restaurant level. All of these things should add up to better guest experiences and we need to be measuring that and that’s what we intend to do. So more to come on that, but I would expect to continued tailwind from our improving – like improvements in operations.

[JoshuaLong:]

Great. Thank you. And then in terms of just thinking about the current pipeline you mentioned some increased costs just in terms of inflation and the general construction process, but was curious and how you feel about the real estate pipeline in general, what sites are available and kind of how that should turn into near term new units over the next year to in terms just quality and availability and pricing on real estate for your portfolio?

[John Cappasola:]

We feel good about the pipeline as we move into 2018 and beyond and so it’s just a matter of really watching the environment very closely understanding it by geography and making sure that we make good decisions in the short run for lasting investments rights. So the sites we signed for 20 years or a franchisees sign for 20 years it’s really important that we set the unit economics up in a way that can continue to yield some nice profits and some nice returns for us over time and we certainly don’t want to get ourselves into deals that are highly inflationary in the short run when there’s other deals to be had out there in the market that are more reasonable. So it’s just a matter of finding them. So again we feel good about moving into 2018 in mid single-digit range and we’ll continue to kind of firm that up over the next couple of months and give you guys some more color on it as we move into ‘18.

[JoshuaLong:]

Understood. Thank you.

[Operator:]

Our next question is from Craig Bibb, CJS Securities. Please proceed with your question.

[Craig Bibb:]

Thanks for the opportunity. I will defer till next quarter.

[John Cappasola:]

Okay. You got it. Thanks, Craig.

[Operator:]

Ladies and gentlemen, we have reached the end of the question-and-answer session. And I would like to turn the call back to management for closing remarks.

[John Cappasola:]

Well, thank you all for your interest in Del Taco. We couldn’t be more excited about the continued opportunities that lie ahead of us. And we wish you all a wonderful day.

[Operator:]

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