El Pollo Loco Holdings, Inc. Q2 FY2022 Earnings Call

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the El Pollo Loco Second Quarter 2022 Earnings Conference Call. Please note that this conference is being recorded today, August 4, 2022. And now, I would like to turn the conference over to Ira Fils, Chief Financial Officer. Thank you. You may begin.

Thank you, operator, and good afternoon. By now, everyone has access to our second quarter 2022 earnings release. If not, it can be found at www.elpolloloco.com in the Investor Relations section. Before we begin our formal remarks, I need to remind everyone that our discussions today will include forward-looking statements, including statements related to the impacts of the COVID pandemic and macroeconomic environment on our business and strategic actions we are taking in response as well as our marketing initiatives, cash flow expectations, capital expenditure plans and plans for new store openings, among others. 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 currently expect. We refer you to our recent SEC filings, including our Form 10-K for a more detailed discussion of the risks that could impact our future operating results and financial condition. We expect to file our 10-Q for the second quarter of 2022 tomorrow and would encourage you to review that document at your earliest convenience. During today's call, we will discuss non-GAAP measures, which we believe can be useful in evaluating our performance. The presentation of this additional information should not be considered in isolation or as a substitute for results prepared in accordance with GAAP, and reconciliations to comparable GAAP measures are available in our earnings release. Now I would like to turn it over to Larry Roberts, our Chief Executive Officer.

Thank you, Ira, and good afternoon, everyone. Let me start by welcoming Ira to the El Pollo Loco family. As many of you know, he's a well-rounded and accomplished executive with a strong 20-plus year track record of leadership and experience in the restaurant industry. I look forward to his many contributions as we execute on our strategic priorities in 2022 and beyond. Turning to our second quarter results. System-wide comparable restaurant sales increased 7.5%, including a 2.9% increase at company-owned stores and a 10.6% increase at franchise locations, helped in part by the success of our Shredded Beef Birria limited-time offer. Labor and commodity inflation continued to persist during the second quarter, pressuring our store-level margins. Nevertheless, our team continues to do an excellent job managing our business, resulting in pro forma diluted earnings per share of $0.21. We believe that efforts toward improving our brand differentiation and awareness were key drivers of our sales growth during the second quarter. As I noted on our last call, our Shredded Beef Birria promotion, which ran from mid-March to early June, performed exceptionally well, aided by our new social media-centric marketing approach. With its success, we will be evaluating whether beef can be a permanent item on our menu. At the very least, we know that we have an exceptional limited-time promotion that will be on the calendar for years to come. To build upon this excitement, we launched our Tostada promotion in early June by utilizing a similar marketing approach as with Beef Birria. This includes creating new and unique content across the major social media channels with a special emphasis on TikTok, all of which is allowing us to send targeted messages to various user groups, particularly our younger consumer base. To date, the response to our Tostada promotion has been outstanding. We have achieved record levels of Tostada sales during its promotion with our Tostada mix averaging almost 18% since the start of the module. This is 400 basis points higher than our peak Tostada mix last year. Despite the success of our recent promotions, we did see some softening in customer traffic starting in mid-June, mostly during our dinner daypart. Quarter-to-date system same-store sales through July 27 increased 2.4%. We believe the softness at dinner is a combination of consumers pulling back due to economic uncertainties and a lack of value advertising for our dinner daypart. We have not advertised family meals since December of 2021. With this in mind, we will be utilizing both TV and social media channels in the near term to promote more value-oriented messaging, starting with our family feast promotion, which includes 8 pieces of chicken, a family-sized salad, and 2 large churros for $24. Additionally, starting in August, we will advertise our fire-grilled value menu with a price point starting at $5. These meals include an entrée with a choice of either a chicken and cheese quesadilla, Original Pollo Bowl, Classic Chicken burrito, or Tacos Al Carbon and comes with chips and a drink. To be clear, neither the $24 family feast nor the $5 value menu are discount offerings, but rather they highlight our strong value proposition in what could be a challenging consumer environment. As we progress through the balance of the year, we will continue to work on additional means of providing great value to our consumers without compromising our margins. While dealing with this challenging operating environment, we remain focused on executing our strategic priorities that are designed to strengthen our average unit volumes, improve our profitability, and in time, accelerate our store growth. Our marketing will continue to focus on those attributes that differentiate El Pollo Loco, including our flame-grilled chicken and freshly prepared food. As we've noted, social media would be a key medium for our messaging. And along those lines, we recently hired a Vice President of Digital Marketing to coordinate our digital and social media efforts. Accordingly, we are getting ready to completely revamp our mobile app and website, which we expect to complete in early 2023. This investment will enable us to significantly upgrade and unify the consumer experience on our website and app as well as greatly enhance our loyalty program. In addition, as part of our strategy to become more relevant to younger consumers, we launched our Abuela Approved TikTok campaign in July. This campaign uses a series of short videos to tap into the growing popularity of abuelas or grandmothers. El Pollo Loco recognizes that the generational gap is narrowing, and there is a unique bond between grandparent and grandchild. In fact, the number of Americans living in a multigenerational household with 3 or more generations has nearly quadrupled over the past decade. Our content featuring abuelas is about acknowledging these dynamics and bringing joy and wisdom with a heavy dose of relatability. To date, the videos have been viewed over 3.5 million times on TikTok. Over time, we expect campaigns like Abuela Approved to attract younger consumers to our brand. Shifting to restaurant operations, which is another of our strategic priorities, we believe we have made significant progress during the quarter with regard to staffing, retention, processes, and routines at all operational levels. Beginning with staffing, staffing inflow has increased significantly. And while a handful of our restaurants remain challenged, our overall staffing levels have improved tremendously. This, combined with improved turnover, has resulted in over 95% of company-owned restaurants being able to operate all channels at all hours every day. We have also made significant improvements in our four-wall execution as demonstrated by the reduction of total drive-through times by approximately 1 minute and significant improvements across multiple consumer metrics. For example, our last visit excellence scores have improved by over 10 percentage points in company-operated restaurants since the first quarter of this year and are at the highest levels we've achieved since 2019. We believe these operational improvements enhance our consumer proposition and drive higher sales over time. Lastly, we continue to work on projects to simplify our restaurant operations. Since the launch of this initiative, we have implemented a number of changes that have reduced complexity as well as the labor hours required to complete various tasks. These include menu deletions, destemming serrano peppers, pre-chopping cilantro, and revising our tea packing procedures. In addition to these, we are testing several initiatives, several of which we expect to implement in the near term that could significantly reduce labor hours required in our back of house. These include new food processes for Salsa, the use of salt tanks for cleaning grills, dishwashers, avocado slicers and simplified onboarding procedures for new employees. These and other projects are part of a longer-term effort to streamline the daily work performed by employees, thereby improving their engagement and enhancing guest satisfaction through better execution in our restaurants. While our efforts to promote brand awareness and improve restaurant operations are key strategic initiatives, we believe it's equally important for El Pollo Loco to engrain the right company culture. We have made significant progress in our restaurants creating a servant-led leadership culture predicated on recognition while still maintaining accountability. This is clearly evident by the recognition boards we have in all of our restaurants, postings on Workplace by Facebook, and the engagement we are seeing amongst our teams. While these efforts will continue at our restaurants, we are also working to create a restaurant mindset within the support center. We want all support center employees to have a greater appreciation for the work our team members do to serve our customers. With that in mind, all new support center employees are now required to work 2 days in our restaurants as part of our onboarding process. In addition, all vice presidents and above are now required to spend 1 day per quarter visiting restaurants with either a senior company operator or a franchisee. And in August, we will be relaunching de El Pollo, where all support center employees will work in a restaurant to show support for our restaurant team members. Finally, our support center employees will be given WOW pins to recognize team members who provide exceptional service when they visit one of our restaurants, either company-operated or franchise. We believe these and additional initiatives will improve overall employee satisfaction, which will translate into a better experience for our customers. On the franchising front, I am very pleased that we recently signed a development agreement with a new franchisee for the Seattle area and are finalizing an agreement for Chico Redding, California, and Southern Oregon. These, along with the opening of our first restaurant in Denver scheduled for September, demonstrate that we are making progress in our efforts to develop in new markets with franchisees. In addition to these signings, we are in discussions with a number of other franchise candidates, which we hope to conclude with new development agreements over the balance of the year. As part of our franchising strategy, we are striving to put our restaurants in the hands of strong operators and one way to accomplish that is to focus on expanded development opportunities with current franchise partners. To that end, one of our current franchisees with 12 restaurants in Phoenix and California has recently teamed up with a former company operator to purchase 5 restaurants in San Antonio and 2 restaurants in Louisiana from other franchisees. Both transactions include new development agreements, 6 new restaurants in San Antonio and 4 in Louisiana. In closing, while we are not immune to the softening trends the industry is seeing in the third quarter to date, we continue to make meaningful and tangible progress in our strategic initiative, which will ultimately position the El Pollo Loco brand to better capture the opportunities ahead of us. I'd also like to thank our team members and franchise partners for their passion, commitment, and dedication to making this brand and this family truly special. With that, let me turn the call over to Ira for a more detailed discussion of our second quarter financial results.

Thank you, Larry, and good afternoon, everyone. Let me start by saying I am very excited to join the El Pollo Loco team, and thank you for welcoming me into the familia. Turning to the financials. For the second quarter ended June 29, 2022, total revenue increased 1.7% to $124.1 million compared to $122 million in the second quarter of 2021. Company-operated restaurant revenue decreased 0.5% to $106.5 million from $107 million in the same period last year. The decrease in company-operated restaurant sales was primarily due to a $2.7 million decrease due to the sale of 8 company-owned restaurants to a franchisee during 2021 and $1 million from restaurants closed during the past year. This decrease was partially offset by a 2.9% increase in company-operated comparable restaurant sales and $0.3 million in non-comparable restaurant sales. The increase in company-operated comparable restaurant sales was comprised of an 8% increase in average check and a 4.7% decrease in transactions. During the second quarter, our effective price increase versus 2021 was 9%. Based on current economic conditions and consumer sentiment, we continue to expect approximately 9% pricing for the full year, inclusive of a 2% to 3% price increase we will be taking in mid-August. Looking ahead, third quarter to date through July 27, system-wide comparable restaurant sales increased 2.4%, consisting of a 0.4% increase at company-owned restaurants and a 5.5% increase at franchise restaurants, all of which reflects the traffic softness that Larry alluded to earlier. Franchise revenue was $10.1 million during the second quarter compared to $8.4 million in the prior year period. This increase was driven by a franchise comparable restaurant sales increase of 10.6% as well as the opening of 5 new franchise restaurants opened during or subsequent to the second quarter of 2021 and revenue generated from 8 company-owned restaurants sold to an existing franchisee during 2021. This was partially offset by the closure of 3 franchise restaurants during the same period. Turning to expenses. Food and paper costs as a percentage of company restaurant sales increased 370 basis points year-over-year to 29.8% due to increased commodity costs and investments in new packaging, partially offset by higher menu prices. Commodity inflation during the second quarter was approximately 21%. We continue to see significant commodity inflation and currently expect it to be approximately 24% in the third quarter. Although still elevated, we expect commodity inflation to peak in the third quarter before easing in the fourth quarter. We anticipate full-year 2022 food cost inflation to be approximately 20%. Labor and related expenses as a percentage of company restaurant sales increased 150 basis points year-over-year to 31% due to higher wage inflation, overtime costs, and other labor-related costs, partially offset by lower workers' compensation expense. Based on the continuing labor pressure that we're experiencing, we are expecting wage inflation of 8% to 9% for the full year. During the second quarter, we incurred approximately $300,000 of COVID-related expenses, including leave of absence and overtime pay. Occupancy and other operating expenses as a percentage of company restaurant sales increased 60 basis points to 24.3% due to higher utility costs and marketplace delivery fees. Our restaurant contribution margin for the quarter was 15% compared to 20.8% in the prior year. We expect margins to be under further pressure in the third quarter as a result of softer sales and elevated inflation. General and administrative expenses decreased to $9.7 million from $10.5 million in the year-ago period, primarily due to a decrease in management bonus expense. As a percentage of total revenues, G&A decreased approximately 80 basis points to 7.8%. We recorded a provision for income taxes of $3.1 million in the second quarter of 2022 for an effective tax rate of 30%. This compares to a provision for income taxes of $3.4 million and an effective tax rate of 27.8% in the prior year second quarter. We reported GAAP net income of $7.1 million or $0.20 per diluted share in the second quarter compared to GAAP net income of $8.8 million or $0.24 per diluted share in the prior year period. Pro forma net income for the second quarter was $7.6 million or $0.21 per diluted share compared to pro forma net income of $10.7 million or $0.29 per diluted share in the second quarter of last year. For a reconciliation of pro forma net income and earnings per share to the comparable GAAP figures, please refer to our earnings release. Turning to liquidity. During the second quarter, as of June 27, 2022, we had $40 million of debt outstanding and $34.3 million in cash and cash equivalents. In late July, we refinanced our $150 million credit facility, extending the term out 5 years to July of 2027. On July 29, we made a $20 million repayment to the credit facility, and our outstanding balance as of August 4 was reduced to $20 million. Lastly, due to the uncertainty surrounding the COVID-19 pandemic and current economic conditions, we won't be providing a full financial outlook for the year ending December 28, 2022. However, we are providing the following limited guidance for fiscal 2022. The opening of 3 to 6 company-owned restaurants and 6 to 10 franchise restaurants, the remodeling of 10 to 15 company-operated restaurants and 20 to 30 franchise restaurants, capital spending of $20 million to $25 million and a pro forma income tax rate of 26.5%. This concludes our prepared remarks. We'd like to thank you, and we are now happy to answer any questions that you may have. Operator, please open the line for questions.

Our first question comes from Jake Bartlett with Truist.

My first question was really on the trajectory of sales. And you mentioned a deceleration in mid-June. We've been hearing from others kind of a mid-May when gas prices were high, and COVID cases were spiking. So I just wanted to just dig into the kind of the mid-June commentary; it's a little bit different. And I'm wondering whether that has to do with kind of the benefit of the Beef Birria ending, I think, in early June? So just help us understand kind of the trajectory of the same-store sales? And then I had a follow-up question to that.

Yes. Thanks, Jake. I think you kind of hit on one of the things I think that delayed the softness we were seeing. Again, as we look through Q2, we got off to a very strong start with Beef Birria and continued to see good momentum with that product. And so for us, we really didn't see a noticeable, I'll say, softening, especially relative to our internal forecast until that mid-June time frame. That's when we really started to see a softening in the dinner business, which was what we thought was the primary driver of that softness. So I do think the Beef Birria promotion may have been something that delayed the onset of the softness in our business because Birria was selling both at lunch and dinner. It skewed more lunch, but it was still a pretty big dinner product. So it wasn't until that was winding down and then we saw the softness of dinner that led to the softening that we highlighted around mid-June.

Got it. My next question is about the consumer and your positioning. Could you remind us about your average income consumer? Additionally, can you confirm that the weakness you observed was primarily among lower-income consumers who seem to be feeling the most pressure right now? Related to that, how do you feel El Pollo Loco is positioned if the current situation deteriorates? How do you view your value positioning now compared to the Great Recession? I don’t have historical data, but could you help me understand how you performed then and how it might differ now?

Sure. When we analyze our customer demographics, approximately 45% of our consumers are from households earning $50,000 or less. This indicates a significant portion of our consumer base consists of lower-income households. This is likely one of the reasons we've observed a decline in dinner sales—not necessarily due to our pricing, but because dining out for dinner is viewed as a more expensive option. We believe lower-income consumers have reduced their spending in that area. Another point to note is that we haven’t advertised family meals or offered them at attractive price points since early this year, with the last promotional push occurring at the end of the previous year. Consequently, the absence of messaging around family meals at a competitive price has contributed to our perceived value issues. Moving forward, we plan to introduce a $24 family feast and are developing a combo meal starting at $5, which we view as effective ways to showcase our value proposition. Additionally, we've made significant strides in our operations, as reflected in consumer data, leading to improved value metrics. Not only have we enhanced customer experience, but our value scores have also seen considerable improvements, positively affecting the overall system. The current economic landscape differs greatly from the great recession, particularly when comparing El Pollo Loco's position in 2009 and 2010, when the entrée segment was considerably smaller, and many value offerings did not exist. Since then, we have expanded and improved our entrée options, including Burritos, Tostadas, and salads. We believe that, over the next few quarters, we need to continually develop strategies to connect with price-sensitive consumers through compelling pricing that can drive transactions while preserving margins. We have various strategies at our disposal and are currently conducting research that will conclude in the coming weeks, aiming to better target our efforts to enhance value for our consumers.

That's really helpful. My other question relates to your food costs and the inflation you're experiencing. If I heard correctly, it increased from 21% in the second quarter to an expected 24% in the third. I noted that back in January, you mentioned having 80% of your chicken prices locked in. What are the main factors contributing to the significant inflation? I'm observing that many commodities in the spot markets appear to be coming down from their highs. Looking ahead to 2023, it seems likely you could experience a notable deflation as you compare against the current high inflation. Is there any reason to think that wouldn't happen? Concerning the 80% of chicken locked in at the beginning of the year, was that price lower than the current spot price? Do you have enough visibility in that chicken segment to suggest that material deflation could be expected next year?

Yes, Jake. I apologize if I caused any confusion earlier. When we discussed what was secured, we indicated that 80% of our chicken on the bone was secured. Approximately 30% of our chicken business consists of boneless products, which have always been variable. A portion of the chicken on the bone was also variable, alongside all our non-chicken products. This situation accounts for the higher inflation on chicken as we progress, since those items were not secured. Currently, we are observing some weekly fluctuations. There are signs of improvement, particularly with boneless chicken, and we've recently begun to notice some favorable changes in avocados and other produce. While we have not fully relied on these improvements yet, we expect to see further progress in the fourth quarter. Looking ahead to next year, predicting commodities in the current economic climate is challenging, but we anticipate that commodity inflation will be significantly lower than this year. Deflation is uncertain, and much depends on the pricing of chicken on the bone, which is locked in at competitive rates compared to current market prices. Given the rapidly changing markets, we will assess our negotiations for chicken on the bone starting soon. If we achieve favorable pricing, there is a possibility for deflation next year.

Our next question comes from the line of David Tarantino with Robert W. Baird.

A couple of questions related to the margins and then I've got one on unit development as well. So first on the margin, I think, Ira, you mentioned the potential for increased pressure on the margins in the second half of the year, and I was wondering if you could perhaps elaborate on what your comment was intended to mean. Do you mean that margin on an absolute basis could be less than what we saw in the second quarter or the year-over-year change is going to be different? I guess anything you can do to maybe help how you're thinking about the margin?

Yes, David, I'll jump on that one. Yes, that commentary was really around what we're seeing in the third quarter with the little deceleration in sales and the higher cost inflation. We would anticipate margins to come in under where we were in Q2. Now again, that was the outlook for Q3. As we look to Q4, then we will start looking to see margins improving based on lower commodity inflation, the idea that we'll really get the overtime and other labor costs under control. Because again, I don't want to digress too much, but when we look at second quarter and even in the third quarter, our #1 priority has really been around getting the restaurant staff, making the investments we need to get applicant flow, hire new people, train new people. Our expectation is as we get in the fourth quarter, some of those hours will start coming back in line to where we've traditionally been, even pre-COVID. So that will be another positive on the margin side as we get into the fourth quarter. And then again, we'll be looking at the pricing that we take in August here in a couple of weeks and potentially looking at another price increase as we move through later in the year. The expectation would be the third quarter with the highest inflation will probably be below Q2 in terms of margins, but then we look to start rebounding and rebound in Q4 on the margin side.

Got it. And Larry, is there a certain long-term margin that you think is a reasonable target that you want to get to? I know we've had all this inflation, but let's assume that some of it sticks, I guess, where do you want to ideally operate longer-term?

Well, I think as I said in the last call, David, I'm looking to get back, and I'm saying, I always like a set rather than a super long-term goal. Okay. What would you expect over the next year, 1.5 years or so as we get into 2023. Just getting the current situation, who knows what's going to happen, but I'd be looking to get into the, call it, the higher teens on the margin side and then go from there to try to get back up to 20% over the longer term.

Got it. Okay. And then my question on the unit development. You mentioned converting some of the pipeline into signed agreements, and I was wondering if you could elaborate on the scale of those agreements and what type of number of units, for example, or sort of in process in some of those contracts?

David, I don’t want to get ahead of ourselves too much, but the prospects we're engaging with tend to be multiunit franchisees and larger businesses interested in development agreements for five to over ten restaurants over time. I should point out that due to the investments we've made in our franchising efforts, we have seen a higher applicant flow this year compared to the total inquiries in 2011. We've received more inquiries so far this year than we did all of last year, but these are initial inquiries, and we need to evaluate which ones are truly viable through considerable effort. Nevertheless, we are currently in discussions with a larger number of potential prospects who we believe are promising, and these are typically larger franchise organizations capable of developing several restaurants. This focus has been significant for us this year, and we are pleased with the progress we are making.

There are no further questions at this time. I'd like to hand it back to Larry Roberts for closing remarks.

Okay. Well, I just want to thank everybody for joining the call today. And as we highlighted, we had some headwinds we're dealing with in the near term. We feel great about the progress we're making on our strategic initiatives, and we're very, very excited about the prospects for El Pollo Loco as we move through the balance of this year and into next year. So again, thanks, everybody, for joining us.

Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time, and have a wonderful day.