Carrols Restaurant Group, Inc.

Ladies and gentlemen, welcome to the Carroll's Restaurant Group Inc's second quarter 2023 audience conference call. At this time, all participants are in a listen-only mode. Following the presentation, we will conduct a question and answer session. Instructions on how to ask a question will be given at that time. I would like to remind everyone that this conference call is being recorded today, Thursday, August 10, 2023, at 8.30 a.m. Eastern Time. and will be available for replay. I will now turn the conference over to Greta Miles, Carol's controller.

Please go ahead.

Thank you, Operator, and good morning, everyone. By now, you should have access to our earnings announcement released earlier today and our earnings presentation that are both available on our website at www.carols.com under the Investor Relations section. Before we begin our remarks, I would like to remind everyone that our discussion, including answers to questions posed to management, may include forward-looking statements or comments with respect to our strategies, intentions, or plans and the future direction of revenues, input costs, or other aspects pertaining to our business. These statements are not guarantees of future performance and therefore undue reliance should not be placed on them. We also refer you to our filings with SEC for more details. both with respect to forward-looking statements as well as risks that could impact our business and results. During today's call, we will discuss certain non-GAAP measures that we believe can be useful in evaluating our performance. The presentation of this additional information should not be considered an isolation or as a substitute for results prepared in accordance with generally accepted accounting principles, and a reconciliation to comparable GAAP measures is available with our earnings release. With that, I will now turn the call over to our President and CEO, Deborah Derby.

Thank you, Greta, and good morning, everyone. I'm delighted to be speaking with you following my first full quarter as Carroll's President and CEO, and what a great quarter it has been, as you will soon hear. My focus over the past few months has been threefold. First, spending time in our restaurants. This included store visits in various regions with our Chief Restaurant Officer, Joe Hoffman, and his field leadership team, as well as with Carroll's retired CEO, Dan Accardino, so that I could benefit from their extensive QSR experience and accelerate my own learning curve. In addition, I had been training and working in our Burger King restaurants, which allowed me to personally interact with our customers and observe firsthand what we expect of our restaurant team members. Second, working with the senior leadership team to identify and prioritize key initiatives to drive our business in 2024 and beyond, a couple of which I will elaborate on further later in our earnings call. And finally, along with the rest of the Carol's team, collaborating with our Burger King counterparts to ensure we are aligned on key strategic initiatives and a vision for the future. I believe that our relationship with Burger King has never been stronger, and I'm excited about where we can take this brand together. Turning to our results, in the second quarter, we had one of the best quarters in the company's 63-year history, as we achieved $485.2 million of sales, delivered adjusted EBITDA of $44.3 million, generated free cash flow of 37.9 million and reduced our net leverage ratio three and a half turns to 3.6 times as we continue to strengthen our balance sheet and pursue the organic growth opportunities we have across our portfolio. One of the most significant accomplishments of the quarter is that our Burger King restaurants are well on their way to achieving the highest possible operator rating under the chain wide evaluation system used by our franchisor. This is a testament to our field management teams operating with an owner mentality and local market mindset, despite the Carroll system being more than three times bigger than the next largest Burger King franchisee. I want to thank our over 24,000 Carroll's employees for this accomplishment. Without their outstanding work each and every day, these results wouldn't have been possible. In addition, during the quarter, we saw the dual benefit of driving demand through operational improvements while also becoming more cost efficient on labor. Operationally, we improved our speed of service by 6% versus the same period last year. More importantly, our customers are noticing this progress, evidenced by an over 30% improvement in our guest satisfaction scores at our Burger King restaurants. All in all, we continue to believe that guest satisfaction is a key driver of repeat visits and incremental traffic growth. On the efficiency front, we continue to see productivity improvements in labor, with inflation decelerating to mid-single digits. lower manager and hourly turnover rates approaching pre-pandemic levels, and enhanced operational efficiency from our team members. As a result, we were able to increase hours of operation by over 3% while reducing labor hours by 3.5%. We are also encouraged by our recent performance at Popeyes, where we have seen strong sales and traffic as well as improved margin performance while increasing customer satisfaction. Looking ahead, we want to not only replicate but accelerate our progress while leveraging our size and scale to impact both our top and bottom lines. One of our new initiatives is an enhanced labor management system, which will allow us to build upon the improvements we've already seen in labor productivity. This initiative will include an improved labor model formula, as well as more sophisticated forecasting and scheduling capabilities. Our efforts over the next several months will be focused on refining the labor model and testing it in our restaurants. We anticipate realizing the financial benefits of the project in 2024. A second area of attention is around growing traffic and becoming even more customer obsessed. In particular, through the investments we have made in our Burger King restaurants, such as our customizable outdoor and indoor digital menu boards, we have an opportunity to leverage our size and scale to drive traffic through locally relevant offers that target distinct customer occasions and complement the national marketing initiatives from our franchisor. We are currently testing these offers in over 10 markets, initial results have demonstrated that we can drive incremental traffic and increase the average check in day parts where we see an opportunity for increased business. We will continue to test and leverage the learnings from these early pilots to develop a more robust local marketing strategy in 2024. Before I turn the call over to Tony, I'd like to touch on some of our thoughts for the remainder of the year. First, we continue to be optimistic about the improving traffic trends we are seeing at our restaurants. We credit this to the combined impact of our work to enhance the guest experience and increased hours of operation. In particular, at our Burger King restaurants, we believe traffic has also benefited from the refreshes we have made to our restaurants, as well as the equipment upgrades we are making under Burger King's Royal Reset Initiative and the incremental advertising investment under their Reclaim the Flame program. Much of this spend is still coming in the quarters ahead and we believe should continue to be a traffic driver. Second, going forward, we intend to be cautious on our incremental pricing actions as inflationary pressures continue to abate and the direction of the economy remains uncertain. We anticipate a year-over-year benefit of mid-single digits on average check improvements by the end of 2023 relative to the low teens average check increase we saw in the second quarter. This more conservative approach to menu pricing is expected to allow us to maintain our positive value gap relative to peers continue providing customers with compelling value while offsetting inflation and protecting our margin structure. Finally, our top priority remains fortifying our balance sheet, reducing our net debt, and staying the course on organic growth. That said, given the improved results we are seeing and our focus on organic growth, we will deploy some additional capital to accelerate certain high ROI remodel projects that were previously slated to begin in 2024. As a result, and with the benefit of improved clarity on our balance of the year spending and project cadence, we now expect capital expenditures for 2023 to be between $45 and $50 million, a slight increase from our earlier plan. This level of capital spending allows us to further avail ourselves of contributions from Burger King and should enhance our portfolio through high-return projects while still generating substantial free cash flow for the year. In closing, it was an outstanding quarter results-wise. and a pleasure working with the talented corporate field and restaurant operations team at Carroll's. What I have experienced and learned during the first few months of my tenure has only reinforced my initial impressions and reasons for joining Carroll's, which is that it is a great company with immense potential. I look forward to building upon the tremendous momentum created in the first half of the year. With that, I will now pass the call over to our Chief Financial Officer and Treasurer, Tony Hull, for a more detailed discussion of our financial results.

Thank you, Deb, and good morning, everyone. Restaurant sales in the second quarter increased 9.8% to $485.2 million, compared to $441.9 million in the second quarter of 2022. For the quarter, comparable restaurant sales at our Burger King restaurants increased 10.4%, comprised of a 12.7% increase in average check, which was partially offset by a 2% decline in traffic. Comparable restaurant sales at our Popeye's restaurants increased 11.6%, comprised of a 7.4% increase in average check and a 3.9% increase in traffic. Turning to expenses, our cost of food, beverage, and packaging improved 350 basis points to 28.2% of restaurant sales, as commodity inflation of approximately 3.5% was more than offset by higher average check. Beef was $2.83 per pound during the quarter, which was a 1% increase from the same period last year. From where we stand today, we expect Commodity inflation to be in the low to mid single digits for the remainder of 2023. Restaurant labor expense decreased 180 basis points to 32% of restaurant sales as labor inflation was more than offset by labor efficiencies and higher average check. Hourly wage rates for our team members increased by 4.4% during the quarter compared to the prior year period. As we look ahead, we expect wage inflation in the mid single digits for the remainder of 2023. Other restaurant operating expense decreased 40 basis points to 15.2% of sales. Rent expense decreased 50 basis points year over year as a percentage of sales compared to the prior year period, primarily from the benefit of higher sales on fixed rental agreements. The 620 basis point improvement in our restaurant level profit margin to 14% was driven by our strong top line results and our continued focus on operational excellence, as well as the moderation of inflation on our input costs. Looking ahead, we're currently seeing an expected sequential moderation in comp sales growth due to a reduced benefit from pricing actions and lapping reductions in discounting implemented late last year, partially offset by improved traffic trends. Accordingly, we currently expect moderation in third quarter restaurant level profit margins from what we've seen in the first half of this year. General and administrative expenses as a percentage of sales increased 40 basis points year over year, due to incentive compensation accruals that were absent in the prior year period. Excluding non-recurring costs, as well as stock compensation expense, and including the impact of higher incentive compensation accruals relative to last year, we anticipate 2023 G&A expense of approximately $23 to $24 million per quarter. For the second quarter, our net income was $15 million, or 23 cents per diluted share. compared to the net loss of $26.5 million, or 52 cents per diluted share, in the prior year period. On an adjusted basis, second quarter net income was $17 million, or 27 cents per diluted share, compared to an adjusted net loss of $8.9 million, or 18 cents per diluted share, in the prior year period. Free cash flow generated in the second quarter was $37.9 million, a significant improvement compared to the negative free cash flow of $5.7 million in the same period. period last year. At the end of the second quarter, cash and cash equivalents totaled $40.9 million, and long-term debt, including the current portion and finance lease liabilities, was $476.8 million. Our overall interest rate on our debt this past quarter was 5.7%, as approximately 90% of our debt is fixed. As of quarter end, there were no revolver borrowings and $10.5 million of outstanding letters of credit leaving us with $204.5 million of availability under our revolver. In addition, we have no covenants applicable on our senior credit facilities at this time. This concludes our prepared remarks. We'd like to thank you for your interesting carols. Deb, Greta, and I are now happy to answer any questions that you may have.

Operator, please open the line for questions. Thank you.

Ladies and gentlemen, we will now be conducting a question and answer session. If you would like to ask a question, please press star and one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star and two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. Ladies and gentlemen, we'll wait for a moment

while we poll for questions. Our first question comes from the line of Jeremy Hamlin with Craig Helen.

Please go ahead.

Thanks, and congrats on the strong results. I wanted to ask about the menu pricing that you're carrying here for Q3, the expected menu pricing. And also just to see if you could provide some color on quarter-to-date trends. It compares get a little bit tougher here in the back half of the year. And as you noted, menu pricing is going to fall some. So I wanted to see if you could provide a little color on what you've seen thus far.

Sure. Excuse me. On the menu pricing, you know, we were about 9% menu price increase in Q2. And that, you know, those numbers are expected to come down to the mid single digit percent increases for the back half of the year, a little bit stronger in Q3 than Q4. But we are lapping some, you know, some pretty sizable, you know, menu price increases that we took in September. But, you know, just on the other side of that equation, we just took a 1.4% increase last week at Burger King, and we're taking... about the same amount for Popeyes this week. So, you know, that the price increasing ability has become really surgical. And, you know, as inflation comes down, you know, we're being more cautious and conservative with menu price increases. So, you know, at this point, that's kind of where we are for the year on price increase for menu price increases. And we'll see how the, you know, obviously be agile and change if we see, a change in inflation, but that's sort of where we are. In terms of, you know, quarter date trends, you know, I think, you know, I think the dial, you know, what we said in the call was really, you know, where we expect, you know, we expect a decline, but still very solid comps in the back half of the year with a little, you know, in the mid single digit range, but You know, we're very encouraged with what we're seeing in traffic. And obviously, you know, we know that there's going to be some, you know, softening on price. But, you know, the question really is how much those two things offset each other. We don't have that. But, you know, we still think the back app is going to be solid, you know, mid-single digits with, again, a little more strength in the Q3 versus Q4. But, again, that could all change. We'll update you on the next call, obviously, when we have the Q3 under our belt.

More specifically, were you able to see, you noted that your relative value and pricing is improving. Has that resulted in getting that traffic to turn positive yet?

I'll take that one. Obviously, traffic continues to be a primary area of focus since it's essential to the long-term health of the brand. We were still marginally negative this quarter, but we saw continued stabilization from the trends that we experienced last year. And I'd say that that is obviously an area of continuing focus, and we're looking at the things that we can impact, such as guest service, operational excellence, and local value initiatives. which we believe will continue to move the needle in the right direction. We're also benefiting from the Fuel the Flame and Royal Reset initiatives that they have at Burger King. And we think that with that additional advertising spend later on top of our restaurant-level efforts, that will continue to improve on traffic and that, you know, down the road we'll move into positive territory.

Great. Thanks for the call. And then just you noted a new major – labor management system and, you know, one that does and test and that you believe, you know, will be ready to roll out in full for 2024. Is there any more color that you can share on that and what you think the potential, because you noted, you know, that you'd see financial benefit you thought in 2024, you know, any sense on kind of magnitude of benefit, you know, from that initiative?

and just a little bit more behind it. I'm sorry, Jeremy. I didn't mean to cut you off. It's too early to comment on the financial benefits that we're expecting to see because this is really in the preliminary stages. But I will say that the new labor formula is going to incorporate traffic trends in addition to sales to better forecast our labor needs. And it's going to use a much more robust historical data set, which will incorporate seasonality and holidays. And we believe that this enhancement of the methodology will ensure more predictability and staffing for both our restaurant crew and managers, and that this greater efficiency will lead to a better guest and employee experience in addition to the labor savings. But as I mentioned, we are just refining the labor model at this point in time of the labor formula. So it's just premature for me to comment on what we anticipate the benefits to say. But that is certainly something we will provide an update on in future quarters.

Got it. Last one really quick here. Free cash flow was super impressive in the quarter at $38 million, more than 10% free cash flow yield just in the quarter. You noted that you're going to increase your CapEx, I think prior guide was $40 million or so, taking that up a little bit. But in terms of, it seems like you would project to generate pretty nice free cash flow again here in Q3. Priorities and use of that free cash flow generation, is it on continuing to pay down a bit more debt, or are there other projects that you would earmark that for?

I think we're going to be very selective in what we do. As Tony mentioned, our priority is going to be focused on stabilizing kind of the balance sheet, and like you said, focusing on the net debt leverage. But we're also going to be, you know, where there's an opportunity for high-return projects, we're going to be very interested in investing in those. And as we made in, you know, the comment in our remarks, we are going to move forward certain projects that we had slated for 2024 that are high-return projects. And now that we have the flexibility with the additional cash flow to start them earlier, we'll take advantage of that. In some cases, it also allows us to avail ourselves of additional contributions from Burger King, which then, of course, only further enhances the return.

Jeremy, I'll just add a couple of timing things to note for the second quarter, $38 million. We have our second quarter interest payment on our bonds of close to $9 million that will hit in Q3 and hit in Q2 last year. And then we also have a really back-loaded CapEx for 2023, our projects have delayed into the back half of this year for 23. So those are a couple other things that will impact your free cash flow number.

Great.

Thanks, congratulations, and best wishes for continued success. Thanks, Jeremy. Thank you.

Our next question comes from the line of Joshua Long with Stephens, Inc. Please go ahead.

Great. Thanks for taking my question. I was curious if you could talk a little bit more about the store-level operational execution. It's been very strong here in the first half of the year. Maybe any updates you have on labor, your labor pipeline, turnover at the restaurant level, especially as you just dial in operational focus here as we think back to the second half of the year.

Yeah, absolutely, Josh. I would say the improvements that we've seen in operations are one of the things that the team is most proud of during this year. this first half of the year because it's been a significant movement. I think what's really exciting is that we've actually seen improvement in every component of the score that we get from our franchisor. So whether it's guest satisfaction, window time, training, retention, brand standards, all of them moved in a positive direction. So it's really across all brands, which I think is paying off in terms of the reaction that we're getting from our guests. In terms of the turnover, all these things generally move together. It's kind of a synergy you get. And I think from the operational improvements we've been able to make, we've been able to spend more time with the training of new associates, been able to staff up. As I mentioned in my remarks, the turnover levels are actually approaching closer to what they were pre-COVID. And I think that the quality of the candidates that we're seeing in the pipeline has also improved. So that's kind of all come together to stabilize the staffing levels at the store and to yield, like I said, improved guest satisfaction results from it.

That's very helpful. Thank you. And when we think about comps moderating in the second half of the year, it definitely makes sense that maybe you have some pricing that normalizes and maybe offset or supported by some improving traffic from the initiatives that you discussed. Can you talk about the restaurant-level margin and the outlook there? I mean, despite ongoing inflation at the particularly on beef, on the food cost line. You've done an admirable job maintaining margins there. Similarly on the labor side. So just as you think about comps moderating and maybe tie that together with restaurant-level margins for the second half, how are you feeling? What are you looking at? And kind of where do you think the major pivot points are?

Well, the major pivot point is going to be how, you know, how traffic moves. So I think... But, you know, we're really encouraged by what we're seeing on that front. But again, it's, you know, no matter how the level of success is going to be, it's going to be a high mountain to climb to offset some of the menu price lapping and certainly the discount reduction lapping that we're going to see in the third and fourth quarter. But having said that, you know, we think margins in the back half are going to approach what we saw in the first quarter. you know, less than what we saw in the second quarter. That was obviously exceptional. But we think they'll approach sort of where they were in the first quarter of this year because, you know, you just have slowing revenue growth against, you know, as you said, continue. There's still some residual inflation that's, you know, that's raising our labor costs and our cost of sales.

That's helpful. Thank you. And maybe the last one for me, when we think about just the what sounds to be some pretty encouraging performance with some of the locally relevant offers utilizing the digital menu boards. Can you talk about what percent of the system has those right now? And I think you mentioned maybe more comprehensive or more complete picture as we get into 2024, but any additional information or outlook you could provide there would be helpful.

Sure. So as I mentioned in my remarks, we have it going on in about, you know, 10 markets. What we're currently doing is really using price-pointed offers that we're focusing on beverages and breakfast. They've been running for about 12 weeks in those markets, and the goal is to expand the reach throughout the balance of the year to additional markets. We're pretty encouraged by the initial results. We're seeing both an increase in traffic as well as in the average check in the areas where those promotions are running, and that's why we're kind of planning on having an even more robust local marketing plan in 2024.

Thank you. Welcome. Thanks for the question. Thank you.

Ladies and gentlemen, if you wish to ask a question, please press star and 1. Our next question comes from the line of Jake Bartlett with Truist Securities. Please go ahead.

Hi. Thank you so much for taking the question. Mine is on the traffic. I think, and it's still being negative, and I think, if I got this right, a little bit more negative in the second quarter than the first. And so the question is, hours have been increasing, so increasing operating hours. One is one to kind of understand better the impact of that. Those might be just low volume hours, so maybe not a huge impact. But when you're seeing traffic still negative, what is your confidence that that will move positively? And then within the negative traffic, are you seeing that, you know, from specific consumers or day parts or just understanding kind of where you're, you know, you're still kind of losing customers?

I mean, I'll make, I guess, a couple of comments on that one. You know, the traffic is one that is a sustained effort over time. And I think that, you know, the efforts that we're putting in at an operational level, as well as that Burger King is putting in at an advertising level, you know, will take time to, to to um you know to take hold i think directionally obviously we're pleased with where it's going but we know that there's a lot more work to be done um you know to get us where we need to go uh you know we continue to see you know we think we have opportunities in the business on on the value side but we're you know very encouraged on what we're seeing kind of at the higher end purchases as well from the consumers so one of the areas that was up the most for us were for transactions over twenty dollars you know some of which include some of the more discretionary occasions like delivery and late night. And those are the areas that we're putting a lot of effort into. So we're encouraged that over time, as those take traction, we'll continue along with the increased advertising spend, which I think on RBI's call, they mentioned that a lot more of the spend has yet to come in future quarters. So I think those combined things are what are encouraging us to say that we believe that, you know, the traffic will ultimately get into the positive territory.

Yeah, Jake, I just had one thing is Q1 had severe weather, so it was very easy comps, especially in January. And the weather was pretty uneventful in Q2 of 2022 and Q2 of 2023. So that's why we had slight decline in traffic sequentially from Q1 to Q2. But I think going forward, I think Deb captured sort of the forward look that gives us confidence.

Great, great. That all makes a lot of sense. And, you know, I guess, to that point on the forward look and kind of what the approach is here, do you anticipate any kind of change in focus just just broadly from, you know, the marketing campaign, another you know hamburger fast food company yesterday talked about a a shift maybe more a little more towards value in their in their marketing approach but do you do you see any kind of need for or reason to to kind of change or refocus um the marketing message or do you anticipate that that that's going to happen in the back half of the year well i think again a lot of the marketing obviously is driven by by burger king so they can provide a lot more detail in terms of

you know, where they see it going. But I know a key part of it is to continue to focus on the core business, on the whopper, which is our strength, while also taking, you know, advantage of certain other opportunities. So the most recent promotion that they had, I think, launched just this Monday, which is on the wraps, the crispy chicken. Coming Monday. Coming Monday. Chicken. Right. You know, that's going to be focused on kind of that value end of the customer or kind of the more occasional snacking opportunity. you know, type of customer. So I think it's going to be a very balanced, you know, core as well as opportunistically where they think that we can grow the business in other areas. And then our plan, obviously, is to complement the national advertising campaign with local marketing initiatives that we can execute at restaurant level to create, you know, a holistic, you know, something that appeals to any of the customers that want to come in.

Great. And then my last question is on marketing. You know, with the balance sheet with leverage coming down, you know, very quickly, it seems like it's like we could, you could start to look again at, you know, at buying, you know, stores and acquiring stores like had been such an integral part of the model in the past. You know, are we nearing the point where you're considering kind of getting back into that, you know, into that cadence where you're kind of a regular grower, kind of a low risk, you know, way to grow? Maybe just remind us where you want to be before that begins and whether that's becoming more of a part of the conversation now that results have increased so much.

So I would say, Jake, that's still the short term. Our focus is really on the organic growth. We continue to see ways that we continue to improve the operation and the appearance of our existing portfolio. So that's kind of, I think, the initial focus today. You know, certainly if there's opportunistic things that would come along that, you know, would make sense for us, particularly smaller acquisitions, we would certainly take a look at those. But that isn't a primary focus right now. That said, you know, we, the senior leadership team and the board are working on a three-year strategy. And I believe that obviously you'll see acquisitions as a component of that going forward. but we're not at a point where we can really share the details of that at this time. That's something that we'll be sharing in future quarters with you.

Got it. Could you just remind me what your kind of target leverage, you know, what's – I know you've mentioned in the past, but I just don't recall it right now. Just what kind of your comfortable leverage ratio is?

Those are two different questions. The historical was – you know, we were looking at four times total net debt leverage. I think the, you know, sort of the going forward number is part of the discussion with the board that Deb just alluded to. And so we'll report on that as we get, you know, feedback from that. You know, I think the important thing in terms of what we're, you know, our sort of near-term, medium-term focus is really fortifying the balance sheet because, you know, we have some debt coming up, you know, in two plus years that we're starting to think about it. We want to be very careful, you know, we want to be very opportunistic, I guess is the best word. And when we, you know, when we capture, you know, when we do that refinancing, so we have obviously a huge runway, but the important thing is we have to balance sort of, you know, reinvestment in the business, which we're keeping pretty modest and generating free cash flow so we can show the credit side of our investor base that we can, you know, we can improve our credit ratings and do everything we can to really, you know, minimize our interest cost on the next, you know, on the next part of, you know, when we do the refinancing. So I think that's, you know, so I think that's going to weigh in pretty big on what that new number is going to be, that new leverage number is going to be, or if it changes at all. So again, all TBD.

Got it. Got it. Okay. Thank you so much. I appreciate it.

Thanks for the questions, Jake.

Thank you. As there are no further questions, I will now hand the conference over to Deborah Derby for closing comments.

Thank you everyone again for joining us this morning and for your interest in Carol's. We appreciate your time and we look forward to speaking with you next quarter.

Thank you. The conference of Carroll Restaurants Group has now concluded. Thank you for your participation. You may now disconnect your lines.