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Carrols Restaurant Group, Inc. (NASDAQ:TAST)

Q4 2012 Earnings Conference Call

February 28, 2013 8:30 a.m. ET

Executives

Paul Flanders - Chief Financial Officer

Dan Accordino - President and CEO

Analysts

Bryan Hunt – Wells Fargo Securities

Andrew Gadlin - CJS Securities

James Fronda – Sidoti & Company

Bryan Elliott - Raymond James

Robert Sassoon – R. F. Lafferty & Co., Inc.

Ken Bann - Jefferies & Company

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Carrols Restaurant Group Fourth Quarter 2012 Earnings Conference Call. During today’s presentation, all parties will be in a listen-only mode. Late we will conduct a question-and-answer session. (Operator Instructions)

As a reminder, this conference is being recorded today, Thursday, February 28, 2013. At this time I would like to turn the conference over to Paul Flanders, Carrols’ Chief Financial Officer. Please go ahead, sir.

Paul Flanders

Good morning, everyone. By now you should have access to our earnings announcement released earlier today, which can also be found on our website at www.carrols.com under the Investor Relations section.

Before we begin our remarks, I would like to remind everyone that our discussion today will include forward-looking statements, which may include comments regarding our strategies, intentions or plans.

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 the SEC for more details, especially the risks that could impact our business and our results.

Please note that during today’s call, we will discuss certain 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 a reconciliation to comparable GAAP measure is available in our earnings release.

With that, I’d like to now turn the call over to the President and CEO of Carrols Restaurant Group, Dan Accordino.

Dan Accordino

Thanks Paul and good morning everyone. Today I will start by discussing results from our core business or our legacy restaurants, then review some highlights regarding Burger King’s brand initiatives and finally provide an update on the integration of the restaurants that we acquired in the second quarter of 2012. Paul will discuss our financial results in greater detail later on the call.

In terms of comparable restaurant sales, our legacy restaurants concluded 2012 with a solid 7.3% increase in the fourth quarter, bringing the increase for the full year to 7.1% above our prior guidance of 6% to 7%. The fourth quarter marked the sixth consecutive quarter of positive trends and sales improved sequentially on a two year basis indicative of the overall success of the Burger King strategy.

The sales increase in our legacy restaurants was driven by both higher customer traffic and an increase in average check, reflecting the effectiveness of Burger King’s menu and product innovation, brand marketing and advertising. These brand initiatives have broadened our appeal to a wider demographic including women and customers 50 and older and have provided a better balance of value and premium offerings.

As we noted throughout 2012, the extensive introduction of new products in April along with the brand’s limited time promotions have been effective in driving both sales and customer traffic throughout the year. Premium limited time offers in the fourth quarter included products such as the Wisconsin Cheddar Whopper, the Angry Whopper and the Chicken Parmesan sandwich. Other promotions included the 55th Whopper anniversary promotion which offered a Whopper for $0.55 when customers bought one at full price and a $1 Minibon promotion and a holiday sweets menu.

In regards to restaurant level profitability, our legacy units expanded margins as we leveraged the higher sales and labor and other operating costs. Restaurant level operating margins, which excludes G&A expense, expanded by approximately 65 basis points in the fourth quarter to 13.1% and more than 80 basis points for the year to 13.5%. On an annual basis, this was our best performance since 2009.

Lastly, we made significant progress on our remodeling initiatives in 2012. We completed 80 upgrades to the 20/20 design image in 2012 and are planning to complete somewhere between 90 and 120 remodels in 2013. Customer response has been solid and we are generally experiencing a sales increase in the 8% to 10% range. Accordingly, we would hope to remodel at an aggressive pace, but recognize that we may need to temper this based on how the year progresses.

While our 2012 results demonstrate that Burger King’s strategies are working, we have experienced an initial sales slowdown early in 2013. We believe that there are a number of causes for this, including tough prior year comparisons, worse weather conditions and lower consumer spending as our customers adjust to the higher payroll tax and rising gas prices. It has been a more challenging competitive environment as our competition has been spending aggressively on value messaging.

To be more specific, January comparable sales increased approximately 1% against the 7.9% increase in the prior year. However, February is tracking towards being negative 4% or 5% against the 6.7% increase in February 2012. For the entire quarter, we expect our comparable restaurant sales to be down modestly compared to last year.

Still, for 2013, we are guiding to a comparable sales increase at legacy restaurants of between 2% and 4%, which includes an expected increase in traffic, a modest pricing increase and the benefit of our restaurant remodeling initiatives. Although we are off to a slow start, we believe that we can achieve our full year expectations with trends improving from the various brand building initiatives at Burger King and our belief that consumer spending should improve as we move further into the year.

Recently the brand introduced a new coffee platform and expanded its specialty coffee menu to include 10 new beverages such as lattes and flavored hot or iced beverages. The innovation of our coffee platform provides the opportunity to capitalize on the market for specialty coffee drinks which remains very strong. It is also an important part of building on the brand’s breakfast platform which will receive increased focus in the future.

Now let’s turn our attention to the integration of the acquired restaurants. It is apparent that our overall financial results were meaningfully impacted by the acquired restaurants. Based on our historical performance, there is still a significant opportunity to improve these results as we continue to improve operations and impose our P&L discipline and control structure. While not necessarily evident by our fourth quarter results, we have in fact begun to make progress and we expect that the P&L will better reflect this as we progress through 2013.

As we said in the last call, we implemented our labor scheduling and labor control systems late in the third quarter. Labor costs in the fourth quarter were generally in line with our guidelines and were more than 200 basis points lower than the third quarter as a percentage of sales. We have also made considerable progress in properly staffing these restaurants. Since we assumed control, we have hired over 300 managers, including filling approximately 180 vacancies that existed when we took over these operations.

Cost of sales remains one of our largest opportunities with the gap to our legacy restaurants at approximately 430 basis points in the fourth quarter. This difference narrowed about 40 basis points in the quarter, in line with our expectations and has continued to improve at an accelerating rate early in 2013.

We believe that we still have a considerable opportunity to increase sales at these restaurants through both operational improvements and as we continue to impose our control disciplines, employee turnover has risen and we expect it to remain higher along with the related training costs for new employees as we continue to address procedural non-compliance. We’re also in the process of replacing the point of sale software in these restaurants which will further enhance our controls and provide us transactional level data so that we can better detect and manage our cash and inventory losses.

In the fourth quarter we took a $500,000 charge related to our termination of the Brink's Armored Service contract for 221 restaurants. We expect to save approximately $1.2 million per year from this action. Repair and maintenance costs were about $1 million higher than normal in the fourth quarter as we continued to address deferred maintenance. However, we believe that this is now substantially behind us.

In conclusion, when we acquired these restaurants from Burger King we understood that it would take some time to instill our operation and cost disciplines to improve the restaurant culture and in turn improve the P&L. we remain confident that we understand the challenges that we face to achieve this. We are addressing these challenges and we are making progress. We would expect this to become more evident in our 2013 financial results.

On a broader level, our core business has been strong. We have experienced positive momentum from the Burger King brand initiatives throughout 2012 as evidenced by the traction in performance at our legacy restaurants and while we have started off a little slow in 2013, we expect to regain momentum and continue to improve our financial results as the overall performance of the acquired restaurants gets better.

With that I will turn the call over to Paul to continue our financial review.

Paul Flanders

Thanks Dan. On a consolidated basis, restaurant sales in the fourth quarter grew 87.5% to $1622.6 million which included $71.7 million sales from the acquired restaurants compared to total sales of $86.7 million for the same period last year.

Comparable sales results at our legacy restaurants were very strong, increasing 7.3% against the 1.5% increase in the fourth quarter last year. This sales increase included customer traffic growth of 1.1% and an average check increase of 6.2% including 1.8% in effective pricing. Average weekly sales for the acquired restaurants were $20,160, lower than our legacy restaurants, but this gap did narrow slightly from the third quarter and while these restaurants were not included in our results from 2011, average sales of the acquired units increased about 1.3% for the quarter.

Adjusted EBITDA, a non-GAAP measure, was $3.3 million in the fourth quarter, compared to $5.5 million in the prior year and Adjusted EBITDA Margin was 2% compared to 6.3% in the prior year. The decline in Adjusted EBITDA primarily reflected our increased G&A costs for districts and regional support for the acquired restaurants. We have also provided supplemental data and restaurant level expenses in today’s earnings release which details the differences in operating margins between the legacy and acquired restaurants.

In the fourth quarter, we leveraged the solid comparable restaurant sales increase at legacy units on both labor and other restaurant level costs. Costs of sales for the quarter increased 26 basis points reflecting a 4.3% increase in beef cost which were $1.94 a pound for the quarter.

Restaurant level operating margins in our legacy restaurants which excludes G&A expense, increased by more than 65 basis points through the quarter and as Dan indicated, we are confident that we can improve the margins of the acquired restaurants over time.

General and administrative expenses increased $6.2 million to $12.5 million for the quarter from $6.2 million in the fourth quarter of 2011. However, included approximately $2.6 million related to settling the litigation with the EEOC which has been going on since 1998. Excluding these costs and the acquisition expenses, G&A was actually favorably leveraged by approximately 55 basis points for the quarter.

Depreciation and amortization expense increased from $4.3 million to $7.8 million due to the addition of the acquired restaurants and from the investments in late 2011 and early 2012 for new point of sale systems and new kitchen equipment for the Burger King game changer initiative.

Interest expense increased from $1 million to $4.7 million in the quarter due to the increase in outstanding debt from our May 2012 refinancing. This refinancing was used to fund the acquisition and to raise capital to fund our restaurant remodeling plans.

At the end of the quarter, our cash balances were $58.3 million, including $20 million of restricted cash held as collateral for our revolving credit facility. Total outstanding debt was $161.5 million at quarter end comprised mostly of our $150 million 11.25% senior secured second lien notes.

The net loss from continuing operations was $8.8 million, or $0.39 per diluted share, compared to a net loss from continuing operations of $0.3 million, or $0.02 per diluted share prior year. The loss in the fourth quarter of 2012 included certain charges which in total reduced earnings by $0.11 per diluted share after tax. These charges included acquisition and inflation costs related to the acquisition of $1.4 million or $0.04 per share and litigation and settlement costs related to the EEOC matter of $2.6 million or $0.07 per share.

Capital expenditures for the quarter totaled $13.9 million, including $10.7 million for restaurant remodeling. The full year CapEx was $37.6 million.

Finally, I will discuss our guidance for 2013. We expect sales for the year to be between $670 million and $700 million, including a comparable sales increase for the legacy restaurants of 2% to 4%. Commodity costs are expected to increase 3% to 4% for the year. General and administrative expenses are expected to be approximately $34 million to $36 million, including the full year effect of field and other G&A increases for the acquisitions.

We plan to close four to six restaurants this year. We expect to have an annual effective income tax benefit of 45% to 50%, including the carryover benefit of the 2012 WOTC credits. And lastly, capital expenditure is expected to be approximately $40 million to $50 million for the full year, including $30 million to $40 million for the remodeling of 90 to 120 restaurants.

And with that, we’ll now open up the lines for questions.

Question-and-Answer Session

Operator

(Operator instructions). Our first question is from the line of Bryan Hunt with Wells Fargo Securities. Please go ahead.

Bryan Hunt – Wells Fargo Securities

I was wondering if you all could talk about food and labor costs in general terms at the acquired stores. You said improvements are accelerating I believe on those factors. When would you expect to achieve legacy Carrols Restaurants cost parameters in those acquired stores?

Dan Accordino

It will be another year and a half to two years, Brian. Our objective when we bought these, the gap between the acquired restaurants and the legacy restaurants was 450 basis points. Our objective is to have that gap reduced to 100 to 200 basis points by the end of 2013 and then the balance in 2014.

Bryan Hunt – Wells Fargo Securities

So based on what you’ve seen and what you saw in 2012, there’s really no change in your base assumptions to narrowing the margin performance?

Dan Accordino

No. it started a bit slower because we really didn’t know what the numbers were for a while because we had the – big inventories and so forth. But we’ve seen in December and January and in February that we’ve made substantial progress in terms of reducing that gap now that we have people understanding the Carrols system.

Bryan Hunt – Wells Fargo Securities

Great. And you talked about employee turnover and I’m sure that’s impacting your labor cost. Could you talk about what you’re experiencing in turnover relative to your core stores and when you would expect your turnover rate to normalize?

Dan Accordino

It’s not really the employee turnover that’s the issue. It’s the management turnover. We had 160 some vacancies when we bought these restaurants and as we said in the statement we hired over 300 managers and unfortunately we still had to turn over many of the managers that were there because there had been some issues in terms of how they deal with our control parameters. So the folks that we have in there now have gone through complete formalized training and I would expect that by the fourth quarter of 2013, that the turnover in the acquired restaurants would be closer to the turnover in the legacy restaurants. Our management turnover in the legacy restaurants is about 21.5% and the turnover in the acquired restaurants is over 31%.

Bryan Hunt – Wells Fargo Securities

Great. Last question. When you look at the major product launches and initiatives such as what you’re doing on coffee, is there any way you could give us an idea of what timing may be of significant items, not what the significant items may be? I don’t want you to give away any secrets, but when you look at major product rollouts, major product initiatives throughout 2013, are there any lumpiness to the rollouts?

Dan Accordino

No. they’re generally quarterly blocks, Bryan. So you have – there are different platforms that will be addressed each quarter.

Bryan Hunt – Wells Fargo Securities

Okay. And within any of those launches, are there any significant additional equipment that has to be installed such as Barista style equipment for the coffee initiative?

Dan Accordino

We already did the latte machines and the vendors. Burger King negotiated arrangements with the vendors so that the capital expense associated with these initiatives was very small.

Operator

Our next question is from the line of Andrew Gadlin with CJS Securities. Please go ahead.

Andrew Gadlin - CJS Securities

Thank you. Dan, in your previous comment about 200 basis point improvement in gross margin, was that a run rate by the end of the year or for the total year?

Dan Accordino

That will be at a run rate. I’ve given them quarterly objectives, Andrew that they’re supposed to hit in terms of improving that and as I said, so far in the first quarter we’re on that target. But that is a run rate. We will be at 200 basis points by the end of the year.

Andrew Gadlin - CJS Securities

Got it. And then in terms of restaurant wages, would we expect to see some margin pickup through the year in that line item as well?

Dan Accordino

Yes.

Andrew Gadlin - CJS Securities

Can you help us size it?

Paul Flanders

I think our view is that it’s probably going to be another couple 100 basis points.

Andrew Gadlin - CJS Securities

Another couple 100 basis points within this year?

Paul Flanders

Yeah, through the year.

Andrew Gadlin - CJS Securities

Through this year, okay. And then other restaurant operating expenses?

Dan Accordino

I think we’ve pretty well normalized now. We expected based upon our due diligence that there was going to be some deferred maintenance associated with these restaurants. What we had not properly sized up was you have to get what’s called a transitional health services permit when you change ownership. So when you go from BKC to Carrols, the health department had to come in and re-inspect each of these 278 restaurants and in conjunction with that inspection there were a lot of things that have not been previously done to the satisfaction of the health department that they mandated we do. The incremental cost associated with that was about $850,000. So we are beyond that and now we think that these R&Ms are normalized and our 2013 plan has the dollar R&M expenses associated with the acquired restaurants to be exactly the same as the legacy restaurants.

Andrew Gadlin - CJS Securities

And you referenced in your commentary earlier that you’re seeing signs of a turnaround within the acquired stores even though it hasn’t appeared in the financials. Could you talk about what some of those signs are? It doesn’t look to me like there’s much pickup in these sales figures which I was somewhat surprised by.

Dan Accordino

The AUV gap between the legacy stores and the acquired stores in the fourth quarter really wasn’t much a difference in what it had been in the third quarter. What we’ve seen so far in the first quarter is that gap has narrowed so that the acquired stores are operating at about a 14% delta to the legacy stores whereas it was running 16% to 17%. The cost of sales controls that we talked about really didn’t manifest themselves to a large degree in the fourth quarter, but we’re seeing a significant improvement in the first quarter.

Andrew Gadlin - CJS Securities

And then you mentioned that within the legacy stores the average check increased by about 6%. What drove that? Was that volume? Was that a mix?

Dan Accordino

Yes. When you look at what Burger King – the marketing focus in 2012 to a large degree was on different platforms, this game changer phenomenon, new products and they were higher ticket products, less emphasis on the value menu.

Operator

Our next question is from the line of James Fronda with Sidoti & Company. Please go ahead.

James Fronda – Sidoti & Company

All my questions were answered. Thank you.

Operator

The next question is from the line of Bryan Elliott with Raymond James. Please go ahead.

Bryan Elliott - Raymond James

First I just wanted to first case make sure I heard something right. The remodel plan at your midpoint, if I did my math right it works out to I think low 300s per remodeled unit. A, is that accurate? And B, is that not a modest bump from where were earlier?

Paul Flanders

No, that’s about right. We have average of around $300,000 of remodel. The legacy units are a little higher than the acquired units so far. At least in 2012 were a little bit lower than that. The 300 is still above our targeted number.

Operator

(Operator instructions). The next question is from the line of Robert Sassoon with R. F. Lafferty. Please go ahead.

Robert Sassoon – R. F. Lafferty & Co., Inc.

I have a couple of questions, firstly on the Adjusted EBITDA. Did you break down how much the legacy restaurants compared to the acquired restaurants contributed to the fourth quarter EBITDA?

Paul Flanders

I think that you can get that number in the release. There’s a table that shows the restaurant level costs such that we can calculate restaurant level EBITDA if you will in the release. Substantially the contribution is coming from the legacy restaurant.

Robert Sassoon – R. F. Lafferty & Co., Inc.

The statement says that the legacy restaurants contributed positively to EBITDA. Without sort of having was it up to the numbers that you’ve pointed to me. Does that suggest that the adjusted EBITDA in the fourth quarter for the acquired restaurants was negative?

Paul Flanders

No, it’s positive but it’s a small number.

Robert Sassoon – R. F. Lafferty & Co., Inc.

Okay. And the other question I have is, is it possible to quantify what you think or view to as estimate how much the impact that Sandy had on the sales and profitability?

Dan Accordino

We don’t think it had a big impact at all, frankly. Our restaurants were not really affected by the storm. Very few of them.

Operator

The next question is from the line of Bryan Elliott with Raymond James. Please go ahead.

Bryan Elliott - Raymond James

I’d like to I guess discuss a really big picture question. I don’t know how much data you might have on this, but I guess the essence of the question is, do you think that Burger King is losing share so far in Q1 or has demand in the industry contracted at a level consistent with your quarter to date sales commentary?

Dan Accordino

I think that is difficult to answer, Bryan. From what we understand everyone is having a little bit of a headwind here in the first quarter. I’m not sure that our degradation in sales is going to be any greater than what you’ll see in the other major competitors in the QSR segment.

Operator

The next question is from the line of Ken Bann with Jefferies. Please go ahead.

Ken Bann - Jefferies & Company

I was just wondering what your thoughts are on pricing given commodities going up 3% to 4% and obviously the market has become a little bit more competitive than I guess other companies they’re being a little bit more promotional. Do you think pricing – do you have any more ideas about pricing increases in this kind of environment or might you try to become a little bit more promotional to drive a little bit more traffic like the other restaurants.

Dan Accordino

I think there are two parts to your question. I think our menu price increases that we’re contemplating will be in the 1% to 2% range. However, the effective price increase maybe much lower than that by virtue of having an increased retail component. What we’ve seen so far certainly is of much higher marketing effort around the value menu which even if you have a price increase therefore your product mix changes and more people love the value menu. That’s not – your effective price increase is certainly going to be much less than what we might increase our prices by.

Ken Bann - Jefferies & Company

And can you do things separately from Burger King Corp in terms of promotions in your own territories?

Dan Accordino

There are certain options that you can select from. You can’t randomly do whatever you want, but there are half a dozen different things that are part of the marketing portfolio that Carrols does do independent of other operators. We spend more on marketing than many other operators because we control entire markets. Therefore we would spend over and above our contractual obligation in order to do specific marketing for Carrols Restaurants within certain DMA.

Operator

Our next question is a follow up from the line of Bryan Hunt with Wells Fargo Securities. Please go ahead.

Bryan Hunt – Wells Fargo Securities

Just a point of clarification. You spoke about taxes earlier. Are you looking at a cash tax when you’re going in 2013?

Paul Flanders

We will have some taxes coming back because we’ve got some carry backs that we’re going to be doing. I’ll talk about the rates quickly. One of the reasons the wage is so high, the benefit is so high in our guidance is because the WOTC program was not renewed by the congress until 2013. So we’ve got the added benefit of last year’s credit hitting the tax, but yeah we will give some cash back.

Operator

Thank you. I’m showing no further questions at this time. I’d like to turn it back to management for closing remarks.

Paul Flanders

All right. I think that concludes our call today and we appreciate your attention and attendance today. Thank you.

Operator

Ladies and gentlemen, that does conclude our conference for today. Thank you for your participation. You may now disconnect.

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