Carrols Restaurant Group, Inc. (TAST) CEO Dan Accordino on Q3 2021 Results - Earnings Call Transcript

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Carrols Restaurant Group, Inc. (NASDAQ:TAST)

Q3 2021 Earnings Conference Call

November 10, 2021 08:00 ET

Company Participants

Gretta Miles - Controller

Dan Accordino - Chairman & Chief Executive Officer

Tony Hull - Chief Financial Officer

Conference Call Participants

Fred Whiteman - Wolf Research

James Rutherford - Stephens, Inc.

Jake Bartlett - Truist Securities

Jeremy Hamblin - Craig-Hallum Capital Group

William Reuter - Bank of America

Operator

Good morning. And welcome to Carrols Restaurant Group, Inc. Third Quarter 2021 Earnings Conference Call. At this time, all participants are in a listen-only mode. Following the presentation, we will conduct a question-and-answer session and instructions will be given at that time. [Operator Instructions] I would like to remind everyone that this conference call is being recorded today, Wednesday, November 10, 2021, at 8:00 A.M. Eastern Time and will be available for replay.

I'll now turn the conference over to Ms. Gretta Miles, Controller for Carrols Restaurant Group. Please go ahead.

Gretta Miles

Thank you, Melissa, and good morning, everyone. By now you should have access to our earnings announcement released earlier this morning and an earnings presentation that are both available 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 including answers to questions posted to management may include forward-looking statements or comments with respect to our strategy, intentions or plans, and the future direction of revenue, input costs or other aspects pertaining to our businesses. 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, both with respect to forward-looking statements, as well as risks that could impact our business and results, including among other things, the impact of COVID-19. 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 in isolation or as a substitute for results prepared in accordance with Generally Accepted Accounting Principles. A reconciliation to comparable GAAP measures is available with our earnings release.

With that, I will now turn the call over to our Chairman and CEO, Dan Accordino. Dan?

Dan Accordino

Thanks, Gretta and good morning, everyone. Before I discuss our third quarter 2021 top line, let me address the elevated labor and commodity cost headwinds that we and the restaurant industry generally are experiencing; they both hit our adjusted EBITDA and margins hard in the quarter.

From a labor standpoint, in the third quarter, we worked to keep our restaurants open from at least 6:00 A.M. until 11:00 P.M. in order to take advantage of the economy reopening. Given the competition to recruit and retain workers, we were required to increase average hourly wages of our team members by 13.3%, and pay shift premiums and overtime in order to meet customer demand. In addition, the Delta variant further challenged our ability to keep our restaurants staffed during the quarter, given sporadic location-specific closures. At least for now, that challenge has abated so far this quarter. We believe we will continue to experience labor headwinds for at least the next six to nine months.

Our supply chain was constrained on numerous levels. We use a combination of frozen beef from overseas suppliers and fresh beef from domestic suppliers. Beef represents about one-fourth of our commodity basket; containerships carrying frozen beef were stranded off the coast of California, unable to unload their product in a timely manner during the third quarter. This supply constraint contributed to our beef costs increasing 15.5% compared to last year. Domestic food and paper producers and distributors supplying most of our commodity requirements faced labor constraints, along with higher fuel costs and many passed those increases on to us. The question we are struggling to answer are, what portion of the higher labor costs are transitory? And will commodity costs follow their traditional cyclical patterns and revert to the mean? We don't have these answers but we do know that the inflationary cost pressures we experienced during the third quarter were not expected to the degree that they impacted our industry. The economic conditions stemming from the pandemic and it's effect on the labor force, supply chain and consumer habits continue to be challenging to navigate and difficult to predict.

Turning to our sales in the third quarter of 2021, comparable Burger King restaurant sales rose 2.7% during the quarter, with a sequential improvement in trends from July through September as year ago comparisons eased and we rolled out pricing increases in late-July and in August. We estimate that we lost about 1% of same-store sales growth due to COVID and staffing-related challenges that reduced operating hours in the quarter. During the third quarter, the eat-in and takeout channels combined contributed about 14% to total sales at our Burger King restaurants, while drive-thru was approximately 80%. We also benefited from a 4.7% mix and delivery sales, which compared favorably to a 2.9% mix in the third quarter of last year. The average check size for delivery held at $17.53, compared to $17.56 in the second quarter of 2021. Our overall third quarter average check for Burger King rose to $9.23, including delivery, compared to $9 in the second quarter. Overall, our Burger King average check increased 7.8% year-over-year as a result of higher menu prices and reduced promotional discounting.

To further mitigate input pressures, we have taken an additional 0.8% [ph] in pricing in early October at our Burger King restaurants. We believe that the impact of price increases on customer demand in the current environment is small. Based on the price actions we have taken so far this year, lower promotional discounts and possible further price action expected next year, we believe that our Burger King average check will increase in the mid-to-high single-digit percent range in the first half of next year.

In terms of the trends in our Burger King sales by day-part, most remain steady. The breakfast and evening late-night day-parts, however, continued to recover in the third quarter of 2021 compared to the same quarter of 2020. Breakfast increased 9% and contributed 12% of our sales in the quarter, and evening late night improved 10% and contributed 13% of our sales in the quarter. We once again outpaced the overall Burger King system as we have done for 21 out of the past 23 quarters. Our third quarter 2021 comparable Burger King restaurant sales increase exceeded the U.S. Burger King system by 430 basis points. We believe we were able to drive positive comparable sales and outperformed the system during the quarter through a combination of menu price actions and actively reinstating restaurant hours.

As an update in October 2021, comparable sales at our Burger King restaurants increased 5% compared to October last year, continuing the sequential improvement we have been seeing since July of 2021. Popeyes comparable restaurant sales in October increased 0.9% [ph]. Only in place a short time, Burger Kings Royal Perks loyalty program is already beginning to have a positive impact on increasing the level of one-on-one engagement with our customers and reducing the use of paper coupons. This platform, which is currently accessible in our restaurants only through the BK mobile app will also be available to our dining room and drive-through guests beginning next month.

To conclude, today we are facing our cost challenges head on with more aggressive pricing, which we believe will help alleviate the margin pressure that we are currently facing. Looking ahead, we believe we will be able to begin recapturing a portion of the margin erosion we are seeing this year as the benefits from menu pricing actions and lower promotional discounts continue to improve comparable sales and cost comparisons, potentially ease on a relative basis.

Finally, as we announced in September, I will be retiring as Chairman, CEO and President by June 30 of next year. I have been with the company for 50 years, a long tenure by any measure. I believe that now is the right time, both for me and for Carol's to begin the transition to the next-generation of leadership. My intention over the coming months will be to work with our Board of Directors and management team to identify my successor and help that person succeed in their new role.

And with that, let me turn the call over to Tony to review our quarterly financials.

Tony Hull

Thank you, Dan. Total restaurant sales for the third quarter increased 3.6% to $421.7 million, compared to the prior year period of $407 million. Our Burger King comparable restaurant sales increased 2.7% during the quarter with an average weekly sales per Berg King restaurant of $30,186; this is an improvement of 3.1% from 2020 levels and more importantly, exceeded 2019 levels by 4.9%. The primary difference between overall sales growth in the quarter to comparable restaurant -- compo Burger King restaurant sales growth was due to the contributions from the 19 restaurants acquired during the second quarter of 2021 and three newly opened Burger King restaurants, offset by the closure of 17 Burger King restaurants since the end of the third quarter of 2020.

Let me give you our Burger King performance by region as we operated 1,027 restaurants as of the end of the Q3 across 23 states. In the Northeast, representing 21% of our Burger King restaurants, comparable sales were up 5.7%. In the Midwest, representing 29% of our Burger King restaurants, comparable sales were up 3.2%. In the South Central, representing 24% of our Burger King restaurants, comparable sales were up 1.7%. And finally, in our Southeast region, representing 26% of our Burger King restaurants, comparable sales decreased 0.9%. With respect to our Popeyes restaurants, which represent less than 5% of our total revenues in the third quarter of 2021, comparable restaurant sales decreased 3.2% versus a positive 5.5% during the same period of the previous year.

Staffing challenges during the evening hours of operation this past quarter were particularly impactful to Popeyes comparable sales. However, our results still represented a 3.8% increase on a two-year basis. We outperformed the Popeyes U.S. system by 140 basis points in the last quarter.

As a result of the inflation challenges experienced in the third quarter, adjusted EBITDA decreased $15.5 million to $18.6 million, while adjusted EBITDA margin decreased 400 basis points to 4.4% of restaurant sales. Cost of food, beverage and packaging as a percentage of net sales increased 130 basis points, primarily because of higher beef, pork and other commodity costs; commodity inflation in the quarter was 9.2%. Recall that last quarter, we stated that our food supplier forecasted beef costs would be between $2.40 and $2.45 a pound from September to December of 2021. At least as far as September is concerned, this did not come to pass and as it was $2.68 per pound in the quarter overall. Although, we have seen modest reduction in beef costs in the last two weeks, we now believe that commodity costs will remain elevated through the remainder of the year.

Restaurant labor expense increased 250 basis points as a percentage of restaurant sales in the third quarter of 2021 compared to the same quarter a year ago. Again, the dramatic contrast between the restrained operating environment we experienced in the third quarter of 2020 and the impact on labor cost of the economy reopening was unprecedented. On an absolute basis, labor costs increased $15 million or 12.1% from $126 million to $143 million. The imbalance between the supply and demand for workers required us to quickly increase hourly wages to remain competitive and operational with adequate staffing levels. While the base numbers of hours worked by team members were about even with the same period last year, the dollar impact of the higher average hourly wages increased our labor cost by $6 million in the quarter, paying team members premiums to take on additional responsibilities such as opening and closing our restaurants in overtime added $4.8 million to the overall increase in labor. The need for overtime hours for our assistant managers that were restricted last year in response to pandemic, along with salary increases for retention, cost us an additional $3.7 million in the quarter.

Other restaurant operating expenses increased 90 basis points due to a number of factors, including higher recruiting spend and other employee-related incentives, utility rate increases and rising insurance costs. We also installed Smart Safes in a majority of our Burger King locations that provide for faster cash collection and greater security, which also added to operating expenses. Restaurant rent expense in the third quarter decreased 30 basis points as a percentage of sales compared to the prior year period, primarily due to sales leverage.

General and administrative expenses fell to $19.2 million in the third quarter of 2021 from $20.4 million last year and declined 40 basis points to 4.6% of restaurant sales. The decrease in dollar terms was due to lower incentive compensation accruals this year, and was partially offset by higher regional administrative costs. Our net loss was $9.9 million in the third quarter of 2021 or $0.20 per ship per diluted share. On an adjusted basis, excluding certain non-operating items, third quarter adjusted net loss was $7.8 million or $0.16 per diluted share. In the prior year period, adjusted net income was $5.7 million or $0.09 per diluted share. Free cash flow for the quarter was the third quarter of 2021 was $13.5 million, compared to $23.8 million in the prior year period. The difference was primarily due to the reduction in adjusted EBITDA this year.

We ended the third quarter with cash and cash equivalents of $89.4 million and long-term debt, including the current portion and finance lease liabilities of $523.3 million. We had $47.1 million drawn on our $215 million revolving credit facility, and had $9 million of letters of credit issued under such facility. This left $158.9 million of unused availability under our credit facility, and when added to our cash balance, provided us with $248.3 million of liquidity at the end of the third quarter. We funded the special dividend -- special cash dividend of $24.9 million on October 5, 2021.

As a reminder, our ability to utilize our revolver capacity requires compliance with one senior secured leverage ratio, and is only in effect with more than 35% of the available capacities being used. At this point, we are below that threshold and have no maintenance covenant requirement. When in effect, we need to stay under 5.75x senior secured net debt to covenant EBITDA. Our senior secured ratio was at 1.24x at the end of the quarter, so we have considerable headroom to use our current available revolver capacity. Our total net debt compared to covenant EBITDA as defined in the senior credit facility stood at 4.03x at the end of the third quarter, in line with the ratio at the end of the third quarter of 2020. We did not repurchase any shares of our common stock during the third quarter.

We now believe that our net capital expenditures will be below our earlier $60 million target as construction delays have pushed some newbuilds and remodeling projects to next year. Our current 2021 capital expenditure forecast is $50 million and will include the remodel of 28 restaurants, half of which will be completed this year and the remainder in 2022. This plan includes nine Popeyes remodels that will mostly be completed next year. We are also building eight Burger King restaurants in 2021, of which six will go online this year. The $10 million reduction in 2021 spend will move into our 2022 capital expenditure plan. On the M&A front, we do not currently have any multi-restaurant transactions in the pipeline.

To conclude, while the near-term cost headwinds affecting our business are certainly clear, as we move into next year, we believe that we'll be able to clawback a portion of the margin erosion we are now experiencing. And we believe this will be achieved through menu price actions taken to date and in the future, combined with potentially easing cost pressures on a year-over-year basis, particularly in the back half of 2022. In the meantime, our liquidity is ample as is our ability to generate meaningful EBITDA.

And with that, operator, let's go ahead and open the lines for questions.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] Our first question comes from the line of Fred Whiteman with Wolf Research. Please proceed with your question.

Fred Whiteman

Hey guys. I just wanted to follow-up on sort of the margin outlook here and I understand that there's inherent degree of unpredictability here. But when you guys are talking about clawing back a portion of the margin loss in the back half of next year, how should we think about sort of the structural revisions to the margin performance of the business going forward?

Tony Hull

I think it's going to be a combination -- first of all, we totally agree with -- it's unpredictable. But we know the menu price increases that we put in place today and how they'll carry over to next year. We plan on doing at least one early year menu price increase next year. So in terms of margins, that will be helpful to margins. The traffic is -- the traffic direction is kind of almost out of our hands because it's really reliant on some RBI activities. But we feel good about the menu price increases, and that they're holding that -- they're not affecting traffic at this day. And then, I just don't -- we don't see the kind of hourly wage; there will be -- there will likely be hourly wage increase next year and certainly in the back half, but we don't believe it could possibly be as strong as we -- as high as it's been this year, given that it's -- we probably got three or four years of wage increases in one quarter of this year. So, you know, our view is it's unlikely that it will be that dramatic next year; so we'll get some sales leverage based on that.

So that's -- again, it's totally unpredictable. We don't -- we have no idea what the labor situation will be like a year from now, but it just seems reasonable. And then, the other thing is we're seeing stabilization in commodity costs. And even though we think that the labor -- the production and distribution aspects of our commodities will not see a lot of relief, you could see some raw materials relief next year. So that could mean that the cost of sales are going up less robustly than they did in the third quarter this year.

Fred Whiteman

Makes sense. And if we just think about the October trends that you touched on, it looks like the two-year trend decelerated versus what you guys did in the third quarter. So, could you sort of touch on what you're seeing on the top line and when we should sort of expect that to get moving in the right direction again?

Tony Hull

We saw 5% in October, and it was -- it consisted of -- average ticket was up in the low single -- low teens and traffic was down consistent with what was down in the third quarter, about 5%, 6%; so that's what we're seeing. I think the big driver -- we probably think that's -- the price is probably good -- the price aspect of it is probably good through the quarter. But again, the traffic piece is a little bit uncertain.

Fred Whiteman

Great. Thanks, guys.

Operator

Thank you. Our next question comes from the line of James Rutherford with Stephens Inc. Please proceed with your question.

James Rutherford

Great. Thanks very much. Dan, congrats on the announced retirement on a very incredible career in the industry, I know we have you for another six months or so, but we'll certainly miss you on these calls once that transition happens. So, congratulations.

Dan Accordino

I still have another call, anyway.

James Rutherford

Sorry, what was that?

Dan Accordino

I said I'll still have another call anyway.

James Rutherford

Yes. But we're glad; we're certainly glad. I want to start from the staffing levels versus 2019 levels. I'm curious how those trended through the quarter? And as a second part to that question, do you think the wage increases that you've put in place are sufficient to make your stores competitive enough? Or do you expect to need to increase wages again at any meaningful level in the fourth quarter to get those staff levels back to 2019 levels?

Dan Accordino

The staffing levels through the quarter actually were pretty consistent. We're ending up with a fair number of applications. The application flow has picked up in the past month. The challenge continues to be with retention. I think the core average hourly rate is fine. Where we're seeing the biggest part of the inflation in labor is we're paying premium wages to keep the stores open past 9 o'clock at night; that's where we seem to be struggling the most, and that's true for the whole industry. We really don't want our restaurants to close prior to 11 o'clock and 12 o'clock at night, and consequently, rather than increase the base wage, we pay a premium wage of $0.50 or $1 to get employees to work beyond that period of time. So in terms of a percent increase in wages in 2022, my sense is it should be much more -- it will be much less of an increase than what we're experiencing currently.

James Rutherford

Okay. And Tony, was that 13.3% wage growth inclusive of the overtime and shift premiums? Or is that additional to that?

Tony Hull

No. It was just the base wage.

James Rutherford

Okay, that's just the base wage. Thank you. And then, just one more question for me and I'll turn it back to the queue. But can you give a sense of how menu price trended throughout the quarter? I don't know if you want to give it necessarily by month or whatever, but with the different increases put in place? And overall, where are you running today with the 80 bps you added in October?

Tony Hull

It went up during the quarter because the first increase was at the end of July, and that was on the backs of March -- late March increase to 2%. And then we did one -- a pretty sizable one in August. So, I think it ended up for the quarter being about 5% plus or minus of the check increase was due to menu price increases. And right now, we're sitting at about 7.5% from menu price increases.

James Rutherford

Okay. And then there's also, I think, a little bit less discounting in there as well which is not included in the 7.5%; is that a fair way to think about total sort of net check?

Tony Hull

Yes. It's pretty significant, James. It's not a small -- I mean, we're -- our discounting is like 300 basis points to 400 basis points less this year this quarter than it was the year ago period. So, it's just an interesting trend that we're seeing that; A) we're raising the prices on some of the promotional items and it's sticking, and there are fewer guests who are sort of spending very few dollars in the restaurant, the more the guests are spending more which helped drive the average ticket price up and reduce the promos and discounts.

James Rutherford

Certainly, it's a very interesting dynamic. Okay, thanks for the help.

Operator

Thank you. Our next question comes from the line of Jake Bartlett with Truist Securities. Please proceed with your question.

Jake Bartlett

Great, thank you. Thanks for the question. And Dan, congratulations on a long and fruitful career, it's been great working with you over these years. I -- my first question was just on the sales trajectory. And I know that RBI has communicated a plan to really take a look at the strategy, work with franchisees, communicate that strategy and then put it into place in 2022 to try to regain market share. But the question is, in the meantime, how confident are you that there's some measures in place or strategies in place to really start to move the needle in the near term? So, rather than waiting for the long-term strategy shift or approach, how confident are you that in the near term that Burger King can regain some of this market share that it's been leasing [ph]?

Dan Accordino

I think it's going to be a challenge for the next six months. The marketing plan for the balance of this year, we know what it is, and it was pretty much put in place some while ago. The new plan and the new strategy will be provided to the franchise community at their -- at the convention in December, but it will take a while for that to take effect and implement. So, I think the market share challenges will continue for at least until the mid-part of 2022, Jake.

Jake Bartlett

Got it. Okay, that's helpful. And then, the -- the less discounting, I believe maybe through less paper couponing seems good support for margins probably impacting sales a bit. But as you shift over to the digital channel, is there an interim period where you have -- we have less of the paper coupons but don't have the digital channel quite up to speed because it hasn't been -- loyalty hasn't been launched in story yet. So the question is, once that does happen, would we just expect the discounting to kind of go back to a more normal level just in the form of -- on the digital channel? Or do you think that there's a kind of a real permanent shift here in less discounting for the brand?

Dan Accordino

Well, it's not just the couponing and the digital; there's been changes in the menu. I mean we had the dollar menu on the value items, those caps were all lifted. So we're charging more now for those items on a regular basis. And a year ago, we had a two for five as opposed to currently we're running at two for six and two for ten kind of things. So I think those changes are probably more relevant than whatever is going on with the couponing, Jake.

Tony Hull

And more sustainable.

Jake Bartlett

Got it. Great. And then the last question is, is really on free cash flow. Tony, maybe if you can just remind us if there's anything lumpy in terms of payment ins and outs in working capital, just so we can kind of make sure we understand that? And then, as we look to 2022 for CapEx; some of the CapEx has been -- you mentioned pushed into '22. Any indication on whether you'd expect to maybe open fewer stores than previously planned, given the environment and the cost pressures? Or also, whether there's -- how likely it is that there is going to be a capital kind of requirement from whatever measure Burger King puts in place to turn sales around? Any indication on what 2022 CapEx could be? And then, just making sure we know the ins and outs on working capital for free cash flow?

Dan Accordino

I'll deal with the CapEx and Tony can deal with the working capital. In terms of opening restaurants in 2022, my sense, Jake, is that we've got some that are already in the works and they'll open in the first part of next year. Beyond that, my guess is, it's probably going to be later in the year simply because we're having problems getting the equipment and so forth. There's about a 3.5, 4-month lead time now to get kitchen equipment. So even if we wanted to open the restaurant, they would be -- it's going to occur later in the year. So I think new store development could be less next year than what we had originally planned. Remodeling, again, we've got some carryovers on remodels, we've got some that we hope to get completed by the first part of next year. And then we'll see again what the supply chain looks like in terms of our ability to get the equipment. In terms of both equipment mandates for both, Burger King and Popeyes, there are -- the digital menu board rollout will be completed by second quarter of 2022 in both brands and the required kitchen equipment for Burger King will be in place by the end of Q1. It's already been ordered and the required kitchen equipment for Popeyes will be in the second half of 2022, again, because of supply constraints.

Jake Bartlett

Got it. And then, Tony, I would just -- the question on the working capital. But again, in terms of the equipment for the Burger King and the Popeyes, is that a significant investment to boost up -- should we expect that to boost the '22 CapEx significantly?

Tony Hull

I don't think it's going to boost the '22 CapEx significantly. The -- the major CapEx dollars are remodels and whatever new construction we may do. So that will be, as I said, that's going to be somewhat fluid based upon the -- our ability to get the supplies to open and remodel restaurants. The CapEx requirements for both, Popeyes and Burger King, are relatively small percentage of our overall CapEx budget.

Jake Bartlett

Great.

Dan Accordino

Yes, and they're lapping what we did this year. So, it shouldn't change that much. you know, I'd say the couple of things that are impacting working capital this year are -- first of all, we have to repay $10 million plus of the FICA deferment that we received in 2020, that's half of the total; so that will hit on December 31. And then, so that's a bad guide to working capital. A good guide -- the biggest good guide to working capital is our interest on our interest expense, our cash outflow for interest expense is going to be a lot less than last year because the interest on the bonds actually is payable in the first couple of days of next year, first -- actually the first day of our calendar -- our fiscal 2022. So, it will be a benefit to cash flow this year. And then, the payment we have -- the second payment we have in 2022 will actually also be paid in the first day or so of 2023. So, just -- that's sort of a new thing now that we have the bonds outstanding.

Jake Bartlett

Great. Thanks a lot. Appreciate it.

Operator

Thank you. Our next question comes from the line of Jeremy Hamblin with Craig-Hallum Capital Group. Please proceed with your question.

Jeremy Hamblin

Thanks. And I'll add my congratulations to you, Dan. It's been a pleasure working with you. And again, you're demonstrating some pretty impressive execution in a really tough environment. I wanted to -- Tony, just start actually with the commodity cost; beef price. I think that the math on that was $2.67 a pound in Q3. I wanted to get an update on where things have kind of trended here to start Q4? And also, I know some of the other commodity costs, whether protein costs, whether it's chicken or pork have also remained elevated. How has that trended here in Q4 and kind of your expectations over the next several months?

Tony Hull

I would say that the general view on commodities right now is that they have stabilized, and we're seeing a little bit of recovery there, a little bit of decline, not huge declines. But the current price for beef is a little bit above the average for the third quarter, and it's heading in a good direction, but really slowly. And I'd say the same with all the other -- I'd say the same with all the other commodities. They seem to have plateaued and they're slowly -- pork is slowly coming down, chicken is slowly coming down. So, some of the French fries are steady, but seems to be coming down, we have hedges in for some bakery items and from some other items; so, we don't have it but RSI, our food distributor does. So, I'd say holding steady and maybe starting to definitely stabilize but maybe some starting to see some light at the end of the tunnel and that coming down a little bit, but not a lot. I mean the inflation in the fourth quarter just because of the comparison to really low commodity costs in the fourth quarter of last year is going to probably be in the low to mid-single teens. So, it's still a headwind versus last year. So, it's going to -- and it's probably going to be the biggest headwind in the fourth quarter that we've seen all year, mostly because the base was so low last year.

Jeremy Hamblin

So cost of sales probably trends up slightly from the run rate that you saw in Q3; is that a fair assumption?

Tony Hull

I think it might be a little bit, yes. But I think it might be steady because of leverage, sales leverage and lower promotions and stuff like that.

Dan Accordino

We've got a lot more pricing.

Tony Hull

Yes, we've got a lot more pricing on that.

Jeremy Hamblin

Okay.

Tony Hull

So, actually I think the net of it is, it may be -- it may be a little favorable to Q3 just because of the leverage.

Jeremy Hamblin

Okay, got it. And then, again, kind of extraordinary environment here on labor. As we look out, typically you have -- well, you have some days in Q4 around the holiday period that your staff and are kind of lower volume labor. Presumably, it sounds like you're getting people in -- or there's an improvement in terms of having staff there. But is the near-term expectation that labor costs are going to continue to be a challenge despite the kind of menu pricing offsetting some of that impact?

Tony Hull

Again, I think for the balance of this year, I think we're in pretty good shape, Jeremy, because things have stabilized recently. Starting with next year, there's a few states that have some minimum wage movement. But generally the minimum wage just doesn't have much effect on us at all because we're paying more than that currently. So, I really -- I think, again, there may be some movement next year but it's not going to be anywhere near the magnitude of what we're currently experiencing.

Dan Accordino

I think the one other thing we're starting to take a really hard look at that because -- just because it's -- we just -- we're able to catch our breath after what happened in the third quarter, is we're really looking restaurant by restaurant ad is staying open till 11 o'clock profitable. And if we find -- because the labor costs are where they are, and a year ago and two years ago, it was kind of a no-brainer on that, but now we're doing analytics and it's not really -- it's not any -- like AI special Swiss Bank [ph] stuff, but we're starting to look at -- it doesn't make sense to close a 10 o'clock instead of 11 o'clock because the traffic we saw over the last six weeks in that last hour was not worth staying over -- staying open, given the labor costs. So, I think that's something -- if we don't get it going in the fourth quarter, we'll definitely start being a little -- much more diligent about that in the first quarter. And the same goes for the -- it doesn't make sense to open at 6:00 A.M. versus 7:00 A.M. in the morning. So we're just taking a lot harder to look at that than I think has been in the past. I haven't been there that long but it seems like it's just -- it's -- given where the wage has gone, it's kind of front and center for us to optimize things a little more than we've had to do in the past on that front, just because it's more of a question than it was in the past; before it was kind of a no-brainer to stay open.

So, I think that will have -- the other point I want to make, Jeremy, is that we're going to start lapping -- the only two quarters left where the labor is probably going to be a big increase versus the prior year is the fourth quarter and the first quarter of next year. When we get to -- we started to see the labor issues in the second quarter of this year; so we're going to start lapping that next year. So it should be less of a headwind -- it still will be a headwind but less of a headwind than we certainly saw in several quarters this year.

Jeremy Hamblin

Understood. Last one for me is, you know, you continue to see underperformance in that South Central region. I know the Southeast also did not perform as strongly. Is there anything that you're seeing -- I don't know how that necessarily compares versus the industry. I know that it's been a frustration here for a couple of years now because they've been stubborn in terms of performance, although you guys have really improved the full [ph] margins. Is there any thought to -- have you ever thought about maybe monetizing those assets? Moving out of that region? Or are there other things you think that can be done to kind of stimulate the productivity of those underperforming areas?

Dan Accordino

Yes. The South Central is primarily the Cambridge restaurants. And actually, they've turned around, we're actually positive now in Cambridge, and we're positive on a two-year basis. So, we did what we said we would do. We said it would take us two years to get this from a sales standpoint, the margins we got much more quickly than that. So, we're making progress there with those restaurants. And because we have a lower labor rate there, I think we'll be -- I think we're making -- we're heading in the right direction. Right now, the struggle is in the Carolinas. We are negative all across North and South Carolina, and we had a call yesterday with Burger King, and they say that's true for the balance of their restaurants in those markets. And we're trying to drilldown specifically, Jeremy, to see if there's a particular reason why it's every aspect of the Carolinas; we're negative in GSA, we're negative in Charlotte, we're negative in Greensboro [ph], and I don't really have -- those are legacy stores, those aren't new restaurants, and they operate well, and we're trying to determine where the market share is going. And Burger King did not have an answer for us when we asked that question, but we're doing some more analytics on that to see if we can determine specifically if there's a day-part across the region that's creating the challenge. But that's really where -- I'm most concerned about that right now.

Jeremy Hamblin

Well, hopefully, the parent can help contribute positively to cause [ph] here in the coming months. Thanks for taking my questions, guys. Best wishes.

Dan Accordino

Thank you, Jeremy.

Operator

Thank you. Our next question comes from the line of William Reuter with Bank of America. Please proceed with your question.

William Reuter

Good morning. So after the 0.8% [ph] price increase in October, I think that we have nothing for the remainder of this year and that you're planning one in early fiscal year '22. Do you have a sense of the magnitude of the fiscal year '22 price increase you'll implement?

Dan Accordino

The one that we will be implementing will be at a 2% to 2.5% kind of number, which will essentially mirror the increase that we had in March of 2021.

William Reuter

Okay. And that's helpful. And then with regards to your increased labor costs, is there a component of this that's being driven by overtime? I guess I'm trying to figure out if there's some way to adjust the increase in labor and try and figure out if you're not paying some of that, how much your actual wages would be increasing?

Dan Accordino

Yes, the overtime piece for the team players was not that significant. And so, we think if the world goes -- it could stay that way till next year, could we still -- we could be required to pay overtime next year because we can't get the staffing up. Alternatively, we can get the staffing up, pay less overtime, but we're paying for more bodies; so it kind of would be a wash either way. So I think that's -- I think that's -- that cost base is going to be with us for a while, regardless of whether it's coming through overtime or more team members. If that -- if the world let's us hire more team members right now, it doesn't seem like we're going to be able to go over the 20 team members per store in any time in the near future. So, it will probably look the same a year from now on that front. And then, the overtime for managers was just a reinstatement of overtime they had pre-COVID. So there may be some ability to cut that back in the future. But generally speaking, it's kind of getting back to pre-COVID levels.

Tony Hull

Our assistant managers are paid hourly, and they have a 50-hour work week. During COVID because of all the challenges and the restricted hours and all the rest of that, we moved all of our assistant managers back to a 40-hour work week. And consequently, they received less income, and they didn't obviously -- we didn't have any management overtime. So that was reinstated in the third quarter of 2020, and we just lapped that. So...

William Reuter

Okay. And then, just finally for me, you mentioned that most of your wages or a lot of your wages are above state minimums; so it's not going to impact sort of rising, minimums won't hurt you that much. I guess looking back at history, if we were to see a dramatic change in terms of the labor environment where the pool grew, is there any precedent for wages going down or do you think the wages can only go up?

Dan Accordino

I think it depends geographically. I think there may be some markets where in fact, we will be hiring newer employees at a lower rate than what we're currently paying. And there are other places like the New York State, where I mean the minimum for fast food workers is $15, and that's the way it's going to be. So, I think in the South Central market, in Tennessee, Alabama, Kentucky, South Carolina; I think there may be an opportunity in the future to actually have new employees come in at a lower rate.

Tony Hull

It's the only benefit of high turnover -- high turnover staff. You can potentially rollback some of the stuff with kind of turnover we see at the team level.

William Reuter

Great. Good to hear. All right, that's all for me. Thank you.

Operator

Thank you. Our next question comes from the line of Michael Kopla [ph] with JPMorgan. Please proceed with your question.

Unidentified Analyst

Hi, good morning, and thank you for taking our questions. You know, we saw that you guys were planning to use free cash flow to reduce debt. I was curious if there is any sort of magnitude or goal that you had in mind for that outside of the working capital and free cash flow priorities that you've mentioned earlier?

Dan Accordino

I mean, two things to -- just to clarify, at this point, we have a $220 million swap; so our senior secured debt is until we -- until and if we change that swap, it's -- we're required to stay at $220 million and then we have $300 million of notes, obviously. So, we sort of have $520 million of debt, and it's not really repayable at this time. We said in our comments that we reduced net indebtedness, which means we'll build cash to reduce our net debt. So, yes, to the extent we generate free cash flow and don't have other extraordinary uses of below free cash flow, which we did have this year; we used the money to reduce our net indebtedness. But again, our target is to stay at 4x leverage or less. And obviously, we're right at the 4x this quarter, and it's not because of the numerator, it's because of the denominator -- just because EBITDA was down versus last year on a trailing 12-month basis. So, that's really what's -- what drove us back to 4x.

Unidentified Analyst

Great, thank you.

Operator

Thank you. Ladies and gentlemen, that concludes our question-and-answer session. I'll turn the floor back to management for any final comments.

Tony Hull

Thank you all for joining us on this call, and we look forward to speaking further with those who would like to speak to us. We have a number of conferences we're attending, either in person or virtually over the next 1.5 months or so. And hopefully, we'll meet a lot of you in person or virtually.

Thanks very much, and we'll talk to you in the next conference call in early next year. Thank you. Bye-bye.

Operator

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

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