EAT – CAN’T HAPPEN FAST ENOUGH!

Conclusion: Margins improved during the quarter, but sales continue to lag the industry.  We will have to wait and see what happens at Chili’s, but management appears to be doing all of the right things and given its upcoming initiatives and quarterly sales comparisons, there is visibility of a turnaround in top-line come fiscal 3Q11.

 

My original thesis around wanting to own this name has not changed; the company is working to fix its business model, which will result in significant margin expansion.  What has changed is the timing around when sales growth will start to materialize, and following the company’s fiscal 4Q10 earnings, I said we were possibly 9 months away from seeing a real turn in the fundamentals.  I think that timing continues to hold true as comps should begin to improve come fiscal 3Q11 when the company is no longer lapping last year’s “3 Courses for $20” promotion.

 

REPORTED MARGIN GROWTH


Margin growth already started to materialize during the first quarter with restaurant-level margins improving nearly 190 bps and EBIT margins up about 240 bps.  Improved cost of sales was the primary driver of margin growth in the quarter, down about 200 bps YOY as a percentage of sales.  Management attributed the decline in cost of sales to its more profitable value offerings (2 for $20 this year versus 3 for $20 last year), menu pricing and lower YOY commodity costs, which drove 70 bps of the 200 bp decline. 

 

The company guided to a similar level of COGS as a percentage of sales for the balance of the year, which would imply a nearly 200 bp full-year decline.  During the second quarter, this YOY benefit should continue to be driven by favorable commodity costs, which are 90% contracted.  Going forward, the company expects food costs to put increased pressure on margins as a result of higher beef costs (only 52% contracted on food costs in 2H11).  These increased food costs, however, should be offset by improvements in the company’s inventory control and actual versus theoretical costs as the company expects to fully implement its POS and back-of-the-house technology in 3Q11.


First quarter margins were also supported by the company’s team service initiative, which was already in place during the quarter.  Labor costs were relatively flat YOY as a percentage of sales as result of sales deleverage and increased manager bonuses, which offset the labor costs savings associated with team service.  Management expects the P&L to continue to benefit from team service savings, in addition to sales leverage in the back half of the year; though the company will continue to invest in manager bonuses if sales trends continue to improve YOY.


ACCELERATING THE ROAD TO 500 BP MARGIN GROWTH (NET 400 BPS)


The company has already completed five kitchen retrofits domestically and two internationally, which have resulted in increased speed and consistency of food with better labor utilization.  For reference, the completed kitchen retrofits are expected to drive 300 bps of the 500 bp margin increase.  The test results have been so successful that the company has decided to accelerate the rollout of its changes to the prep process.  These changes are expected to optimize the labor component of prep and maximize food prep yield, which will benefit both the labor and COGS expense lines once fully implemented in January (beginning of fiscal 3Q11). 

 

The company expects to begin the rollout of its reimage program during the fourth quarter as long as test results prove favorable.  The priority of the reimages will be to further drive sales and will follow the implementation of team service, POS and the total kitchen transformation.

 

DOING THE RIGHT THINGS, BUT SALES CONTINUE TO LAG


Brinker is fixing its business model and transforming its cost structure at Chili’s while working to improve its guest experience and yet, the stock is trading down over 7.0% today.  The company needs to see a turn in sales performance at Chili’s before investors will be convinced that the stated initiatives are working.  Margins are improving already, but in this environment, investors need to see solid top-line trends and unlike most of its casual dining peers that have reported before it, Brinker reported a comp miss relative to street expectations.  And, trends at Chili’s continue to lag the casual dining industry.

 

Same-store sales at Chili’s declined 5.0% relative to the street’s -4.1% estimate.  That being said, trends improved nearly 130 bps on a two-year average basis from the prior quarter and got better sequentially throughout the quarter.  Adjusting for the one week calendar shift that resulted from the fact that fiscal 2010 was a 53-week year relative to 52 weeks in fiscal 2011, blended comparable sales were -5.8% in July, -5.2% in August and -0.8% in September.  This compares to -8.8% in July of last year, -3.1% in August 2009 and -5.4% in September 2009, which implies a 420 bp acceleration in two-year average trends from July to September.  It is important to remember that the company first introduced its “3 Courses for $20” at Chili's in mid-July of last year after starting out the month with a double-digit decline in comps, continued the promotion into August and then was off of it in September.  To that end, the company saw its best comp growth during September when it was no longer lapping “3C”. 

 

Chili’s ran its “3C” promotion for six weeks in fiscal 1Q10 and about 10 weeks in fiscal 2Q10 (I included the chart of Chili’s comp performance from 4Q09 through 1Q11 as a reference of the concept’s comparisons for the remainder of the year).   With Chili’s continuing to lap last year’s strong promotional calendar during fiscal 2Q11, trends should remain sluggish, but like we saw in September, trends should see an uptick come 3Q11 when the company is lapping more comparable promotional offerings.  Trends should also improve as guest service continues to improve once the increased speed and consistency initiatives (resulting from the improved prep process) are fully implemented in January.

 

EAT – CAN’T HAPPEN FAST ENOUGH! - EAT SSS

 

Howard Penney

Managing Director


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