EAT - A BADGE OF HONOR

Conclusion: I walked away from a recent meeting with management with a very clear impression that things are mending and the consensus is taking the “wait and see” approach.   

As measured by our Casual Dining sentiment monitor, EAT is at the bottom of the pack.  As I told this to Brinker’s CFO, Guy Constant, I noted that all the great concepts in the restaurant space have been there at one time or another: MCD, SBUX, WEN and DRI to name a few.

His response was that the sentiment around Brinker’s stock is like a “badge of honor.”  I thought this was a positive indication, given the context, of how this CFO thinks.

A major component of the EAT thesis I outlined in my Black Book earlier this year was the company’s focus on operations with the aim of expanding margins and improving the guest experience.  Soft sales trends in recent quarters are adding a sense of urgency to improve both the front and back of the house from an operational perspective.  The 187 bps improvement in restaurant level operating margins in the past quarter was evidence that those efforts are taking hold.

The Street’s wait-and-see approach is clearly focused on the top line.  There is some evidence of improvement in September, with Chili’s same-store sales declining only 0.8% when adjusting for the one week calendar shift that resulted from the fact that fiscal 2010 was a 53-week year relative to 52 weeks is fiscal 2011.  The real evidence will be seen when we turn the calendar and begin to focus on the second half of Brinker’s fiscal year 2011.

As we head into 2HFY11, an acceleration of the sales will be evident for the following reasons:

(1)    Chili’s is lapping the introduction of menu changes that caused sales to decline last year

(2)    “2 for $20” is to become permanent menu item; this will be incremental to sales in 2HFY11

(3)    In January, Chili’s will be rolling out a new lunch menu focused on gaining traction in a day part that has been challenging for the company.

By the time sales trends start to improve (3Q of FY11), management expects to have fully implemented the margin initiatives across the entire Chili’s system.  The prospect of a combination of improved sales flowing through a more streamlined restaurant suggests that Brinker should begin to enjoy positive sales trends in conjunction with positive operating margin growth.  On a quarterly basis, I track the operating status of companies depending on their sales and margin growth and divide the space into four quadrants.  The top right of the chart – what I call “Nirvana” – is where I see Brinker in 2HFY11.  As an aside, my last examination of the “Nirvana” group indicated that, on average, companies operating at that level trade at approximately 9.5x NTM EV/EBITDA. 

Currently trading at 6.1x EV/EBITDA, EAT is trading at a multiple just slightly above RRGB at 5.9x.  The difference between the companies, and their respective prospects, couldn’t be any more clear.  RRGB’s management team has no control over their business trends.  Additionally, EAT is trading at a discount (on an NTM EV/EBITDA basis) to RUTH, CPKI, MRT and RT, all of which lack the size, scale, and brand presence that Chili’s has.  The strength of Brinker’s balance sheet and their cash flow generation are two other strong differentiators.  I am not surprised that Brinker’s CFO relished the company’s lowly standing in the sentiment stakes; he knows that the only way is straight up.

EAT - A BADGE OF HONOR - eatsent

EAT - A BADGE OF HONOR - eat matrix

Howard Penney

Managing Director