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The theme coming out a recent visit to the Oklahoma City market (the first remodeled market) with senior management: money motivates!

Earlier this week, I visited EAT’s Oklahoma City market with senior management.  This is the first market in which the company has remodeled its stores, reflecting its enhanced image.  They have currently reimaged 16 stores and they appear to be hitting the company’s hurdle rates for return on investment.  The best way to describe how the company is thinking about the remodels is that they don’t want to simply “preserve the status quo.” 

The upgrades are designed to make the brand more contemporary and relevant, while maintaining the Chili’s flavor profile.  The reimaged look fits with where the concept is going with its menus and new lunch combo program.  As management stated to me, they are losing some “clown” aspects of the old look.  They are going to remodel the Florida and California markets next.  If they can prove out the recent success in Oklahoma City in both of those markets, the company will likely aggressively roll out this remodel program to additional markets, and therefore, we should begin to see a benefit to overall company results as we exit fiscal 2011 and head into fiscal 2012.

After meeting with both senior management and store-level managers, I would say the most prevalent theme coming out of the trip was money motivates.  Saying that money motivates is not a big surprise, but it is more surprising that margins are the motivating force of the Brinker turnaround story.  Momentum begets momentum and I get the sense that we are only in the beginning stages of that at Chili’s.

While margin improvements are obviously important for the “stock” and company profitability, driving these improvements is also having a motivating force on the Chili’s employee base.  For the past two quarters, store managers are seeing bigger pay checks from improved margins and are now starting to see the benefits of the company’s initiatives.  The store managers with whom we met now want more and are looking forward to keeping the momentum going.

I understand that there are critics of the EAT margin improvement story.  Margin improvement stories are rarely sustainable and can compromise the guest experience.  The changes that EAT is making, however, will actually enhance the guest experience once completed.  The company has already reported increased guest satisfaction scores, largely in response to its Team Service initiative implemented nearly eight months ago.  At the same time, this initiative has resulted in lower labor costs while enabling servers to earn more money per hour and has already delivered 100 bps of margin growth.

There are not many companies that have used the economic downturn as motivation to get better or make changes that are sustainable and will allow them to be better competitors.  Listening to the Starbucks annual meeting yesterday, it was evident that they used their internal and external challenges to change how the customer uses the brand. 

Right now, EAT is playing from a position strength, as operational changes are improving profitability right when the company needs it most.  The margin improvement and cost savings initiatives are allowing the company to take a wait and see approach to pricing.  EAT can hold off on raising pricing, while the competition is forced to raise prices in an uncertain time for the consumer.  The news reported earlier of a customer pulling an air gun on a Taco bell employee over the price increase of a burrito is an example, though extreme, of how price-sensitive the consumer really is.

As I see it now, the EAT turnaround plan is progressing slightly better than management talked about at its analyst meeting last year; though the comprehensive program is rolling out quite differently than initially anticipated.  The remodels are taking, on average, three weeks to complete, while the kitchen makeover can be done overnight. 

  1. Team service is fully implemented and is benefiting margins and employee morale
  2. The food prep portion of the kitchen retrofit program was rolled out earlier than initially expected at the end of fiscal 2Q11 and is now fully implemented, but fiscal 4Q11 will be the first quarter to report the full margin benefit
  3. The benefit of the kitchen technology is showing a real improvement to margins, but the rollout is slower due to some changes in specs and recipes to allow the food to be cooked properly in the ovens. 

My sense is that the new lunch menu is having a significant impact on the lunch business, which was one of the hardest hit dayparts over the past three years.  While at lunch at Chili’s earlier this week, I did notice many tables of women that ordered the soup and a half sandwich.  If you order off the lunch combo menu, you can get lunch at Chili’s (including tip) for around $8. 

My main takeaway after the day of visiting remodeled stores is that the momentum is just getting started at Chili’s.  As I wrote in the Chili’s Black Book of April 2010 “Beyond the next two quarters, it seems margins will go higher even without Chili’s gaining meaningful market share.  We expect that, as consumers adjust to the changes made at Chili’s and as industry sales continue to improve, comps will turn positive at Chili’s.  Same-store sales seem to be on track to recover at the same time margins are headed higher – beginning in FY11. Again, I think the margin story will materialize without a significant tick up in trends.  I am modeling a nearly 1% comp increase at Chili’s for FY11, with all of the growth coming in the back half of the year.  That being said, as better sale sand margin trends both become clear to the market, the stock should be trading closer to $24.”

While there were a few bumps in the road relative to the timing around a sales recovery, the company has made significant progress in improving profitability in a very difficult environment.  To that end, I would expect the company to continue to report improved margins in fiscal 2H11, along with the beginning signs of a real turnaround in comp growth at Chili’s.  The lapping of last year’s 3C promotion early in fiscal 3Q11, combined with the company’s new expanded daypart initiatives at lunch and happy hour, should translate into positive same-store sales growth at Chili’s during the third and fourth quarters (after 10 quarters of reported declines).  With the momentum I’m seeing now, the company could get close to earnings of $2.00 per share (or close to it) in fiscal 2012, which implies a mid $30’s stock in the next 12-18 months.

Howard Penney

Managing Director

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