EAT - MOMENTUM IS AN IMPORTANT FORCE

Here is a run through of our thoughts on Brinker heading into the release of the company’s 4QFY11 earnings results. 

Brinker continues to be one of our favorite names in casual dining on the long side.  Knapp Track trends have been robust lately and, given the size of its system, we think Chili’s – especially given the slowing of Applebee’s comps quarter-to-quarter – could be driving that strength.  Below, we discuss the forward looking statements from Brinker’s most recent earnings call.

THE BIG MACRO

“I've said it before, but let me reiterate, the financial health of the company is strong, the business model continues to improve, providing flexibility to invest in the business and return value to shareholders through dividends and share repurchase. There's still much work to do to achieve our goal of doubling EPS in five years, but we feel very good about the progress made thus far.”

HEDGEYE: This statement epitomizes the overall tone of the earnings call on April 27th.  Management seemed very confident about the progress it is making in its goal of turning the company around.

“And while, historically, rising gas prices have not had a significant impact on the casual dining industry, we would be in uncharted waters if its prices significantly eclipsed the levels last seen in the summer of 2008, particularly in the light of the slow economic recovery. There's no historical precedent to indicate how we or the industry as a whole might react, so we must ensure our operating model as a whole is sustainable in a variety of conditions by giving the guests better service, better food quality while still delivering our net 400 basis points of margin improvement we promised.”

HEDGEYE: I remember thinking at the time this was a shot across the bow of RT.  Nevertheless, I think positive comp sales that started in February and March (including positive traffic) have sequentially improved throughout the 4th and Chili’s can post SSS of 1-2%.  That would imply that Chili’s could see as much as 150bps sequential improvement in SSS

“As we said last quarter, we are currently targeting three key dayparts, early week lunch, dinner and the Happy Hour, primarily 3:00 to 6:00 p.m. and after 9:00 p.m. Monday through Friday.”

HEDGEYE: We know now that Applebee’s sales trends slowed quarter to quarter.  In part it could be due to the success of Chili’s continued focus the three day parts.

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“It is because of the threat of things like a slow economic recovery and inflationary pressures that you do want us working on the strategies we've discussed. These initiatives are geared towards improving our basic financial fundamentals, enhancing value in our menus while delivering a superior customer experience.

HEDGEYE: The only way Brinker can offset any downside in the macro environment is by “improving our basic financial fundamentals.”  If you contrast this to last week’s note on PFCB, the two companies’ approaches to turning around the respective concepts are starkly different.  PFCB’s approach is expense-focused whereas EAT is more focused on cost-cutting.

“And at Maggiano's we continue our impressive sales trends with 3.4% sales growth. That's our fifth consecutive quarter of positive comp sales growth at Maggiano's. And 3.3% increase in guest counts, sixth consecutive quarter of traffic growth.

HEDGEYE: The performance of Maggiano’s is a tailwind for the overall performance of the company.

 

4Q11 GUIDANCE

“While we typically would not outline our projections if they were not materially different than our annual guidance (which contributed to approximately $0.09 to the prior year's EPS), we recognize that it is harder to forecast when we're lacking a 53rd week in the prior year, particularly in this coming quarter, when the extra week occurred a year ago. Thus, we would outline that our expectations for fourth quarter EPS would fall between $0.43 and $0.47.”

“We also expect headwinds on our commodities to increase from trends seen thus far in the fiscal year, including some pressure on the cost of sales line.”

"Predicated on the continued solid performance of the company, I would anticipate incentive compensation in both labor and G&A would continue to be higher than the prior year."

“I'd like to remind you that Macaroni Grill transition service agreement has concluded in the third-quarter.”

“We will continue to assess the impact that inflationary pressures in the economy and competitive activity might have on the consumer, as we thoughtfully consider our pricing decisions and strategies going forward.”

"The net result or our strong P&L that we've got now gives us the flexibility to determine whether there's an opportunity for us to move some share by not taking price. If that opportunity doesn't present itself, then we of course could take price like everybody else. But we would like to see what happens competitively before we make that decision.”

HEDGEYE: Consistent with other companies in the industry, I would expect to see management raise prices modestly this quarter.

“We didn't provide a comp assumption, but you'll recall that overall we expected Brinker aggregate sales to be flat to down 2% for the year, and we still expect to be within that range. And it's underlying that implies it – that we expect it to be flat to positive in the back half of the year, and we got there in the third quarter, and we would expect that to continue in the fourth quarter.”

HEDGEYE: As we’ve said before, we continue to believe that Chili’s is now taking share in the casual dining space.

 

MARGIN TRENDS

“With respect to commodities, we are approximately 92% contracted through the end of the fiscal year. Provided this visibility, we expect to be slightly unfavorable as we move into the fourth quarter. We are 54% contracted through the end of calendar year 2011, and anticipate about 100 basis points impact to cost of sales due to inflation in our commodity basket for fiscal 2012 as a whole based on our existing contracts and our forecasts.”

HEDGEYE: Looking for more detailed guidance this week, but there is little chance that there is going to be an upside surprise here.

“Solid margin improvement continues with 160 basis points increase in operating margins, thanks in part to the robust top line, coupled with a menu restructure Maggiano's put in place last fall when we launched the Classic Pasta program.  Maggiano's continues to pull off the simultaneous feat of driving compelling value, but also achieving improvements in their P&L. In February-March, Maggiano's score for great food, also making the guests feel special, and value were at recent historical highs. The strong top line trend bodes well for Maggiano's future.”

HEDGEYE: The performance of Maggiano’s is a tailwind for the overall performance of the company.

“General and administrative expenses increased nearly $4 million over the same quarter last year to $36 million. The increase was primarily driven by an increase in incentive-based compensation costs, professional fees and a reduction in transition services income. These headwinds were somewhat offset by lower stock-based compensation expense and payroll related expenses. We would expect these trends to continue into the fourth quarter.”

“Well, consistent with what we've talked about in the last month or so as we visited many of you, beef continues to present the most significant inflationary pressure in our commodity basket.  That is an item that we have contracted through the August timeframe, particularly for burger meat. So we do expect that in the first half of fiscal 2012, we'll be renewing that contract, and if we were renewing them today, it would present a pretty significant inflation over what we've contracted at today.”

HEDGEYE: Food inflation is an issue for the industry, but EAT is doing what they can to offset its impact as much as possible.

LONG-TERM PLAN-TO-WIN

“We certainly feel comfortable with the success of those initiatives, but from a timing perspective they might come a little bit later which might mean a little bit better EPS growth in fiscal '13 than we might have originally thought. But the underlying premise you have of accelerated EPS growth in fiscal '12, we're still comfortable with that, and we'll obviously provide more clarity at our August call.”

“The places where we really haven't got much of a start in terms of impact to the P&L, although I think we're quite a ways down the road in terms of understanding what it could mean in the future, are the installation of the kitchen equipment and the installation of our point of sale and back office systems. Both those are the first kitchen equipments in 15 restaurants today, the point of sale and back office equipment is in 24 restaurants today. Both are anticipated to start rolling out aggressively here in the start of the first quarter, end of the fourth quarter. So we would expect to see progressing benefit from those as fiscal '12 rolls through."

"And the point of sale and back office systems will be complete in fiscal 2012."

"The kitchen retrofit will take even into a little bit of fiscal '13 to get completely through the system. So we would expect to see progress on both of those. And the kitchen equipment is certainly of a magnitude of Team Service and the point of sale back office systems is probably in the order of magnitude of the kitchen of the future prep component that we've already rolled out."

"The full impact of all of it would come in fiscal '13."

HEDGEYE: I continue to believe that the Plan-To-Win is working as management has planned.

 

REMODEL PROGRAM

“Now on the re-image, we would expect, we'd talked about CapEx being in the $160 million range for fiscal 2012. With some of the capital not being spent here in fiscal '11, some of that may now move into fiscal 2012 and require a little bit more CapEx spend but that will only be to affect things that we were expecting to get done this fourth quarter that may now happen in the first quarter next year, and the bulk of that will be the re-image and the implementation of the new kitchen equipment.”

“So we're moving forward, very optimistic about where we'll go from there and after we finish these next markets, we'll have about 60 restaurants re-imaged and that should be a significant enough number for us to feel good about then aggressively moving it forward.”

“The impact to next year will really be dictated somewhat on how fast we can get the re-image program rolling through but we're optimistic that we can move fairly quickly and that it would have some impact to next year's sales although it won't be huge because of just the timing of when those restaurants will actually have the full remodel in them throughout the year. We are counting on having some impact but I wouldn't say it would be excessive.”

HEDGEYE: The momentum of the remodel program will allow Chili’s to continue to post improving SSS as we move thru fiscal 2012.

From a sentiment perspective, Brinker is still not loved by the sell-side with a mere 33.3% of analysts rating the stock a Buy and 52.4% rating it Hold while 14% rate it a Sell.  From a valuation perspective, too, EAT is attractive with an EV/EBITDA NTM multiple of 5.8x versus RT at 6x, the casual dining average at 6.7x.

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Howard Penney

Managing Director

Rory Green

Analyst