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Where the stock goes from here is largely a function of whether or not investors believe that this management team can walk the walk.  After some struggles in the past, it is natural that it will take time for the company to win back the Street’s trust.  I certainly carry plenty of baggage when it comes to certain stocks.

The 2% revenue growth in the first quarter of FY12 was the strongest in the past 10 quarters and 43% EPS growth was the strongest in the past five years.  Additionally, the EPS growth came on the back of 24% EPS growth in the prior year quarter.  Margins improved 80 basis points despite a decline in average check.  The company operated well in 1QFY12.  These figures are backward-looking and you’ll end up in a ditch if you drive looking backwards but the improvements management has made in terms of margin should not be discounted.  I think it is fair to say that they have exceeded the expectations of the Street and of management.  The conference call was dominated by a uniform line of questioning from the sell-side that anchored off one theme: can the company comp the upcoming comps?

If the company was not executing I could understand the why so many remain skeptical, but that is not the case.  At the beginning of calendar year of 2011 (six months into FY 2011), the consensus estimate for FY2012 was $1.60 it now stands at $1.85 following a significant upward revision following the most recently reports quarter.   

The tone of skepticism was set from the very beginning of the Q&A period with the following question: “I think a lot of investors wonder about this quarter in light of the entire year, basically people are wondering about whether the traffic and the margin gains that you're getting today, if you can sustain those as perhaps the margin comparisons and the sales comparisons get tougher as the year goes on. I oftentimes look at things in terms of the trend, but I think the comparison sometimes scare people with regard to Brinker and its story.”

The question is fair when thinking about sales trends but misses the point when thinking about margins.  The Bar &Grill space is hyper-competitive and there are a number of rival brands that have announced a lunch promotion with a $6 or thereabouts price point.  History has taught us that being proactive about price points within the industry is a far superior strategy than being reactive.  Chili’s is changing the category with this latest strategy and the proof is in the reaction of its competitors.  To get back to the question of margins, margin comparisons do indeed step up next quarter, from +187 basis points y/y in 1QFY11 to +212 basis points y/y in 2QFY12.  From there, however, as traffic comps step up, margin compares become easier with +152 basis points and -3 basis points in y/y restaurant operating margin growth in 3QFY11 and 4QFY11, respectively.   Chili’s 1QFY12 comparable-restaurant sales growth was less-than-expected at +1.7% with +1.9% of that coming from transaction growth.  Taking this into account makes us confident that the company is executing at a high level from a margin perspective.  Clearly, Chili’s share of market needs to grow for the more difficult compares, due to the successful rollout of the $6.99 lunch promotion, that come in the second half of 2HFY12. 

There are several reasons for our optimism relative to the Street (not that that even implies optimism) regarding Chili’s top-line as we progress through FY12.  Firstly, we contend that the remodels being carried out by the company will have a meaningful impact on brand perception and customer satisfaction.  During the McDonald’s reimaging tour, management explained a “halo effect” that has been observed in Australia, Europe and is expected in the U.S.; as the proportion of the system that has been renovated approaches 50%, there is a noticeable sales lift.  Chili’s is at least a few years away from that, given that it expects to be at 200-250 stores remodeled at the end of the year.  As yet, 65 are remodeled in different test-cities across the country.  For context, 250 restaurants is equal to 19% of the system store-base.  In terms of winning new guests, the remodel program, proactive and compelling price points, and the various consumer experience-boosting initiatives around labor and food prep are strong positives we see that the company is not comping. 

In conversation with management, we discussed the difficulty in comping an initiative like $6 lunch but came away confident that the back-of-the-house technological improvements are broadening the scope of dishes that the concept can produce for its customers.  In terms of launching new platforms, which management intends to do once per year, the new technology allows operators to do so with far greater ease than competing chains.  Additionally, consistency and quality has been improving with the rollout of the new kitchen equipment while improving efficiency.  The improvements management has proposed are not only helping EPS growth, but have also been embraced by franchisees.

Unless there is a significant step-up in discounting across the industry over the next twelve months, Brinker’s margin story, for us, remains intact.  We will be monitoring the national brands like Applebee’s and Olive Garden for any evidence of this.

Another question that we felt reeked of skepticism was the following: “My question relates to traffic.  I'm a little surprised that traffic has not improved at a greater pace, especially given the comments you provided about survey information you've collected. What do you think needs to change at Chili's to drive better traffic? I mean, is the advertising message an issue?"

When we consider that Knapp Track Casual Dining Guest Counts declined an average of -0.17% during the 3QCY11, Chili’s 1.9% growth seems impressive considering that it is a mature category.  The company also did not advertise on TV during three weeks of September, which hurt the top-line.

Yet more skepticism came from the following question: “… on kind of the longer term outlook and guidance and how you're going to get there.  As I've understood it in previous calls or meetings you've had, you've always talked about getting up to 3%, 4% comps in 2013, '14 and '15, to enable you to get to your 400 basis points of net margin expansion.  And I guess I'm still, I'm curious as to why you have the confidence that your comps are going to accelerate to that level.  Is it that you think that the broader industry is going to rebound with the economy, do you think your market share gains are going to accelerate, and why do you have such confidence in one of those two things happening that you've incorporated in your guidance?”

The preface to this question was mistaken, as management pointed out; the 3-4% growth target was actually a revenue goal and not comparable sales growth.  However, even if comparable restaurant sales was the metric, 1.7% this quarter, adjusted for weather and September’s advertising step-down would most likely not be very far away from the 3-4% range that the question was asking about (but that management was not guiding to).   

We have not seen the work behind the downgrade today by Sterne Agee, but pessimism around the company’s ability to continue to comp the comps is likely a factor.  We believe that the kitchen initiatives, remodels, and focused approach with which management is executing this turnaround bode well for the company’s prospects. 

As far as we are concerned, a company that is executing well at a time when skepticism on the stock is consensus is nothing to be afraid of on the long side. 

Until we get evidence that company is not on the right path, we remain positive on Brinker on the TRADE, TREND and TAIL durations.

Howard Penney

Managing Director

Rory Green