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EAT – MANAGING THROUGH TOUGH TIMES

EAT proved again that it is managing the aspects of its business that it can control in today’s difficult economic environment. The company experienced sequentially worse same-store sales results in fiscal 2Q09 across all of its concepts with the overall company down 4.5% (following a -3% number in 1Q). Despite this sequential quarterly slowdown, which was felt across the casual dining industry (on average, 4Q casual dining same-store sales declined 190 bps from 3Q according to Knapp Track data), EAT’s fiscal 2Q09 restaurant and operating income margins improved about 140 bps and 130 bps, respectively, from the prior quarter. Additionally, although the company did not provide an update to its previous guidance, which included the expectation of a 2%-4% decline in same-store sales and a 15%-25% decline in EPS, management stated that relative to its internal targets 2Q results came in better than expectations from a cost perspective, and that was with comparable sales coming in lower than the company’s guided range. The company attributed this better margin performance to better cost control across the business. Specifically, the company benefited from better management of food costs, increased labor efficiencies and more disciplined G&A spending.

Management said that it is managing its business under the assumption “that this could be a protracted economic downturn...rather than just being a short-term blip.” To that end, management recognizes the need to make some real changes to its business, with value being the key to those changes. Management acknowledged that “faster and cheaper is the American way” so it is reviewing all aspects of its business to see how it can increase turnover times, decrease labor costs, create exciting new food products, etc. Specifically, management recognizes that the gap between QSR and casual dining has widened in terms of check averages and with faster and cheaper being what people want that EAT is effectively fighting against QSR for market share. This does not mean that EAT wants to compete on price with QSR, but instead that it needs to improve the relative value of the entire Brinker dining experience based on pace and convenience, better food quality and service, facility relevance, price and overall customer satisfaction at a lower cost. Ultimately, management knows that it must get more people into its restaurants.

After examining its entire restaurant portfolio, EAT announced that it will be closing 35 underperforming restaurants, which is expected to boost operating margins by 30 bps. Most of these closures are expected during 3Q with some to follow in upcoming quarters as current leases expire.

EAT had already significantly cut its capital expenditures in fiscal 2009 (down $99.6 million YOY in 1H09 from its reduced new unit development), but management again lowered its capital spending guidance to $110 million from its prior range of $135-$140 million. The company decided it would be prudent to push out the timing on some of its Chili’s reimages to provide increased financial flexibility relative to its current declining sales trends. Management is also committed to using its free cash flow and cash proceeds from the sale of Macaroni Grill to pay down debt and has suspended its share repurchases to further preserve its strong balance sheet in this difficult environment, in which it has little visibility of when trends will materially improve. That being said, EAT stated that after a weak start to January, that sales trends “have firmed up” in the last two weeks. Although two weeks do not make a trend, on the margin, some stabilization is a positive as it relates to recent results.


EYE ON CHINA 2: RETAIL SALES

Chinese Retail sales data for December showed a decline to 19% year-over-year, the slowest rate of growth since November 2007, as shoppers in China start to show some of the same reluctance to spend as consumers globally. Visually, the chart below illustrates a divergence between one, two and three year change in growth rates that is pronounced and distressing. By stepping back and doing a common sense gut-check however, 19% Y/Y starts looking very positive on the margin while continuing to support the investment thesis of relative strength. On a pound-for-pound basis, the impact of easing and other stimulus packages could have greater effect on retail sales in China, where consumers are less burdened by personal debt.

This is not a contrarian view. Reports in the Wall Street Journal and International Herald Tribune this morning commented on Wal-Mart and other large retail chains’ plans to continue expansion on the mainland in 2009 –clearly 19% year-over-year is also enough to motivate them to invest in China.

Our China thesis holds that growth there will be helped tremendously by increasing domestic demand, as it will in derivative economies like Taiwan where exports to the mainland account grew to almost 20% of total exports BEFORE the recent political “panda diplomacy” thaw took effect.

Andrew Barber
Director

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CASUAL DINING – DECEMBER TRENDS WORSENED

Casual dining comparable sales fell 8.9% in December with traffic down 9.9%, making it the worst month of the year. These numbers are particularly discouraging because people had reason to go out in December as they did their holiday shopping, which typically translates into increased dining out. Looking forward, it would seem that people have less reason to go out in January. Brinker stated on its fiscal 2Q09 earnings call this morning that after a weak start to January, however, that it has seen its own sales trends improve and “start to firm up” in the last two weeks. Although two weeks do not make a trend, on the margin, Brinker’s seeing some recent stabilization is a positive as it relates to the deteriorating casual dining results in December.

EYE ON CHINA: GDP

Today’s GDP contraction data was expected. The 6.8% figure for Q4 was in line with median estimates, but it was still disappointing for the glass half full crowd who were hoping for just a little bit more and have run for the exits -sending FXI, which we are long, down over 5%. We do not use hope as part of our process and we are retaining our long bias.

As we all know, the Q4 meltdown spurred a sharp contraction in trade globally and regardless of relative strength China could not avoid the pain, even if they are better off than many of their neighbors (Korea for instance, which we are short via the EWY ETF, printed numbers showing a 5.6% contraction in GDP and an 11.9% contraction in exports). We knew the backdrop for all of this was in the cards, but that is looking in the rear view mirror. In the here and now, a 4 trillion Yuan spending package is just starting to trickle through the system and the five cuts in the key lending rate, initiated in Sept. are just starting to nudge the Dragon.

It is critical to remind ourselves that China is still a communist nation –as such the party leaders are very aware that they must stem job losses and rescue symbolic industries in order to sustain the minimal rate of economic growth assumed to prevent internal social problems. Critics of some of our work on China often point out, correctly, that there is a good deal of “massaging” in reported Chinese economic data -but you can’t fool your hungry people with fake data (something that Christina Kirchner is discovering too late in Argentina).

These leaders don’t run for election, they don’t need to build consensus and they don’t have to apologize for bending rules. To achieve the growth levels they need, the Chinese government will use ANY and ALL tools at their disposal -including shrugging off any protests by team Obama over currency manipulation no matter how loud.

We are Watching China and its derivative economies closely and as always will be looking to change our exposure as data points present themselves.


Andrew Barber
Director

WMS: TAKEAWAYS FROM IGT

From IGT’s conference call:

Analyst question: Why were domestic product sales better than I expected?
My answer: Because you don’t do the work.

Industry unit sales were up around 40% in the December quarter based on our exhaustively detailed schedule of new casinos and expansions. Clearly, the sell side doesn’t maintain this incredibly useful database.

All the slot guys will have a strong December quarter in terms of slot sales. I was actually very happy to hear this question because if the analysts didn’t know that Q4 slot sales were going to be good, then they certainly don’t know that 1H CY2009 slot sales will be awful. We project industry unit sales to new and expanded casinos to fall 40% and 70% in FQ1 and FQ2 2009, respectively.

Yeah but replacement demand is facing an easy comp from 2008 so that will pick up some of the slack, right? Wrong. IGT’s CEO, TJ Mathews, clearly stated that industry replacement demand will be lower in 2009 than 2008 due to capex cutbacks by the operators.

So with these industry dynamics, how does WMS meet the 10% revenue growth projections? More market share gains? WMS market share would have to almost double from its recent 15-20% to make the consensus revenue projections for 1H CY2009. WMS market share has actually trended lower the last 2 quarters. How about gaming operations? Slot play is trending lower, not higher, due to the economy. I wouldn’t bet on gaming ops beating consensus expectations.

IGT’s quarter essentially confirmed our thesis that slot sales, while strong in Q4 CY2008, will be down considerably in 1H CY2009. This is not good for WMS.


How does WMS grow revs 10% in 1H CY2009 in this environment?
What have you done for me lately?

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