EAT – Bullish about margins

EAT’s CFO Chuck Sonsteby presented this morning at an investor meeting and said that relative to when the company reported its 2Q09 earnings in January that he is feeling bullish about margins. During the second quarter, EAT reported better than expected earnings as a result of better cost control and better than expected margins. At that time, however, Mr. Sonsteby said he was pessimistic about the company’s ability to maintain that level of margins with sales slowing. Today, he commented that he is optimistic about margins because EAT is benefiting from slower unit growth, which takes costs out of the business. In the past, EAT’s business model, particularly as it relates to margin growth, was built around growing the top-line through new unit growth. This growth led, inevitably, to increased costs and inefficiencies within the system. With slowed growth, management is more focused on eliminating these inefficiencies and better managing costs. As a result, Mr. Sonsteby said that EAT is experiencing improved labor productivity, lower employee turnover and better food cost control. Management is also working to take fixed costs down by renegotiating with its landlords. At the same time, commodity costs are coming down.

Although Mr. Sonsteby did not say that sales trends are improving, the fact that he is more comfortable with margins shows that the company is managing the things it can currently control. And, when sales do finally pick up, EAT will be well positioned to outperform! That being said, EAT, particularly Chili’s, has consistently outperformed the casual dining industry’s same-store sales growth as measured by Malcolm Knapp, and the monthly Knapp Track numbers improved sequentially in January. If Chili’s has been successful in maintaining its gap to Knapp, that might be one reason for Mr. Sonsteby’s optimism.

Controlling what it can, management is focused on using its free cash flow to pay down debt and increase the company’s financial flexibility in this difficult environment. In fiscal 2009, the company is expecting to spend $115 million in capital expenditures, which is down $155 million from fiscal 2008. Based on this lower capital spending, EAT said it should generate over $180 million in free cash flow in 2009, up from $48 million in 2008, and this is with an expected year-over-year slowdown in same-store sales growth.

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