10/14/09 10:19AM EDT

It’s the right time and place for Chili’s to shake up casual dining!  How far will management go?

Brinker is scheduled to report fiscal first quarter 2010 earnings on Tuesday, October 20 before the market opens.  I don’t think it will be as bad as what we experienced following the day the company reported 4Q09 numbers when the stock traded down 17.5%, but I am not sure there is much near-term upside either.  Longer-term, the focus is on where the company is taking the Chili’s brand and how much it will cost to get there.

EAT is still down 16% since that day and down nearly 8% in the last 3 months relative to the casual dining group’s average +6% move.  The company has already taken a significant hit relative to the industry, but I don’t think Brinker will be let out of the penalty box until management unveils its plans for the Chili’s brand. 

To recall, we learned on the 4Q09 earnings call that management was pursuing a new long-term strategy for the Chili's brand that would include “a couple of things with looking at innovation around food, continued improvements with our core menu, our famous and favorite, how can we take the items that people come in and get at Chili’s each and every day and make them better. And couple that too with the environment that we're in to be able to provide our guest ongoing, compelling value, reasons to come into our restaurant. Add all that on the top of everyday focus on operational excellence and having a more consistent execution each and every day when people walk in.” 

Since then, we learned that Chili’s has revised its preparation methods for its ribs and burgers.  The ribs are now slow-smoked over pecan woodchips rather than mesquite as before, and the hamburger patties, which had been delivered to stores pre-formed, are now hand-shaped in the kitchens.  Additionally, the restaurants are now also offering premium-topping add-ons such as avocados, onion strings, bacon and different cheese types. 

These menu adjustments definitely show a renewed focus on its core products, which I think is necessary, but they alone, are not enough and don’t “go for the jugular” as I said the company needs to do (please refer to my 8/6/09 post titled “EAT – What is Management Going to Do?” for more details).  Although fresher products could bring in more customers, they will also raise the company’s cost of goods, which will put increased pressure on margins.  What management says about its plans for Chili’s will have a big impact on the stock’s performance as the current direction of the brand is in question.  To that end, the magnitude of investment behind these new initiatives is unknown and is a major question mark relative to the company’s Q1 and FY10 guidance. 

Following 4Q09, management provided Q1 EPS guidance of $0.12-$0.14, which was below street expectations.  The company attributed the low guidance to an extremely weak July, when Chili’s same-store sales growth was down low double digits for the first three weeks of the month.  Although same-store sales had recovered to a down low to mid-single digit range by the fourth week of the month, management said that July is seasonally the most significant month to profitability in the first quarter, making it hard to fully recover from a profit standpoint. 

July was a bad month for the overall casual dining industry with comparable sales growth -8.3%, as measured by Malcolm Knapp, but Chili’s down low double digit performance obviously pointed to a significant loss of share.  Based on the fact that EAT traded up prior to Malcolm Knapp’s release of August same-store sales for the industry and subsequently fell off, investors seemed to be expecting more of an improvement in trends than we got from the reported -5.4%.  Management attributed its under performance in July to the fact that its initial value initiative of 10 meals for under $7 did not resonate with customers, but stated that its newer 3 course meal for $20 promotion was responsible for the recovery in sales in late July. 

Based on the company’s commentary on its 4Q09 earnings call combined with what we are hearing from other restaurants operators, I am not expecting much from a sales perspective when EAT reports Q1 numbers.  I think management was fairly successful in setting the expectations bar low so I don’t think we will like what we see, but I also don’t think it should come as a surprise.  If August and September same-store sales at Chili’s returned to July levels despite the sequentially better numbers we got from Malcolm Knapp in August (we should receive the September numbers in the next week), then that would be bad (and worse than my expectations).  On the other hand, knowing what we know about July trends, if Chili’s same-store sales growth comes in better than -6% for the quarter that would be positive relative to my expectations because it would point to a significant sequential improvement in both August and September. 

We are looking for Chili’s to post same-store sales down 7%, which implies a 2% deceleration in the chain’s two-year average sales trends from last quarter.  For On the Border and Maggiano’s, we are looking for a 6% and 7% decline, respectively.  On a consolidated basis, this implies a nearly 7% decline in comparable sales growth.  EAT did not have a good quarter.

That being said, even with continued top-line weakness, I am having a hard time getting my EPS number down to management’s guided $0.12-$0.14 range.  For reference, the street does not appear to believe management’s Q1 and full year EPS growth guidance as the Q1 consensus estimate is at $0.15 and full-year estimates imply only a -8.5% decline relative to the company’s provided -10% to -20% outlook.  I think management is being extremely conservative with both its full-year EPS and same-store sales guidance (-2% to -4%). 

In the first quarter, cost of goods as a percent of sales will come under pressure as a result of the 3 for $20 promotion and labor expense as a percent of sales will be higher due to the abysmal sales results in July.  Even considering this, I think the company’s earnings will come in better than the street’s $0.15 per share estimate.  The company is still benefiting on YOY basis from cost savings initiatives implemented in the back half of 2009.  Again, I don’t know how much money the company is putting behind its new Chili’s initiatives.  So in sum, EAT should continue the trend of beating on the bottom line despite continued top-line weakness, but I don’t think the stock will move significantly higher until the company eliminates the question about the direction of Chili’s.


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