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Looking for changes on the margin that impact operational performance

Nirvana - At the restaurant level, the company is operating smoothly.  Sales and margins are headed in the right direction.  On the surface this gives management the benefit of the doubt that they are not aggressively using pricing to manage the business.  There is sometimes the potential, however, that a company is operating in Nirvana as a result of positive comps that are driven entirely by pricing.  In that case, if customers are not coming in the door, positive same-store sales growth will not be sustainable.

Who’s got it right as of their last reported quarter?  CMG, MCD, YUM U.S., YUM China, DPZ, PNRA, SBUX, CAKE, MRT and TXRH

As shown in the sigma chart below, it should be of no surprise that the companies operating in Nirvana, on average, also trade at the highest NTM EV/EBITDA multiples. 

Moonlighting in Nirvana?  Most of the names located in the upper right quadrant did not come as a surprise; that is, except for TXRH and MRT.  In 1Q10, TXRH and MRT both reported positive comparable sales growth for the first time in about 2 years (slightly longer for TXRH).

TXRH’s full-year same-store sales guidance of flat to +1% implies that same-store sales remain relatively positive for the balance of the year (toughest comparison in 4Q10) even if trends slow somewhat on a two-year average basis, as has been the case for the casual dining industry on average in 2Q10, as measured by Malcolm Knapp.  That being said, TXRH’s YOY restaurant level margin compares get more difficult in 2Q10 and even more so in the second half of the year.  Lower food costs in 1Q10 were the primary driver of the significant margin growth in the quarter and management stated that food deflation will be less for the balance of the year and lowest in 2Q10.  Remaining in Nirvana will be challenging; though same-store sales improved substantially in 1Q10 on a 1-year and 2-year basis and the trend in top-line may be more important to investors now.

As for MRT, the company started out 2Q10 strong with same-store sales up 6% in April and guided to +4% to +6% same-store sales for the quarter.  Maintaining positive comps in 2H10, particularly in 4Q10, as comparisons get more difficult, is unlikely.

Other Nirvana Standouts: 

CMG – The Company will likely put up positive comps for the balance of the year, even if top-line trends slow somewhat on a 2-year basis from the first quarter.  CMG’s full-year same-store sales guidance of up mid single-digits implies steady-to-slightly better two-year trends for the remainder of the year.  On a YOY basis, the company most likely posted its strongest restaurant margin growth, however, in the first quarter.  Restaurant level margin will face increased pressure in the second quarter and could potentially turn negative in 2H10, pushing CMG into the “Trouble brewing” quadrant.  After benefiting from favorable food and labor costs as a percentage of sales in 1Q10, management guided to modest commodity inflation in 2H10 and higher labor costs as of 2Q10 due to wage rate inflation and the lapping of labor efficiency initiatives implemented in 2Q09.  Also hurting margins for the balance of the year is the expected increase in other operating costs as the company ups its marketing spend to 1.8% of sales for the full year from 1.1% in the first quarter.  Specifically, management said, “we expect to de-lever this line during the rest of the year as we invest in our new marketing campaign.”  Given the increased cost headwinds, remaining in Nirvana will be difficult in the second half of the year, but investors may be more focused, in this environment, on the company’s ability to maintain positive comparable sales growth.

CAKE – Like CMG, CAKE most likely posted its strongest FY10 quarter in 1Q10 from a YOY margin growth perspective as restaurant level margins get increasingly more difficult going forward, largely in 2H10.  Also, like CMG, the company expects to face increased pressure from higher commodity and marketing costs in 2Q10. These increased cost pressures will likely push CAKE out of Nirvana as we trend through the year even if the company is able to maintain its positive same-store sales growth (management guided to flat to +1% growth in 2Q10 and for the full year).  And, even if the company achieves its full-year guidance, it will be challenging for the company to maintain its positive comp growth in 4Q10 given the sequentially more difficult comparison.

YUM U.S. – YUM’s stronger-than-expected 2Q10 results in the U.S. enabled the company to move out of what we call the Deep Hole (negative same-store sales and YOY decline in restaurant operating profit margin) earlier than I had anticipated.  I had expected this segment to begin to recover in the second half of the year as the company lapped easier comparisons, but as of 2Q10, the company is now straddling the line between Life-line (negative same-store sales and positive restaurant operating profit margin growth) and Nirvana.

YUM China – YUM continues to expect to face labor and commodity inflation in the second half of the year.  Overall, as expected, China continued to operate in Nirvana during the second quarter, but will likely move into the Trouble Brewing quadrant (positive same-store sales and YOY decline in restaurant operating profit margin), and potentially, into the Deep Hole, during the back half of the year as higher food and labor costs materialize.

Deep hole - The concept is experiencing negative same-store sales and declining restaurant level margins. 

They are feeling the pain: DIN, SONC, BKC, KONA, EAT, PZZA, PFCB, RRGB, CPKI, JACK, JACK, BOBE and TAST

Deep hole Standouts:

EAT – Sales will remain choppy in the near-term as consumers adjust to the significant menu changes at Chili’s and the company could remain in the Deep Hole for another reported quarter.  Beginning in FY11, EAT should begin to move up and to the right on the sigma chart as margin initiatives materialize and same-store sales recover.

PFCB – PFCB has the potential to report the biggest sequential quarterly swing in same-store sales growth at the Bistro in 2Q10 as the company implemented a +1% to +2% price increase during the quarter in late May.  At the same time, PFCB hopes to support average check, which declined 3.5% during 1Q10, by reducing its reliance on discounting.  Although traffic was positive in 1Q10, it will be important to see if the company can sustain its recent traffic momentum at the Bistro while also increasing prices.  Prior to the price increase, management stated that for most of April both the Bistro and Pei Wei experienced a roughly 200 bp improvement from 1Q10 comp trends. 

Margins should improve as the company refines the Happy Hour initiative at the Bistro and improves execution.  It is important to remember that the inefficiency around executing this new program, along with some other incremental discounting activities at the Bistro, cost the company about 80 bps on the COGS line and 100 bps on the labor line, or about $0.13 per share in 1Q10.  I would expect restaurant level margin to decline again in 2Q10 (though to a lesser magnitude) and gradually improve during the balance of the year, pushing PFCB up and to the right in the sigma chart.

Trouble brewing - positive same-store sales and YOY decline in restaurant level margin.  We recognize the trends associated with operating in both the Life-line and Trouble brewing territories as unsustainable.  Typically, if a company is posting positive same-store sales and declining margins, the company is unable to leverage its positive top-line and is therefore spending too much on either growth related costs or increased discounting.  Either way something has to give and it usually ends ugly.   

The red flags are being raised for:  BJRI and BWLD 

Trouble brewing Standout:

BWLD – With same-store sales only up 0.1%, BWLD was extremely close to falling into the Deep hole in 1Q10.  Same-store sales slowed 30 bps in 1Q10 on a two-year average basis and deteriorated 420 bps sequentially in April from the 1Q10 level.  Given that same-store sales were down 3.7% in April, I do not expect BWLD’s sigma position to improve in 2Q10, but rather the company could fall into the Deep hole if top-line trends did not improve materially during the balance of the quarter.  I would expect continued pressure on restaurant level margin in 2Q10 despite the fact that the company will benefit from lower YOY chicken wing prices after facing inflation of 17% in 1Q10 (traditional wings account for about 20% of restaurant sales).

It all comes back to sustainability, and BWLD lost it….BWLD grew too fast.  New unit volumes are declining.  Growth related costs will become more evident as same-store sales remain under pressure.  BWLD needs to slow growth and cut costs and that does not yet appear to be in the plans. 

Life-line - Negative same-store sales and YOY increase in restaurant level margins.  At Hedgeye we have another term for this and it’s called “pulling the goalie.”  When you are down and out (customers are not coming back), you need to do anything to make the numbers and preserve margins.  The reduction in costs is not sustainable and can lead to further issues down the road.  It will certainly not do much to bring the customers back in the door.   

Looking for answers: DRI, RT and WEN

Life-line Standout:

RT – RT’s same-store sales trends have gotten better on a one-year and two-year basis for the last five quarters.  Maintaining this trend on a one-year basis will be more difficult in fiscal 4Q10.  Management’s full-year comparable sales growth guidance of -1% to -2% implies a pretty wide range of results during the fourth quarter of -2.5% to +1.5%.  Whether or not same-store sales turn positive (I am modeling a slightly negative comp, roughly in line with 3Q10), restaurant level margin is expected to be down in the fourth quarter, shifting RT into either the Trouble brewing quadrant or the Deep hole.  Management guided to a 25 bp to 50 bp decline in full-year restaurant profit margin as a result of the company’s focus on offering compelling value and the associated negative impact of food costs.  This full-year guidance implies a 25 bp to 125 bp decline in the fourth quarter. 


Howard Penney

Managing Director