Description

Brinker International (EAT) is a highly-leveraged casual dining chain that has been masking declining traffic trends with menu price increases for a decade. With its prices now quite high, it can no longer rely on pricing to bolster same store sales (SSS). Traffic has declined at an accelerating rate in recent quarters (down ~8% in the last Q) and a guidance cut in the next quarter or two is very likely. EAT has a negative tangible book value of $15.00 per share and a permanently declining FCF outlook. The shares ran up from $29 to $40 in the past 3 months on no news, after EAT reported its worst quarter in recent history. The stock trades at 8x LTM EBITDA which is its takeover value (recent casual dining transactions have averaged 8x). Given EAT’s melting ice cube outlook, I estimate the shares are worth 6x EBITDA in a year, or $21, for 48% downside. Longer term, if the business continues to deteriorate, EAT’s equity value could approach zero.     

The pdf file below has better formatting:

https://www.dropbox.com/home?preview=EAT+VIC+Jan+2018.pdf

Business description

EAT owns and franchises two casual dining chains: Chili’s (grill & bar) and Maggiano’s (Italian). Its $3.2 billion revenue base is split as follows: 84% from Chili’s company-owned restaurants, 13% from Maggiano’s company-owned restaurants, and 3% from franchise & other fees. Franchise & other accounts for a higher percent of profits as this revenue stream is high margin.  

Chili’s was started in 1975 in Dallas, and it originally focused on burgers and beer. The concept’s menu and locations expanded rapidly over the decades and today Chili’s has 1,254 U.S. restaurants (75% owned, 25% franchised) and 378 international restaurants (4% owned, 96% franchised). The chain has 9% domestic share of the U.S. grill & bar market. Its closest peers are Applebee’s (12% share), TGI Friday’s (4%) and Ruby Tuesday (3%). About 53% of the U.S. grill & bar market consists of chains, and 47% is composed of independent restaurants.

In its first few decades of operation, Chili’s resonated strongly with baby boomers (today aged 52-70). The concept benefitted from the increase in disposable income of this demographic as well as the growth in popularity of food away from home (i.e., eating out) in the U.S. In recent years, Chili’s has struggled to appeal to millennials (ages 19-35) which recently surpassed boomers as the largest generation in the U.S. (75.4 million millennials vs. 74.9 million boomers in 2015).  Millennials in general prefer independent businesses and healthier food options to chains, large corporations, and processed foods (the boomers were the opposite). Chili’s is on the wrong side of this tectonic shift.    

Chili’s is a dying concept

I will focus on Chili’s company-owned restaurant results as this segment accounts for the vast majority of EAT’s revenues (84%). The left side of the following table breaks down the composition of Chili’s SSS over the past decade (the right side shows Maggiano’s’ results). SSS is the sum of the changes in traffic, price and mix. From FY 2008 to 2017, Chili’s same store traffic declined by a cumulative 27.1%, the company raised menu prices by a cumulative 18.9%, and mix had a cumulative positive impact of 2.5% resulting in SSS over the 10-year period being down 10.6% in total.

Chili’s & Maggiano’s SSS Breakdown (FY end June)

Inflation: Food Away From Home (Restaurants) vs. Food At Home (Supermarkets)

Source: Bureau of Labor Statistics (Y/Y change in consumer prices)

Chili’s had positive traffic in only 1 year during the past decade, with traffic up just 1.5% in FY 2012 (ending June 2012). The strength in that year was driven purely by macro factors as commodities inflation caused “food at home” (supermarket) inflation to soar to over 6% in late 2011 while “food away from home” (restaurant) inflation was about 3%, its widest spread in recent history (see preceding chart showing calendar year data). While the restaurant industry tends to raise menu prices at a consistent rate each year (2%-3% per year in recent years), commodity prices, which are more fully reflected in supermarket prices, are far more volatile. Chili’s was able to generate positive traffic growth only in a year when supermarket prices surged while restaurants maintained their modest pace of price increases, making eating out a better deal than buying food at the supermarket, when taking into account cooking time at home.

In recent years, traffic trends at Chili’s have deteriorated at an accelerating rate from (3.7%) in FY 2016 to (5.8%) in FY 2017 to a shocking (8.7%) in 1Q18 (the September 2017 quarter). Hurricane disruption accounted for just 60 bps of the weakness in 1Q18, resulting in adjusted traffic of (8.1%). The 1Q18 decline was on the back of a 4.1% traffic decline in the year-ago quarter, for a ~12% decline in same store traffic over a 2-year period.

1Q18 results were weaker than they appeared

Management’s most recent turnaround plan (the prior one didn’t work) involved reducing Chili’s menu items by 40% in order to bring food out faster and hotter, as long wait times and below-ideal-temperature dishes were consistent customer complaints. Chili’s’ menu now offers far less variety and is focused on burgers, ribs and fajitas. EAT went live with its 40% reduced menu in just the final 6-weeks of 1Q18. When unhappy customers asked “what happened to (whatever dish they liked that was eliminated)?” Chili’s servers responded with “it was discontinued but you should really try our new $6.99 burger offer.” Chili’s added a $6.99 burger & fries value option in the quarter, making it a no-brainer for an unhappy customer to stay put, have a burger and save some money (Chili’s average check is $15.70). However, the true loss of traffic due to the 40% smaller menu may not be fully known for another quarter or two, as some unhappy customers are unlikely to return.  

In addition, the $6.99 burger & fries value option brought in some customers who had not been to Chili’s in some time. These customers are part of a pool of value conscious consumers who have little loyalty to any concept and simply go wherever the best deal is being offered. No one really wants these customers, but a restaurant knows that this group will come in the door when it needs to boost traffic, as long as they are offered a compelling price.  

While Chili’s 1Q18 adjusted traffic trend of (8.1%) is concerning in and of itself, it is more alarming when considering that it was boosted by “bottom feeder” traffic, and by the fact that unhappy customers who found their favorite dish eliminated likely did not walk out the door (hunger plus a $6.99 burger & fries deal will tend to keep most people in their seats.).  

In addition, 1Q18 mix shift of +2.5% and pricing of +2.8% are not sustainable. As the preceding table shows, Chili’s had a cumulative mix shift benefit of 2.5% over the past decade. Getting a 2.5% boost from mix in one quarter is the definition of “an outlier event.” Most of the 2.8% pricing boost came from a 10% price increase put through in January 2017 on the popular “2 for $20” dinner value offer (2 appetizers and 2 entrees) taking it to $22. Beginning in January 2018, Chili’s laps this price increase.

Management readily admits that Chili’s average check of $15.70 is high for casual dining. In addition, recent commodities deflation has resulted in a historically wide spread between eating out and preparing food at home, in favor of food at home (see preceding chart), making Chili’s even less competitive among all of the food options consumers have. On the 3Q17 (March 2017) call, management said that menu pricing had gotten a bit ahead of itself, and stated that they now have room to “invest in price” (i.e., “reduce prices”) in the future. But given the subsequent deterioration in traffic, on the 1Q18 call, management said they will keep raising prices by 1%-2% annually going forward.

Management is trapped in a downward spiral. Continuing to raise already high menu prices in an effort to offset weak traffic will only weaken traffic further. In the past 18 months, Chili’s average check of $15.70 is up $1.00 (almost 7%), while supermarket prices had seen deflation from late-2015 to mid-2017, which recently turned into very modest inflation of 0.6%.           

EAT shares jumped 6% after reporting 1Q18 results as reported EPS of $0.42 was in line with consensus, but was negatively impacted by $0.03 from hurricane disruption, resulting in a “beat.” EAT shares have continued rising on no news. My guess is the company was incorrectly seen as a play on tax reform (EAT’s tax rate is 28%. Tax reform won’t lift its profits much. DineEquity [DIN], which owns Applebee’s, has a 40% tax rate. EAT may have been lifted with DIN. The recent buyout of Buffalo Wild Wings could have also contributed to EAT’s rise).

Low barriers to entry with intensifying competition everywhere

Anyone living in the U.S. has witnessed the exponential rise in the quantity and quality of restaurant options at reasonable prices during the past decade. In my opinion, Chili’s simply has not kept up, and it is quite overpriced for its very mediocre quality level. Another negative for Chili’s is that with the increasingly faster pace of life, the work lunch has become an endangered species. Fast casual has gained share as it provides the quality and speed that modern consumers are looking for. Intensifying competition from non-restaurant alternatives is also putting pressure on EAT. In recent months, grocery chains have not passed along commodities inflation to consumers due to increasing competition from online and deep discount chains. Amazon recently entered the business through the acquisition of Whole Foods and lowered Whole Foods’ prices, and German deep discount chains Aldi and Lidl are expanding their U.S. presence. In November 2017, food PPI (supermarket cost inflation) increased by 3.5% but consumers paid just 0.6% more (the largest negative spread for supermarkets in more than 3 years). Supermarkets are attempting to cut costs to absorb the inflation, while holding down the prices of staples such as milk, eggs and meat that shoppers watch closely as they are afraid of losing share to online and deep discount competition.

Food is a very low barrier to entry business and non-traditional competition for restaurants is flooding into the market. For example, Kroger recently began piloting Prep+Pared Meal Kits, which are prepared at home in 20 minutes and priced to compete with restaurants. Kroger management recently stated about the Cincinnati pilot of this new product, “We can hardly keep them on the shelf.” Kroger has expanded the meal kits to 200 stores and plans a further expansion in early 2018. Prep+Pared Meal Kits offer fresh, seasonal, prepped and measured meals that provide customers with only what is needed for each recipe (no waste). The kits feed two adults and are priced at $14-$20, beating Chili’s “2 for $22” dinner value offer. Kroger also hired outside talent to improve its prepared food business and referred to it as one of its strongest departments. Blue Apron ships its meal kits to consumers’ homes. OTG, a rapidly growing private firm, is bringing healthy and gourmet food options to airports (Chili’s has a decent presence in airports). In my view, the competition is offering consumers new, fresh and innovative meal options while Chili’s has shrunk its menu and is doing the same thing it has done for decades (cranking out mediocre quality) with its remaining menu.

CFO departs abruptly

In April 2017, EAT’s CFO departed abruptly after only 2 years at the company. A brief press release was put out stating that a search for a replacement was underway, and the I.R. head was named interim CFO. 4-months later, its former I.R. head, Joe Taylor, was named CFO.

I met EAT’s former CFO, Tom Edwards, at the company’s Investor Day (I originally looked at the stock as a long). I chatted with him for quite a while and found him to be down to earth, smart and realistic. It is almost unheard of for the CFO of a major public company to leave immediately for another opportunity, without allowing for a transition period. Edwards took the CFO role at Michael Kors.

(If I had to guess, I believe Edwards saw where the business was heading and was concerned about EAT’s leveraged recap [discussed later]. He was likely against it, but as a relatively new CFO was likely ignored by the board, which had committed to an aggressive capital return strategy. This is purely my educated guess.)

A guidance cut is inevitable

Former CFO Edwards’ final guidance was for a return to flat to +1% SSS, which the company failed to meet. New CFO Taylor maintained this outlook when issuing FY 2018 guidance. 1Q18 SSS came in at (3.4%) and this number was boosted by unsustainable items. Nonetheless, the new CFO maintained his guidance for flat to +1% SSS, and flat FCF, in FY 2018.

The 2Q18 quarter (December 2017) holds the holiday season. Last year, EAT—and brick and mortar retailers in general—saw a sharp decline in traffic as Americans increasingly shifted holiday shopping online. EAT historically benefitted during the holidays as hungry shoppers walked into its restaurants. But with the “Amazon effect” likely to only accelerate, the holidays season now looks like an increasing source of weakness going forward. In January 2018, Chili’s laps the 10% price increase on its dinner-for-two offer.

In short, every single component of SSS—traffic, pricing and mix shift—appears to have a downward outlook. At some point, the unsustainably large gap between traffic and SSS will narrow, and EAT will report high single digit declines in SSS. Closest peer Applebee’s reported (7.7%) SSS in its last quarter. DineEquity, the parent of Applebee’s and IHOP, cut 2017 FCF guidance by 20%. Ruby Tuesday’s SSS were (5.8%) in its last quarter composed of (9.4%) traffic partially offset by a +3.6% increase in the net check. Ruby Tuesday’s revenues declined by 15% as the company closed 95 underperforming restaurants. Chili’s has not moved into net restaurant closure mode (net locations have been flattish), but if current trends persist or worsen, it will be forced to rationalize its store base.

EAT’s FCF declined by 32% in 1Q18, making flat guidance on this metric highly optimistic.  

EAT’s leveraged recap continues on auto pilot

In FY 2016—prior to the sharp deterioration in traffic—management believed EAT could sustain 1%-3% SSS growth, 1%-2% growth in company-owned restaurants and modest annual margin improvement, leading to 4% to 7% EPS growth. Another 6% to 8% of EPS growth was to come from share buybacks, resulting in 10% to 15% sustainable EPS growth. Management seemed to “get it” as EAT had two mature casual dining concepts which were never going to generate competitive shareholder returns on their own but, with intelligent capital allocation, EAT could generate an attractive TSR.   

Starting with an under-levered balance sheet in FY 2010 (0.6x net debt/EBITDA), the company embarked on a multi-year leveraged recap where all of its post-dividend FCF, boosted by rising debt levels, was applied toward share buybacks. In addition, EAT raised its dividend every year.

The strategy worked wonders in its first few years, and from early-2010 to late-2014 EAT shares gained 250% vs. a 91% gain for the S&P 500. Management saw weak FY 2016 SSS (down 2.6%) as transitory, impacted by weakness in oil-exposed markets, as the decline in the price of oil hurt states such as Texas and Oklahoma where EAT is over-weighted. Unprecedented discounting by the major burger QSR chains which pulled traffic away from casual dining was also seen as transitory.     

In 2016, management laid out a 4-pronged growth/turnaround plan. The details of the plan are not important because, one by one, each initiative turned out to be a dud. As the EAT story changed from one with the potential for a strong turnaround to one of a melting ice cube, one thing did not change: the company’s leveraged recap. In fact, EAT accelerated its debt-fueled buybacks, viewing its declining stock as “attractive.” In FY 2017, the company’s first year of down overall revenues, EAT repurchased a record $370mm in stock. FCF was $210mm, dividends were $71mm, leaving post-dividend FCF at $139mm. The remaining $231mm was funded by debt and a reduction in cash which fell to just $9mm (from $55mm two years prior).

In 1Q18, as traffic at Chili’s fell by over 8%, EAT repurchased $42mm in stock. FCF was $28mm (down 32% Y/Y), dividends were $17mm, for post-dividend FCF of $11mm. The $31mm hole was filled with debt. On the earnings call, management stated that subsequent to the end of the quarter, EAT had repurchased an additional $30mm in shares (you can’t make this up).  

Leverage reached a record 3.8x, above the high end of management’s 3.5x to 3.75x target range. EAT leases 83% of its company-owned restaurants, resulting in lease-adjusted leverage of around 4.5x.

When EAT raised its leverage target to 3.5x-3.75x in 2016, management stated that it had stress tested for a recession and that the company would be fine. But management did not consider a scenario where down 8% traffic would be the new norm. When companies stress test, they typically look back to prior recessions to see how bad things got. In FY 2009, during the financial crisis, Chili’s experienced down 8.0% traffic (see preceding table). Management’s stress test likely viewed the financial crisis as a 100-year storm. With Chili’s traffic down ~8% in the September 2017 quarter, when U.S. GDP growth accelerated to 3.3%, traffic could easily be down double-digits in a garden variety recession. EAT’s balance sheet is poorly positioned for such a scenario. Also on auto pilot, EAT recently raised its dividend per share by 12%. Given the large share shrink, the increase is closer to 5% on a dollar basis.

Negative shareholder’s equity

EAT has a shareholder’s deficit of $539mm (more liabilities than assets). When removing goodwill and intangibles from the asset side, EAT’s tangible shareholder’s deficit is $729mm, or $15.00 per share. Assuming the highly unlikely scenario that future FCF remains flat with FY 2017’s $210mm (which is management’s guidance), EAT would need to stop share repurchases, not raise its dividend ($74mm annually), and build up cash for more than 5 years just to get to a zero tangible book value.

Earlier this year, competitor Ruby Tuesday (RT) received a buyout offer from private equity firm NRD Capital (which specializes in restaurants), after RT announced it would explore strategic alternatives. RT’s revenues had been declining for 4 years and the company went into cash burn mode in the past year (in fact, CFFO turned negative). NRD has virtually no downside risk as it paid $2.40 per share and RT has $4.93 per share in tangible book value. In my view, the RT buyout is likely to be a liquidation. NRD could realize 105% upside if it can get tangible book value in a liquidation. Some of NRD’s other portfolio companies could benefit from RT’s locations and restaurant equipment, purchased at 50 cents on the dollar.

EAT’s financial position is the opposite of RT’s. EAT does not have the backstop of a strong balance sheet. I asked EAT’s CEO at their last Investor Day if private equity would be interested in EAT. He said (paraphrasing), “when private equity buys a restaurant, they’re looking for real estate value. We don’t own much real estate and we have the highest margins in the business. There’s nothing for private equity to do with Brinker.” 

Financial Projections & Conclusion

In my base case, which assumes no recession, I have projected company-owned restaurant revenues (which include Chili’s and Maggiano’s) to decline by 4% annually, and franchise & other fees grow by 1% per year as Chili’s continues to expand overseas through franchises. I’ve assumed flat margins on all components except G&A which I kept flat on a dollar basis and assumed 20bps of annual deleverage on restaurant expenses which will face labor and rent inflation. I assumed a 26% tax rate going forward (down from 28%) giving EAT credit for tax reform. I further assumed that EAT stops buying back stock, maintains its dividend at its current rate, and deleverages going forward.

On a steady state basis, EAT’s revenues decline in the high-3% range annually, EBITDA declines by ~6%, FCF declines by ~9% and EPS (no longer bolstered by share buybacks) declines at an 12-13% annual rate.

EAT currently trades at 8x LTM EBITDA, which is its private market value. Given its melting ice cube outlook, I believe 6x is more appropriate, if not generous.    

Casual Dining Transactions

EAT Projections

At 6x EV/EBITDA, EAT is worth ~$21 a share in a year (every 0.5x turn impacts fair value by ~$4 per share; at 5.5x EV/EBITDA, EAT is worth ~$17 in a year). Going forward, as FCF reduces net debt but EBITDA continues to decline, the stock is worth slightly less each year, reaching a fair value of $18 in FY 20201 (using 6x EV/EBITDA).

In a recession, the stock could be worth far less as the company’s aggressively leveraged balance sheet and large shareholder’s deficit will take center stage. Longer term, if Chili’s proves to be a dying baby boomer concept, it is not hard to see EAT’s equity value approach zero.   

Risks

• EAT’s FCF exceeds EPS due to D&A exceeding capex. In FY 2018, I project $2.82 in EPS (midpoint guidance = $3.30) and $3.78 in FCF (midpoint guidance = $4.38). If leverage is ignored, the stock appears “cheap” at 10.6x FY 2018 FCF.

• Brick and mortar store traffic improved in the 2017 holiday shipping period as the U.S. savings rate fell to a 10-year low of 2.9% in November. Macy’s and JC Penny reported +1% and +3.4% SSS respectively in the Nov-Dec holiday shopping period. If Chili’s got a short-term benefit from hungry shoppers coming into its restaurants, I expect the lift to be short lived. Each time the U.S. savings rate fell to such an extreme low, it has foreshadowed a recession.

• If commodities inflation ramps up substantially and supermarkets pass it along to consumers as in 2011, EAT could see positive traffic growth for a time. While the revenue benefit would be offset by margin pressure as EAT would not be able to raise prices in line with inflation, this scenario would nonetheless be unpleasant for shorts. Intensifying competition at supermarkets makes a repeat of 2011 less likely.  

• While Maggiano’s (13% of revenues) is experiencing declining SSS, its performance is not as concerning as that of Chili’s. I believe Maggiano’s has a decent future and do not see it as a dying business like Chili’s. If EAT ever needed to sell Maggiano’s to delever, I believe there would be interest from strategic and financial buyers. But with just $63mm in EBITDA, if Maggiano’s is sold for 9.8x EBITDA (in line with the highest multiple ever paid in a casual dining transaction: Roark Capital’s recent purchase of Buffalo Wild Wings), it would bring in just $617mm in pre-tax proceeds (~$440mm after-tax). This would help reduce EAT’s $1.4 billion debt load, but wouldn’t change the long-term outlook for the remaining Chili’s business.     

• EAT is heavily, but not insanely, shorted (6.5 days).

Catalyst

• Guidance cut

• Increasingly negative SSS

• Declining FCF

• Ceasing of share repurchases to strengthen weak balance sheet