Brinker International Stock: Near-Term Outlook Appears Weak

Investment Conclusion

Brinker International (NYSE:EAT) is the owner and operator of Tex-Mex Grill, Chili’s, and Italian cuisine purveyor, Maggiano’s. We believe the company is likely to struggle over the near term because Chili’s which accounted for ~89% of EAT’s total sales in FY2022, is experiencing declining customer traffic, once again, a recurring theme since 2016. Margins, impacted by inflationary headwinds, have turned similarly downwards. Considering sweeping initiatives being planned to turnaround the business, including limiting discounting, rolling-back of rewards program incentives, reducing spending company-wide, and even culling the store count, it appears the situation is urgent.

We are encouraged that management is focused on improving Chili’s financial performance. However, although we would not want to bet against the new CEO who previously held leadership roles at Kentucky Fried Chicken and Pizza Hut, given lackluster results associated with prior turnaround attempts, we are not convinced that the current effort will succeed. In our judgment, the Chili’s brand has turned stale because it failed to modernize with the times (beyond facilitating e-commerce and order delivery), and to keep pace with Environment, Sustainability, and Governance (ESG) trends that appeal to newer generations (~50% of its target customer population). Whereas restaurant concepts are focused of preparing food from scratch with fresh ingredients in their kitchens, Chili’s is serving up Kraft Mac & Cheese and Margaritas prepared from mixers.

In contrast, Maggiano’s business is thriving, with rapid growth in sales and customer traffic. We view the brand as a key long-term growth driver for EAT. However, Maggiano’s represented only ~11% of EAT’s sales in FY2022. Nevertheless, the concept is low hanging fruit, an opportunity for EAT to benefit from, whenever management believes it’s prudent.

Given our conflicted opinion on Chili’s, we suggest investors remain on the sidelines until the brand’s fundamentals improve, substantially. We are initiating on EAT with a Neutral Rating and a 1-year Price Target of $47/share based on inputs to our 10-year Discounted Cash Flow model.

Investment Thesis

The EAT business is comprised of two restaurant groups: Chilis’s and Maggiano’s. Chilis, founded in 1975, in Dallas, Texas has 1,596 locations, 1,232 located in 49 U.S. states, and 364, in international geographies. Of the restaurant mix, 1,136 are operated by EAT and 460 are driven by franchisees. Maggiano’s first restaurant was opened in 1991, in Chicago, Illinois. The concept has 54 restaurants in 24 states, and no foreign presence.

In FY2022, EAT generated: ~$3.80 billion in revenues, reflecting a growth rate of 14% compared to FY2021, same-store sales growth of 7.83% over the prior year, ~$118 million in net income reflecting a contraction of ~10.6% on a year-over-year basis, $2.58 in earnings per share (negative 8.84% compared to FY2021), and ~$52.2 million in operating cash flows. At the end of June 2022, EAT had a cash and cash equivalents balance of ~$13.5 million and long-term debt of ~$921 million on its balance sheet.

The predominant issue garnering investor concern is whether Chili’s turnaround efforts will succeed this time around? The secondary element surrounding the EAT story is related to Maggiano’s potential to offset some of the decline in Chili’s, if the chain continues to struggle, over an elongated time horizon.

Chili’s Turnaround Not Impossible. However, Needs Significant Effort.

During FY2022, Chili’s retail sales associated with company operated stores, increased by 10%, total revenues expanded by 10.4%, and domestic same-store sales advanced by 8.3%. However, based on F4Q2022 financial outcomes, it appears that the brand’s business deteriorated towards the end of the period. In that regard, it is important to note that during the fourth quarter, Chili’s sales declined 2.5% to ~$877 million, average weekly sales decreased 1.3% to ~$59,500, restaurant operating margins contracted by 690 bps to 10.2%, and operating income decreased 52.7% to ~$59.5 million. Although, some fraction of the underperformance can be attributed to inflationary pressures, a larger portion is clearly due to a weakening in the concept’s business fundamentals. During the F4Q2022 Earnings Call, management admitted that Chili’s appeared to be slowing down, and announced sweeping changes to turnaround the concept.

To begin with, significant shifts are expected in the quantities of discounted food and free food available to customers at Chili’s. In that regard, with a view to substantially reduce discounts on menu items, the brand will limit the number of selections available under its 3 For Me value offering, and that associated with its $9 lunch combo. In addition, it will right-size the mix of everyday menu-items available as value deals. Further, the loyalty program will be retooled to support increase in the frequency of customer visits while rolling-back the amount of food given away as rewards. Moreover, strategic menu price increases are in the works to account for spending associated with delivery orders, particularly commissions paid out to third party aggregators.

Furthermore, strategies to remove complexity from back-of-the-restaurant activities, including streamlining kitchen preparation activities, improving capacity and procedures associated with the Fry Zone which typically is overwhelmed during dinner rush hour, and reducing administrative documentation, are expected to be deployed. In addition, plans are being devised to reduce the number of food items currently being utilized by the virtual brands, which management believes is considerably large for a business that generates ~6% of EAT’s total sales.

Moreover, with the goal of opportunistically utilizing current menu offerings to maximize sales potential, cuisine being marketed under EAT’s ‘Its Just Wings’ virtual brand is now available as part of Chili’s ‘Raise The Bar’ initiative, which features new bar food and beverages. In an additional swap, Chicken Tenders, available at Chili’s restaurants, are now being offered on the ‘Its Just Wings’ menu. Finally, with a view to focus national attention on Chili’s value deals, advertising is anticipated to be concentrated on campaigns that will promote the brand’s discounted menu items (including the $10.99, 3 For Me offering, and the $9 lunch combo), among low income guests, that represent the target audience for the fare.

Given business dynamics associated with Chili’s, management expects continued decline in customer traffic for FY2023. Specifically, EAT expects Chili’s customer traffic to decrease by low single digits over the upcoming fiscal year. For the organization, revenues are anticipated in a range of $3.9 billion to $4 billion, representing a year-over-year growth of 3.9%, from the midpoint of the estimate. Earnings per share are expected to come in between $2.45 to $2.85, reflecting an annualized expansion of 2.7%, from the midpoint of the projection. For the whole fiscal year, price increases of 8% and 7% are planned for Chili’s and Maggiano’s. EAT expects to add 19 new restaurants to its footprint over FY2023.

Considering, the challenges ahead for Chili’s and its reflection on FY2023 financial guidance, it appears that turning around the brand is likely to be a long drawn out struggle. In our opinion, more than cosmetic changes will be required to materially improve Chili’s business. Less than a complete overhaul of the entire enterprise is likely to represent a short-term bandage.

Trends Indicate Maggiano’s Could Develop Into Secular Growth Driver

In contrast to Chili’s fast casual roots, Maggiano’s is a more polished upscale full-service restaurant concept with huge dining-rooms, designated banquet facilities at every location, and catering services for medium to large parties. Each restaurant is uniquely designed with stately facilities including dining rooms and banquet areas decorated with fresh flowers, warm carpets, and soft lighting. Maggiano’s serves lunch and dinner, prepared from scratch in each restaurant’s kitchen under the supervision of an Executive Chef. In addition, the brand offers a full off-premise menu, with meals available for take-out and delivery through third party platforms.

Maggiano’s has outperformed financially over recent quarters, experiencing growth well beyond pre-pandemic levels. To be specific, over FY2022, the concept generated ~$407 million in sales and ~$425 in revenues. In addition, during F4Q2022, sales expanded 18.3% to ~$111 million, comparable sale advanced by 30.1%, average weekly sales increased 29.3% to ~$163,000, restaurant operating margins declined 170 bps to 12.1%, and operating income expanded 3.4% to ~$14.1 million.

In the context of growth potential, we are cognizant that footprint expansion might be relatively curtailed considering that Italian food is a niche category. However, with just 54 stores in 48 cities across 24 states, the restaurant base appears sufficiently small to encourage significant geographic diversification across the U.S. and abroad, particularly in Canada. In that regard, Olive Garden, though not an apples-to-apples comparison, given its more plebeian profile, with dinner entrées priced between $10 to $20, average check of $21, and median restaurant size of 7,700 square feet, has 887 domestic restaurants. Maggiano’s restaurants arguably more higher-end, with entrées priced in a range of $8.99 to $42.99, average check of $29.40, and restaurant size of between 8,100 to 28,400 square feet, with 60 to 100 tables, and 260 to 770 seats, definitely has substantial white space for geographic diversification, given its differentiated profile, as the only one of its type in scope.

Given, Maggiano’s persistent financial outperformance since its founding, it appears that customers that enjoy Italian food find the concept highly appealing. Therefore, it would be prudent for EAT to increase its focus on Maggiano’s, accelerate the development of the business, and consider it a significant long-term growth driver, rather than a secondary subsidiary.

Risks

Limited Compliance With ESG Could Disappoint Customers. Millennials are hyper-attentive to concepts such as Diversity, Equity, and Inclusion (DEI) and Environment, Sustainability, and Governance (ESG). Based on a section devoted in EAT’s most recent 10-K on DEI initiatives it has implemented, it is clear that the company has done enough to satisfy its target customer group. However, with respect to ESG policies, EAT appears to have fallen short, particularly in regard to packaging material and waste, and opportunities in nutrition and health.

Chili’s continues to utilize plastic boxes for delivery and take-out orders, incorporate frozen produce in customer meals, and deploy microwaves and heat lamps to maintain food temperature. EAT’s Morningstar provided ESG Score is 23.7, which indicates that the firm is at medium risk for non-compliance. In our opinion, EAT has a lot to gain in form of customer satisfaction scores, if it were to roll-out ESG initiatives at Chili’s that demonstrate greater environmental and sustainability awareness.

One-Year Price Target

We utilized 10-year Discounted Cash Flow analysis including a perpetual growth based terminal value, to arrive at a 1-year Price Target of $47/share for EAT. We assume a normalized 10-year revenue growth rate of 3%, (vs. FY2022 revenue growth rate of ~14%). In addition, we derive our net income for 10-years using a net profit margin of 4% (vs. net profit margin of ~3.09% in FY2022). Based on our analysis of EAT’s historic financial reports, we model normalized 10-year operating cash flows as 8.55% of revenues/year and straight line 10-year capital expenditure as 3.39% of revenue/year. Furthermore, we deploy a perpetual growth rate of 3% and a weighted average cost of capital of 12% to reach our terminal value and present value of free cash flow figures. We utilize the current diluted outstanding share count of 44.8 million to arrive at our 1-year Price Target.

Bottom Line

EAT is a classic case of a company going to seed. At one point, the firm was comprised of nine brands, today it has two. Although, there have been no additional untoward incidents associated with Chili’s since its customer data breach in 2018, and the instance of cockroaches running around in the kitchen and dining areas of its Florida based restaurant, also in 2018, something appears off about the brand, and customers sense it too. We suggest current investors closely follow the turnaround effort at Chili’s and adjust their positions in EAT accordingly. The concept could be on the ropes within a few years, in our opinion.