Brinker: A Strong Start To FY24 With Traffic Outperformance

The CY-Q3 Earnings Season for the restaurant sector has begun, and while it's been a mixed start so far for casual dining with Dine Brands (DIN) disappointing, Brinker International (NYSE:EAT) was an exception. Not only did the company meet its expectations and enjoy its fourth consecutive quarter of outperformance vs. the industry at its flagship Chili's brand, but it also saw a significant improvement in restaurant operating margins which soared more than 400 basis points year-over-year. And while this was partially because of lapping easy year-over-year comparisons, the company noted that October traffic has been positive; it raised its full-year annual earnings per share guidance, and it continues to see key operating metrics trend in the right direction. Let's take a closer look at the results below and see whether the stock is worthy of investment at current levels.

Fiscal Q1 Results and Updated FY2024 Outlook

Brinker International ("Brinker") released its fiscal Q1 2024 results (CY-Q3) this week, reporting quarterly revenue of ~$1,012 million, a 6% increase year-over-year. This was driven by 5.8% comp sales growth (6.1% Chili's, 2.6% Maggiano's) on the back of higher menu pricing and favorable mix, offset by a 5.8% traffic decline. The last figure might seem alarming and certainly is not ideal, but it's important to note that Chili's outperformed the industry average and 4.0% of this traffic decline across its system was related to the de-emphasis on its virtual brands: It's Just Wings and Maggiano's Classics. Hence, the traffic decline was closer to 2% without this impact, and while this drag will continue to show up in the fiscal Q2 and fiscal Q3 results, the drag will be much less significant by year-end.

Digging into the results a little closer, the focus on the Core 4 menu items (Burgers, Fajitas, Chicken Crispers, Margaritas) at Chili's appears to be paying off as is its higher marketing spend, with key operating metrics continuing to trend in the right direction. This includes improved guest food scores and lower incidences of guests with a problem [GWAP]. Meanwhile, a focus on simplifying operations and investments in labor also appears to be having a positive impact on labor, with the company noting that it has seen much lower management turnover which should help with hourly turnover rates and ultimately improve guest satisfaction (more experienced employees/managers make fewer mistakes and provide better/quicker service, delivering a better guest experience overall). And as noted above, these improvements appeared to have persisted into Q4 despite a drop-off in industry-wide traffic, with Chili's set to report high single-digit comp sales growth for October (first month of fiscal Q2) with 6-7% effective pricing and positive traffic.

Moving over to margins, we saw a meaningful improvement in Brinker's results, with food and beverage costs improving nearly 500 basis points year-over-year to 25.8% with strength in Chicken Crispers (higher chicken mix with chicken price deflation) and favorable pricing for dairy and pork. Meanwhile, labor also improved year-over-year by 20 basis points to 34.7% despite investments in wages, benefiting from the high single digit pricing at Chili's and Maggiano's. Finally, while other expenses rose year-over-year, this was more than offset by leverage in the cost of goods sold and labor expenses, with restaurant operating margins improving to ~10.4% vs. 6.0% in the same period last year. And given the strong results, Brinker has raised its FY2024 annual EPS guidance to $3.35 to $3.65, up from $3.15 to $3.55 previously.

Assuming Brinker even delivers at the low end of guidance, this would translate to a meaningful improvement in its earnings after a tough FY2023 because of commodity inflation, and we should see further earnings next year if the company can continue to execute successfully. That said, Maggiano's performed a little weaker than I expected (partially due to removing It's Just Wings from the menu and reducing its focus on $6 Pasta To Go), so it would be nice to see some more improvement here even if key metrics at Chili's are trending in the right direction.

Industry-Wide Trends and Recent Developments

Moving over to industry-wide trends and recent developments, Brinker noted it will benefit from deflation in its commodity basket in fiscal Q2, which is a positive divergence from some brands that have a higher weighting of their menu to beef. Hence, if the company can maintain its industry-leading traffic, this would set up another solid quarter for margins on deck. That said, while the labor situation has improved, we will likely see an increase in labor as a percentage of sales in fiscal Q2 and Q3 vs. fiscal Q1 levels given that Brinker will see some roll off in price, with the company planning to exit fiscal Q2 at mid-5% pricing vs. high single-digit pricing in fiscal Q1 (9.5% Maggiano's, 8.8% Chili's). Hence, while margins were strong in the period, some moderation would not be surprising unless it can continue to outperform internal expectations on traffic.

As for traffic, company commentary and pricing, the company noted that it would be tactical with pricing in the back half of the year vs. employing blanket pricing given the difficult macro outlook. Meanwhile, it shared that it's seeing continued spending across all income cohorts and growing wallet share, but with its more affluent guest growing faster. This is consistent with other company-wide commentary, which suggests that some less affluent guests are getting pinched and potentially priced out of casual dining which is not overly surprising, but it's clear that Brinker is seeing less impact here at least based on its most recent results. And while traffic did come in at negative levels in fiscal Q1 even after separating out the impact of less contribution from It's Just Wings and Maggiano's Classic (Virtual Brands), it's clear that Brinker outperformed, especially looking at seated diners growth in the United States which showed steeply declining traffic through most of fiscal Q1 (July through September).

Given that the company appears to have found a way to buck the negative industry-wide traffic trends with its increased marketing, reduced deep discounting, but still maintaining a strong value proposition while others like Applebee's have struggled (Q3: 2.4% comp sales decline), the above traffic trends are less of a worry than they might be for other brands. That said, things aren't getting any easier with personal savings rates continuing to trend lower into an expensive holiday season while credit card debt sits at record levels. So, although the recent results are positive and it's encouraging to see Chili's continued to outperform, I still think it makes sense to ensure a significant margin of safety before starting new stock positions in more sensitive industry groups, especially when the backdrop is so challenging. Let's look at Brinker's valuation below:

Valuation

Based on ~45.5 million shares and a share price of $35.30, Brinker trades at a market cap of ~$1.6 billion and an enterprise value of ~$3.6 billion. This leaves the stock trading at ~9.0x EV/EBITDA, which is slightly below its 10-year average of 9.2x EV/EBITDA. Meanwhile, Brinker trades at just over 10.0x FY2024 earnings estimates ($3.36), also a reasonable valuation vs. its historical multiple of 12.8x. That said, I believe a more reasonable multiple for the stock is 11.0x earnings given the interest rate environment and challenging macro backdrop, and this points to a fair value for EAT of $37.40, pointing to only a 6% upside from current levels. And if we apply a 25% discount to fair value to ensure a margin of safety, EAT is nowhere near its ideal buy zone, which would come in at $28.10 or lower. Hence, while Brinker may be executing better than some of its peers, I still don't see enough of a margin of safety at current levels.

Summary

Brinker reported better than expected fiscal Q1 results and certainly outshined Dine Brands (DIN) which has slid sharply on earnings after more disappointing results out of Applebee's. Notably, key operating metrics continue to trend in the right direction, and while we may have seen peak margins in fiscal Q1 and could see some moderation as pricing rolls off, the outperformance from a traffic standpoint is encouraging, as is its commentary on labor turnover. That said, I prefer to buy at a deep discount to fair value or pass entirely, and while Brinker is reasonably valued, I don't see enough margin of safety at current levels. Hence, if this rally were to continue, I would view any rallies above $37.40 before year-end as an opportunity to book some profits.