Brinker International: Nice Comps Fuel The Rally

| About: Brinker International, (EAT)
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Summary

EAT has seen its shares trade higher after earnings on strong comps.

Labor costs are too high and must come down but the business is very strong otherwise.

I think earnings estimates are reasonable and EAT's current price offers some margin of safety.

Shares of Brinker International (NYSE:EAT) have been on a tear. A multi-year rally has seen EAT rise from the $20 area to $56 on strong earnings and improving investor sentiment. The company's October earnings report initially sent shares diving on traffic and expense worries but since that time, shares have resumed the uptrend and new highs are being made. After the latest earnings report, is there more left in the tank at Brinker or are investors expecting too much? In this article, I'll take a look at EAT to see if the rally should continue or if investors may want to look at taking profits here.

To do this I'll use a DCF-type model you can read more about here. The model uses inputs including earnings estimates, which I've borrowed from Yahoo!, dividends, which I've set to grow at 6% annually and a discount rate, which I've set at the 10 year Treasury rate plus a risk premium of 6.75%.

 

2013

2015

2016

2017

2018

2019

2020

Earnings Forecast

             

Prior Year earnings per share

 

$2.71

$3.08

$3.51

$3.98

$4.52

$5.12

x(1+Forecasted earnings growth)

 

13.70%

14.00%

13.38%

13.38%

13.38%

13.38%

=Forecasted earnings per share

 

$3.08

$3.51

$3.98

$4.52

$5.12

$5.80

               

Equity Book Value Forecasts

             

Equity book value at beginning of year

 

$0.60

$2.56

$4.89

$7.61

$10.79

$14.50

Earnings per share

 

$3.08

$3.51

$3.98

$4.52

$5.12

$5.80

-Dividends per share

 

$1.12

$1.19

$1.26

$1.33

$1.41

$1.50

=Equity book value at EOY

$0.60

$2.56

$4.89

$7.61

$10.79

$14.50

$18.80

               

Abnormal earnings

             

Equity book value at begin of year

 

$0.60

$2.56

$4.89

$7.61

$10.79

$14.50

x Equity cost of capital

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

=Normal earnings

 

$0.05

$0.23

$0.44

$0.68

$0.97

$1.30

               

Forecasted EPS

 

$3.08

$3.51

$3.98

$4.52

$5.12

$5.80

-Normal earnings

 

$0.05

$0.23

$0.44

$0.68

$0.97

$1.30

=Abnormal earnings

 

$3.03

$3.28

$3.54

$3.83

$4.15

$4.50

               

Valuation

             

Future abnormal earnings

 

$3.03

$3.28

$3.54

$3.83

$4.15

$4.50

x discount factor(0.09)

 

0.917

0.842

0.772

0.708

0.650

0.596

=Abnormal earnings disc to present

 

$2.78

$2.76

$2.74

$2.71

$2.70

$2.68

               

Abnormal earnings in year +6

           

$4.50

Assumed long-term growth rate

           

3.00%

Value of terminal year

           

$75.00

               

Estimated share price

             

Sum of discounted AE over horizon

 

$13.69

         

+PV of terminal year AE

 

$44.72

         

=PV of all AE

 

$58.40

         

+Current equity book value

 

$0.60

         

=Estimated current share price

 

$59.00

         

We can see the model produces a fair value of $59, a couple of dollars higher than shares currently trade for. That is important as the model is designed to provide investors with a margin of safety at the fair value price. That implies that not only is EAT reasonably valued right now but a moderate margin of safety is also implied. EAT looks like a good value but let's dig in to see if the fundamentals hold.

The company's earnings report was pretty nice; comps came in at around 2% for the system, a nice number in today's restaurant environment. The in-line EPS number, however, was overshadowed by the top line miss of about 3%. The store count was also up almost one percent in the quarter and there was particular strength from company-owned Chili's stores. One cause for concern was restaurant labor costs, which were up nearly 4% in the quarter, far outpacing revenue gains. Keep an eye on this going forward as margins in the restaurant industry are low enough as it is without adding undue labor cost into the model. But overall, the report was decent and while there were some hiccups, EAT showed pretty solid execution in the quarter and the selloff was unwarranted.

EAT has favorable fundamentals right now. The company is showing demand is strong for its products, it's adding stores and it is doing so profitably. Analysts are looking for 4% sales growth next year and I think that's pretty reasonable; the company should add around 2% or 3% to the store base and comps should come in at around 2%. Of course, that leaves some potential upside if the company can get people in the door and boost comps.

One area where I do have some concern is that EAT's operating margins have been flat to down for the past three years. After boosting operating margins to 8.2% in 2012, EAT saw 9% in 2013 but last year, that number fell to 8.3%. The TTM number is higher at 8.4% but in order for EAT to hit the high bar of ~14% projected EPS growth, it needs to grow operating margins. I highlighted the growth in labor costs at the restaurant level earlier and this is where that number becomes very important. I would really like to see EAT get restaurant labor costs under control because it simply cannot sustain 4% growth in labor costs for long. Operating margins are suffering for it and it must be addressed quickly. If we continue to see labor costs rise more quickly than revenue you can forget about 14% EPS growth because margins simply will not support that with higher labor costs.

One more word of caution on EAT has to do with its mounting debt. EAT has been a heavy borrower for years now and long term debt on the balance sheet has soared to $865 million. The company has been spending roughly $250 to $300 million each year to pay the dividend and buy back stock and that is money the business simply doesn't produce on its own. Thus, EAT has been borrowing to finance those activities as well as capital spending and the level of debt is starting to become concerning. Luckily, the business is profitable and growing so I'm not concerned about default but I would like to see the borrowing slow down. I love dividends and buybacks but there is a point where the costs of the debt outweigh the benefits of its use.

Overall I think EAT looks pretty reasonably valued here. I think earnings estimates are a little optimistic but the good news is that EAT is pricing in lower growth than what analysts are expecting, leaving a little room for error. I'd like to see labor costs get under control as they are rising unsustainably quickly and I'd also like to see the borrowing stop (unlikely) or at least slow down. EAT's business is strong right now and that's something a lot of restaurant chains cannot say; with a few chinks in the armor, I still think EAT looks good here.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.