Conclusion: Darden continues to deliver from an earnings perspective and management is not raising any red flags. With respect to Red Lobster, there are structural issues that need to be addressed.
Darden’s earnings call brought few surprises to the fore this morning with management reaffirming their long-term EPS guidance within their 10-15% growth range. This is based on a long-term same restaurant sales growth target of 2-4%. Currently, for FY11, the company is trending at or above the higher end of the longer term EPS range (guided to +14-17% growth) and at the lower end of the same restaurant sales range (guided to approximately +2% growth, down from its prior +2-3% guided range). While this dynamic is unsustainable, it puts a premium on sustained management of cost efficiencies and continued strong performance of new units.
Looking at same-store sales trends, there is reason to be concerned by the decline in the GAP-TO-KNAPP which has narrowed significantly for Darden over the past couple of years. Looking at The Olive Garden, on a fiscal year basis, the Gap to Knapp has come down meaningfully from levels sustained throughout much of FY08, FY09, and most of FY10. The second chart below shows the Gap to Knapp for Red Lobster and it is clear to see why many investors view this as DRI’s “everlasting turnaround”. The brand has been struggling for some time, relative to the performance of Olive Garden, and now LongHorn.
President and Chief Operating Officer, Andrew Madsen, emphasized Darden’s wariness of “utilizing deep discounts to combat difficult industry conditions”. It seems to me that the Great Recession may have changed the playing field in such a way that Red Lobster, in its current form, is suffering from structural problems as it relates to today’s Red Lobster customer.
Management talked around this issue during this morning’s call, singling out “price specificity” in its marketing message as being a key driver of traffic at Red Lobster but it is clearly lower prices, a.k.a. discounting, that is driving traffic at the concept.
There was a promotional timing mismatch with Red Lobster’s Endless Shrimp promotion (began two weeks later and was one week shorter than the Endless Shrimp promotion in FY2010), which was altered to “help address the very difficult business conditions”. It is fair to say that the promotion mismatch was a negative year-over-year for Red Lobster. However, at the same time, explicitly stated in management’s explanation of this mismatch and general commentary today is the view that business conditions, year-over-year, are much improved from their “difficult” level of FY2010. It seems that the Red Lobster customer has been rendered an “impaired asset” by the Great Recession and the price elasticity of demand is high relative to other casual dining customers as a result.
In contrast to Red Lobster, The Olive Garden’s environment has improved year-over-year relative to necessary value-driven marketing (only ran 10 weeks of value-oriented, price-point advertising this year versus 18 weeks last year). This was outlined in management’s comments surrounding their wariness of discounting and the same was true for LongHorn as it was for Olive Garden. All in all, I think that the bifurcation between these two brands and Red Lobster, in this regard, underlines the need for management to address the glaring issues with Red Lobster gaining traction with its customer base.
Margin performance in 2QFY11 was strong, thanks to an improvement in food and beverage expense that was attributable to lower food costs offset by negative mix changes related to the company’s promotional offerings strategy. Labor expense declined by 120 basis points thanks to improved productivity and lower turnover, partially offset by higher benefit expense. Management said more than once that with comps turning positive, they expect to see more leverage across the P&L, particularly on the labor cost line.
In terms of outlook, management expressed comfort with their earnings target for the full fiscal year 2011 in spite of same restaurant sales being at the lower end of their embedded range of 2-4%. It is important to note that even with DRI lowering its blended comp guidance to +2%, they might not have lowered the bar enough. A +2% comp for the full year implies a significant uptick in two-year average trends from current levels. Even if I assume a significant acceleration in trends at Red Lobster, combined with continued steady improvements at Olive Garden and LongHorn, I have a hard time getting to +2% for the year. Management said the improved trends should be driven largely by:
- An improvement in the overall casual dining environment during its 2HFY11 relative to 1HFY11
- An increased benefit at LongHorn from more advertising in 2HFY11
- A more balanced YOY promotional marketing schedule in 2HFY11
- Improvements at Red Lobster as the concept gains traction from better delivering affordability.
We will have to see how the industry overall fares, but according to Malcolm’s Knapp’s most recently reported November numbers, trends slowed slightly on both a one-year and two-year average basis. And, although comp trends were positive in November at each of DRI’s three largest concepts, two-year average trends slowed across the board from October levels.
Leverage over the labor line was highlighted as a bright spot for last quarter but it is clear that commodity costs will be a determining factor in DRI’s earnings performance for the remainder of FY11. Management forecasts commodity costs to be 1-1.5% higher in 2HFY11 on a year-over-year basis. Specifically, the company guided to flat food and beverage costs as a percentage of sales for the full year. Given that these costs were about 80 bps favorable in 1QFY11 and 10 bps favorable in 2QFY11, the food and beverage expense line will become a headwind for the company on a YOY basis in 2HFY11. In terms of visibility, most of their commodity costs are locked with the exception of beef which is only 25% covered and constitutes 14% of DRI’s food cost basket. Management expressed their intent to extend coverage after the holidays.