DRI - There does not appear to be a Macro Process

My number one concern about DRI continues to stem from the company’s new unit growth targets, which I don’t think properly reflect the current environment. Management acknowledged the tough environment saying, “There's no question it has been a difficult quarter and given the difficult economic environment, it looks like it is going to be a challenging year. Our current sales and earnings outlook reflects that.” Despite these challenging times when operating profit growth declined at each of the company’s core concepts, Red Lobster comparable sales declined for the third consecutive quarter with traffic down about 5.5% in 1Q and LongHorn posted a 4.9% same-store sales decline with traffic down about 7%, DRI maintained its FY09 unit growth targets (75-80 new restaurants, or 4%-5% unit growth).
DRI management has been saying for some time now that the company’s plan to achieve sustainable growth at Red Lobster has three phases: first phase was to strengthen brand fundamentals. The second phase included refreshing the brand, broadening its appeal and building guest counts. The third phase included accelerating new unit growth. As early as 4Q07, DRI communicated that this plan included the expectation that phase 3, or new unit growth, would begin later in FY09. I would have thought phase 3 would have been contingent on phase 2 having been accomplished, but the company stated again today that it will resume meaningful unit growth in 2H09 and expects to open 10 net new restaurants. Management admitted that although operating fundamentals (phase 1) have greatly improved, that Red Lobster is still working to “broaden the appeal of their brand and recapture lapsed users,” which communicated to me that they understand that phase 2 has not been completed, but they are moving ahead with phase 3 regardless. Traffic continues to decline (again, part of phase 2), but management appears unwilling to back away from their initial forecast for growth in FY09.

Apparently, I am not the only one concerned about DRI’s growth outlook as management was questioned on its conference call this morning about its continued commitment to restaurant development at Red Lobster in 2H09 relative to the concept’s performing below expectations. CEO Clarence Otis replied by saying that from a traffic standpoint, Red Lobster has outperformed the industry in the last couple of years with a materially higher average check, which leads him to believe Red Lobster has performed strong competitively. I found this answer to be a little surprising because the industry has experienced negative traffic for the better part of the last three years so outperforming these negative metrics will not lead to enhanced returns.

Additionally, Mr. Otis said that the decision to add new Red Lobster units is more of a restaurant by restaurant and market by market type of analysis. “I don't know that we have a pace of expansion that we think makes sense versus we scour the country and look at the markets and decide market by market does this restaurant make sense from a return perspective. And so it is very much a bottom up driven expansion. Here's a market that's expanded, that is strong a trade area we think we can get X guests out of. It makes sense to open this restaurant. All that adds up to five one year, other years to ten. It is more about that, and to the extent that the guest count level that we start to make that restaurant by restaurant assumption from is lower and we scale out over 30 years, fewer trade areas will make sense. So that's a little bit of how we think about Red Lobster. I don't know that there's a master plan as opposed to a unit by unit investment decision.” I found this comment to be interesting because if the CEO does not know the master plan, who does? Given the trends in the quarter and the outlook for the balance of the year combined with the current level of unemployment, trends in macro factors would point to a different strategy.




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