Investor Days are important events; there are always messages being communicated – explicitly and/or implicitly – by management teams to the Street. We are adopting a “wait and see” stance with Darden’s stock; management is clear about the direction it is taking the company but we see some twists and turns in the road ahead.
The positive aspects of the Darden story are still the same as they have been for some time; the company has a strong balance sheet, is well-organized, and has strong competitive advantages within casual dining due to the economies of scale inherent in its business model. Before we can get more comfortable on the long side of DRI, some clarity is needed regarding several issues. Paramount among these issues is restaurant operating margin. Investors in restaurants absolutely care about restaurant operating margins; healthy margins help to insulate the company from the myriad of macro and industry- or company-related issues that can impact a company over the longer-term.
The most prominent messages from the management during Friday’s meeting were:
- The business is poised to outgrow the industry over the next five years
- The company continues to generate strong cash flow
- The current trends at Olive Garden suggest that the worst has passed for the concept
- Management is focusing on EBIT margin more than ROP margin going foward
THE LONG-TERM BUSINESS MODEL
The company reiterated that it expects to achieve 5-year annual revenue growth of +7-9% from annual same-store sales growth of +2-4% and unit growth of roughly 5%. Given those top-line numbers, management believes that EPS growth of 10-15% can be achieved.
By brand 5 year outlook is as follows
- OG = 6% revenue growth (+2.5% SSS; +3.5% New Units)
- RL = 5% revenue growth (+4.0% SSS; +1% New Units)
- LH = 14% revenue growth (+4.0% SSS; +10% New Units)
- Specialty = 20% revenue growth (+3.0% SSS; +17% New Units)
CASH FLOW GENERATION
Management stated that over the next 5 years, they expect to add between $2.6 billion to $3.3 billion in cumulative dividends and share repurchase. This represents roughly 40-50% of the company’s enterprise value. Over the longer term TAIL duration, this is a highly positive data point for the stock. Absent a significant deterioration in the fundamental performance of the company, shareholders will likely be rewarded greatly through the dividend and share repurchase programs over the next 5 years.
Olive Garden has been a point of contention for analysts covering Darden. As the largest component of the Darden portfolio with AUV’s at $4.7 million at the 776 Olive Garden restaurants currently in operation, the Olive Garden’s recent woes have caused many investors to take a step back. Management assuaged concerns, somewhat, by announcing better-than-expected preliminary 3QFY12 results (following two consecutive misses) with blended same-store sales of 4% versus guidance of 2.5-3% and 2.3% in 1HFY12. Olive Garden’s preliminary 2% (flat ex-weather) 3QFY12 comparable restaurant sales number was impressive versus its 1HFY12 comp of -2.7%. While this number was aided by weather, a flat-to-positive top-line print is good news. However, we are waiting to see more evidence of the turnaround at Olive Garden. It is important to be cognizant of both the weather impact that benefitted the restaurant industry during the winter months and the fact that over half of the Olive Garden store base is in need of remodeling.
On the negative side, Friday’s Investor Day saw management push out the completion date for the Olive Garden remodeling program by one year to FY15. The unknown is how the new promotional offerings at Olive Garden will perform. With offerings like three-course dinners for $12.95 and a new advertising campaign being launched, management is clearly targeting increased traffic while focusing more on EBIT margin than ROP margin.
MANAGING TO EBIT MARGINS
We were interested to hear what we believe is a distinct shift in management’s focus on margins. While Clarence Otis was correct in saying that the company has always managed to EBIT margins, our chief concern is that this has typically been done via higher restaurant operating margins in the past. During the 2011 Investor Day, the focus on unit level margins by brand stood out; the company was managing with those metrics in mind. While EBIT margins were a prominent focus during last year’s presentation, what was noteworthy this year was that management is now suggesting that some restaurant-level margin may have to be given up in order to grow traffic and expand EBIT margins. In theory this is possible but will likely be more difficult to bring about in practice.
We raised this topic with management during the Q&A segment of the presentation and Clarence Otis offered a fair response, saying that the company has been consistent in its focus on EBIT margins in managing Darden. This may be true from his perspective, overseeing the portfolio from the CEO’s seat, but having covered the company for some time and thinking about the different components of the portfolio over time, Friday’s commentary from management indicated to us that the company is now willing to sacrifice restaurant level margins to grow traffic.
With the benefits of the remodel program still a year away and the persistent value perception problem at Olive Garden still unresolved – although efforts are underway to address it – we are going to wait and see before taking a definitive positive or negative view on Olive Garden.
Commodities have hampered EPS growth over the past year but management expects food cost inflation to ease meaningfully in FY13. Food basket inflation is expected to be +12% for FY12 (ending May) versus +2% in FY11. Seafood costs are expected to be down 3% in FY13 while beef and chicken are expected to be up 12% and 2%, respectively. Seafood, beef, and chicken FY13 needs are 60%, 95%, and 40% locked, respectively.