Darden reports 4QFY12 earnings on Friday the 22nd of June at 7:00 am.  The earnings call begins at 08:30 am.  We have adopted a stance of “casual dining caution” since April 20th as sales trends and underlying macro fundamentals for the casual dining group seemed to be softening.  Darden's stock has long been considered the bellwether of casual dining but, beyond our concerns about the broader group’s outlook, we believe there are additional company-specific factors working against Darden as we move into FY2013.  We believe that besides initial FY13 guidance, commentary on Olive Garden – specifically traffic trends and additional guidance on the remodel program – will be the primary focus for investors when the earnings release hits the tape. We would not be buyers of the stock ahead of earnings.


Consensus estimates for 4QFY12 have declined by roughly $0.02 over the past month but expectations for FY13 have remained unchanged, suggesting that the Street expects the company to push through the recent slowdown in sales.  Any deviation from this narrative, on the part of the company, will likely cause the stock to sell off.  Excluding one-time items that the Street may not traditionally pay for (like cutting G&A), there is still a chance the company misses $1.15 4QFY12 EPS expectations.  Overall, we believe that the company is in "investment mode", attempting to bolster its appeal to customers at all of its concepts.


Casual Dining Backdrop


Below, we show the Hedgeye Casual Dining Index versus Initial Claims (inverted) and also Darden versus Initial Claims (on the right).  The soft employment backdrop is negative for both casual dining and Darden; we expect management to allude to this during the conference call. 


DRI SHAPING UP TO DISAPPOINT - cas dining dri initial claims



3QFY12 Recap and Look Ahead


Macro: Management referred to the "choppy" environment during the earnings call on March 23rd.  At that time, according to the company, improving employment was being offset by the impact of rising gas prices.  Given that employment trends have softened since March, and gas prices peaked in early April, it will be interesting to hear which of these management weighs more heavily in its outlook for the rest of the calendar year.  In late April, CFO Branford Richmond, speaking at a conference, stated that “that’s [the broader industry] really driven … by job creation.”  We expect the tone to be negative if/when management touches on the macro environment as the employment picture has deteriorated since the most recently reported quarter.



Olive Garden: Weak traffic trends at Olive Garden are a concern for investors and will be one of the first numbers we look for when the press release hits on Friday morning.  Although promotions helped Olive Garden to narrow the Gap-to-Knapp during 3QFY12, we expect the sequentially weakening industry sales (Knapp Track) to weigh on Olive Garden trends.   


According to Consensus Metrix, the Street is anticipating Olive Garden’s 4QFY12 comps to come in at 0.48%, which would imply a two-year average trend of 0.2% versus 1.0% in 3QFY12.  While this two-year average decline would be a negative, we estimate that 0.48% would imply a sequential improvement in the Gap-to-Knapp metric: we estimate that it would imply +0.8% versus Knapp Track.  Olive Garden has underperformed Knapp for six consecutive quarters and, while the gap has been closing, we do not think that the pace at which the gap narrowed during 3QFY12 continued into 4Q. The promotions offered during 3QFY12 at Olive Garden compared very favorably to the 3QFY11 promotional offerings which performed poorly.  We think that the Street is overly optimistic in expecting 0.48% same-restaurant sales growth at Olive Garden in 4QFY12.


DRI SHAPING UP TO DISAPPOINT - olive garden gap to knapp



Red Lobster: Red Lobster posted a 6% same-restaurant sales growth number for 3QFY12, as preannounced, which benefitted by 480 basis points due to an earlier start to Lent 2012 versus 2011. According to Consensus Metrix, the Street is expecting 1.28% same-restaurant sales growth in 4QFY12 as the Lent benefit reverses.  This implies a two-year average decline in comps of 60 basis points and sequential decline, we estimate, versus Knapp Track.  During the most recent earnings call, management stated that “Red Lobster's fourth quarter same-restaurant sales will be adversely affected because of the shift forward in Lent and Lobsterfest.”


DRI SHAPING UP TO DISAPPOINT - red lobster gap to knapp



LongHorn Steakhouse: LongHorn remains a key focus for the company; the chain has been growing comps in the mid-single digit range for six consecutive quarters and new LongHorn units continue to exceed sales and earnings targets set by the company.  LongHorn is likely to continue to perform strongly.  While the chain is important for the longer-term TAIL story, we see Olive Garden and Red Lobster as being more important for the stocks near-term TRADE and intermediate term TREND price action.


DRI SHAPING UP TO DISAPPOINT - longhorn gap to knapp



A note on weather: Looking at top line trends for Darden’s restaurants versus 3QFY12, we see a risk that the street underestimates the boost that weather provided to the company during the winter months.  As we wrote on 2/22 in a post titled “WINTER WONDERLAND”, the state of Texas was heavily impacted by the adverse weather conditions for an entire week in February in 2011.  A year later, there was little-to-no snow in the Southern Region of the United States, according to data from the National Operational Hydrologic Remote Sensing Center.  According to a New York Times article of 2/4/11 titled, “Snow and Ice Paralyze Texas From Rio Grande to Oklahoma Border”, a snow storm on that morning hit much of Texas and created chaos for travelers traveling ahead of the Superbowl that Sunday.  During a conference on 4/24/12, Darden’s management team included Texas as a state that does not "traditionally see much of a weather impact", the implication being that the market there had improved its sales during 3QFY12 without any significant boost from weather, as occurred in the North East during January and February of 2012.  We think that the weather data and media reports suggest otherwise.  In light of the dramatic year-over-year change in weather conditions within Texas (a state with 148 of Darden’s 1,849 restaurants), we think that 3QFY12 comps may have been helped aided by weather more than management has implied.  





Howard Penney

Managing Director


Rory Green


BBBY: Showing Some Risky TAIL

BBBY showed its TAIL risk after the close with comps decelerating nearly 400bps sequentially, producing the greatest negative deviation relative to our home furnishings index we’ve seen since its inception. On top of 2 non-core acquisitions over a 1 month time period this is a complete validation of every concern we’ve had for BBBY.


Our Home furnishings index, which we use as a leading indicator for BBBY comps, implied a +6.5% comp. The +3% print was simply a massive miss. Our model is based in large part on Personal Consumption and Retail Sales for different home goods products. It’s proven to be extremely accurate over time, with a 0.75x correlation, and if you ex-out the period when it was putting Linens ‘n Things out of business (and posted outsized comps) the correlation is closer to 0.90x. Directionally, something went very wrong this quarter.  Yes, there’s definitely the on-line share loss factor , but it’s also no mistake that this is happening in conjunction with BBBY’s headquarter move. The margin of error there is too great to ignore – especially with the company integrating two acquisitions.


We’ve remained negative on the intermediate term TREND and long term TAIL and are reiterating our stance. Consider the Following:


  • After adjusting for the $0.06 tax benefit, BBBY 1Q12 EPS came in a penny below expectations driven by light revenue growth (+5.1% vs. +6.4E) and weak gross margins (-65bps vs. -25E)
  • The Gross Margin decline in the quarter was driven by both an increase in coupon redemptions & redemption amount as well as the continued shift to lower margin product categories. In light of BBBY citing AUR as a driver of the +3% comps, the shift to lower margin product categories suggests the pricing mix may also be shifting upwards, driving a greater coupon redemption dollar amount. Notably, per our in store AMZN/BBBY sku overlap analysis (see chart below), AMZN has 10-15% lower prices in higher ASP product categories suggesting a shift to higher price point categories could keep BBBY at risk of additional couponing or online attrition pressuring margins further.
  • The sales to inventory spread declined 5 points sequentially to -1% in Q1 after having popped into positive territory last quarter. This creates a somewhat bearish gross margin setup over the intermediate term TREND especially given the incremental coupon use at a time when PIR highlighted a balance in full price and promotional selling with no major negative change in the discounting environment relative to last year.
  • BBBY said that it remains focused on enhancing its omni channel experience and expects its new 800,000 square foot e-commerce fulfillment center to be operational in 2H12. Today, e-commerce accounts for ~1% of total sales and has been declining over the past 3 years. Customer demographics continue to be a key issue here. 65% of BBBY’s current online consumers are above the age of 35. Industry data suggests that BBBY’s exposure to the 55 & up demographic increased nearly 300bps in 2011 vs. 2010 to 26% putting BBBY 9th in terms of the most exposed to the older demographic relative to the 95 companies we’ve analyzed. It is nearly impossible for e-commerce to really gain traction without investing and while not a direct comp, WSM’s omni channel model currently boasts e-commerce nearing 40% of sales.
  • Although BBBY reiterated its full year EPS growth of HSD-LDD and comp of +2-4%, operating margins are now expected to be down vs. flat to down slightly previously. Despite the net negative change in outlook on the margin, this still seems aggressive. At a minimum, it seems like the time where we can all give them a free pass on beating guidance is gone.
  • BBBY has leveraged operating expenses nearly 200bps over each of the last 3 years with operating expenses up only ~1% in Q1 and down 2.2% on a per square foot basis. BBBY had originally guided advertising activities to remain flat in F12 however if BBBY expects a reacceleration in the business and traction online, they will have to spend to get it.

We remain bearish here – not because of what happened, but because of what the quarter and recent strategic actions signify. The company’s model remains exposed to the online threat (with a 93% direct sku overlap with with its competitive advantage remaining in its in-store experience. Though it seems demand is slowing (per our Home Furnishings Index below) BBBY’s current share is slipping for the first time in many years -- which will require incremental investments back into the business following 3 years of opex leverage. Not good with BBBY sitting at peak ~17% operating margins. We remain negative on the long term TAIL call here. 


Matt Darula



BBBY: Showing Some Risky TAIL - BBBY comp index


BBBY: Showing Some Risky TAIL - AMZN BBBY pricing


BBBY: Showing Some Risky TAIL - BBBY SIGMA

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HedgeyeRetail Visual: H&M European Reacceleration?


We’re surprised by the sequential improvement in trend line sales by country at H&M through Q2. It’s notable to us that the only major countries H&M serves that are incrementally trending down on the margin are the US as well as Sweden. While none of H&M’s second tier countries are knocking  the cover off the ball – i.e. all up less than 5% on a 2-year run-rate – they’re all running up sequentially except for the Netherlands (5% of sales). The company also noted that 2Q markdown activity was unchanged vs. last year confirming that aforementioned sales were not discount driven – an incremental positive re ongoing concern over European demand.




HedgeyeRetail Visual: H&M European Reacceleration? - top countries


HedgeyeRetail Visual: H&M European Reacceleration? - 2nd tier 


Discover Financial Services (DFS) has been a darling for the market over the last several quarters. Between improving credit and the ability to return capital, the company at face value looks very solid.


Behind the curtain, however, are issues that raise concerns. So much so that Hedgeye Financials Sector Head Josh Steiner has immediately gone bearish on TRADE, TREND and TAIL durations. Steiner has effectively found four main issues with the company and the stock that make his case clear:


  • Peak earnings on what is now a peak multiple. When everything is going right, it’s usually not long before something goes wrong.
  • We see 18% downside just from mean reversion, and that incorporates no credit quality deterioration.
  • Volume slowdowns precede credit slowdowns. We’re seeing evidence on multiple fronts now that volume growth is decelerating.
  • Sentiment on DFS is uber-bullish. Not one sell rating among 26 analysts (19 buys / 7 holds) and short interest in its bottom quintile since coming public.

So while the banks and sellside analysts remain primarily bullish on DFS, Steiner continues to stand contrarian. It appears that the good times can only roll for so long before something goes wrong.





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