Takeaway: "Growth" remains the religion of choice at $DRI. The trends are not sustainable and something's got to give

Darden’s Annual Report arrived this past weekend and made for some great reading.  The primary takeaway for us was that the “growth” ethos at Darden is as entrenched as ever.  Against a backdrop of sustained traffic declines, it is jarring to read the following sentence: “Our brands have strong individual and collective growth profiles”.   We think management is setting itself up to miss expectations.


If you have read our Darden Black Book you are aware of our conviction that the continued acceleration of Darden’s new unit growth over the past couple of years has served to mask evidence of a secular decline in the company’s two most important brands.  The Letter to Shareholders in the Annual Report contains no evidence of management slowing growth any time soon.  Management’s growth targets are bold to say the least.  How they get there while maintaining the financial health of the company remains to be seen.


This is not the first time we’ve held a view on a stock that is diametrically opposite to that of management.  MCD and SBUX were two names I went against the grain on in 2002 and 2006, respectively.  Of course, we’ve been wrong before but feel strongly about our thesis on Darden.  Conversations with clients and industry experts, without exception, have increased our confidence in our thesis.  This thesis is not going to play out today or tomorrow; we are aware that we are early on this one. 



It’s Not The Economy


Darden’s annual report suggests that management sees the economy as the biggest issue facing the company and, furthermore, sees weakness in trends at its core brands as being transitory in nature.  The longer-term view, as defined by the data, suggests an altogether different story.  On a very basic level, we believe that companies acknowledging their issues are generally more apt to arrive at solutions.  The traffic trends at Olive Garden and Red Lobster clearly are demanding action of management.  The economy is undoubtedly a factor but the poor performance of the “Big Two” versus the Knapp Track casual dining benchmark is a clear indication that the company’s sluggish traffic trends are not entirely attributable to the macroeconomic environment.  The data points that we are pointing to – traffic trends – as a primary reference for our thesis are indicative of, at least in part, self-inflicted wounds. 





If the company has become dependent on growth as a drug for all ailments, the Annual Report suggests that management does not seem to have freed itself from the “denial” stage of its addiction.  Stating that the “core brands remain highly relevant to restaurant consumers” can be supported by pointing to the average unit volumes at Red Lobster and Olive Garden as being some of the strongest in the industry.  We believe this statement to be misguided, however, when considering same-restaurant sales trends – a far more relevant metric when assessing relevance to the consumer:

  1. Red Lobster’s two-year average same-restaurant sales have declined over 10 of the last 16 quarters
  2. Olive Garden’s two-year average same-restaurant sales have declined over 8 of the last 16 quarters.

Red Lobster’s positive traffic trends in FY12 were driven largely by aggressive discounting while Olive Garden’s most recent data is deeply concerning.  The charts below illustrate the cumulative price and traffic trends for Olive Garden and Red Lobster relative to FY08.  Price has been taken steadily while traffic has generally trended lower with the exception of brief spurts into positive territory driven by LTO discounting.  Our concern is that the core brands of Darden, whether deemed relevant or not by management, are losing appeal for consumers as time goes by. 


The remedy for what ails Olive Garden, a system with 430 restaurants in need of remodeling, is not going to materialize imminently.  We believe that more dramatic measures may be needed to boost the competitiveness of the “Big Two”. 





What’s Consistent About Darden’s Margins?


The Darden Annual Report states, “our success will be driven by strong total sales growth and consistent margin expansion as we leverage our collective experience and an increasingly efficient support platform.”  We would like to address this quote in two parts. 


First: “consistent margin expansion”.


Darden’s EBIT margins are consistent in their absolute level but they are not expanding.  Contributing to Darden’s strong EBIT margins are the company’s restaurant level margins which were 23% in FY12.  Darden stands alone among the companies we follow in terms of its margins but we find it difficult to believe that significant expansion in that metric is likely from here given the reality of Olive Garden and Red Lobster’s traffic trends.


The outlook for margins is far more important than what is in the rear-view mirror and we contend that the need to improve the relative value proposition at Olive Garden and, to a lesser extent, Red Lobster is likely to lead to an easing in pricing trends.  Maintaining restaurant operating margins under this scenario will likely be difficult.  At the Analyst Meeting in February, management was vocal about lower menu prices improving traffic and allowing Darden to leverage G&A, thereby offsetting the restaurant operating margin decline and even expanding EBIT margins.


Second: “our success will be driven by strong total sales growth”.


Total sales growth has been strong but rather than focus on total sales or average unit volumes, we focus on traffic and comparable-sales trends as true indicators of top-line health.  Leveraging the balance sheet to buy top line growth is not a winning strategy, particularly for a stock whose ownership seeks stability and yield.  Traffic trends are expected to decline in FY13.



Operating Cash Flow Targets a Little Rich


Darden is projecting a doubling of its operating cash flow over the next five years despite its best-in-industry margins being at peak levels with traffic trends slowing.  This is a lofty goal when we consider that operating cash flow has declined 1% since 2008.  How does the company get there?





The chart, above, taken from the company’s Annual Report, shows that the company is guiding to operating cash flow doubling to $1.4-1.6 billion by FY17.  The company is also guiding to sales of $11.5-12.5 billion in the same year.  Looking at operating cash flow margin over the last five years, it seems that FY17 will have to be a very good year for the company to hit its implied target of 12.5%.  Over the past five years only once, in FY10, with 12.7%, did the company achieve or better the operating cash flow margin that is implied by the FY17 estimates.  FY10, it is also worth remembering, saw food and beverage costs decline 6.8% in what was the only year of the last five during which this cost declined for Darden.


In order to double its operating cash flow over the next five years, the company will require a sizeable recovery in sales at its two largest brands.  At a minimum, we believe that Olive Garden is two years away from a sales recovery beginning.  Over the past five years, from FY08 through FY12, the company has spent $2.6 billion to generate an incremental $242 million in EBITDA. 



Big Promises


The company has made the following commitments to its shareholders for the period ending FY17.

  1. SRS of 2-4% with 1-2% in FY13
  2. 500 new stores or ~$3.4 billion in capex (Hedgeye estimate)
  3. 2x operating cash flow to $1.5 billion
  4. Cumulative dividends and share repurchases of $3.2 billion

We believe these are tall orders, individually and collectively, for the company to deliver.  We will address these targets below:


Same-restaurant sales of 2.4% are dependent, according to management, on “normal” economic conditions (whatever that means).  Historically, the company has had pricing of 2-3% included in its comps but we believe that the primary brands’ pricing power will be diminished going forward.  Traffic in the casual dining industry declined 40 basis points in 2011 and 90 basis points over the last twelve months, according to Malcolm Knapp’s Casual Dining Same-Restaurant Sales Index. 


New restaurant growth is a key focus for Darden and the company has sufficient cash flow to grow 500 units over the next five years.  The more salient question is whether or not the company should allocate that capital to 500 new units over the next five years.  We believe the company should slow growth given decelerating Returns on Incremental Invested Capital.


Operating cash flow is unlikely to double in five years given the current run-rate of capital spending.  We anticipate roughly $3.4 billion of capex between now and the end of FY17.  As we highlighted earlier, operating cash flow margins need to expand significantly (300 bps) from FY12 to FY17 in order for operating cash flow targets to be made, assuming the sales guidance comes to fruition.


Returning cash to shareholders is a key Darden selling point.  The 3.8% dividend yield is highly appealing to investors and, since FY08, the company has raised the dividend 150% while EPS has grown 31%.  More importantly, the operating cash flow of the company has declined 1%, from $767 million to $762 million, between FY08 and FY12.  In order to pay the dividend and accomplish other capital-intensive goals, the company has burned through $689 million in cash.  In FY12, dividend and capital spending accounted for 113% of operating cash flow.  As a result, adjusted debt/EBITDA at the beginning of FY13 was 62% (prior to the recent acquisition), leaving the company little room to maneuver from an operational perspective and raising the stakes should margins decline.  The company’s long-term goal of returning $3.2 billion in cash to shareholders is dependent on expanding operating margins.  If this does not materialize, either the dividend or capex will need to be cut.






Senior management at DRI has a very ambitious 5-year plan, where there is very little room for error.  As we see it for management to accomplish this 5-year plan the following must happen:

  1. RL and OG need to improve traffic trends ASAP with no margin degradation.
  2. The company needs to leverage 2-4% same-store sales with little pricing
  3. Enterprise wide cost cutting is must
  4. Real estate site selection must be perfect and new unit sales trends must be above average
  5. Margin expansion is a must and there is little room for food or labor inflation (the impact of the new heath care will likely be inflationary)
  6. The company must overcome significant macro/demographic headwinds
  7. Darden must protect share against some rejuvenated competitors in EAT and BLMN
  8. Margins must be maintained as increased leverage is going to limit the operating flexibility of the company

We believe that Darden could, even while achieving its cash flow targets, burn through between $550-650 million in cash between FY13 and FY17.  The current path for Darden looks to be fraught with risk and largely unsustainable in its current form.



Howard Penney

Managing Director


Rory Green




Follow The Lightning

This note was originally published at 8am on August 16, 2012 for Hedgeye subscribers.

“I follow the lightning, And draw near to the place that it strikes.”

-Navajo Chant


Now I know that a lot of our clients want to talk about what consensus versus contrarian thinking is, in this no-volume marketplace, but I’m thinking they’d have a tough time advising their kids to go hard core contrarian like the early 19th century Navajos did.


Admittedly, I am developing a Darwinian confirmation bias in my reading list this summer as I delve into more Native American history with a book I started reading this week titled Blood and Thunder – “The epic story of Kit Carson and the Conquest of the American West.”


Whether it was the ability of the Navajo and Comanche tribes to adapt and survive the late 18th and early 19th centuries, or it’s what you are staring at on your screen this performance chasing morning, our goals remain common in human nature; evolve or die.


Back to the Global Macro Grind


Buy stocks or bonds?


Rarely can I time that question as critically as I’ll timestamp it this morning. Yes, these are the thralls of August. But Mr Macro Market couldn’t care less about our summer vacations. Timing matters right here and now, big time.


Timing was especially important in answering this same basic asset allocation question in the middle of March 2012 (see Darius Dale’s Chart of the Day): 

  1. Stocks wouldn’t go down
  2. Bonds wouldn’t go up
  3. Volatility went away 

In fact, by the time the VIX hit 14.26 on March 26th (the Russell2000 topped for 2012 on the same day at 846, +5.2% higher than where it is today), there was a massive consensus (both buy and sell side)  that “growth was back” and “earnings are great.”


Fast forward to June… and US stocks were gasping for air in the middle of a double-digit drawdown (Russell2000 and SP500 down -13% and -10% from their late March highs) as US Treasuries put on a massive move to the upside (10yr yield dropped -42%, from 2.4% to 1.4%).


What drove the correct answer to the stocks vs bonds question?


Global #GrowthSlowing. Period.


What will get you to the correct answer for the next 1-3 months, from here?


Follow The Lightning.


The most abysmal volume and volatility readings I have ever recorded in my US Equity model aside, there are 2 basic realities that both bulls and bears have to deal with this morning: 

  1. US stocks are making both intermediate and long-term lower-highs
  2. US bonds are making both intermediate and long-term higher-lows 

In other words, if you believe Growth is going to improve from here, you buy stocks. If you’re more confident (like we and the data are) on #GrowthSlowing, you buy bonds.


Our predictive tracking algorithm (the one that called for #GrowthSlowing when few did in March), which is a multi-factor, multi-duration model, is telling us that this is a fairly straightforward call to make because:


A)     Oil prices are up +32% (Brent) from the June low (that slows growth)

B)      Corporate Revenue growth’s slope is as weak as it has been, globally, since Q308

C)      Chinese Growth continues to surprise on the downside


Chinese what? Yes, while I suppose you could say that China’s Foreign Direct Investment (FDI) print this morning of -9% year-over-year was better than India’s Export growth tanking to -15% year-over-year earlier this week, we highly suggest you take China’s word for it:


“In the second half, China’s foreign trade and export situation will be more grim, there will be more difficulties, harder tasks, and the pressure of achieving the full-year target will be bigger…” –China Ministry of Commerce (this morning)


Now, before you zap me with the bull counterpoint (for stocks) to this (rate cuts, stimuli, bailouts, etc.), just remember that doing more of the same will only keep food/energy prices higher (and growth slower) for longer. That’s bullish for bonds, longer term. And our long-term TAIL risk line for growth (bond yields) remains intact at 1.94% on the US Treasury 10yr.


My immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar, EUR/USD, 10yr UST Yield, and the SP500 are now $1601-1612, $111.69-116.21, $82.34-82.97, $1.22-1.24, 1.56-1.82%, and 1391-1410, respectively.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Follow The Lightning - Chart of the Day


Follow The Lightning - Virtual Portfolio


The Macau Metro Monitor, August 30, 2012




Hong Kong-listed Success Universe Group Ltd. said the target completion date for Phase 3 of Ponte 16 is 2014.  Phase 3 will comprise of an entertainment and recreation complex including a shopping arcade, restaurants and “space for gaming expansion.”  Ponte 16 is 49% owned by an indirect subsidiary of the company, while 51% is owned by SJM.

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Walking Away

“In many cases, they simply walked away.”

-Hampton Sides


That’s a quote about the Anasazi people of Chaco Canyon in Chapter 31 of Blood and Thunder. By 1150 AD, “just as quickly as they had burst upon the scene, the Chacoan culture ebbed… the Anasazi had overfarmed, overhunted, and overlogged.


After a 200 year ( AD) “cultural boom that has no parallel in North American pre-history… archeologists have come to call this the Chaco Phenomenon… this environmental upheaval led, predictably enough, to a social upheaval.” (pages 266-267)


Whether some study history doesn’t matter. Markets do. They rise and fall. For centuries,  ideologies, regimes, and civilizations have lived and died by the sword of evolution. Just when you don’t think it could never happen to yours, it starts happening.


Back to the Global Macro Grind


How long can Keynesian governments over-spend, over-consume, and over-promise on bailout resources that they do not have?


I don’t know. And neither did Jim Rickards on our Currency Wars conference call yesterday. What we both agreed on, however, is that within the framework of considering global markets as a complex system, we’re getting real close to the tipping point.


Rickards explained it using “critical threshold” math. I always discuss it internally within the Chaos Theory of emergent properties triggering phase transitions. For those of you who are Keynesians or Monetarists, we’re talking a different risk management language here. Alongside physics, applied math, etc., we’ve chosen to think outside the Western academic box. We’ve evolved.


To simplify the complex, a “phase transition” is the transformation of a dynamic system (global markets, across asset classes) from one state to another. Pundits don’t get why they call it this, but they call it something like “risk on, risk off.”


Unfortunately, phase transitions don’t happen like the Karate Kid learning how to wax. There is no centrally timed “on, off.” There is no “smoothing mechanism” or certainty in analyzing when emergent properties (risk spreads) move into a phase transition.


In thermodynamics, you can understand what a phase transition is by reading an 8th grade Chinese textbook (they have them in English too). “For example, a liquid may become gas upon heating to the boiling point.” (Wikipedia)


What’s the market’s boiling point?


To answer that question, many people who have not evolved their process in this business would answer using the US stock market and maybe a 50-day moving average sprinkled with some storytelling dust.


*Risk Manager Note: the US stock market is not the dynamic and globally interconnected currency, commodity, bond, etc. market that our 27 multi-factor, multi-duration model is writing about every day.


Jim Rickards is very good because markets have humbled him enough over the years to answer the aforementioned question with “I don’t know.” That’s also a cornerstone of what we (Chaos and Complexity Theorists) do vs. what they (Keynesian Policy Makers) do.


We Embrace Uncertainty.


One suggestion I had to answering the most frequent question I get from clients (again, what’s the boiling point, or point when this entire centrally planned gong show of broken policy promises implodes) was measuring Spread Risk in key Global Macro relationships:

  1. The long-term spread between Money Supply (rising as they print money) and Velocity of Money (falling, fast)
  2. The long-term spread between the US Dollar and the CRB Commodities Index
  3. The long-term spread between the SP500 priced nominally versus priced in Gold (see Rickards’ Chart of The Day)

I’ve probably geeked out enough on the math this morning, but since Paul Ryan is going all-math on CNN’ers, I’m cool with it.  I’ll also leave you this morning with more questions than any of us have answers.


But that’s cool too - if that’s the story of your professional life, you really are constantly learning and evolving.


The Hedgeye Portfolio is beta adjusted net short for this morning’s US market open. We continue to think you sell stocks and commodities at VIX 14-15 and buy bonds there too.


Timing matters; especially when entire populations of investors are Walking Away from something that’s been abused and broken – the market’s trust.


My immediate-term risk ranges for Gold, Oil (Brent), US Dollar, EUR/USD, 10yr Treasury Yield, and the SP500 are now $1, $111.79-113.76, $81.11-81.97, $1.23-1.26, 1.58-1.71%, and 1, respectively.


Best of luck out there today,



Keith R. McCullough
Chief Executive Officer


Walking Away - Chart of the Day


Walking Away - Virtual Portfolio


TODAY’S S&P 500 SET-UP – August 30, 2012

As we look at today’s set up for the S&P 500, the range is 18 points or -0.67% downside to 1401 and 0.60% upside to 1419. 











    • Increase versus the prior day’s trading of 386
  • VOLUME: on 08/29 NYSE 509.30
    • Decrease versus prior day’s trading of -1.39%
  • VIX:  as of 08/29 was at 17.06
    • Increase versus most recent day’s trading of 3.46%
    • Year-to-date decrease of -27.09%
  • SPX PUT/CALL RATIO: as of 08/29 closed at 1.69
    • Up from the day prior at 1.49


  • TED SPREAD: as of this morning 32.55
  • 3-MONTH T-BILL YIELD: as of this morning 0.10%
  • 10-Year: as of this morning 1.64%
    • Decrease from prior day’s trading of 1.65%
  • YIELD CURVE: as of this morning 1.38
    • Unchanged from prior day’s trading

MACRO DATA POINTS (Bloomberg Estimates)

  • 8:30am: Personal Income, July, est. 0.3% (prior 0.5%)
  • 8:30am: Personal Spending, July, est. 0.5% (prior 0.0%)
  • 8:30am: PCE Deflator M/m, July, est. 0.1% (prior 0.1%)
  • 8:30am: PCE Core M/m, July, est. 0.1% (prior 0.2%)
  • 8:30am: Initial Jobless Claims, Aug. 24, est. 370k (prior 372k)
  • 9:45am: Bloomberg Consumer Comfort, Aug. 26 (prior -47.4)
  • 10am: Freddie Mac mortgage rates
  • 10:30am: EIA natural-gas change
  • 11am: Kansas City Fed Manufacturing Activity, Aug. est. 3 (prior 5)
  • 11am: Fed to purchase $1.5b-$2b notes 2/15/2036-8/15/2042
  • 1pm: U.S. to sell $29b 7-yr. notes
  • TBA: ICSC Chain Store Sales Y/y, Aug. (prior 1.9%)


    • Romney accepts Republican nomination as candidate for presidency
    • House, Senate not in session
    • FERC meets on coordination between natural gas, electricity markets in Mid-Atlantic Region, 9am
    • SEC holds closed meeting on enforcement matters, 2pm
    • California holds trial auction of carbon allowances, 1pm


  • Isaac’s threat to offshore energy production eases
  • China’s Wen says Spain, Italy and Greece must step up overhaul
  • Barclays names Antony Jenkins as CEO to replace Diamond
  • Euro-area economic confidence falls more than forecast
  • CIBC 3Q earnings beat est.; boosts dividend to C$0.94
  • Caterpillar says China growth may recover on stimulus
  • Japan Air seeks $8.4b in biggest IPO since Facebook
  • WPP cuts sales growth forecast as clients reduce spending
  • German unemployment rises for 5th month in August
  • Nokia Siemens said to be close to selling business-support unit
  • Mando may buy former affiliate Halla Climate from Visteon
  • Pandora jumps in extending trading after break-even 2Q earns
  • Samsung unveils pen-equipped Galaxy phone to keep lead on Apple
  • Comcast said near U.S. approval to encrypt cable signals
  • Hewlett-Packard plans first Windows 8 touch-screen laptops
  • August same-store sales may gain 1.8% on back-to-school


    • Royal Bank of Canada (RY CN) 6am, C$1.18
    • China Sunergy (CSUN) 6am, $(1.41)
    • Toronto-Dominion (TD CN) 6:30am, C$1.83
    • Ciena (CIEN US) 7am, $(0.02)
    • Esterline Technologies (ESL) 4pm, $1.11
    • Cascade (CASC) 4pm, $1.29
    • Zumiez (ZUMZ) 4pm, $0.13
    • SAIC (SAI) 4:02pm, $0.33
    • National Bank of Canada (NA CN) 4:15pm, C$1.90
    • Omnivision (OVTI) 4:18pm, $0.24
    • Splunk (SPLK) 4:35pm, $(0.03)


  • Dust Bowl Kansas Farmers Set to Plant Winter Wheat: Commodities
  • Africa Gas Rush Imperils $100 Billion in Australian LNG: Energy
  • U.S. Gasoline a Bargain as Motorists Pay 63% Less Than Norway
  • Oil Declines for a Second Day as Stockpiles Rise, Storm Weakens
  • Copper Rises on Reduced Concern About Euro-Region Debt Crisis
  • Wheat Drops as Rally May Prompt Farmer Sales; Soybeans Decline
  • Gold Set to Advance on Speculation Bernanke to Hint at Stimulus
  • Cocoa Rises as West Africa May Have Little to Sell; Coffee Falls
  • Weakening Tropical Storm Isaac Eases U.S. Gulf Energy Risk
  • France’s Wine Production Will Be ‘Extraordinarily Low’ in 2012
  • China’s Iron Ore Output Dropped 10% in August as Prices Slid
  • India Set to Get Above-Average Monsoon Rains in Next Two Weeks
  • Record Gas Trade Shows Italy Craves Hub by 2015: Energy Markets
  • China Copper Demand Seen Growing at Slowest Pace in 15 Years
  • Grain-Barge Logjam From Isaac Rains Compounding Drought Slowdown
  • Wheat Imports by Thailand May Double as Local Rice Prices Surge
  • Copper Set to Decline on Ichimoku Cloud Top: Technical Analysis





USD – manic media back-pedaling, hard, on the Bernanke bailout drugs tomorrow; Washington Post article may have stole little Hilsenrath’s thunder, suggesting what Gold prices have all wk, no drugs for u. With the USD/Gold immediate-term TRADE inverse correlation -0.91 right now, this matters, big time. Paul Ryan is USD bullish, on the margin.






RUSSIA – big economy, big beta – watching this one closely as the USD makes higher-lows and Oil/Gold lower-highs; Russian Stocks (RTSI) have led European losers this wk and now the RTSI just moved back into crash mode (-20% from YTD top); beta is not alpha.






JAPAN – another lower-high for Japanese stocks on another fundamental growth miss (Japanese Retail Sales -0.8% y/y now that subsidies burned off); Nikkei is down -12.4% since #GrowthSlowing began, globally, in March; ugly session in Asian Equities taking them to flat for AUG.










The Hedgeye Macro Team

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