DRI - Cutting costs at the right time

DRI beat 3Q09 expectations and raised its full-year 2009 guidance based on slightly better than expected sales performance and significantly better cost management. At first glance, I was not surprised to see that DRI had beat street expectations as I continue to maintain that DRI, along with EAT, is well positioned to outperform as a result of its consistently superior same-store sales relative to the overall industry and strong balance sheet. I was somewhat surprised, however, to learn how DRI achieved its better than expected earnings.

As restaurant companies have become more focused on eliminating costs to offset the challenging sales environment, this type of cost cutting earnings beat has become more common. Yet, DRI is one of the few casual dining companies that has not scaled back on new unit growth. Instead, DRI’s FY09 capital expenditures are expected to total about $575 million, up 34% from FY08. This capital spending number includes about $80 million of costs related to the company’s new corporate headquarters, but even excluding these costs, capital spending is expected to increase 15% from 2008 levels.

Most other casual dining companies have been able to cut costs as a result of their having slowed down new development and capital spending, which enables them to cut back on resources and eliminate the inefficiencies associated with new unit growth. DRI, on the other hand, was able to achieve such substantial cost savings on top of its continued unit growth. The company stated that it was able to mitigate the impact of sales deleveraging on margins, primarily as a result of aggressive cost reductions, which lowered costs by $10 million in the quarter. Management said these savings were achieved earlier and were of greater magnitude than it initially expected. Acquisition synergies also helped to lower costs in the quarter. The company anticipates that annual acquisition synergies will level out at about $55 million with much of those savings already in place.

Relative to DRI’s prior FY09 guidance, the company is expecting better operating margin performance a result of improved leverage of its food and beverage, labor and restaurant expenses. And, this is based on only slightly better 2H09 same-store sales growth at Red Lobster, Olive Garden and LongHorn Steakhouse of -1.5% to -3% from its prior guidance of -2% to -4%. Although I was happy to see the company achieve these substantial cost savings in the quarter and improve its restaurant margins in 3Q09 by over 280 bps on a sequential basis from the second quarter, I am somewhat wary of the company’s ability to continue to deliver such incremental savings on a go forward basis as the company maintains its unit growth targets. DRI did slightly lower its FY10 new unit growth expectations to 53-65 from about 70 in FY09, but this is still significant growth in today’s environment. Despite my reservations around DRI’s ability to further materially reduce costs, I continue to believe that DRI will outperform its competitors, largely as a result of its nationally recognized brands.

There was some concern communicated on the earnings call about DRI’s declining gap to Knapp trends in 3Q to about 3% for its Red Lobster, Olive Garden and LongHorn Steakhouse concepts on a blended basis from 5% in 2Q. Such a decline signals that DRI is potentially losing share to its competitors, which is never a good thing. This 5% outperformance in 2Q, however, followed a 2.7% spread in 1Q so although there has been variability quarter to quarter, I think it is important to note DRI’s consistent outperformance, most notably at the Olive Garden.

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