This note was originally published December 08, 2012 at 08:51
The recent DRI press release stating the latest disappointment stopped short of dealing with reality.
A recent note we published highlighted the DRI Annual Report as an important document for investors given the primary takeaway which was: the growth ethos at Darden is an 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 believe that management has, and is continuing to, set itself up to miss expectations.
Unfortunately, the press release of December 4th did not address the most important issue that the company is facing: excessive growth.
Clearly, in light of the fundamentals at the company’s largest brands, the five-year growth plan outlined in the Annual Report needs to be reevaluated. The thesis of our Darden Black Book this past summer expressed our conviction that Darden’s continuing acceleration of new unit growth over the past couple of years has masked evidence of secular decline in Olive Garden and Red Lobster. Knowing what we now know about how FY13 to-date only adds to the need for management to address how its pace of growth can be sustained without further erosion to the financial health of the company.
The message from Darden’s management team highlights the economy as the biggest issue facing the company and, furthermore, sees weakness in trends at its core brands as being transitory in nature. We have suggested that the longer-term view, as defined by the data, suggests an altogether different story.
The traffic trends at Olive Garden and Red Lobster clearly are demanding significant 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 – traffic trends – that we are pointing to as a primary reference for our thesis are indicative of, in no small part, self-inflicted wounds.
If the company has become dependent on growth as a drug for all ailments, management’s message is not indicating that Darden is facing up to its growth problem. 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.
Going back to the very first conference call announcing Clarence Otis as CEO of the company, the pervading theme throughout his tenure has been “growth”. Acquisitions of LongHorn Steakhouse and, more recently, Yard House, are testament to the unwavering loyalty Darden’s CEO has to his philosophy.
Now the numbers don’t add up. The balance sheet is levered up and margins are declining. The company is not generating enough cash to pay the dividend given the current rate of capex growth. The dividend has become a liability.
Will management admit its past mistakes or, at least, change course and slow growth? Or will reality continue to be ignored? The earnings call on December 20th will be the first chance for management to face the music. The sooner they do it, in our view, the better.