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Takeaway: With one statement - “we have been too protective about our margins” - the management of Darden declared war on casual dining.

With one statement - “we have been too protective about our margins” - the management of Darden declared war on casual dining. This not going to end well for anybody, but DRI has the most to lose.

Going forward, all of DRI advertising spending will focus on price point promotions and move away from “brand building” initiatives. Knowing what we know now, it looks clear why the company’s CMO jumped ship last month! Consumers will definitely “sea food” differently.

We believe that the company is taking a very big risk on the future of the company and there is a better-than-average chance it could end up being pivotal moment for the casual dining industry. We already know that the Red Lobster customer is transitory and only coming back consistently when the food is on sale; now the company will be training the Olive Garden customers to behave the same way. This is a difficult habit to coax consumers out of, once they have attained it. As our Chief Compliance Officer, Moshe Silver, likes to say, “it is much easier to make a mess than it is to clean it up”.

The company will be adding another 100 new store to this potential mess in FY2013 and likely another 90-100 in FY2014!

The massive discounting strategy they conveyed to the street is reactionary and defensive. We believe there are several important issues to consider when assessing the current strategy:

1. LACKING CREDIBILITY: Over the last two years DRI senior management team has proven they are not in sync with what the consumer wants!

2. CART BEFORE THE HORSE: DRI has not fixed the cost structure of the company, especially the middle of the P&L (food and labor costs) to effectively compete at lower price points.

3. NO PRICING POWER: Once you go down the road of discounting, it is difficult to turn back. Future inflation in input costs is felt more acutely as discounting increases.

4. MARGIN: How much margin will they need to give up before they see a sustained improvement in traffic? Do they have the ability to predict consumer behavior around the current promotions?

5. BLOATED COST STRUCTURE: As a multi-brand restaurant company DRI carries significantly more infrastructure and growth related expense. It should also be noted that the top six executives at DRI took home over $23 million in compensation.

In FY1H13 DRI earned $1.13 on $3.994 billion in revenue. So what does the company strategy of significant discounting mean for FY2H13? We have the company earning $2.00 on $4.485 billion in revenues. The street consensus is for the company to earn $2.27 on $4.60 billion in revenues. As we have seen over time with DRI conformation bias exists in the numbers; the street has historically given management the benefit of the doubt. We are taking the other side of that trade.

Bottom line, we think uncertainty overwhelms the ability of the street or the company to know how this new tack will be reflected in the company’s results. We would suggest that more pain than expected, not less, is likely before the company’s repositioning is complete.

In six months, every management team in the casual dining space is going to be wishing that DRI would go back to raising prices 2-3% every year and driving customers away!

Howard Penney

Managing Director

Rory Green

Senior Analyst