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We would not short Darden today, as our short thesis that we first outlined in July has become common knowledge, but we retain a bearish bias.  It is possible to construct a valuation/earnings case for 8-20%of downside but, for want of catalysts, we would not be taking a short position today.  With the emergence of a catalyst, we may become more vocal on the short side of DRI but for now we are covering our short position in the Hedgeye Restaurants Position Monitor.

Our rationale:

  1. The company has announced that earnings over the next 5 quarters will be disappointing
  2. SRS are likely to see a sequential uptick in 3QFY13
  3. The company has reduced capital spending enough to cover the dividend

Our bearish bias remains due to capital spending plans that remain overly aggressive and the fact that Darden’s most important asset – The Olive Garden – is a long way from being fixed.  

Summary of Our Thoughts on the Darden Meeting

The theme for the meeting, “Operating Successfully in a New Era”, was the first indication that this presentation would be somewhat detached from reality.  Several of the statements from management surprised us but most striking was the company only now stating that the change in the casual dining industry has been structural, not cyclical.  Darden has the largest system in casual dining.  Its national competitors have been recognizing the structural nature of the shift in casual dining customers’ habits for several years.  The demographic changes that we have written about are among the most obvious indications that the go-go days are over for casual dining.

Core Brands Remain the Problem

We believe that management has been tone deaf to consumer trends.  That may sound like an exaggeration but the two charts, below, speak to that argument.  An objectivity-damaging trust in internal customer satisfaction results rather than actual traffic trends is one factor we inferred from the presentation content.  The fact that the “Darden i-Tracker” is implying a consumer perception diametrically opposite to the trend in same-restaurant traffic growth perhaps calls into question the relevance of the internally generated metric.

The charts below show that, by the metrics that matter, Olive Garden and Red Lobster need a lot of work.  What’s more, management wasn’t forthcoming with many details on the Olive Garden turnaround; the technology segment of the Analyst Meeting was longer in duration that the Olive Garden segment. 

DRI: EASY YARDS ARE OVER - dri big 2 gap to knapp traffic

Sacrificing Growth to Keep the Dividend

The company pointed out that cash flow had to be managed more conservatively to support the dividend.

  • The current dividend is currently running at roughly $263mm on an annual basis
  • Free Cash Flow is anticipated to be $245-265 million in FY13
  • Mgmt has a policy of raising the dividend each year with a target of 50% payout ratio
  • The roughly $125 million cut in cap ex will eliminate that funding gap for the dividend

 

Cutting CapEx at Olive Garden

  • Cutting back CapEx from $700-$725 million in FY 2013 to $600-$650 million in FY 2014
  • OG new units scaled back from about 35 to 15 and
  • OG remodels put off until late FY14
  • LH openings from 40+ to 35-40

Olive Garden

The company’s most important business unit had the shortest presentation.  The new President, Dave George, is still settling into his role and impressed us with his observations and perspectives.  There were two major takeaways from the Olive Garden segment:

  • Remodels are being stopped and new unit openings are being slowed likely until sometime in FY14
  • Details of Tuscan remodel being tweaked, logo being updated
  • No new initiatives were announced

 

Red Lobster

Inconsistency has plagued Red Lobster over the last few years as promotions have failed to deliver steady results.  The Bar Harbor remodel program has been yielding some positive results for traffic but it seems that the turnaround at Red Lobster will take some time.  

Pricing

Management’s claim that limiting price increases to 1% will help drive incremental traffic growth seems to contradict recent Knapp Track, Gap-to-Knapp, and company data.  The underperformance of Olive Garden and Red Lobster in recent years would suggest that management’s understanding of its customers may not be acute enough to make such a claim.

The theory goes:

  • Management said “we are trying to target the check to the guest that need the relief” but how?
  • They said they are just now building the technology to have the ability know the consumer better, so how can they have target messaging now?
  • This technology will not be in place until late in FY 2014

Truth Hurts

We were a little perturbed by a statement from CEO Clarence Otis, at the end of the second day, that the company’s traffic problem is only a year old.  The data (charts earlier in this post) show otherwise and we believe this Analyst Meeting exposed a degree of detachment between Darden’s CEO and the nuts and bolts of the company’s operations. 

Howard Penney

Managing Director

Rory Green

Senior Analyst