Darden is being mismanaged, plain and simple.


The earnings call on Friday underscored our argument that Darden needs a shakeup in the C-Suite. $1 billion in operating cash (annually) is not being put to productive use and statements from the company’s leadership on Friday did not demonstrate an ability to turn the company around. There was a mea culpa, of sorts, at the beginning of the call where management acknowledged the detrimental impact of operational reorganization and margin pressure from promotional strategies. That said, we believe that the past five years’ performance has been indicative of a mismanaged business. The sum of the parts is greater than the whole, at Darden, and we believe there is a striking opportunity for an activist to enter the fray, unlock value, and benefit holders of the company’s stock.



Too Big To Move Traffic


“Now as fiscal 2013 unfolded, I think many of you know that we moved with added urgency to address the same restaurant traffic erosion we'd been experiencing since the recession started. First, we began to match the competitive promotional intensity around affordability. And that included being more aggressive with our offers and our advertising messages and with our use of tactical support like daily and weekly digital specials. Second, we began to more aggressively address affordability in our core menus. And that included launching, with some heavy media support, a new Red Lobster core menu that has a significant affordability component, and then also accelerating introduction of new more affordable core menu offerings at both Olive Garden and LongHorn Steakhouse. And then third, we increased the resources dedicated to reshaping our guest experiences to respond to what guests want beyond affordability. And that meant reorganizing our marketing and operations groups, and ramping up investment in better digital and other capabilities.”


We would guess that management’s commentary on traffic did not sit well with many of the investors listening to the earnings call on Friday. Two-year average traffic has been negative for much of the past year as the company has struggled to regain customers lost during the Great Recession. Management has delivered different plans of action, with sporadically successful promotions being the most common focus. Without a reliable means to drive traffic, however, comps at the most important concepts have been highly disappointing on a two-year average basis. 


The reality is this: it has been evident for some time that the company has had a traffic problem. Given the CEO’s comment during Friday’s earnings, call, that traffic is the “best measure of brand health”, the lack of urgency in attacking the problem has been striking. Traffic has been an issue at Darden since 2008. The company generates a billion dollars in operating cash flow, annually. Like McDonald’s, the company should be able to out-muscle the competition over the long-term. Instead, the company has been a long-term under-performer; we believe that shareholders are likely at the limit of their collective patience. The charts below show little evidence of “urgent action” on the part of management.









Statistics and Statistics


And so we talked about the period from fiscal 2008, our fiscal 2008 through fiscal 2012, with industry decline cumulatively of 20%; and our brands declining about half that, 10%. And that's an issue we've got to address. And so we need to do what we need to do from a guest experience perspective, both affordability and the things that we're delivering, to really reverse that.


In the investment research business, half-truth and bias are prevalent in narratives presented by parties of all kinds – management teams not excluded! During Friday’s earnings call, DRI highlighted that during the period FY08-FY12, the company’s brand’s experienced a cumulative decline of roughly 10% versus the industry decline of 20%. While this statistic is true, we don’t believe that FY08-FY12 is the only period over which Darden’s performance should be judged. Firstly, the recession is not the sole factor in Darden losing traffic over the past five-to-six years. A diminishing value proposition at Olive Garden is just one of the other factors to consider, as well as an over-reliance of promotions at Red Lobster which has led to wildly inconsistent results. The company has released data through FY13 that, depending on the date range one indexes it over, can tell a wide variety of stories.


A clearer indication of most recent traffic trends at Darden, and across the industry, is arrived at by considering two-year average trends. As the charts, above, illustrate, traffic at Darden’s most important two brands (80% of revenue) are stagnating in negative territory on a two-year average basis. We encourage investors to be wary of the notion that Darden’s core concepts have seen a traffic recovery, as some of the questions from the sell-side implied during the earnings call.



The False Promise of the Portfolio Restaurant Company


We're confident that the Specialty Restaurant Group is working on the right things to achieve our long range growth targets, and we're well-positioned to take full advantage of all of Darden has to offer, including robust supply chain, information technology, consumer insights, finance and other capabilities, and make significant contributions to Darden's sales and earnings growth.


Darden’s management team has, for years, been describing the supposed virtues of the “portfolio” business model. We believe that the best test of that idea is the company’s stock price, which has underperformed rival stock Brinker and the broader XLY since it began its “diversification” strategy in August 2007, when it acquired LongHorn Steakhouse parent RARE Hospitality International.  


Comparing Darden’s and Brinker’s respective operating margins also tells a story. Brinker has simplified its portfolio as Darden has added to its own. Despite the general belief that “scale” and “a robust supply chain” will improve profitability, we see below that the opposite may actually be true. Darden’s G&A expense, as a percentage of sales, has not demonstrated the leverage over time that believers in the “portfolio” business model would expect.




DRI: BEWARE OF FALSE NARRATIVES - eat dri op margins





Payout Ratio


Given the diluted net EPS, we expect in fiscal 2014, which I'll talk more about later, this equates to a payout ratio on a forward basis of approximately 70%. While this is above the 40% to 50% payout range we've discussed before, we're in the process of reviewing our target range and will likely take it higher sometime later this year.


The prudent company raises dividends in line with earnings growth to maintain a stable dividend payout ratio.  From 2008 to 2010, DRI was able to grow its dividend at an accelerated rate to play catch up with a more appropriate payout ratio.  For the past two years, we are unsure as to why DRI continued to raise the dividend at a rate inconsistent with the fundamentals of the company.  Now management wants to change its target dividend payout range.  Why did management feel the need to raise the dividend given the deceleration in earnings growth?


What message is management sending to shareholders and the rating agencies?  There is no creditable evidence that management has fixed the business and is on a path of improving the multi-year decline in traffic.  As a result, the company’s margins and returns are in a decline.    


Given the secular decline in the fundamentals of the company, Darden cannot responsibly maintain a payout ratio of 70%.  Doing so is, to us, a sign of weakness not strength.  Given the company’s significant capital spending needs, Darden is expected to generate only $80 million in free cash flow in FY14.  A meaningful deceleration in comps and margins could lower that number substantially, possibly impeding the company from generating enough cash flow to cover the dividend.



DRI: BEWARE OF FALSE NARRATIVES - dri eps growth payout ratio



Howard Penney

Managing Director


Rory Green

Senior Analyst




E-Cigs Take the $tage

Takeaway: A summary of our conference call with electronic cigarette maker and Ballantyne Brands CEO John J. Wiesehan, Jr.

This note was originally published June 20, 2013 at 16:25 in Consumer Staples

Yesterday (6/19) we hosted a call on electronic cigarettes titled “e-Cigs: The Untapped Market for Electronic Cigarettes”, featuring John J. Wiesehan, Jr., CEO of the Charlotte based company, Ballantyne Brands. (Presentation: CLICK HERE ; Podcast: CLICK HERE)


E-Cigs Take the $tage - cigs


On the call John provided an overview of his company, makers of the Mistic e-cig brand, and offered up some valuable industry insights, which we have included in summary form below.  


We are very bullish on the evolving e-cig category. There has been a rapid pace of innovation, which, along with increased marketing and distribution, is bringing significant awareness to the category. We believe e-cigs offer a compelling alternative to traditional cigarettes and offer a consumer a much different experience than a nicotine patch or gum. The involvement of Big Tobacco (RAI, LO, MO) in the category should continue to lend credibility to e-cigs and accelerate growth; we expect e-cigs to be margin-enhancing to the combined cigarette category for Big Tobacco and 2014 to be a breakout year for them, having tested the waters (through acquisition and mix) through 2013.


The runway for e-cig converters is huge globally:  in America alone, nearly one in five American adults smoke. We expect pending regulation from the FDA to deem e-cigs a tobacco product, and that the regulation could come down harder on online sales, and we expect that the taxation of the product will remain only at the state level. Finally, we believe e-cigs consumption will continue to benefit from its significant price point advantage over traditional cigarettes which will help to grow repeat purchase behavior. 


We think e-cigs is an exciting category with investible potential. For investors looking for a publically traded pure play on e-cigs there is one option, Vapor Corp (VPCO).



On the Category, Industry’s Size, and the Players:

John J. Wiesehan, Jr. is very bullish on the industry. Some analysts have suggested that over the next decade e-cigs could be as big as tobacco is today, a $90 billion industry. He estimates that sales in the U.S. were $150MM in 2011; $500MM in 2012 ($300MM across retail channels and $200MM over the internet); and are projected to be around $1-2B in 2013.


He thinks it is very positive that Big Tobacco has entered the market because it brings credibility (and marketing support) to the category, especially to retailers that will realize the category is not going away due to the backing of Big Tobacco.  He also views regulation from the Federal government (FDA) and regulation on a state-by-state basis as positive for the category.


Despite the involvement of Big Tobacco in the category, John thinks there is plenty of room for non-Big Tobacco players, like a Ballantyne Brands or NJOY.


[Note: Lorillard (LO) acquired e-cig maker Blu Ecigs in April 2012; Altria (MO) will launch its first e-cig under the MarkTen brand in August 2013; and Reynold American (RAI) has the Vuse e-cig].



On Retail Distribution, the Products, and Market Data:

Ballantyne Brands has a national footprint that distributes Mistic e-cigs  across Grocery stores, Drug stores, the Mass Channel, and Convenience stores.  The company notes that disposables sell well at convenience stores, whereas rechargables sell better across their other channels.


The company is focused on product quality, first and foremost the liquid that produces the vapor, insuring that it is consistent and safe.  The liquid is composed of four main ingredients: water, nicotine, propylene glycol (a bonding agent), and tobacco flavoring (traditional or menthol) -- making it an attractive substitute versus the some 4,000 to 7,000 ingredients in a traditional cigarette. None of its products are patented, however, there are some Chinese patents on the hardware that they assemble for the company. [Note: given the existing pace of innovation versus the long time frame for patent approval and desire to protect IP, most e-cig brands have not patented their products].


The company offers two different variations of e-cigs under the Mistic brand, a rechargeable and disposable. For the rechargeable option, customers buy an initial starter kit, which contains 2 cartridges with a MSRP of $14.99, and then buy replacement cartridges as needed (a box of 5 cartridges has a MSRP of $14.99).  John suggests each cartridge is equivalent to approximately two packs of traditional cigarettes.


Replacement cartridges come in traditional and menthol flavors, with 4 levels of nicotine respectively, including a zero percent nicotine level for both flavors. The company does not have any flavors (like coffee, vanilla, pina colada, chocolate, etc.), and markets strictly to tobacco users as an alternative product to traditional tobacco products; in John’s words, “The company is not in the business of recruiting new nicotine users.”


For the disposable e-cig, labeled under the MisticBlack brand (and available in Traditional or Menthol flavors), customers buy a pack of soft tip e-cigs that they dispose of after one use; they have the look, feel and size of traditional cigarettes.  [MisticBlack has a MSRP of $5.99 and will be on the market in July in places such as Wal-Mart.]


The company’s hope is to convert a MisticBlack user to a rechargeable user.  The rechargeable e-cig is in line with the razor, razor-blade model, and is a higher margin business than the disposable for the company and the retailer.  John suggests the gross margin for disposables is in the 40’s (%) for the company and that rechargeable e-cigs are north of that figure, considering the consumer already purchased the battery in a starter kit. 


After the consumer buys the start-up kit John thinks the conversion rate for rechargables will be high (more data supporting this claim is pending), while he thinks converting the disposable user (back to a disposable) will be at a lower rate. 


Mistic brands ranks #3 behind NJOY and BLU in terms of Sales Dollars and Sales Units (according to Nielsen data ended 3/16/13 that does not include internet sales). Importanly, Mistic has been able to holds its share with an average retail price at or above most of its competitors, which John attributes to its high marks on taste and marketing campaigns.



On the FDA, Regulation, and Clinical Studies:

The company believes its products will be treated as a tobacco product in a pending  FDA announcement. On regulations, John admits that it is unclear where the FDA will shake out on e-cigs.   He thinks that regulation is likely to be based on nicotine level, and speculates that a cap could be put in place. Further, the sale of e-cigs could be regulated differently on such factors as internet sales versus retail sales and tobacco flavor vs menthol and other flavors.


John expected an announcement from the FDA back in April. His team now figures that an announcement could be imminent to later this summer.


He notes, today there is no talk of the Federal government issuing an excise tax on e-cigs, but rather expects any taxes will be determined on a state-by-state basis. To date, there are only two states issuing a tax, Minnesota and Oklahoma. In Minnesota, 70% of the cost of goods is taxed, which retailers pass fully onto the consumer. In Oklahoma, e-cigs are taxed at 5% based on liquid content. For Mistic, that translates to a 5 cent tax on a pack of disposables and 25 cent tax on one package of cartridge refills (5 cartridges to one pack). The company is generally comfortable with the Oklahoma tax structure, and it believes that its value proposition over traditional cigarettes will remain a huge tailwind to consumer demand.


To date, there is no clinical study that the FDA recognizes supporting that e-cigs are less harmful than traditional cigarettes.  There are however many independent studies in which the results show that e-cigs are less harmful. He thinks that common sense would indicate that a product with 4 ingredients verses 4,000 that is not burned to consume is a “healthier” alternative, however it’s premature to speculate on how the FDA will rule on e-cigs. The company is pushing hard with its lobbyist in Washington, D.C. that the FDA suggests e-cigs are less harmful than traditional cigarettes.


On Value Proposition and Consumer Appeal:

An average cost of a carton of traditional cigarettes in the U.S. is $60. In comparison, a 5 cartridge replacement pack of Mistic, which is equivalent to a carton of cigarettes, has a MSRP of $14.99. [The company also has a 10pack with a MSRP of $24.99].


John argues that they are not marketing their products to stop smoking, but simply as an alternative to traditional smoking, and nothing else.  However, testimonials do suggests that consumers are using the products to reduce consumption of traditional cigarettes. John believes the consumer’s appeal to an e-cig, versus a nicotine patch or gum, is that that an e-cig satisfies four main desires of smokers: hand to mouth; inhale something and get a kick in the throat; exhale something (a vapor simulates smoke); and the taste of the nicotine (without the burning sensation of a traditional cigarette).


That is to say, with other products like a nicotine patch or gum, the consumer is really not getting a cigarette substitute, just the nicotine.



On Advertising and Restrictions:


The company launched the “Easy Choice” advertising campaign back in April 2013. It is 100% all print, including USA Today and WSJ, targeting 15-20 key metropolitan areas where distribution is strong. The company has chosen to be compliant with the advertising restrictions of tobacco companies, so it does not advertise on television or on billboards. 


It is also focused on age restrictions, and is a member of the WE Card Manufacturing Advisory Council, which forces anyone under the age of 18 at a retail store to be carded.



On International Involvement:

Ballantyne Brands is looking to Europe and Asia for distribution. There are, however, countries in which they are not allowed to sell into, including: China, Canada, Australia, and Brazil. John notes that some parts of Asia are “open”, while some are not.


In Europe, the UK will be a major focus.  A recent decision from the UK’s version of the FDA is to regulate e-cigs as medicines by 2016. The company is broadly comfortable with the regulation because it won’t take its product off the market, ban it, and any implementation of the regulation won’t come until 2016. The company believes that the regulation will fall on the level of nicotine in e-cigs, to make sure it is consistent with traditional cigarettes, which Ballantyne Brands believes it should have no problem complying with. 




Stay tuned as we continue to do work on the electronic cigarette space.


Matthew Hedrick

Senior Analyst

Morning Reads on Our Radar Screen

Takeaway: A quick look at stories on Hedgeye's radar screen.

Keith McCullough – CEO

Gold Slips to 34-Month Low (via Bloomberg)

Violence in China's Xinjiang 'kills 27' (via BBC)

Picture (for those too politically polarized to see #GrowthAccelerating) (via Hedgeye)


Morning Reads on Our Radar Screen - radar


Jay Van Sciver – Industrials

For those who want to know why FedEx Ground has been taking share for over a decade (via


Darius Dale - Macro

The 5 Happiest Countries (DD note: Interesting analysis on what makes people happy across the developed world; US is not even in the Top-10 .. video via Marketwatch)


Howard Penney - Restaurants

McDonald's rang cops on disabled woman in Taiwan (via Herald Sun)


Josh Steiner – Financials

Think It's a Level Playing Field in the Financial Sector? Think Again. (via Bespoke)


Jonathan Casteleyn – Financials

Biggest Banks’ Wind-Down Plans Seen Failing to Cut Risks (JC note: Balkanization or local banking rules are creating lots of noise and in the end will shrink assets but raise ROEs …  via Bloomberg)


Matt Hedrick – Macro

No Government No Problem as Czechs Unfazed by Instability (via Bloomberg)

Turkey to Romania Seen at Risk as Emerging-Market Inflows Slump (via Bloomberg)

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This indispensable trading tool is based on a risk management signaling process Hedgeye CEO Keith McCullough developed during his years as a hedge fund manager and continues to refine. Nearly every trading day, you’ll receive Keith’s latest signals - buy, sell, short or cover.

Got Growth Right?

Client Talking Points


The Weimar Nikkei is really starting to underperform now. It doesn’t even go up on dead cat bounce days in China or Europe. The Nikkei was down another 1% overnight and is down -17.8% since May 22. It remains well below our 13,683 TREND line of resistance. #Ugly.


The crash in Gold continues after both US Durable Goods and New Home Sales showed that Bernanke needs to taper. That of course was the May data; our models suggest that April - June may be the top in sequential US #GrowthAccelerating. That said, we remain data dependent on this. Go ahead and ask Gold (down -4% this morning and a monster -27% YTD) how US growth is doing. I'm sure he'll tell you it's doing just fine. #Nasty


Can you spell R-I-P? 2.59% last on the 10-yr. Folks, there is no immediate-term TRADE resistance to 2.69%. Velocity and volume here matters. The simple speed of the move, combined with the most bond outflows since October 2008 is not a buy signal for bonds. That whining you're hearing in the distance is bond bulls begging for Bernanke.

Asset Allocation


Top Long Ideas

Company Ticker Sector Duration

Financials sector head Josh Steiner is the Street’s head bull on residential mortgage originator/servicer Nationstar, projecting $9 in earnings for the company in 2014.  This is well above the company’s own guidance range, which tops out at around $7.50. NSM had a successful start to the year as it won servicing bids on substantial mortgage portfolios.  They also reported significant increases in their profit margins on those portfolios, and double-digit increases in their own originations.  Housing prices are ramping significantly higher, as Steiner predicted, as demand continues to exceed supply in both new and existing homes.  Steiner says this quality mortgage company could ride the crest of a sustained wave of sector improvement.


Gaming, Leisure & Lodging sector head Todd Jordan says Melco International Entertainment stands to benefit from a major new European casino rollout.  An MPEL controlling entity, Melco International Development, is eyeing participation in a US$1 billion gaming project in Barcelona.  The new project, to be called “BCN World,” will start with a single resort with 1,100 hotel beds, a casino, and a theater.  Longer term, the objective is for BCN World to have six resorts.  The first property is scheduled to open for business in 2016. 


WWW is one of the best managed and most consistent companies in retail. We’re rarely fans of acquisitions, but the recent addition of Sperry, Saucony, Keds and Stride Rite (known as PLG) gives WWW a multi-year platform from which to grow. We think that the prevailing bearish view is very backward looking and leaves out a big piece of the WWW story, which is that integration of these brands into the WWW portfolio will allow the former PLG group to achieve what it could not under its former owner (most notably – international growth, and leverage a more diverse selling infrastructure in the US). Furthermore it will grow without needing to add the capital we’d otherwise expect as a stand-alone company – especially given WWW’s consolidation from four divisions into three -- which improves asset turns and financial returns.

Three for the Road


Who the hell signs off on a central planner telling you what he "intends" a market price to do? @federalreserve

@KeithMcCullough (responding to a Fed President's statement on CNBC that the bond market reaction was outsized versus the Fed's intentions).


“Many men go fishing all of their lives without knowing it is not fish they are after.” -Thoreau


About $60 billion has been wiped from the value of precious metals exchange-traded product holdings this year. (Bloomberg)

Are Staples Cheap Enough?

Valuation alone is never a catalyst in our investment process; however below we updated charts on forward P/Es of the consumer staples sector and its main sub sectors.


Needless to say, while valuations have come in over the last two months, they remain stretched, and cheap alone (think CPB or TAP) is not a signal for us to buy. At 17.5x, the consumer staples P/E is just under a two standard deviation move, and compares to an average of 14.5x over the last 5.5 years.


Of note is that sub sectors of HPC and Beverage have come in the most over the last ten days, yet all sub sectors are priced well over one standard deviation.


Our quantitative real-time set-up for consumer staples (etf: XLP) is bullish, trading above its intermediate term TREND line of $38.71, and we would buy it (cheaper) closer to this level. 


Are Staples Cheap Enough? - ww. 1


Are Staples Cheap Enough? - ww.2


Are Staples Cheap Enough? - ww. 3


Are Staples Cheap Enough? - ww. 4


Are Staples Cheap Enough? - ww. 5


Are Staples Cheap Enough? - ww. 6


Are Staples Cheap Enough? - ww. 7


Are Staples Cheap Enough? - ww. 8


Matthew Hedrick

Senior Analyst

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