BEST IDEA UPDATE: LONG DRI

Takeaway: We suspect 2QF14 will be ugly, but we are bullish on the long term prospects of Darden.

LONG DARDEN

We added Darden to the Best Ideas list as a long on 10/10/13.  That being said, we expect the company’s 2QF14 earnings release on Thursday to be a disaster as its two largest brands, Olive Garden and Red Lobster, continue to struggle. 

 

Our bull case is centered on the inherent value of Darden.  As we’ve been saying for the majority of the year, we believe the business is grossly mismanaged and in need of a major overhaul.  Barington Capital entered the fray as an activist back in October, but has been relatively quiet since then. That changed this morning, when the company released an 84 page report detailing its recommendations to improve long-term shareholder value at Darden.  If these changes are implemented, Barington values Darden’s stock between $71 and $80 per share.  If our plan to fix Olive Garden is implemented, we see even more upside in the stock.

 

The full report, featuring several of our own quotes, can be accessed HERE.  Barington intends to promptly share these recommendations with Darden Chairman and CEO, Clarence Otis.

 

If Barington, or another activist, is successful in forcing change, we would expect significant shareholder value creation.  In our opinion, the most value will be created from cutting excessive G&A spending and turning around the company's crown jewel, Olive Garden.  You can read more about the activist situation and our thoughts on the matter in a recent article published by Barron’s: Darden Shares Could Jump 40% On Hedge Fund Plan.

 

 

2QF14 EARNINGS

Moving back to 2QF14 earnings, we believe the release and subsequent call will be the most important of CEO Clarence Otis’ career.  His commentary will be closely scrutinized and could shed light on the timing of future events.  The current consensus EPS estimate for the quarter is $0.22, significantly above the $0.15 that we are currently modeling.  We expect to see sales deleverage in the quarter and believe food costs, labor costs, and other expenses will pressure margins more than the street anticipates.  Following the call, we would be buyers of any sell-off.  We believe Darden is currently the best positioned big cap casual dining company heading into 2014.

 

SAME-RESTAURANT SALES

Same-restaurant sales trends at Olive Garden and Red Lobster have been horrible lately, due primarily to declining traffic.  Current consensus estimates are for same-restaurant sales to increase +0.1% at Olive Garden and decrease -1.8% at Red Lobster.  Both of these estimates are, in our opinion, aggressive.  If we are right and comps are worse than expected, this would have a negative effect on the majority of line items.

 

BEST IDEA UPDATE: LONG DRI - OG

 

BEST IDEA UPDATE: LONG DRI - RL

 

 

COST OF SALES

Current consensus estimates are for cost of sales to increase +30 bps y/y in 2QF14 to 31.28% of sales.  We believe shrimp prices will pressure margins more than the street expects, particularly given Red Lobster featured Endless Shrimp Tuesday during the quarter.  We expect cost of sales to come in above consensus.

 

BEST IDEA UPDATE: LONG DRI - chart1

 

 

LABOR COSTS

Current consensus estimates are for labor costs to increase +35 bps y/y in 2QF14 to 32.78% of sales, after increasing over +100 bps y/y in each of the last three quarters.  In 1QF14, restaurant labor expenses were +110 bps higher due to lower average wage inflation, reduced productivity and sales deleverage at Olive Garden and Red Lobster.  Given the current sales trends, we do not see how the labor costs will improve that materially from 1QF14.  We expect labor costs to come in slightly above the street.

 

BEST IDEA UPDATE: LONG DRI - chart2

 

 

OTHER EXPENSES

Other restaurant expenses have been up significantly (+100 bps on average) for the past four quarters, due to the acquisition of Yard House among other reasons.  Currently, street estimates are for other expenses to increase +17 bps to 16.78% of sales.  Street estimates have come up recently, however, they are still conservative and do not account for a large enough impact from sales deleveraging at Olive Garden and Red lobster.  We expect other expenses to come in above consensus.

 

BEST IDEA UPDATE: LONG DRI - chart3

 

 

GENERAL & ADMINISTRATIVE

In an effort to cut some fat from the company cost structure, we are expecting to see an approximate $7 million (net) expense associated with G&A cuts in 2QF14.

 

BEST IDEA UPDATE: LONG DRI - Chart4

 

 

Recent Notes

12/11/13 – Restaurant Impossible: Fixing Olive Garden

10/30/13 – DRI: Pending FY2Q14 Disaster?

10/18/13 – Dismantling Darden: Hedgeye vs. Barington

10/15/13 – DRI: A Generational Opportunity

 9/12/13 – Dismantling Darden

 8/21/13 – DRI: Restructuring Charge Looming?

 6/26/13 – DRI: Beware of False Narratives

 6/21/13 – DRI Comps Flatter to Deceive

 6/17/13 – DRI Remains a Win-Win

 5/23/13 – DRI’s Jamie Question

 

 

Let us know if you have any questions or would like to discuss any of our current ideas in more detail.

 

 

Howard Penney

Managing Director


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