Mushrooms can tolerate some light, but they thrive best in the dark while they grow in composted manure. If you are being “mushroomed,” you are likely being left in the dark and fed a steady diet of offal. I hope this is not an accurate metaphor for Darden’s independent Directors.
With that being said, I must ask a simple question: Are Darden's independent Directors being “mushroomed” and left in the dark by management?
I ask this because, from where I sit, I see a disconnect between what management is telling shareholders and reality.
During my tenure as an analyst, I have been both complementary and critical of Darden. My first priority is, and has always been, to look out for the shareholders of any company I follow. While I am not always right, I have built an honest and respectable track record. Admittedly, my opinions can be very critical at times. This is, without a doubt, the most difficult part of my job.
For the past year, I have been rather critical of Darden’s performance and the overall direction of the company; I’m not alone in this. I have encountered numerous Darden shareholders who are bewildered and frustrated by the direction in which management has taken this company. I firmly believe that Darden is now at a critical juncture in its existence, and I am concerned that management may be withholding the critical concerns of Darden’s less vocal shareholders from the Board. Management wants shareholders to believe they have overwhelming support in their “value creation plan.” From what I have seen, this is far from the truth.
As an analyst covering Darden, I frequently hear from institutional shareholders who have grown frustrated over the wall of silence that has been built around the company. It is this wall that has allowed the poor decision making of management to persist with impunity.
The recent cancellation of the company’s analyst day is an obvious case in point – and note that the open analyst day has just been replaced by a “sell-side” analyst day (to which I was not invited), which presumably will allow management to cozy up to more cooperative members of the analyst community. I believe holding an open dialogue with shareholders is a sound business practice. I also believe the Board has a fiduciary obligation to fully weigh shareholder concerns before signing off on decisions that will materially affect the company’s future.
MY MESSAGE TO THE BOARD IS THIS:
I encourage you to hold conversations with current shareholders to gain an unfiltered perspective and understanding of their current mindset. To be clear, I think it is more than reasonable to assume Staboard will be successful in gathering the appropriate votes needed to call a Special Meeting and prevent the Red Lobster spinoff. A number of institutional shareholders are very frustrated over their inability to communicate with the company. None of them has indicated to me which side they are inclined to take in this dispute, but if Starboard is successful, you will face a much different situation than you currently do.
It should also be noted that the SEC, under the leadership of its new chair, Mary Jo White, has placed renewed emphasis on issues of corporate governance, the proxy process, and shareholder participation in corporate decision-making. Given the chain of events that I believe will unfold in the coming months, it would behoove you to be proactive and meet with these shareholders.
A CLOSER LOOK AT RED LOBSTER
Looking back to earnings call commentary regarding Red Lobster since 4QF11, the brand appeared to be performing well. That is until 3QF13, when the positive impact of the remodels began to diminish. By 4QF13, the company began aggressively discounting in a desperate attempt to drive traffic. These efforts failed, as declining traffic persisted and aggressive discounting efforts led to sales declines and margin contraction. As management quickly learned, discounting never leads to increased profitability. Needless to say, the Red Lobster brand has been treading downhill since.
We’ve identified, in our previously published Brand Life Cycle, discounting as a Stage 2 Panic condition. We have found that management teams tend to follow a certain pattern in their decision making process when a concept gets in trouble. Stage 2 Panic, as we’ve identified, tends to prelude the initiation of the healing process. After sacrificing margins by implementing a deep discounting program fails to drive customer counts, management tends to realize they need to make major changes across the enterprise.
Red Lobster’s extreme discounting in 4QF14 led to a significant, sustained decline in the chain’s profitability. In 1HF14, Red Lobster restaurant level margins and operating profits declined 2.6% and 85% respectively. These numbers gave management no choice but to respond to activist pressure.
RED LOBSTER EARNINGS CALL COMMENTARY
RED LOBSTER MOMENTUM
“After a slow start to fiscal 2011, Red Lobster has regained profitable same-restaurant sales momentum by optimizing their promotion strategy to feature craveable dishes at specific price points versus starting-at price points.” (Drew Madsen, 4QF11 earnings call)
CONTINUED RED LOBSTER MOMENTUM & OLIVE GARDEN DISAPPOINTMENT
“We are also pleased with the results of our refined promotion strategy during the first quarter, especially at Red Lobster and LongHorn. Our earnings shortfall compared to our internal expectations during the quarter was primarily driven by soft guest counts at Olive Garden and a search for affordability by our guests across all brands, generating a negative menu mix that was due in part to more check management than normal.” (Drew Madsen, 1QF12 earnings call)
“Red Lobster same restaurant sales increased 6.8% during the second quarter, 620 basis points above the full service restaurant industry benchmark. Red Lobster has delivered competitively superior same restaurant sales since October last year when they began emphasizing craveable, new seafood dishes and price certainty in their promotions. And that momentum continued during the second quarter.” (Drew Madsen, 2QF12 earnings call)
“Red Lobster same-restaurant sales increased 6% during the third quarter, 340 basis points above the full service restaurant industry benchmark. Red Lobster has delivered competitively superior same-restaurant sales since October of 2010 when they began emphasizing craveable new seafood dishes and price certainty in their promotions, and that momentum continued during the third quarter.” (Drew Madsen, 3QF12 earnings call)
“This growth was fueled by strong results at Red Lobster.” (Clarence Otis, 4QF12 earnings call)
“Red Lobster same-restaurant sales declined 2.6% during the first quarter, although operating profit increased on both a percentage and absolute dollar basis, due in part to lower seafood costs. As you recall, last year during the first quarter, Red Lobster delivered same-restaurant sales growth of 10.7% behind the introduction of their Four Course Seafood Feast promotion. And we’re pleased that Red Lobster was able to hold on to the large majority of last year’s growth this quarter and deliver a same-restaurant sales increase of slightly more than 8% on a two-year basis.” (Drew Madsen, 1QF13 earnings call)
“LongHorn has completed a remodel of their existing restaurant base and Red Lobster will be approximately 75% complete with their remodel program by the end of this fiscal year. Both programs have significantly elevated brand perceptions among all guests and contributed to value-creating guest count growth.” (Drew Madsen, 2QF13 earnings call)
THE BLOOM IS OFF THE ROSE &THE NEW ERA OF CASUAL DINING IS IN
“On a blended same-restaurant sales basis the results for Red Lobster, Olive Garden and LongHorn Steakhouse declined 4.6% in the third quarter. In contrast, our Specialty Restaurant Group saw continued same-restaurant sales gains of 2.3% on a blended basis.” (Brad Richmond, 3QF13 earnings call)
“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.” (Clarence Otis, 4Q13 earnings call)
RED LOBSTER OPERATING RESULTS – WE’VE BEEN MUSHROOMED
Looking at Red Lobster’s financials, the numbers are much worse than management has led analysts to believe over the past five years. An 85% decline in operating profits to-date in 1HF14 would be a staggering number for any company, let alone one with a relatively new asset base.
These financials reveal just how poorly Red Lobster has been managed since FY09:
- Food costs are up 100 bps
- Labor costs are down 100 bps
- Restaurant expenses are down 100 bps
- Restaurant level margins are up 50 bps
- Operating margins are down 200 bps
The 150 bps spread between the decline in restaurant level margins and operating margins speaks directly to the inefficiencies of the Darden business model. Even worse, a vast majority of operating margin contraction was driven by a 150 bps increase on an inflated G&A line. G&A currently stands at 11.3% for Red Lobster, well above the 9.9% Darden average. This trend continues to worsen, as G&A was up 80 bps in 1HF14 vs 1HF13. Management has no cost control!
These numbers look so out of line that we are now questioning if it is a misprint. If they are indeed accurate, we may have underestimated how much G&A there is to cut in the entire Darden portfolio.
From FY09 to FY13, Red Lobster spent approximately $716.5 million in capex. We estimate that only $60 million of this was used to develop new units. This suggests that management spent over $650 million on upgrading the Red Lobster asset base. A majority of the Bar Harbor remodels occurred between FY11-FY14. During this time, management consistently assured outsiders that remodeled restaurants were maintaining a sales increase of 4% to 5%, which implies these stores surpassed the stated return on investment hurdle.
From FY09 to 1HF14, same-store sales have declined in 41 of 69 (59.4%) months and traffic has declined in 49 of 69 (71%) months. From FY11 to FY13, same-store sales have declined in 11 of 24 (46%) months and traffic has declined in 13 of 24 (54%) months. These trends negatively affected the P&L as EBITDA declined 8.5% from FY09-1H14, suggesting that the remodel and efforts to revive Red Lobster were unsuccessful.
Despite all of this, there is some good news! Red Lobster’s assets are not in need of a significant upgrade. The brand, if run properly, also has the ability to generate a significant amount of free cash flow. The wild card will always be sales and traffic volatility, but a strong management team and a calculated, purposeful menu and promotional strategy could mitigate this effect.
We believe Red Lobster has a valuable asset base that makes Darden’s overall real estate portfolio materially more attractive than it would be without it. We fear management’s current plan to spinoff Red Lobster is reactionary and lacking integrity. They haven’t given a plan to stabilize and turnaround Red Lobster, but merely an excuse to cast off the struggling chain.
Operations driven quarter. BYD, you can do this too.
- Graton - continues to gain momentum with each passing week
- Closed on $2bn debt refi
- Revenue challenge is that customers were less willing to spend
- LV Strip continue to show evidence of recovery
- Strip: Visitor room nights were flat; gaming volumes grew
- Favorable population trends in LV locals market should continue in 2014
- $8 bn invested in LV city projects, highest since 2007-2008
- New developments should benefit Red Rock
- Mobile sports gaming: signups exceeded expectations.
- Fertitta Interactive: online gaming has gotten off to a slow start but are optimistic; payment process impediments e.g. Visa
- 2013 capex: $86MM
- 2014 capex guidance: $110-120MM
- Have improved leverage ratio by 3 turns since restructuring in June 2011
- Consolidated cash: $138MM
Q & A
- Locals market: no material improvement from last couple of quarters
- Good trend in visitation but seeing low spend per visit
- Still have room for cost improvement
- LV promotional environment: stable last couple of quarters
- Graton will report annual results in a few weeks
- Ex Red Rock, $80-85MM maintenance capex run rate
- 2014 excess FCF: focus is to pay down debt and delever
- Online DE/NJ interstate compact: helpful but not game changer
- Promotional spending as a % of revenues declining: maximizing marketing $$; diligent and disciplined
- Graton: $46MM receivables left, will be paid back to Stations at some point in 2014
- $48MM in interest reserve
- North Fork referendum will happen
- Broad-based strength across Las Vegas valley
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Takeaway: Whatever Amazon does, customer attrition is critical.
Editor's Note: Below is a brief, complimentary excerpt from Hedgeye Retail analysis. For more information on our services, click here.
- "Amazon.com Inc. is hoping to offer an on-demand music-streaming service to customers of its Amazon Prime program, but it may limit how much a person can listen to any given song, according to people familiar with the matter."
- "The Seattle-based company has held negotiations with record companies and music publishers seeking to license their music for the planned service, but it remains far apart from some record companies on financial terms, these people said."
- "The music service is one of several new features that Amazon may add as it raises the price of Prime to as much as $119 a year."
Takeaway from Hedgeye’s Brian McGough:
Here’s the deal. Amazon’s (AMZN) world continues to revolve around its Prime service in the same way Costco’s membership-only warehouse club revolves around its membership fee. Costco loses money excluding its fee, and Amazon loses money regardless.
Perhaps a boost in customers subscribing to Prime would put Amazon solidly into the black. Because, in truth, $119/year represents a 50% increase from current levels.
But you have to keep your customers. Attrition is critical. Simple as that.
To us, this move just sounds risky.
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Editor's Note: Below is a complimentary research note from Hedgeye Restaurant Sector Head Howard Penney published March 10, 2014 at 12:33 PM. For more information on our services, click here.
The following are quotes from Don Thompson taken directly from the monthly sales press releases. Reading between the lines, the evolution of the language suggests that management still does not have a plan in place to improve same-store sales:
September – management not giving up
"We remain confident in the fundamental strength of the McDonald's System and our ability to connect with customers and deliver the menu choices, value and convenience they expect from McDonald's."
November – management not giving up
"We remain confident in the fundamental strength of the McDonald's System and our ability to drive initiatives that will deliver the greatest benefit for our customers."
December – management begins to waver, as they admit they need to make “investments”
"As consumer expectations and the marketplace continue to evolve, we are making investments in our menu, restaurants and service to strengthen our connection with customers and build our business for long-term profitable growth."
February – management is intent on improving performance
"We are intent on improving our performance by building on our customer-driven strategies and the fundamental strengths of our proven business model."
March – management is now thoughtfully evolving its approach
"We are intent on improving our business performance by thoughtfully evolving our approach to ensure that we are delivering the most compelling value, service and convenience to each of the approximately 70 million customers who choose McDonald's each day."
On a global basis, MCD had a relatively strong May-August sales period. Since then, trends have continued to deteriorate. Since the December sales press release, it has been clear that management is still looking for an answer to evolving consumer expectations. We don’t believe installing high density tables will help solve this problem.
The language in the February release says they are working hard, but there is still no actionable plan in place. After missing numbers yet again, today’s press release suggests that whatever plan they thought they had in place must be reevaluated.
The red lines in the charts below signify a company that is in a secular decline. Europe and APMEA look to be bottoming, but the secular decline in the US is dragging down global numbers.
Until we begin to see these trends improve, we remain bearish on MCD.
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