DRI: Room to Breathe

We are removing DRI from our Investment Ideas list as a short.

We do, however, maintain that Darden’s stock is moving significantly higher ahead of a turnaround in the core Olive Garden business.  In addition, there are valuation concerns following Friday’s “beat-and-raise” 3Q15 earnings release.

For the quarter, the company reported above consensus EPS of $0.15 (on slightly better same-store sales, lower costs, and higher margins) and guided to FY15 EPS of $2.45-2.48 versus the prior $2.25-2.30 range.  Lastly, Darden issued an above consensus 4Q15 EPS target range of $0.91-0.94.

DRi shares are fully-valued, trading at a 2016 P/E of 23.2x – we still see fair value in the range of $55-58.

Management also guided to the following 4Q15 same-store sales targets:

  • Olive Garden +1.5 to 2.5% versus consensus of 1.6%
  • LongHorn Steakhouse +4.0 to 5.0% versus consensus of 2.3%
  • Specialty Restaurant Group collectively at +2.5 to 3.5%

In the short run, the next 6-12 months will be a crucial cost cutting opportunity for the new management team.  As we suspected on the call, management held out a significant number of carrots to the investment community to highlight the changes that are being made within the company.  It has formally announced the sale leaseback of its headquarters in Orlando and has begun to test the waters by selling some properties upon which its restaurants sit. 

Management was very upbeat with how things are progressing on that front so far, noting that cap rates have been below 6%.  More generally, management maintains that it wants to move to a more asset-light model if it makes business sense.  Management provided little detail on the implications of the math on the income statement if they significantly reduced the number of properties they owned.

Operationally, management deliberately ran less price-point oriented promotions at Olive Garden in 3Q15 than a year ago, allowing for significantly improved profitability at Olive Garden.  They also scaled back media spending to historical levels.  These factors should continue to be in play for the next six months, during which it would be unwise to short the stock.

A simple reminder that Olive Garden is still struggling is that it continues to lose market share.  Traffic has now declined for the past four years and continues to trail the industry by about 1%.

We think it’s premature to give credit to management for improved SSS trends at Olive Garden.  Given the industry-wide noise created by weather and lower gas prices, it’s difficult to tell what the real trends look like at Olive Garden.  To that point, the earnings call was focused on financial engineering with little mention of food or operational changes being made to improve the concept.  Olive Garden needs a significant dose of innovation and improved assets before this chain be on a sustained path of positive traffic trends.