Stock Report: Darden Restaurants (DRI)

Takeaway: We added DRI to Investing Ideas on the short side on 2/16.

Stock Report: Darden Restaurants (DRI) - HE DRI table 2 19 16

THE HEDGEYE EDGE

 

Where do we go from here?

 

Having pulled all the levers to create shareholder value, it’s now down to the facts about how Darden's core business is performing. There are cracks in the Olive Garden story and the brand is not as healthy as the consensus believes.

 

Major capital investments are needed:

 

Olive Garden has been in need of a major remodel since FY2007. While the sales trends at Olive Garden have improved slightly, to sustain long-term growth the concept is in need of a major overhaul which will be expensive. As sales trends rollover at the brand, the need for significant capital investment will become more evident.

 

The real numbers suggest multiple compression:

 

Under the new business model the company is posting peak margins. In addition to significant capital investment, the company will need to invest in incremental food and labor costs to drive positive traffic across the enterprise.

 

INTERMEDIATE TERM (TREND)

 

Management doesn't seem to be thinking about Olive Garden the right way:

 

During the 2Q16 call DRI management was asked about unit growth plans:

  • CEO Gene Lee stated, “I think we’re going to get back on a path where we’re opening somewhere between 8 to 12 Olive Gardens a year, so that will be a big boost to our numbers. Olive Garden is still an incredible investment from a new restaurant perspective. There will be some cannibalization, but we think that Dave and the team have the strategy to identify trade areas that could support Olive Garden, but without so much cannibalization that we can’t make the returns work.”
  • He went on, “Obviously, we’re going to continue to push Yard House. And we think LongHorn can get back up to low double digits also. And so with those types of new restaurant development, we can firmly be in that 2% to 3% [unit growth] range.”

Management’s thinking about unit growth is clearly evolving as the year goes on, and yet, Olive Garden’s top line performance continues to struggle. Plus, they have gone from vocalizing that they will open 1 to 2 Olive Gardens a year, to 8 to 10, which implies 1.2% unit growth.

 

Additionally, they are not spending aggressively on fixing the business:

 

Olive Garden’s last remodel was completed at the end of fiscal year 2001, when Joe Lee held the CEO position and Clarence Otis was the CFO. Management defended the remodels during 2002, although they struggled to increased their alcohol sales, which were supposed to be a benefit of the remodels.

 

In fiscal 2011, management started early remodeling tests on Olive Garden. Olive Garden has about 400 older RevItalia restaurant models that are in dire need of remodeling. In 2011, they remodeled 35 to test the effectiveness of the prototype. Clarence Otis successfully kicked the remodel can down the road until he met his demise in 2014:

  • 2011 Annual Report: “Olive Garden will begin remodeling more than 400 early restaurants to be consistent with the Tuscan Farmhouse design of the restaurants opened in the past six years.”
  • 2012 Analyst Meeting 2/23/12: “Olive Garden now testing a remodel program for 430 pre-Tuscan Farmhouse restaurants that were built before March 2000.”
  • 3Q13 Earnings call transcript: “Olive Garden is preparing to implement their remodel program in the second half of this fiscal year.”

To date, Olive Garden has done 32 remodels, and is far behind schedule, on a massive remodel project. Clearly, no one wants to remodel the Olive Garden concept because it will be disastrous for earnings.

 

LONG TERM (TAIL)

 

The Olive Garden is still not fixed and is in desperate need of a large capital investment to turn around their negative trends. Until management realizes this the business will continue to decline and the stock will go with it. Determining what management will do in the TAIL duration is not possible, and we don’t like to participate in that guessing game. What we know now is that Olive Garden is not fixed and management does not currently have a plan to rectify the situation.

 

Additionally, Darden is a multi-concept restaurant company and in our past experience it is very difficult for management teams to allocate capital effectively amongst its brands. On one hand you have high growth concepts such as Yard House, and on the other you have Olive Garden which makes up roughly 56% of sales and is in need of cash just to prevent declines. We look forward to following the story over the next couple of years to see what course of action management takes to recover the business.

ONE-YEAR TRAILING CHART

Stock Report: Darden Restaurants (DRI) - HE DRI chart 2 19 16

 


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