DRI – BLUE LOBSTER?

UBS upgraded DRI this morning going into the quarter.  Casual dining in general does not look good and I don’t think DRI’s numbers will look good so I don’t understand the reason for getting behind this name now.

Darden is scheduled to report fiscal 2Q10 results after the close tomorrow.  My EPS estimate is $0.02 shy of the street’s $0.41 per share estimate.  The extent to which commodity costs prove favorable on a YOY basis is the biggest question mark and could provide some upside to my numbers.  After the first quarter when food costs as a percentage of sales declined nearly 200 bps YOY, management said the food cost benefit would continue into the second and third quarter but would moderate somewhat from Q1.  Management offered this Q2 outlook with a high level of confidence as 80%-90% of its commodity input costs were locked in for the first half of the year at that time. 

Relative to full-year EPS numbers, estimates have come down 2% since last quarter to a much more reasonable range.  I am still a couple of pennies lower than the street but estimates are not as glaringly high as they were going into the Q1 report.

Management lowered the low end of its blended same-store sales guidance after Q1 to -3% to flat.  Even a -3% number assumes some acceleration from Q1’s reported -5.3% and based on industry trends as reported by Malcolm Knapp, we are not yet seeing any improvement.  As I said following Q1, management stated that some of the implied improvement will result from the “arithmetic” or easy comparisons, but the -3% assumes a pick-up in 2-year average trends as well. 

CEO Clarence Otis also said DRI’s guided comparable sales range assumes some acceleration of share gains relative to the industry.  During the first quarter, DRI’s three largest brands combined (Olive Garden, Red Lobster and LongHorn) outperformed the Knapp industry benchmark, excluding DRI, by 250 bps and Mr. Otis said he expects to widen that gap to 300 bps for the full year.  With discounting mounting and DRI choosing not to play the discounting game at LongHorn and Red Lobster, in particular, it might be difficult to increase the company’s gap to Knapp.  I am not saying that DRI cannot achieve -3% comparable sales growth for the year, but again, based on current industry trends, it is not a given and will rely on a pick-up in overall restaurant demand.

For the second quarter, my blended same-store sales estimate of -4.5% is only a little light relative to the street’s expectation of -4.3%.  On a brand by brand basis, my estimates are less aggressive than the street at Red Lobster and LongHorn but more favorable for Olive Garden.  I am modeling -8% at Red Lobster, -8% at LongHorn and -1.5% at Olive Garden.  We know that blended numbers came in roughly -4% to -5% in September (1.9% better than Knapp) because management stated that September was running similar to August.

It is important to remember that all of the company’s concepts are facing difficult comparisons in November due to the holiday shift which benefited Q2 last year and will negatively impact Q2 results this year.  For reference, this Thanksgiving holiday shift benefited last year’s Q2 same-store sales numbers by 70 bps.  Comparisons at Red Lobster are particularly difficult in September as well so a tough September combined with a tough November should yield a pretty ugly number for the quarter, even in light of the company’s running its Endless Shrimp promotion going into the quarter.

On its last earnings call, management talked about doing some more value initiatives at Red Lobster but insisted that it would not damage the brand by participating in the discounting tactics used by its peers.  DRI’s ability to build traffic in the near term will depend on how far management will go to push value and blur the line around discounting.  I hope management will further address its sales building initiatives for Red Lobster on its Q2 earnings call.

Relative to margins, I am modeling a 100 bp contraction in Q2 margins following Q1’s 55 bp margin expansion.  As I said before, the extent to which food costs are favorable in the quarter will factor in here.  Regardless, I think margins will continue to decline for the balance of the year.

Working against margins in Q2:

-Lapping cost saving initiatives implemented in 2Q09

-There will be spending in this year's second quarter related to the company’s field supervisory conferences. Many of these conferences were postponed last year because of the difficult economic environment and the resumption this year will boost selling, general and administrative expenses in this year's second quarter compared to the same quarter last year.

-In addition, last year's second quarter included employee benefit-related favorability that the company does not anticipate this year. That favorability, which was included in selling, general and administrative expenses, was fully offset over the balance of the year by increased tax expense.