THE HEDGEYE EDGE
Darden Restaurants (DRI) runs great restaurants and has been very focused on simplification, everyday value and improving food quality, but we believe improving competition specifically on value will be too much for these concepts to withstand in the near to medium term. It is also worth noting both core concepts are up against the toughest compares they have faced since 3Q16.
DRI is on the Best Idea SHORT list, as we believe that sales trends will slow meaningfully over the next six months putting pressure on the stock price!
Recapping The Quarter
DRI put up a great quarter, with Olive Garden putting up one of its best quarters in recent memory, just the second quarter with a comp over 5% since FY12, and well above the five-year average comp of 1.4%! Olive Garden’s SSS was 5.3%, strongly beating consensus estimates of 2.7%, representing a 20bps sequential increase in the two-year average. Olive Garden is leading the industry in traffic with growth in 1Q19 of 1.5%, with pricing slightly below industry average at 1.9%. Importantly, 30% of the growth was driven by off-premise.
Can it get any better than this? To put this performance in context, the 10-year average NTM EV/EBITDA multiple is 8.5x and back in 2008 the stock was trading closer to 7x. With the stock trading at nearly 2 standard deviations over its 10-year average, the good news is priced in.
Looking through the noise, there was little flow through from a strong top-line performance. Labor is a problem for DRI and other players in the industry. What happens to margins when sales slow into the middle of the fiscal year?
No evidence that independent operators are gaining share. According to DRI, chains have a distinct advantage in the current labor environment. Off-premise grew 13%, and is now 13% of sales, and the management team has a problem with the delivery proposition.
Key Thesis Points
1. The Competitors Have Regrouped: During the time period from 2015 to 2017 DRI and Olive garden were putting up its best SSS performance, while their biggest competitors, Chili’s, Applebee’s and Outback Steakhouse were experiencing significant sales pressure. During this period, Olive Garden was gaining significant market share from the competition. All three of the largest casual dining chains have reported significantly better sales trends in 1Q18.
2. Strategic Mistakes? DRI is not following the competitors in the deep discounting game, which is good and bad. While the company’s value perception scores have improved over the past year, the lack involvement in the promotional landscape suggests the company is resting on its laurels. Importantly, in the current quarter, Olive Garden is moving away from one of their traditional deep discounting promotion (BOGO) because of over use of said promotion. In addition we see the latest acquisition of Cheddar’s as a strategic mistake for the company. Between this acquisition and management’s commentary it would suggest they want to make more acquisitions which we view as a long-term negative for the stock.
3. Margin Pressure: Unfortunately for DRI, the slowing sales trends are happening at a time when labor inflation is accelerating. Not only is DRI seeing 4-5% labor inflation in the restaurant, but they are seeing distribution inflation as well. DRI, like many other consumer companies are having a difficult time finding drivers for their trucks. How this plays out will depend on the company’s pricing strategy going forward. In 3Q18, DRI experienced lower check growth and pricing which put incremental pressure on the P&L.
We think the sell-side is turning a blind eye to competition. We believe DRI’s strategic decision not to run their BOGO promo during one of the more promotional times in the restaurant industry will be a strategic mistake. Olive Garden in particular has been winning while their competition has faltered over the last few years, we don’t believe they can win when everyone else is improving in this zero sum game!