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DRI is scheduled to report fiscal 3Q10 earnings after the close next Tuesday.   I am not expecting too many surprises out of the quarter as the company preannounced better than expected sales and earnings prior to its February analyst day.  According to management’s revised guidance, it is going to be a good quarter with same-store sales improving on a 2-year average basis across each concept (with the biggest sequential improvement coming at LongHorn) and EBIT margins moving about 80 bps higher YOY.  I am modeling $0.93 earnings per share for the quarter at the high end of the company’s revised guidance and $0.01 above the street’s estimate.

Investors are already anticipating a strong quarter, however, as the stock moved nearly 4% higher on the day the company preannounced fiscal 3Q10 numbers and raised its full-year EPS guidance to +5% to +8% (from its prior flat to +4% range).  Specifically, management stated, “The signs of sales and traffic improvement we began to see late in the second quarter and discussed during our December conference call with investors continued into January and February.”  DRI has moved about 12% higher since the day prior to that announcement. 

What will matter more next week is what DRI has to say about current trends in early fiscal 4Q10.  Even if the industry continues to experience sequentially better trends, DRI’s 4Q same-store sales trends will likely not look as good as 3Q because the company benefited by about  80 bps in the third quarter from a holiday shift.  This benefit will go away in the fourth quarter and the company is lapping more difficult comparisons, particularly at Red Lobster (due to the earlier Lent this year, which helped 3Q10 and will hurt 4Q10).  EBIT margin comparisons get more difficult in the fourth quarter as well and into 1Q11. 

That being said, DRI looks to be in a good position for fiscal 2011.  If top-line trends continue to improve sequentially (this is obviously a big ‘if” but I am only assuming a moderate improvement), FY11 EBIT margin should move close to 50 bps higher, even considering a somewhat tougher commodity environment.  DRI guided to flat to +0.8% food and beverage inflation in fiscal 2011. 

Capital spending is expected to increase about 10% in FY11 as the company accelerates both its unit growth to about 4% from 3% in FY10 and its remodel initiatives at LongHorn and Red Lobster.  Through a combination of new units and remodels, 100% of the company’s LongHorn units will reflect the Ranch House look by the end of fiscal 2012 and 100% of its Red Lobster units will be in the Bar Harbor image by the end of fiscal 2014.  In FY11, nearly 20% of DRI’s capital spending is expected to be allocated to remodels, up from about 10% in FY10.  Additionally, the level of spending on remodels will remain elevated through FY14 as the company plans to accelerate its more expensive Red Lobster remodels as it winds down on the LongHorn reimages. 

DRI – RETURNS ARE MOVING HIGHER - DRI NEW UNIT GROWTH

Even with capital spending moving higher, DRI’s return on incremental invested capital looks to be moving higher in FY11.  DRI’s ROIIC has been coming down since fiscal 2007 but moved significantly lower in 2009 and 2010.  We won’t see an immediate return to the mid-to-high teen ranges of fiscal 2005 and 2006, but a double-digit number seems likely in fiscal 2011.  As I have said numerous times before, a stock’s performance will often follow the trajectory of returns.  And, I don’t think my numbers fully reflect the higher return associated with the bigger portion of capital spending going to remodels, which typically yield higher immediate returns.  Management guided to a 3% to 4% traffic lift from remodels at LongHorn and a 4% to 5% boost at Red Lobster.

DRI – RETURNS ARE MOVING HIGHER - DRI ROIIC

DRI’s strong free cash flow will remain intact with capital spending moving higher as well.  DRI guided to $50 to $60 million in share repurchases in the back half of fiscal 2010, despite the fact the company has about $150 million in debt coming due.  Share repurchases are likely to move higher in FY11 as the company maintains its dividend and pays down another $75 million in debt (due in April 2011).

Howard Penney

Managing Director

DRI EBIT margins:

DRI – RETURNS ARE MOVING HIGHER - DRI EBIT MARGINS

 The 50-65 yrs cohort is important for DRI:

DRI – RETURNS ARE MOVING HIGHER - DRI SSS