DRI – GLIMPSE AT MAY INDUSTRY TRENDS

Darden is scheduled to report fiscal 4Q10 earnings after the close tomorrow.  Casual dining names, in general, have traded lower in response to CPKI’s revised calendar 2Q10 guidance issued yesterday.  CPKI provided the first real glimpse of May trends and it was not good.  CPKI announced that May same-store sales declined 7.9%, following a 2.7% decline in April.  For reference, CPKI was facing its easiest monthly comparison of the quarter in May so 2-year average trends decelerated rather significantly for the concept as well.   We have yet to hear how the industry as a whole fared in May as Malcolm Knapp will likely report industry data soon after Darden reports its quarterly numbers, but judging from CPKI’s May numbers, the Knapp May whisper-number of -1%, which implies flat 2-year average trends, seems aggressive. 

Darden widened its gap to Knapp performance during its fiscal 3Q10 and I would expect the company’s outperformance to continue in the fourth quarter.  Through April, the industry on average, as measured by Malcolm Knapp, improved about 100 bps sequentially on 2-year average basis from Darden’s fiscal 3Q10 timeframe.  May is obviously the big question mark for both Darden and the industry but my same-store sales estimates for Darden assume that 2-year average trends during 4Q10 held steady to improved slightly sequentially from 3Q10, excluding the estimated holiday and weather impacts, across all of the company’s concepts.  My -0.1% blended same-store sales estimate is slightly better than the street’s -0.4% estimate, reflecting my expectation for a stronger LongHorn performance (+2.0%) and slightly weaker Red Lobster number (-3.0%) relative to the street's estimates.  For reference, DRI guided to a -2.5% blended same-store sales number for the full year, implying -1% in the fourth quarter. 

Based largely on my slightly better than expected same-store sales estimate, I think the company’s earnings will come in at $0.90 per share, better than the street’s $0.88 per share estimate.  That being said, I expect both restaurant level and EBIT margins to decline about 40 bps YOY during the quarter as a result of sequentially more difficult comparisons; though EBIT margin should remain above 10% in the quarter.  It is important to remember that DRI reported a 10.8% EBIT margin in 3Q10 (excluding the $0.04 charge related to the company’s decision to adjust gift card redemption assumptions), a near peak margin, but management commented that it has “new targets for peaks at this point.”

Outside of May trends, investors will be most focused on what management has to say about FY11 guidance.  Darden provided its long-term EPS guidance of up 10% to 15% and said it was comfortable with this range on its last earnings call, but did not give a specific range for FY11.  It will be important to hear what the company says about its outlook for same-store sales growth and commodity costs.  The company’s long-term earnings guidance assumes +2% to +4% same-store sales growth which, depending on how the company fared in May and into June, could be a stretch as it assumes a continued improvement in 2-year average trends.

I am expecting there to be a lot of investor questions about the company’s food cost outlook in response to all of the media focus on the expected increase in seafood costs as a result of the oil spill in the Gulf of Mexico.  Just yesterday, it was reported that as a result of the oil spill, Red Lobster was removing oysters from its menu in a few weeks when the current supply runs out.  Although oysters only make up a small percentage of Red Lobster’s menu, potentially higher shrimp costs would have a greater impact on the concept’s margins.  This is not a concern for 4Q10 as the company is 100% locked in on all of its seafood costs for the quarter and guided to a mid-single digit decrease YOY.   As of February, however, the company was only locked in on 23% of its seafood costs through December 2010 or about halfway through fiscal 2011.  Seafood costs represent DRI’s largest ticket food item, accounting for 30% of total food costs. 

We will have to hear what Darden says on its earnings call on Thursday morning but, for now, I am comfortable with the company’s ability to grow EPS by at least 10% in FY11, within its long-term guided range of +10% to +15%.  The street is currently estimating 12% EPS growth.  I would not be surprised, however, if same-store sales fall slightly short of the 2% to 4% range. 

I continue to believe that DRI is one of the best positioned restaurant companies going forward and that return on incremental invested capital is moving higher in FY11.

DRI – GLIMPSE AT MAY INDUSTRY TRENDS - DRI 3Q10 RL SSS

 

DRI – GLIMPSE AT MAY INDUSTRY TRENDS - DRI 3Q10 OG SSS

 

Howard Penney

Managing Director