Among the casual dining restaurant industry, there is no doubt Darden Restaurants Inc. (NYSE:DRI) is one of the leading players, with more than 2,150 restaurants. Owning and operating restaurant chains in the U.S. and Canada, its core brands are Olive Garden, with 832 units, Red Lobster, with 704, and LongHorn Steakhouse, with 438. This firm also operates a smaller group of grands: Capital Grille, Yard House, Bahama Breeze, Seasons 52 and Eddie V’s. Indeed this chain’s strategy focuses on developing new restaurant concepts as to take advantage of the variety of consumers’ preferences in the restaurant industry, such as Italian, Seafood, Grill or Caribbean, while strengthening its mature brands with constant innovation.
Nevertheless, big chains find it hard to sustain its growth, and the diversity sometimes plays against both quality and efficiency. Given the macroeconomic instability and the consumers’ volatile spending capacity, Darden has had to put up with some setbacks these past months.
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Washed off Darden
This mega-chain had some hard times, with dismal fiscal second-quarter 2014 results. Earnings declined 42.3% year over year, due to higher expenses, and despite the revenue growth of 4.6% year over year, it didn’t meet the analysts’ expectations for this figure. Its core brands where the ones which underperformed, resulting in soft sales. As most companies declared, the culprit was weather, and Darden CEO Clarence Otis said, “Both the industry and our brands were hit with usually severe winter weather in much of the country.”
We should although remember Daren is one of the top recognized casual dining restaurant firms, which has historically sustained same-store sales and unit-level productivity metrics. The company holds bargaining clout with suppliers and its technology efficiencies, maintaining industry-leading operating margins, with free cash-flow as to constantly enhance investors. But Darden seems to be falling short these days with brand equity generating less economic profit, and we cannot blame it all on the weather. The industry has been indeed hit by cyclical and competitive headwinds, and traffic has been affected. Yet peers have managed to remain profitable, with promotional strategies and menu innovations, which Darden failed to deliver.
Higher Costs, Less Margins
Despite Darden’s intangible assets, which has historically lead to strong traffic growth and modest pricing power, these scale advantages are not generating same excess economic profit they once did. The emergence of fast-casual restaurant concepts and constant competition among the restaurant industry worries Darden, and the operating margin and ROIC trends are revealing a weakened competitive position for the firm.
Inflation and higher costs are pressuring margin levels, and Darden expects, as all peers in the industry, to see some increased expenses this year. Commodity inflation is expected in the range of 2.5% to 3.0% in fiscal 2014. All of these will affect earnings for this year, declining in the range of 15.0% to 20.0%. Labor expense ratio is also likely to go up, due to lost sales leverage and higher compensation expense, and given the implementation of the Affordable Care Act, the company will have to provide coverage for workers, raising costs even more.
A Brand Renaissance Plan has recently been presented by the company. This plan includes a set of initiatives at Olive Garden which include simplifying kitchen systems, developing new core menu items, and investing in the Tuscan Farmhouse remodel program. These innovations are likely to improve guest traffic as well as sales, and might lead to better prospects for the year to come. Still, this improvement is limited to one brand, and has yet to reveal its realization. Recently, management has acknowledged a willingness to sacrifice profitability to maintain guest counts.
No More Lobster
Shareholders directed a strong criticism towards the company, reacting to the lower-than-expected results. In response, Darden declared a comprehensive plan with a possible spin-off of its Red Lobster segment, a more aggressive Olive Garden turnaround, a limited expansion and an increase on shareholder return. Despite canceling the meeting with shareholders the company had scheduled for March 28, it seems the new plan to enhance shareholder value and leverage the benefits of the company's position is en route. By separating its Red Lobster business it aims to lower unit expansion, reduce capital spending by at least $100 million on an annual basis, increase cash flow and return to shareholders via dividends and share repurchases. Nevertheless, the efforts towards solving the performance setbacks are yet to be seen. This plan will however free up capital to invest in newer Darden brand’s intangible assets.
Some analysts think the management’s decision to reduce capital expenditures by more than 10% this year should provide additional resources to improve its competitive positioning, and spare cash to invest in nascent chains. Relying on the company’s history, brand recognition and scale advantages, bulls think Darden will increase growth, and given its commitment to dividends and share repurchases, it should lift total shareholders returns in the medium term. Others are regarding some structural and internal issues in the company, and state the restricted consumer budgets, the competitive pressures, and rising costs will continue hitting the company’s margins.
Disclosure: Damian Illia holds no position in any stocks mentioned.