Darden Restaurants is a Master Class in Restaurant Operations

Prologue: In spite of the banking crisis, recession fears, inflation and weak consumer sentiment, Darden Restaurants stock is trading at an all-time high.  Remarkably, even though the stock is up nearly 20% over the last twelve months, it is one of only 9 other restaurant stocks that currently has a dividend yield over 3%.

We have found Darden management commentary, especially following quarterly earnings reports, to be candid and informative relative to industry developments. In this update we will review management comments from the most recent conference call to highlight how the company has been able to produce industry leading operating performance in the full-service restaurant sector.

CEO, Rick Cardenas:

“I will say, go back in our history since we’ve been a public company, we’ve never had a 10-year period that we have had less than a 10-year — 10% annualized total shareholder return. So, we feel confident over the long run that we’re going to get to 10% to 15%.” 

THE BOTTOM LINE

 There are very few mysteries underlying success (or failure) within the restaurant industry. Analysts, operators, equity investors and lenders should experience very few surprises, if they are paying attention to the details, almost all of which are readily apparent.

 As long-time readers know, we believe that listening/reading restaurant conference calls helps investors and restaurant industry competitors understand how industry-wide challenges such as staffing, commodity inflation, unit growth and product innovation are dealt with. After reading the transcripts of over thirty public restaurant companies, it becomes clear that, relative to their peers, Darden is among the “best of breed” in terms of running a full-service restaurant company.  Moreover, we view Darden management to be uniquely candid and descriptively informative in this regard. They apparently have no fear of tutoring their competitors, since the “walk” is a lot more difficult than the “talk”.

Our word to the wise to Darden’s competitors in the full service casual dining industry: If you can’t provide your employees with the quantitative and qualitative benefits (as described by Darden) you will be hard pressed to attract the best personnel.

Focusing on Employees has Numerous Benefits

While every management team talks about the importance of their employees, especially their frontline employees, Darden’s commitment to helping their employees be the best at their jobs continues to manifest itself in very tangible ways. For example, in their last earnings presentation, Darden has the following slide that shows all of the awards the company has won for Employer of Choice and Best Practices.  These awards are given based on metrics such as employee turnover, a brand’s employee retention as well as sales and traffic performance, gender, and racial diversity.

On the recent earnings call, management highlighted again the numerous ways that Darden has been able to separate itself from many of its competitors in terms of operating performance. For example, in the latest quarter, the company’s same store sales performance outpaced the industry by 450 basis points, and their same-restaurant guest counts performed even better as they exceeded the industry benchmark by 700 basis points. Unlike many competitors, Darden is again providing full staffs at both the frontline and manager level. Management described the competitive advantage as managers can spend more time training and developing their team members. A well trained staff improves the guest experience, leading to a virtuous cycle of repeat business, higher tips and the best possible front line service.

“Our restaurants continue to be well staffed, and our manager staffing remains at historic highs.”

Analyst Question:

“And I think, obviously, we’re in an environment where it’s important to kind of retain people and continue to pay better than your peers. How does that kind of factor into what you expect from a wage inflation perspective going forward?”

Answer:

CEO Rick Cardenas:

“We have more managers per restaurant than we’ve ever had in our history. So, we feel really good about where we are. But we have a great employment proposition. Our turnover is significantly reducing. We’re hiring great people and we’re being as discerning as we had been before COVID.

“We’ve actually spent a lot more time, as I said on our last call, every one of our General Manager, managing partner conferences in August, talked about how to make each brand a better place to work — an even better place to work. Our first 90-day turnover is significantly improved from where it was just six months ago because of the focus that we’re putting on training and making sure that those team members feel up to speed before they get thrown out on a busy Friday.

“The manager role in our restaurants is the most important role we have, especially the general manager, the managing partner. And being fully staffed there gives them more time to spend with their team and train their team, develop them, make them stronger and just spend that time forecasting their business and spending time with guests. If you’re under staffed with managers, the restaurant doesn’t run as well. But the other thing about being fully staffed with managers and we have the highest staffing in our history, is that that helps us open restaurants going forward, right? If you think about our pipeline of new units, we have about 25 net openings coming in this quarter, and we are ready for it with the managers that we have. So, there’s a lot of benefits of being fully staffed so managers can spend more time with their team, they can spend more time with guests, and we have the managers to open our restaurants.”

Another Way in Which the Company’s Focus on Their Employees Show Up is with Better Customer Satisfaction Scores.

While the food quality must be high to maintain guest satisfaction, Darden’s results clearly show that food is not the only competitive advantage. Management constantly talks about how customers view Darden brands as providing a great value relative to other brands. Part of this is due to Darden underpricing inflation by over 400bps since Covid. But another important factor is the overall dining experience. The more engaged and motivated the staff is, the better the dining experience, and the more likely the customer is to return, all leading to the virtuous cycle described above.

CEO Rick Cardenas

“We know from our recent engagement survey results that our overall level of engagement is very high, and our team members understand what is expected of them at work. This is helping drive high guest satisfaction metrics, both internally and externally. Data from the American Customer Satisfaction Index shows customer satisfaction is down across all industries. However, across all of our brands, our internal guest satisfaction ratings remain exceptionally strong. In fact, Cheddar’s Scratch Kitchen, Yard House and Bahama Breeze achieved all-time highs during the quarter. Additionally, for the second consecutive quarter, the Darden brand was ranked number one among major casual dining brands in each measurement category within Technomic’s industry tracking tool.”

Darden’s Guest Traffic Continues to Hold Up Better than the Industry.

 It is no secret that, over the last few years, most casual restaurant chains have seen a meaningful decline in guest traffic. Some chains are reporting that traffic is still 10-15% below 2019 levels. However, because of the company’s emphasis and success on training and maintaining managers and employees, Darden is significantly outperforming its competitors in terms of guest traffic trends.

 CEO Rick Cardenas

“We significantly exceeded the industry benchmarks for same-restaurant sales and traffic, outperforming more on traffic than we did on sales. We also continued to underprice inflation, resulting in lower overall check growth relative to the industry. Our ability to make this investment and provide strong value to our guests reinforces the power of our strategy, which comes to life through our four competitive advantages and executing our back-to-basics operating philosophy.

 “This same restaurant sales performance outpaced the industry by 450 basis points, and our same-restaurant guest counts performed even more as they exceeded the industry benchmark by 700 basis points. During the holiday season, Olive Garden and LongHorn Steakhouse set new all-time weekly sales records, only to break them during Valentine’s week. In fact, all of our brands achieved record total sales for the quarter. Even with the traffic growth we achieved during the quarter, to-go sales remained strong, accounting for 26% of total sales at Olive Garden, 14% at LongHorn and 12% at Cheddar’s. We continue to leverage technology to make it easier to order a pick up and pay without having to pass the added expense of third-party delivery on to our guests.. For example, to-go orders accounted for 33% of Olive Garden’s total sales on Valentine’s Day. 700 basis points of outperformance is pretty strong. It all really depends on what the total traffic growth is for the industry. If we do — if the industry is growing at 1%, do we expect to get 7% every quarter in outperformance, no? We’re very pleased with that outperformance of 700 basis points this quarter, but we wouldn’t expect to be 700 basis points every quarter. And there might be quarters that we have lower performance and traffic than our competition. But we think about this over the long term. And over the long term, we expect to outperform.”

 Observations Re: Consumers Continuing to Dine Out in Spite of Economic Headwinds

While we tend to focus on bottoms up analysis of restaurant companies, many readers are interested in the impact of macro-economic trends. Management gave some very insightful observations that we believe readers can benchmark against other restaurant companies.

CEO Rick Cardenas

“What’s interesting is, for most of calendar year 2022, customer sentiment was pretty bad, but consumer spending was significantly high. So even though they were thinking that things were bad, they were still spending. And so, we think as long as the unemployment rate is low and wages are increasing, consumers should continue to spend.I will also say the data from our proprietary brand health tracker suggests that most consumers are not pulling back from restaurant visits, and they do not appear to be trading down from full service to limited service based on the data that we have. Now there is a tension between what people want and what they can afford. Consumers continue to seek value, which is not about low prices, consumers are making spending trade-offs. And food away from home is one of the most difficult expenses to give up because going out to a restaurant is still an affordable luxury for them. And so, what does that mean for us? For our brands, we believe that operators that can deliver on their brand promise and value will continue to appeal to consumers, despite economic challenges. And that’s what we remain focused on doing, no matter what happens in the industry and whatever happens to the category. The good news is we haven’t seen a material change in mix from the last time we talked to now in that lower end consumer. But if it manifests itself, it generally starts with managing check. Generally, consumers will manage their check first, and then they’ll manage their visits later. And so far, we really haven’t seen a whole lot of check management. So, that tells you, based on what I said earlier, consumer sentiment was pretty bad in ’22, but consumers still spent. And as people shifted to restaurants, we benefited. So, we haven’t seen it yet. We may see it. And when we do, it will start at check probably and then it will impact probably more likely impact our lower-end consumer brands, not that they’re lower end brands, they just have a bigger mix of lower-end consumers, and it will impact less our high-end brands. 

Analyst Question:

 “So I guess the question is the grocery in terms of total number of meals consumed is still bigger than restaurants, actually multiple, maybe 2-plus x restaurants depending on how you want to calculate it. Grocery pricing has actually been well in excess of restaurant pricing. It remains so now. When you guys think for it and this is, I guess, a forward-looking question, really a view of your industry. Grocery pricing often follows commodities. Commodities are expected to drop just in your own language from what was 10-plus percent to very low single digits. Is there like a way to kind of be prepared for grocery kind of retaking relative value relative to restaurants? And is that something that you think about internally and maybe to Jon Tower’s question of maybe bringing back some advertising, bringing back some promotion just to make sure that you’re keeping customers maybe the bottom 5% or 10%, whatever you want to say, still coming to your brand and using the brand even if year-over-year groceries and other brands, perhaps limited service included, start to emerge as a pricing opportunity for them.”

CEO, Rick Cardenas:

“One of the things I want to let everybody make sure they hear is we’re not going to risk margin, significant margin declines because of what happens in the economy. If food costs go down, think about what we’ve said in the past, a 1% decline in commodity inflation will offset a 2% decline in traffic, all else equal, with us doing nothing. So if commodity costs come down and inflation comes down, we can weather a little bit of a traffic decline and still get to the same EBITDA……So, I think we have to think — and the industry has to think long term about how they drive traffic through discounting. And we have made that shift, even started it before COVID to drive traffic through better experiences, better overall value and not discounting to a very small — a small portion of our guest base. So, that’s our strategy going forward. If things change, we’ll let you know.

Construction Costs are Increasing, But Opening Volumes are Above Average and Offsetting Those Increases.

One of the biggest problems facing restaurant chains that are growing units is rising construction costs.  Darden is one of the few companies that provides detailed numbers about construction costs of new restaurants at the brand level. Comparing the numbers from FY19 to FY23 shows the increase in costs per square foot over the last four years. The company will provide updated information in its 10K that will be filed after the next quarterly report.

What is interesting is that the company says that the returns on the new, more expensive units are actually similar to the returns it was achieving before the increase in construction costs because the new units are opening at volumes that are above historical levels.

CFO Raj Vennam:

“As far as the comment on the returns, when we look at our new units actually — especially the recent openings have actually outperformed on the top line more than we expected going into. So, they are actually opening at most of our brands. They’re opening at volumes that are exceeding what we would have estimated going into the — when we approved the capital for the project. 

SUMMARY: AS DESCRIBED IN “BOTTOM LINE” ABOVE

Roger Lipton

Darden Restaurants (DRI), operating 1,875 locations,  is one of the best managed publicly held full-service restaurant companies, owning Olive Garden, Long Horn Steakhouse, “Fine Dining” (Capital Grille and Eddie V’s) and “Other” (Season’s 52 – my favorite, Cheddar’s, Yard House, Bahama Breeze). If anybody can successfully cope with the continuing challenging environment, it is “DRI”. They reported their first fiscal  quarter, ending August, basically in line with previous guidance.

Total revenues in Q1 were up 6.1% to $2.4 Billion. Blended same store sales were up 4.2% and EPS was down as expected to $1.56/share vs. $1.76. On a monthly basis, blended SSS were up mid-3% in June, low 1% range in July and about 8% in August (lower gas prices?). Each of the individual segments had positive same store sales and lower profit margins. The Company repurchased $199M of its stock during Q1, with $912M remaining under the current $1B authorization. Guidance for the current year, ending May’23 remained unchanged: SSS of 4-6%, 55-60 openings, diluted EPS of $7.40-8.00/share.

The reported results are of course important, along with the formal commentary and guidance, and there are myriad places to find that information. . For our purposes,  since Darden provides more complete and candid conference call commentary than most, we like to  report on that event.

THE CONFERENCE CALL

The quarter ending August provided what they called “a return to normal seasonal patterns”. In Q1’, ending August, a year ago, the Covid rebound was in place. Sales were firm, and stores were of necessity understaffed, so comparing against last year’s bottom line was predictably difficult. Restaurant labor was only 50 bp higher, driven by hourly wage inflation of just over 9%, fortunately offset by better productivity. Total restaurant labor inflation, including management, was 7.5%. A larger detriment this year was CGS, up 280 bp, including robust commodity inflation of 15%.  Restaurant expenses were 10 bp higher, driven by higher repairs and maintenance due to supply chain challenges and utilities inflation of 16%. Marketing was 20 bp higher, with increased testing of digital and television marketing. G&A expense was 130 bp lower, driven by a $7M reduction in deferred compensation plans and equity compensation expense. While Operating Income margin of 10% was 220bp lower than in August’21, it was 60 bp better than pre-Covid Aug’19.

Blended SSS, as indicated above, were up 4.2% and all segments against Pre-Covid August ’19 (Q1 fiscal ’20) are equally encouraging. Sales at Olive Garden were 3.7% above last year, and average weekly sales (AWS) were 101% of the pre-Covid level, especially promising considering a the heavy promotional activity and couponing three years ago. Long Horn sales were up 6.6% YTY, and AWS were up 126% vs pre-Covid. Q2 Sales in the Fine Dining segment were up 8.6% YTY, and AWS were 120% of the pre-Covid levels. The “Other” segment sales were up 9.9% YTY, and AWS were 109% of the pre-Covid levels.

Looking ahead to the balance of the May’23 fiscal year: EPS will be between $7.40 and $8 for the year. In the Q2 to date, sales trends are above the high end of the annual SSS outlook range (4-6%).  Management speculated that lower gas prices recently may be a contributing factor.

Inflation seems to be “just a bit” affecting households making less than $50,000/year, most noticeable at Olive Garden and Cheddar’s. In the first quarter, total inflation was roughly 9.5% and total pricing was approximately 6.5%, almost 300 basis points below inflation, and less than most competitors. It is expected that the gap between pricing and inflation, having peaked in the first quarter., will moderate through the 2^nd and 3^rd quarters, and reverse in Q4. In the same way, the profit margin decline should moderate in Q2, with commodity inflation somewhat better at 13%, generating positive EPS in the second half, “flat to slightly below” for the full year.

Management’s summary of marketing principles is instructive: “First, it needs to elevate brand equity by bringing the brand’s competitive advantages to life. Second, it should be simple to execute. We will not jeopardize all the work we have done to simplify operations, which allows our teams to consistently deliver exceptional guest experiences. And finally, it will not be at a deep discount. We are focused on providing great value to our guests, but doing that in a way that drives profitable sales growth.”

It sounds like SSS comparisons YTY will continue to be difficult, depending on gas prices, going against the Covid-rebound late last year until the last week of December when, in December ’21, the Variant hit and ran through February’22.

Digital is 10% of total ($240M out of $2.4B) and 62% of Off-Premise, therefore about $387M, which is about 16% of total. Since delivery is minimal, To-Go is essentially the same as Off-Premise, which accounted for 24% of total sales at Olive Garden, 14% at Long Horn Steakhouse and 13% at Cheddar’s, apparently minimal at Capital Grille and the others. Since customers have learned new ways to get served by casual dining restaurants, the result is less dining room traffic, exacerbated by that fact that some consumers are still afraid to eat in crowds. While Long Horn is generating Dine-In traffic above pre-Covid levels, most other brands are not.

Credit to David Palmer, the analyst at Evercore, whose conference call questioning pinpointed the decline in Dine-In activity (at Olive Garden) in comparison to pre-Covid. After a somewhat confusing (to me) discussion of Guest Count Retention (“GCR”), the apparent change in Dine-In traffic, recent Q4 and Q1 vs. pre-Covid Q4 and Q1, Palmer suggested that the recent Dine-In traffic is down about 15% from three years ago. Management responded as follows:

“Yes, David. Let me start by saying your numbers are right. Does that present an opportunity in the dining room? Absolutely. But we’re going to go about it in a manner that’s actually sustainable and that’s where we go back to — over the last three years, we’ve invested so much into under-pricing inflation. If you look at where Olive Garden’s pricing has been over the three years, combined three years is at 10%. When you look at where full-service CPI — restaurant CPI was for the same time-frame, it’s 17.5%. So we’ve actually significantly under-priced the industry and that is the way we believe to build back that guest. And Rick mentioned getting that one extra visit from our loyal guest, we think this is a sustainable, durable way to really get our guests back. I would argue that we’re starting to see the fruit of some of that, but it takes time.”

“The good news is that if our dining rooms aren’t back to full, we’ve got capacity. And as we continue to see some improvement, as we continue to do the things that we have been doing over the last few years, focusing on simplification, making it easier for our teams to do what they do, investing in our food, investing in our teams, then we’re going to have an even better experience as guests come back, and they are coming back. So, that just gives us more opportunity to grow in the long run because our dining rooms in some of our brands aren’t back to pre-COVID levels. That’s being offset in most of our brands by To Go.”

THE TAKEAWAY

Darden, generating almost $10B of sales from 1,875 restaurants is doing as well as can reasonably be expected. Management accurately states four competitive advantages: Significant Scale, Extensive Data and Insights, Strategic Planning, and a Results Oriented Culture. The consistent performance across multiple brands is admirable and there is no indication that they have lost their focus or ability to profitably gain market share. They have emerged from the Covid period in a superior competitive position, and have the financial and operational strength to continue in the same vein. Their commentary indicated that the recently reported firm sales trends are continuing, with less promotional activity than several years ago. Menu pricing has lagged the CPI and that of their peers, so customers should accept increases when necessary. Store level and corporate margins are now approximating pre-Covid levels, so rebuilding Dine-In traffic, if most of the Off-Premise buildup can be retained, could provide margin leverage. It’s been a literal “jungle” out there, but the worst of it could be over in terms of the rate of wage and/or commodity inflation. The Company is “returning cash to shareholders” to the tune of 4-5% stock repurchase (annually) and a dividend yield of about 4%. The balance sheet is strong with long term debt less than one times TTM EBITDA. With (1) unit growth above 3%, (2) same store sales growth assumed in the low to mid-single digits, (3) 4-5% of the stock retired annually, EPS and EBITDA per share annual growth should be in the double digits, and margin leverage could add to that. Darden’s Restaurants (DRI), trading at an Enterprise Value of about 11x trailing twelve-month EBITDA, represents excellent value.

Roger Lipton

DARDEN REPORTS FOURTH QUARTER – AN EDUCATIONAL CONFERENCE CALL AND AN EXCELLENT INVESTMENT VALUE

Darden reported fourth quarter and full year (ending May’22) results late last week. The headlines were mostly positive, but with lowered guidance for the first half of fiscal ‘23. Fourth quarter EPS was $2.24/share, beating estimates by $.02. Guidance for May ’23 was $7.40-8.00/share, below the $8.00+ previously expected. The quarterly dividend was raised from $.1.10 to $1.21 and a new $1 billion stock buyback (about 6% of the equity value) was announced, after buying back $237M in Q4. Comp sales were strong in the fourth quarter: Consolidated same store sales up 11.7%, with Olive Garden up 6.7%, Long Horn Steakhouse up 10.6%, Fine Dining up 34.5% and Other Business up 18.5%.

Beneath the surface, fourth quarter results were not quite as compelling as the headlines, with Q4 segment profit down at both Olive Garden and Longhorn Steakhouse. With the guidance in H1’23 lowered, the stock, after initially rising from $115 to $122, sold off and closed at around $115. It rallied the next day to $127, within a strong  daily stock market, and analysts remembering that Darden is THE class act within full service casual dining.

We have long felt that Darden’s quarterly conference calls should be required reading for restaurant operators as well as investors, because management’s candor, as well as long term operating performance, has been “best of breed”. Though long time CEO, Gene Lee, is retired, Rick Cardenas (President) and Raj Vennam (CFO), can be expected to  maintain that standard. Within that context, the most salient points as we see them, are as follows:

The general menu pricing strategy is to increase prices slower than inflation. Though sales have softened a touch in June, they are still in the 4-6% guidance range and stronger than industry peers. Operating costs were inflated by 7.5% in Q4, partially offset by pricing of 6% for the quarter and 3% for the year. Food and beverage expense was 300 bp higher in Q4, with food up 12%. Restaurant labor was down 40 bp, driven by operational simplification. Labor inflation was 7% YTY, primarily driven by hourly wages up 9%. Marketing spend was 230 bp lower. G&A expense was 140 bp lower. Restaurant level EBITDA was 19.9%, 40 bp above pre-Covid level. Corporate EBITDA margin was an impressive 16.6%, 170 bp better than pre-COVID. Staffing levels essentially are back at pre-COVID levels.  Hourly wage inflation is currently about 8%, total labor (including store management) up about 6%, embedded in guidance.

CONFERENCE CALL “COLOR”

On the conference call, management elaborated regarding sales trends intra-quarter, as well as short term expectations. Comps built from March to April and into May, with a “not dramatic”…“check management” at the modestly priced Cheddar’s. Olive Garden “to-go” is above 25%, Long Horn around 15% of sales, much higher than pre-Covid. 60% of to-go is digital, which is 10-12% of total sales. Darden has not embraced delivery, so the increase in to-go business is a result of investments made to reduce the friction in ordering, paying, and picking up. The much stronger comps at Long Horn, compared to Olive Garden is a result of Long Horn’s pre-Covid “refresh” of its concept.

LOOKING AHEAD

Reference was made to industry wide sales, including DRI, that have softened in June, but it was suggested that it could be seasonality that didn’t take place last year. On the other hand, management’s reference to current consumer “uncertainty” (as evidenced by horribly weak sentiment surveys), especially visible at the lower priced Cheddar’s, indicates a justifiable reluctance for management to be aggressive with guidance. On the positive side, cost of goods, including chicken and wheat and dairy, in particular, seems to have peaked and is expected to retreat. We suggest that the “2^nd derivative” of wage increases (i.e. a change in the rate of increase) may have peaked as well, so, along with recently imposed higher menu prices, there could be further improvement of store level margins. Other than reiterating that store level margins should remain above pre-Covid levels, management did not go as far as we are suggesting. A further indication of management’s optimism is the increase in store openings, 55-60 in the current year, up from 37 in the year just ended.

CONCLUSION

Readers should review the operating statistics as presented in the “Corporate Descriptions” portion of this website. Below: (These Descriptions are current for every publicly held restaurant company.)

https://www.liptonfinancialservices.com/2022/03/darden-restaurants/

Best of Breed DRI has only rarely traded with an Enterprise Value less than the current 10.3X trailing twelve month EBITDA and equity value about 16x next twelve month EPS. With a secure dividend that was just increased to yield about 4% annually, and  a $1B stock buyback in place, DRI represents an attractive long term participation in the casual dining industry. Recession or not, people have to eat and they have lots of options within Darden’s portfolio of well managed brands.

Roger Lipton