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Darden cheap to McDonalds

| September 14, 2018

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Darden Restaurants has completed debt reduction, reducing leverage into their target range. Positive fundamentals should be reflected in earnings to be reported on September 20. Darden’s long-end debt looks particularly cheap relative to that of McDonald’s, and has room to outperform.

Leverage within target range

Darden Restaurants (DRI) will report fiscal 1Q19 results on September 20, 2018.  Since the company last reported results on June 21, 2018, the credit has been relatively quiet from a headline perspective.  Furthermore, August was a quiet month on the hurricane front, which bodes well for same store sales (SSS) at DRI.  With debt reduction now complete and leverage of 2.15x comfortably within management’s 2.0x-2.5x target range, DRI will step up shareholder remuneration slightly.  Management increased its annual share repurchase target by $50 million, to the $150 -$250 million range.  For fiscal 2018, DRI generated $605 million of free cash flow and returned $548 million to shareholders.  Had DRI increased share repurchases by $50 million, shareholder remuneration still would have been within the confines of free cash flow generation.

Outperforming peers

DRI posted SSS growth of 2.4% in fiscal 4Q18, beating street estimates of 1.2%.  Both Olive Garden and Longhorn Steakhouse, DRI’s two largest banners, witnessed SSS growth of 2.4% in the quarter.  The 4Q18 marked Olive Garden’s 15th consecutive quarter and Longhorn’s 21st consecutive quarter of SSS growth. Both banners also outperformed the benchmark index by 190bps.  In fact, all of DRI’s banners witnessed positive SSS growth with the exception of Cheddar’s, which declined by 4.7%.  The decline largely reflected the acquired franchise restaurants, which posted a decline of 7.0% relative to a decline of 3.3% at the original company restaurants.  DRI recently completed the integration of the Cheddar’s restaurants by transitioning them to DRI’s point of sale system.

Relative value in the long end

 While DRI has no investment grade casual dining peers, we continue to like the DRI credit (Baa2/BBB/BBB) relative to McDonald’s Corp. (MCD – Baa1/BBB+/BBB).  McDonald’s has been increasing leverage to return cash to shareholders.  We estimate that lease adjusted leverage for MCD is currently 3.4x (using a 6.25x lease up), which is over a turn higher than DRI.  Even with DRI’s latest acquisition of Cheddar’s, management kept leverage within its target range.  We think DRI 4.55% 2/15/48 bonds look attractive relative to MCD 4.45% 3/1/47 as they are currently trading 40 bp wide to MCD.  The spread between the two issues, shown in Exhibit 1, has been volatile over time but appears to be recovering. At issue the DRI bonds were trading about 15 bp behind MCD 4.45% 3/1/47.  When MCD announced a tap of the 2047 issue in March, bonds traded as close as 5 bp apart and then settled back to roughly 15 bp -20 bp apart.  At the wides, the differential was roughly 55 bp – 60 bp apart.  DRI credit default swaps trade roughly 15 bp behind MCD.

Exhibit 1: DRI 4.55% 2/15/48 and MCD 4.45% 3/1/47

Source: Bloomberg

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