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Low leverage and plenty of cash at Darden

| June 21, 2019

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 (DRI) had a decent quarter despite a miss in same store sales growth. Even with a potential acquisition on the horizon, DRI’s leverage is likely to remain at least a turn better than that of McDonald’s (MCD). The DRI 4.55% 2/15/48 bonds currently look attractive relative to MCD 4.45% 3/1/47 as they are trading 50 bp wide, compared to trading 15 bp wide at issuance.

A decent quarter despite miss in same store sales growth

Despite missing street estimates for same store sales (SSS) growth when it reported fiscal 4Q19 results, DRI hit its twice updated full year SSS guidance of 2.5%, which was in line with management’s annual SSS target of 1%-3% growth. Overall EBIT margin grew 10 bp year-over-year to 11%, also in line with DRI’s annual target range of 10 to 30 bp.  For the quarter, the company posted SSS of 1.6%, which was below estimates of 2.4% as DRI’s largest banner, Olive Garden, came in below expectations. Olive Garden posted 2.4% SSS growth in the quarter which was below street consensus of 3.5%. Despite the miss, this quarter marks Olive Garden’s 19th consecutive quarter of SSS growth and the banner outperformed the industry benchmark by 270 bp. For the year, SSS at Olive Garden were a solid 3.9%. Management chalked up the somewhat weaker results at Olive Garden to a little industry softness coupled with fewer incentives at the chain. Traffic was down 0.4%, while pricing was up 1.8%.  Adjusting for the reduced incentives, DRI noted that traffic would have been positive in the quarter. That said, management is prepared to step up its level of incentives at Olive Garden should a weaker traffic trend persist. Operating profit margin at Olive Garden was flat year-over-year at 21.2%.

Longhorn Steakhouse, DRI’s second largest banner, posted SSS growth of 3.3% for the quarter, marking its 25th consecutive quarter of growth.  Longhorn outperformed the industry benchmark by 360 bp in 4Q19. For the full year, Longhorn also saw SSS growth of 3.3%. Traffic was up 0.3%, while pricing was up 1.8%. Longhorn saw a slight decline in its operating profit margin of 5 bp to 18.95%.  Management noted that Longhorn continues to benefit from multiple year investments which have simplified operations and promotional constructs. These investments have greatly improved customer retention.

Cheddar’s starting to turn a corner?

Cheddar’s posted yet another decline in SSS for the quarter, which was down 3.2%.  For the year, SSS were down 3.4%. DRI noted that the majority of the decline was due to the former franchise restaurants which were down 6.1% in the quarter. Management was encouraged with traffic trends as they improved sequentially and were 180 bp better from 1H19 to 2H19.  The improving traffic trend should eventually lead to SSS growth, according to management.  Importantly, Cheddar’s delivered double-digit profit growth in the quarter as they continue to focus on more efficient food and labor costs. Moving forward, DRI believes there is opportunity to highlight the value proposition that Cheddar’s provides relative to their other banners, which could help improve sales growth.

Balance sheet remains strong   

DRI management remains committed to keeping lease adjusted leverage in the 2.0x-2.5x range, which is currently estimated at 2.2x.  Leverage, not adjusted for leases, remains under a turn at 0.78x. DRI ended the year with a much stronger than average cash balance of $457 million, putting net debt at $470 million. Given the higher than usual cash balance, DRI could be gearing up to make a tuck-in acquisition. Bids were submitted back in May for Del Frisco’s Restaurant Group (DFRG) with DRI being one of three bidders. Speculation emerged that DRI was the highest bidder at $9/share, translating to an EV of $860 million for DFRG. Should DRI pursue the acquisition, management would likely use the majority of its cash on hand plus some debt, in an effort to keep leverage within or close to its target range to preserve ratings. This would be similar to its approach in financing the Cheddar’s acquisition back in 2017.

Initial 2020 guidance

Management provided conservative fiscal 2020 SSS guidance of growth in the 1%-2% range.  Notably this was the initial guidance that management provided for fiscal 2019 at the same time last year.  DRI proceeded to increase guidance to the 2.0%-2.5% range and then ultimately to 2.5%.  Capital spending is expected to be in the $450- to $500-million range. Capital spending for fiscal 2019 totaled $452 million, in the middle of management’s guidance range of $425- to $475-million. While capital spending has been increasing on an annual basis, adjusted EBITDA/capex has been declining annually.  For fiscal 2019 adjusted EBITDA/capex was 2.6x, down a tick from 2.7x in the prior year.

 Relative value

While DRI has no IG casual dining peers, the credit (Baa2/BBB/BBB) can be compared relative to McDonald’s Corp. (MCD – Baa1/BBB+/BBB). McDonald’s has been increasing leverage to return cash to shareholders, making lease adjusted leverage currently 3.8x, which is over a turn higher than DRI.  Even with a potential acquisition on the horizon, DRI’s leverage is likely to remain at least a turn better than MCD. The DRI 4.55% 2/15/48 bonds look attractive relative to MCD 4.45% 3/1/47 as they are trading 50 bp wide to MCD. At issue the DRI bonds were trading only about 15 bp behind MCD 4.45% 3/1/47 and have traded as close as 5 bp apart. In 5-year CDS, DRI trades roughly 15 bp behind MCD.  In 30-year CDS, which is less liquid than 5-year, DRI trades 30 bp behind MCD.

Exhibit 1: Historical g-spreads of DRI 4.55% 2/15/48 and MCD 4.45% 3/1/47

Source: Bloomberg

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