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An encouraging sign for the holiday season

| October 25, 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. This material does not constitute research.

The Bloomberg US Weekly Buying Climate Index recently hit an all-high since its inception in late 1985. The survey asks American consumers to rate the economy and provide feedback regarding their personal finances and buying power. The index hitting a high could be supportive of a much better than expected holiday period for the consumer cyclical sector, such as retailers and restaurants. With a stronger buying climate, retailers and restaurants are likely to have a better shot at passing off the higher costs from increased wages and tariffs. This could translate to some margin expansion in what is seasonally a promotion heavy time period.

Exhibit 1: Bloomberg US Weekly Buying Climate Index hits all time high

Note: The index is based on responses from a sample size of 1,000 consumers aged 18 and older, using a 4 week rolling average of 250 surveys a week. Those participating in the survey are asked to rate their finances in four categories: excellent, good, not so good and poor. Source: Bloomberg

A boost for Darden

While casual dining has started to witness some softness this year in same restaurant sales (SRS), Darden (DRI) continues to outperform the casual dining index.  DRI’s two largest banners (Olive Garden and LongHorn Steakhouse), which represent over 70% of total revenues and 75% of operating profit, continue to post strong results. In the most recent quarter, Olive Garden posted SRS of 2.2%, which beat street estimates of 1.6% and outperformed the industry benchmark by 340 bp. This was Olive Garden’s largest gap to the index over the past four quarters and its 20th consecutive quarter of SRS growth. LongHorn posted even stronger results with SRS of 2.6%, outperforming the industry benchmark by 380 bp.  LongHorn’s sales growth streak is even longer than Olive Garden’s, with 26 consecutive quarters of SRS growth.

DRI has effectively used both pricing and costs savings to help offset commodities and continued investments in the business. During the quarter, DRI raised pricing by 2% versus commodity inflation of 1.5%. Additionally, labor inflation of 4% was also offset by pricing, mix and productivity in restaurants. That said, Olive Garden saw quarterly profit margins improve by 40 bp year-over-year, while Longhorn posted relatively flat margins from the year ago period, despite elevated beef inflation (above the total 1.5% inflation level).

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 2.0x. Leverage, not adjusted for leases, remains under a turn at 0.7x. DRI ended the quarter with a much strong cash balance of $351mm, putting net debt at $583 million.  DRI lost out on its bid to purchase Del Frisco’s Restaurant Group (DRFG) as the assets are being sold to private equity. When asked about potential acquisition activity going forward, management noted that they and the Board of Directors continue to look at opportunities to add to the portfolio when appropriate. It seems likely they will consider acquisitions that are of the “tuck-in” size. This enables management to use cash on hand as well as some debt to finance the acquisition, while keeping leverage within or close to management’s target range.

Guidance reaffirmed

Management reaffirmed all aspects of its fiscal 2020 guidance including SRS sales growth in the 1%-2% range, net sales growth of 5.3%-6.3% and total capital expenditures in the $450-to-$500 million range. 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.  When questioned about their confidence in the full year guidance range given the initial traffic softness that is being experienced across the casual dining sector, management noted that their reiteration of all guidance underscores their confidence.

Relative value

While DRI has no IG casual dining peers, the DRI credit (Baa2/BBB/BBB) looks positive relative to McDonald’s Corp. (MCD – Baa1/BBB+/BBB).  MCD continues to increase leverage to return cash to shareholders.  Estimated lease adjusted leverage for MCD is currently 3.8x, which is over a turn higher than DRI. DRI 4.55% 2/15/48 bonds continue to look attractive relative to MCD 4.45% 3/1/47 as they are trading 70 bp wide to MCD.  At issue, the DRI bonds were trading about 15 bp behind MCD 4.45% 3/1/47 and have traded as close as 5 bp apart.   In 5yr CDS, DRI trades roughly 9 bp behind MCD.  In 30-year CDS, which is less liquid than 5-year, DRI trades 22 bp behind MCD.  For investors searching for yield that 70 bp is an attractive pick up to move into a less liquid credit.  Furthermore, a swap out of the MCD 4.45% 3/1/47 into the DRI 4.55% 2/15/48 provides for a take-out of approximately 11 points.

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