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Darden equity off to a good start, bonds next?

| January 10, 2020

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 Inc. (DRI) equity has had a nice start to the year, with the stock up 4.94% (as of market close on 1/9/20), outperforming the S&P 500 by 358 bp. DRI’s value proposition, menu enhancements and off-premise expansion should not only help continue to drive same restaurant sales (SRS) but fuel margin growth. The outperformance of the equity could follow-through to the bonds, re-tightening spreads to competitors. At issue DRI 2048 bonds traded 15 bp back of McDonald’s 2047. Investors searching for yield can swap out of the MCD 4.45% 3/1/47 into the DRI 4.55% 2/15/48, picking up 70 bp of yield, and for a take-out of nearly 11 points.

Consensus estimates for fiscal year 2020 are calling for EBITDA margin growth of 20 bp to 14.3%, as DRI continues to aggressively manage non-restaurant expenses to offset both food and labor inflation. The margin growth is impressive as management remains committed to keeping price increases below both inflation and that of its competitors. That said, while DRI raised prices by 2% in the most recent quarter to offset commodity increases of 1.7%, labor inflation of 4% was offset by a combination of pricing, menu mix and productivity increases.  This led to a 30 bp improvement to the operating margin during the quarter.

Gaining Market Share

While casual dining witnessed some softness last year, Darden (DRI) continued 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 drive growth and gain share. In the most recent quarter, Olive Garden posted SRS of 1.5%, which outperformed the industry benchmark by 120 bp. This was Olive Garden’s 21st consecutive quarter of SRS growth. LongHorn posted impressive results with SRS of 6.7%, meaningfully outperforming the industry benchmark by 640 bp. LongHorn’s sales growth streak is even longer than Olive Garden’s, with 27 consecutive quarters of SRS growth.

Balance sheet/liquidity remains strong  

DRI management remains committed to keeping lease adjusted leverage in the 2.0x-2.5x range, which we estimate is currently 2.25x.  Leverage, not adjusted for leases, remains under a turn at 0.8x.  Liquidity is strong as DRI ended the most recent quarter with total cash on hand of $157 million and availability under its revolver of $683 million. Furthermore, the company has no debt maturing until 2027 and generated nearly $800 million of free cash flow on an LTM basis.

Last year, DRI lost out on its bid to purchase Del Frisco’s Restaurant Group (DRFG), with the assets being sold to private equity. While management consistently looks at opportunities to add to the portfolio when appropriate, management is unlikely to deviate from its historical financial policy and continue to look at acquisitions that are of the “tuck-in” size. This enables DRI 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 again

Management once again 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. Management’s reiteration of guidance underscores their confidence in their banners as they continue to outperform peers and take market share.

Relative value

While DRI has no IG casual dining peers, the DRI credit (Baa2/BBB/BBB) can be compared relative to McDonald’s Corp. (MCD – Baa1/BBB+/BBB). MCD continues to increase leverage to return cash to shareholders, with estimated lease adjusted leverage currently at 3.8x, over a turn higher than DRI. The 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 2048 bonds were trading 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 4 bp behind MCD. In 30-year CDS, which is less liquid than 5-year, DRI trades 26 bp behind MCD. For investors searching for yield the 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 nearly 11 points.

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