The Long and Short
Darden Restaurants rebounds above pre-pandemic performance
Meredith Contente | September 24, 2021
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.
DRI’s fiscal first quarter 2022 results highlighted the company’s comeback from the lows witnessed during the height of the pandemic. The company’s equity is up over 35% year-to-date given the top line improvement and increased traffic at restaurants. While DRI debt spreads have improved from the start of the year with the broader credit market, they remain off the levels witnessed in June by roughly 20 bp. Given that DRI is now outpacing pre-pandemic sales and guidance for the year is strong, ratings are likely to be upgraded which could tighten debt spreads relative to peers such as McDonald’s.
Exhibit 1. DRI Curve vs. MCD Curve
While comparable sales for the quarter of 47.5% beat lofty estimates of 44%, it was the average weekly sales for the quarter that caught our attention. Even with staffing issues, DRI saw first quarter consolidated average weekly sales of $96,170, which is up from the $65,029 witnessed in the year-ago period as well as the $91,757 posted pre-pandemic. The biggest gains were seen at Longhorn Steakhouse as well as the company’s fine dining business (which includes The Capital Grill) as evidenced by Exhibit 2. Management noted that sales peaked in July and while they slowed in August due to the delta variant, they remained positive relative to pre-COVID levels. That said, sales per operating week were up 4.8% in the first quarter and 7% in the first three weeks of September versus pre-pandemic levels. Guidance for the full year was also raised. On a relative value basis, DRI 4.55% 2/15/48 bonds are roughly 50 bp behind McDonald’s Corp. (MCD) 4.45% 3/1/47 bonds yet were only trading roughly +30 bp back in June. That relationship should collapse back to levels witnessed this summer as the DRI curve has steepened relative to MCD’s curve as shown in Exhibit 1.
Exhibit 2. DRI 1Q22 Segment Sales Performance (Versus Pre-COVID results)
Margin Performance Impressive
We appreciate management comping the quarter to the two-year ago period as it provides for a better understanding of growth. As seen in Exhibit 3, margins improved at all four business units. In fact, management noted on the earnings call that all segments delivered record first quarter profit. The ability to drive both sales and profit growth, given increased COVID costs coupled with inflation and supply chain issues, underscores the strength of DRI’s business model. Management has been laser focused on operational efficiencies for roughly six years which was evident this quarter. We note that DRI’s consolidated restaurant-level EBITDA margin was 20.9%, up 290 bp from the two-year ago period. The fine dining unit witnessed the most growth as the margin was up 490 bp. DRI noted that strong sales performance and operational improvements more than offset double-digit commodity inflation at this segment.
Exhibit 3. DRI 1Q22 Segment Profit Margin (Versus Pre-Covid results)
Full Year Guidance Raised
Management raised full year guidance based on the strong fiscal 1Q results and its expectation for the rest of the year. DRI now believes total sales will be in the $9.4 billion-$9.6 billion range, which represents growth of 7%-9% from pre-COVID levels. This factors in comp sales growth of 27%-30% and the addition of 35-40 new restaurants. We note that this is up from previous forecasts of total sales growth of 5%-8% and comp sales growth of 25%-29%. While EBITDA is now expected to be in the $1.54 billion-$1.6 billion range (up from $1.5 billion-$1.59 billion), the outlook for margin growth remains the same. While higher sales are helping to offset inflation, management continues to expect total inflation of 4% with commodities inflation closer to 4.5% and restaurant labor inflation of 5.5%. Management did note that staffing continues to remain a problem and we believe that restaurant labor inflation could continue to rise in an effort to entice employees back to work. Lastly, EPS is expected to be in the $7.25-$7.60 range which is up from original guidance in the $7.00-$7.50 range.
Balance Sheet and Liquidity Remains Strong
DRI management remains committed to keeping lease adjusted leverage in the 2.0x-2.5x range, which we estimate is currently at the higher end of the range at 2.4x. Leverage, not adjusted for leases, remains under a turn at 0.8x. Based on current guidance we believe lease adjusted leverage will decline to the 2.2x area by year-end, as EBITDA continues to expand. Liquidity is very strong as DRI ended the most recent quarter with total cash on hand of $948 million and full availability under its $1.0 billion revolver. Furthermore, the company has no debt maturing until 2027 and generated nearly $875 million of free cash flow on an LTM basis.
We note that DRI chose not to tap the public debt market for liquidity needs during the pandemic but did put in place a $270 million term loan and drew down on it $750 million revolver. That said, DRI was last seen in the debt market in 2018 when it issued its 2048 bonds. The term loan was a 365-day term loan and matured in April of this year. The $1 billion revolver was put in place earlier this month to replace the $750 million revolver, which was fully repaid.
Ratings Likely to be Upgraded
All three rating agencies have positive outlooks on DRI’s current Baa3/BBB-/BBB- ratings. We note that outlooks were all revised to positive earlier this year as performance improved. Moody’s noted that the rating affirmation and positive outlook reflect not only the improved operating performance but the cost savings initiatives that helped to strengthen both credit metrics and liquidity. Furthermore, the positive outlook was also rooted in management maintaining a prudent financial policy. We note DRI has maintained a conservative financial policy since the sale of the Red Lobster business back in 2014, with shareholder remuneration maintained within the confines of free cash flow. S&P noted that ratings will be upgraded once leverage (S&P adjusted) hits 3.5x and free cash approaches $800 million, levels they have already achieved this quarter. Fitch noted that EBITDA could trend towards $1.2 billion by May 2022. Given the faster than expected rebound, EBITDA is currently above that level and is expected to be at least $300 million higher by fiscal yearend. That said, we could see upgrades to mid-BBB sooner than expected.
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