The Long and Short

Omicron takes a bite out of DRI results

| March 25, 2022

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.

Darden Restaurants’ (DRI) fiscal third quarter results came in below street estimates, and the high end of full year guidance was revised downward. Despite the Omicron driven headline weakness, sales and EBITDA margin are above pre-pandemic levels, indicating the company is managing inflation and staff shortages effectively. Through the recent volatility and spread widening in the credit market, DRI’s curve has steepened over the past month versus the consumer discretionary BBB index. This presents a good buying opportunity for DRI long bonds, particularly relative to peers SBUX and MCD.

Even with the highly transmissible Omicrom variant impacting guest demand and restaurant staffing, DRI’s consolidated sales were up 4.4% versus the company’s fiscal third quarter 2020 period (which ended February 23, 2020). Additionally, the company’s EBITDA margin of 16.1%, was up 50 bp from pre-COVID levels despite inflation of 7% in the quarter.

Exhibit 1. DRI vs. Consumer Discretionary BBB Curve (Today vs. 1 Month Ago)

Source: Bloomberg TRACE; APS

The DRI 4.55% 2048 bonds are trading around the 230 bp area for a yield of roughly 4.87%.  DRI long-dated paper offers a spread pick up of nearly 65 bp from SBUX 2048 bonds (Baa1/BBB+/BBB) and 75 bp from MCD 2048 bonds (Baa1/BBB+). Over the past month, MCD 2048 and SBUX 2048 paper tightened 13 bp and 17 bp respectively, while DRI 2048 paper remained flat on a spread basis.

Exhibit 2. DRI Average Weekly Sales

 

*Pre-COVID comparisons shown vs. FY20
Source: DRI Earnings Presentation

February Sales at Record Levels

DRI sales were negatively impacted in January as the Omicrom variant took hold (Exhibit 2), which greatly impacted restaurant traffic while causing staffing shortages. Average weekly sales were 9% below levels witnessed Pre-Covid, but quickly rebounded in February as pent up dining demand outweighed the spike in COVID cases.  Management noted that sales in the month of February not only exceeded internal expectations, but were a record high for a fiscal February.  Furthermore, March average weekly sales are outpacing February levels. The operating environment created by the dramatic spike in Omicrom cases was similar to the environment witnessed at the initial onset of COVID approximately two years ago.  DRI witnessed high levels of sick pay and increased overtime costs due to staffing shortages, while supply chain disruptions helped to further exacerbate inflation. In fact, some restaurants were down as much as 40% of their staff, while others had to limit their hours of operation or move to take-out only in order to operate effectively. Given those headwinds, the EBITDA margin expansion of 50 bp versus pre-COVID levels is impressive.

Full Year Guidance Revised Downward but Strong Margin Growth Still Expected

DRI updated fiscal year 2022 guidance to reflect performance year-to-date as well as expected performance in the fiscal fourth quarter. Management lowered the high end of its sales range and now expects full year sales to be in the $9.55 billion-$9.62 billion range, down from previous guidance of $9.55 billion-$9.7 billion. This brings their same-restaurant sales growth range for the fiscal year to 29%-30%, versus a previous expectation of 29%-31%.  Total sales growth from pre-COVID levels are expected to be in the 9%-10% range, with the high end of the range also reduced by a percentage point. Inflation, which was previously forecasted to be roughly 5.5% for the year, is now expected to be closer to 6%, with commodities inflation accounting for the increase. EBITDA was reduced as well, to a range of $1.53 billion-$1.55 billion (down from $1.55 billion-$1.6 billion), but full year-margin growth of 200 bp (versus pre-COVID levels) is still in line with management’s previous expectations.  Additionally, the full year guidance implies a stronger fiscal fourth quarter than what was communicated on the prior earnings call.

Exhibit 3. DRI Updated Fiscal 2022 Outlook

1 Comparison to twelve months ended fiscal 3Q20 due to impact of pandemic on fiscal 4Q20 and full year fiscal 2021 sales
2 Non-GAAP measure
Source: DRI Company Presentation

Balance Sheet Remains Strong

DRI ended the year with cash on hand of $555 million, which remains above average pre-COVID quarterly cash levels of roughly $300 million. While the company continues to return cash to shareholders via dividends and repurchases, shareholder remuneration is expected to remain largely within the confines of free cash flow generation. Management still targets lease-adjusted leverage within the 2.0x-2.5x range, and adjusted leverage is roughly 2.9x. Based on full-year EBITDA guidance, adjusted leverage should decline roughly a tick to 2.8x, with the potential to be at the high end of its target range sometime in fiscal 2023. DRI’s lease-adjusted leverage is currently flat to MCD’s, and compares favorably to SBUX, whose adjusted leverage is closer to 3.4x.

Meredith Contente
meredith.contente@santander.us
1 (646) 776-7753

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