Jill_InspiredByDesign
Investment Conclusion
We like Darden Restaurants (NYSE:DRI). The restaurant chain is the owner and operator of Olive Garden and LongHorn Steakhouse, and several additional full-service restaurant concepts in the U.S. and abroad. All of DRI’s restaurant brands are well established and popular, as represented by significant sales growth, higher than industry average profit margins, and substantial average unit volumes. The considerable profit margins are driven by purchasing power given the breadth of the organization, and economies of scale related to lower marginal fixed costs/dollar of earnings, associated with corporate overheads, advertising, and technology. In addition, considering that DRI’s target population spans a majority of demographic segments, customer traffic is sheltered to some extent during economic crises.
Moreover, although the company has a significant presence in the contiguous U.S., the restaurant footprint is far from saturated, with substantial white space, as a considerable fraction of the DRI’s restaurant groups are largely regional. In addition to organic growth, the firm grows through acquisitions. With a debt/adjusted EBITDA ratio of 1.8x, the company certainly has the wherewithal to immediately acquire a new business, if the opportunity presents itself. We view BJ’s Restaurants (BJRI), with substantial revenue growth, but a weak margin profile, as a likely candidate, given that it’s selling at a discount, pending a turnaround.
Overall, business conditions described above indicate that DRI is well-positioned to evolve as an organization over the long-term. We are initiating on the firm with a 1-year Price Target of $137/share, based on our 10-year Discounted Cash Flow model. As the stock is trading at slightly below its intrinsic value, our Rating is a Buy.
Investment Thesis
Headquartered in Orlando Florida, DRI, is comprised of nine full-service restaurant chains, that encompass 1,867 company operated stores and 60 franchisee operated stores, located in 50 U.S. states and international territories. Based on size, economic characteristics, and the sub-section of full-service dining within which each brand operates, the business is divided into four segments: 1) Olive Garden 2) LongHorn Steakhouse 3) Fine Dining (composed of The Capital Grille and Eddie V’s) and 4) Other Businesses (comprised of Cheddar’s Scratch Kitchen, Yard House, Bahama Breeze, Seasons 52, The Capital Burger and franchise operations).
During FY2022, DRI generated: $9.63 billion in total sales (+33.8% on a year-over-year basis), same-store sales growth of 30.9%, net income of ~$955 million (+51% relative to the prior year), and diluted earnings/share of $7.40 (+54.2% compared to FY2021). In addition, sales associated with Olive Garden, LongHorn Steakhouse, Fine Dining, and Other Businesses, expanded by 25.3%, 31.1%, 75.1%, and 46.4%. Average unit volumes associated with Olive Garden, LongHorn Steakhouse, Fine Dining, and Other Businesses, were $5.1 million, $4.4 million, $8.8 million, and $5.7 million. Profit margins were 22.1%, 17.6%, 21.3%, and 15.2%, for Olive Garden, LongHorn Steakhouse, Fine Dining, and Other Businesses.
Given business dynamics, the predominant element surrounding the DRI story, is whether the company can sustain its considerable success over the near-term, particularly if an economic pullback unfolds. The secondary issue garnering investor attention, is related to DRI’s long-term growth potential, as the business has expanded significantly over the past decade.
Well-Positioned For Near-Term Growth. Best Positioned For An Economic Recession
DRI outperformed during FY2022 on a year-over-year basis and compared to FY2019, with dramatic increases in revenues, gross profits, operating profits, net income, number of guests, and average unit volumes, across all of its restaurant concepts. Given strong trends evident during the initial portion of F1Q2023, the firm has guided to solid growth over FY2023, projecting total sales of between $10.2 billion to $10.4 billion, representing a year-over-year growth in a range of 6% to 8%, same-store sales growth of 4% to 6%, capital expenditure in a range of $500 million to $550 million, and commodity inflation of 6%. In regard to margins, DRI expects leverage in gross profits due to a decline in inflationary pressures, improvement in labor productivity, and reduced spending on new employee training.
There are several key factors that will drive revenue upside in the period, including a potential dramatic increase in customer demand for Olive Garden, as initiatives, particularly the increased focus on a bottomless first course, higher national advertising spending, and efforts to improve off-premise sales as a fraction of total sales, gain traction. Further upside in sales will be fueled by our expectation that customers in large numbers are likely to return to DRI’s urban fine-dining chains, which appeared to be on path to a solid recovery from the downturn experienced during the pandemic, with private dining and large parties, showing improvement over recent quarters. In addition, based on management commentary, company-wide digital sales, including delivery and take-out orders are likely to exceed levels observed during the viral outbreak.
With regard to the possible unfolding of an economic recession, DRI is better positioned competitively, as cumulatively, its restaurant portfolio, addresses most of the economic classes, with guests ranging from the high-end, middle-income, and lower end. In that respect, it is important to note, that Cheddar’s Scratch Kitchen, is the only one among the company’s brands where check management by guests is evident, which might be driven by significant sales of a limited time value offer of T-bone steaks. In addition, if the economy were to pull-back, some decline in sales is likely to be offset by lower commodity prices, as every 1% of decrease in prices of supplies mitigates 2% of losses in customer traffic. Further, even if same-store sales growth is tepid, DRI plans to launch between 55 to 60 new restaurants, over FY2023, which will counter some of potential softness in customer demand.
Overall, given the elements described above, we believe DRI is well positioned to not only sustain the significant progress its business generated over FY2022, but continue to experience near-term growth, even if an economic recession were to materialize.
Significant Long-Term Growth On Cards Despite Established Profile
Although, on a long-term basis, same-store sales are likely to expand substantially, major growth will be derived from dramatic expansion of the restaurant footprint and acquisitions of well-established restaurant groups.
In that regard, granted, domestically, Olive Garden with 887 restaurants and LongHorn Steakhouse with 564 restaurants appear sufficiently penetrated. However, DRI’s additional brands remain largely regional, with small footprint sizes. In that context, Cheddar’s Scratch Kitchen has 176 restaurants, Yard House has 85, The Capital Grille has 62, Season 52 has 45, Bahama Breeze has 43, Eddie V’s has 28, and The Capital Burger has 3 restaurants. In addition, restaurants associated with LongHorn Steakhouse and Bahama Breeze are limited to the East Coast, The Capital Grille, Yard House, The Capital Burger, and Eddie V’s have a presence only in major metropolitan areas, and Cheddar’s Scratch Kitchen restaurants are located in Texas, the mid-west, and the mid-Atlantic, reflecting a solid opportunity for significant geographic diversification. In addition, given the substantial popularity of Olive Garden and LongHorn Steakhouse, DRI continues to rapidly expand footprints, associated with the restaurants concepts.
With respect to M&A, five of DRI’s nine restaurant concepts are takeouts. The company acquired The Capital Grille and LongHorn Steakhouse in 2007, Eddie V’s in 2011, Yard House in 2012, and Cheddar’s Scratch Kitchen in 2017. We believe that BJ’s Restaurants is a likely strong acquisition target. Our conviction that the brand represents an appropriate addition to DRI’s restaurant portfolio is based on several elements, including that DRI lacks a Sports Bar concept, BJRI’s sales have recovered strongly from the pandemic, and strategies are being implemented to drive margin growth to pre-COVID-19 levels. Given that the Brew House is in turnaround mode, it is considerably undervalued on a relative basis, further enhancing its appeal as a takeout target. Moreover, BJRI carries insignificant debt and is trading at a LTM EV/EBITDA multiple of 14.2x. DRI acquired Cheddar’s Scratch Kitchen (its most recent acquisition) for a LTM EV/EBITDA multiple of 10.4x.
Cumulatively, although DRI has evidenced considerable expansion in revenues and earnings over the past decade, business conditions indicate that the organization has the wherewithal to derive solid additional long-term growth.
RISKS
COVID-19 And/Or Its Variants Could Resurface. All bets are off, if a major viral outbreak were to unfold, reflecting in mask and vaccination mandates, limited indoor dining, shortfall in labor availability, supply-chain restrictions, and wage inflation. That being said, overall, the restaurant industry is better positioned to navigate the impact of large scale disruptions related to COVID-19 or its variants, specifically in regard to off-premise sales, with mobile order and payment systems that are well developed, and infrastructure for delivery orders, take-out orders, and curb-side orders, in place. In addition, the popularity of drive-thrus during the pandemic, has resulted in substantial growth in drive-thru footprints industry-wide.
In the context of DRI, given the combination of superior business dynamics the firm enjoys, along with its preparation for a viral outbreak, we believe the organization has an edge over competitors in regard to the potential unfolding of another pandemic.
One-Year Price Target
We utilized 10-year Discounted Cash Flow analysis including a perpetual growth based terminal value, to arrive at a 1-year Price Target of $137/share for DRI. We assume a normalized 10-year revenue growth rate of 8%, (vs. FY2022 revenue growth rate of ~33.8%). In addition, we derive our net income for 10-years using a net profit margin of 10% (vs. net profit margin of ~9.9% in FY2022). Based on our analysis of DRI’s historic financial reports, we model normalized 10-year operating cash flows as 14% of revenues/year and straight line 10-year capital expenditure as 5% of revenue/year. Furthermore, we deploy a perpetual growth rate of 3% and a weighted average cost of capital of 9% to reach our terminal value and present value of free cash flow figures. We utilize the current diluted outstanding share count of 127.8 million to arrive at our 1-year Price Target.
Bottom Line
It’s not as if there is a lack of better restaurant groups in the country. It’s the collection of restaurant brands, that are all well-run, with good food, excellent service, and an inviting atmosphere, that renders DRI formidable. It’s the size stupid, large sales translates to large absolute profits due to a superior margin profile. In addition, given that major growth at DRI is driven by M&A, means it can secure plug and play concepts, simply by dropping enough change, collected through the growth of the business, and or debt, which if secured, will only optimize the capital structure, given the firm’s relatively low leverage. Overall, at the current moment, DRI appears bullet proof. Buy Buy Buy.
Be the first to comment