Back on December 3, 2012, I discussed my views on Darden Restaurants (DRI). In that piece I wrote that I thought Darden had shown impressive dividend growth and that a EPS charge was likely due for calendar Q4 related to the Yard House acquisition. While I was correct in predicting a small charge related to Yard House, what I was not expecting was a full blown profit warning for calendar Q4 only a few hours afterwards. The profit warning for Darden's calendar Q4 (fiscal 2Q) caused shares of Darden to plunge well below its previous floor of $48. Currently, shares of Darden are trading for $44.92.
On December 20, 2012 Darden reported earnings and as forewarned, they were fairly bad. Darden announced earnings per share of $0.26, a 37% decrease from the $0.41 per share in the second quarter of last year. Second quarter revenues for Darden came in at $1.96 billion, an increase of 7.0% compared to the second quarter of last year. The increase reflects a same-restaurant sales increase of 0.7% for the Darden's Specialty Restaurant Group, incremental sales from the 11 Eddie V's restaurants acquired on November 14, 2011, the acquisition of 40 Yard House restaurants on August 29, 2012 and the addition and operation of another 99 net new restaurants compared to the second quarter last year, offset by a combined same-restaurant sales decline of 2.7% for Olive Garden, Red Lobster and LongHorn Steakhouse. In the second quarter, U.S. same-restaurant sales decreased -0.8%, -2.7% and -3.2% for LongHorn Steakhouse, Red Lobster and Olive Garden, respectively.
The real shocker in the report was the decline in same-restaurant sales for all three of Darden's top chains. The -3.2% for Olive Garden was particularly bad. Darden hinted during the firm's earnings call that they will become more promotional in order to drive sales back to Red Lobster, Longhorn Steakhouse, and Olive Garden. Building menus with more affordability (sub $15) is critical for Darden, with rivals become more aggressive and consumer confidence waning. However, these extra promotions may be sparking fears of a price war in the industry. On January 9, Darden announced new brand presidents for Olive Garden and Longhorn Steakhouse in addition to naming a new chief marketing officer. These moves are in my opinion a net positive for Darden. While the use of discounts will hurt margins, Darden must stop the declines in same-restaurant sales in its 3 linchpin brands. Quarter on quarter, total revenues declined $75 million, or 4%.
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I had in my earlier article predicted that Darden would have negative free cash flow for Q4 2012 (its fiscal 2Q). It turns out that they did. Darden had -$191 million, or -$1.45 per share, in FCF for Q4. Q4 has been the weakest quarter of the year for 5 years for Darden. This trend is easily visible in the following chart:
Along with its earnings report, Darden declared a quarterly cash dividend of $0.50 per share. At current prices, Darden yields 4.45%. The TTM payout ratio using earnings is 52%. However, this is a not an accurate measure of its safety. A better measure to use when determining a dividend payout ratio is using TTM free cash flow. Using this metric, the payout ratio is 81%. We can see Darden can indeed afford its dividend. However, Darden cannot really afford many more quarters like its last.
Since its earnings announcement, Darden has underperformed the S&P. Darden has declined 3% including dividends, while the S&P has gained 2.5%. Due to Darden's horrible recent earnings, I no longer think it is prudent to own its shares at the moment. The promotion campaign that was hinted in the earning call will hurt Darden's operating margins. The restaurant business is already an extremely margin sensitive industry. Q1 has tended to be a good quarter for Darden. I would wait until the next earnings report so that full effects of the promotions may be revealed. However, the recent management shakeup does not paint a pretty picture.