Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Darden Restaurants, Inc. (NYSE:DRI)

F1Q07 Earnings Conference Call

September 20, 2006 8:30 am ET

Executives

Matthew Stroud - Investor Relations

Linda Dimopoulos - Chief Financial Officer

Drew Madsen - President and Chief Operating Officer

Clarence Otis - Chairman and CEO

Analysts

Steven Kron - Goldman Sachs

David Palmer - UBS

Jeff Bernstein - Lehman Brothers

John Glass - CIBC World Markets

Mark Wiltamuth - Morgan Stanley

Joseph Buckley - Bear Stearns

Michael Smith - Oppenheimer & Co.

John Ivankoe - J.P. Morgan

Andrew Barish - Banc of America

Rachael Rothman - Merrill Lynch

Donald Trott - Jefferies & Co.

Presentation

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the first quarter earnings release conference call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session. Instructions will be given at that time, and we do ask that you limit yourself to one question and one follow-up please.

(Operator Instructions)

As a reminder, this conference is being recorded. I would now like to turn the conference over to Matthew Stroud. Please go ahead.

Matthew Stroud

Thank you, Mary. Good morning, everyone. With me today are Clarence Otis, Darden’s Chairman and CEO; Drew Madsen, Darden’s President and Chief Operating Officer; Linda Dimopoulos, Darden’s Chief Financial Officer; and Brad Richmond, Darden’s Chief Financial Officer Designate. We welcome those of you joining us by telephone or the Internet.

During the course of this conference call, Darden restaurants officers and employees may make forward-looking statements concerning the company’s expectations, goals, or objectives. These forward-looking statements could address future economic performance, restaurant openings, various financial parameters, or similar matters. By their nature, forward-looking statements involve risks and uncertainties that could cause actual results to materially differ from those anticipated in the statement. These risks and uncertainties include the impact of intense competition, changing economic or business conditions, the price and availability of food, ingredients and utilities, labor and insurance costs, increased advertising and marketing costs, higher-than-anticipated costs to open or close restaurants, litigation, unfavorable publicity, a lack of suitable locations, government regulations, a failure to achieve growth objectives, weather conditions, risks associated with our plans to improve financial performance at Bahama Breeze and to reposition Smokey Bones and other factors and uncertainties discussed in the company’s SEC filings.

Because of these numerous variables, you are cautioned against placing undue reliance on any forward-looking statement made by or on behalf of the company.

A copy of our press release announcing our earnings and Form 8-K used to furnish the release to the Securities and Exchange Commission and any other financial and statistical information about the period covered in the conference call, including any information required by Regulation G, is available under the heading investor relations on our website at darden.com.

We plan to release same restaurant sales results for fiscal September 2007 during the week beginning October 2nd. We plan to release same restaurant sales results for fiscal October 2007 during the week beginning October 30th, and we plan to release fiscal 2007 second quarter earnings and same restaurant sales for fiscal November 2007 on Tuesday, December 19th, after the market close.

Additionally, we plan to hold an investor and analyst meeting on January 11th and 12th, 2007, in Orlando. Details will be forthcoming soon.

We released first quarter earnings yesterday afternoon. Results were available on TR Newswire, First Call, and other large services. Let’s begin by updating you on our first quarter earnings.

First quarter net earnings were $88.5 million, and diluted net EPS was $0.59. This represents an 11% increase in diluted net earnings per share. In the first quarter, the company adopted SFAS-123R on a modified perspective basis, which reduced diluted net earnings per share by $0.02 in the quarter. Absent the adoption of SFAS-123R, diluted net earnings per share grew 15% in the first quarter.

Olive Garden had a very strong quarter competitively, with solid sales and operating profit gross. Red Lobster had a more challenging quarter, but there was improvement throughout. Overall, sales fell slightly and operating profit was essentially flat to prior year. Bahama Breeze had a solid quarter, with modest sales growth but significant growth in operating profit.

Our challenges at Smokey Bones continued during the quarter, but the team remains focused on making the brand more appealing for a broader range of dining occasions, and they made progress in developing their plans for improvement.

Linda will now provide detail about our financial results for the first quarter. Drew will discuss the operating company’s business results, followed by Clarence with some final remarks, and then we will respond to your questions.

Linda Dimopoulos

Thanks, Matthew. Darden’s total sales increased 3.3% and the first quarter to $1.46 billion, driven by same restaurant sales growth at Olive Garden and our operation of 39 more restaurants than the first quarter of the prior year. Olive Garden same restaurant sales are up 2.9% for the quarter -- its 48th consecutive quarter -- yes, that is 12 years -- of same restaurant sales growth and its total sales increase of 6.3%.

Red Lobster had a same restaurant sales decrease of 2.1% for the quarter, and total sales decreased 0.7%. However, as we have reported, monthly sales increase showed sequential improvement from June through August.

Bahama Breeze had a same restaurant sales increase of 1.2% for the quarter as did total sales.

Smokey Bones had a same restaurant sales decrease of 8.6% for the quarter, with total sales increased 7.7% because of 17 net new restaurants.

For context, industry same restaurant sales, as measured by Knapp-Track and excluding Darden, were down approximately 2.4% for the quarter. Thus, relative to the industry, you can see that Darden performed quite well.

Before getting into the margin detail for the quarter, I would like to remind you of two important issues that do affect our margins. First, as Olive Garden accelerates new restaurant growth, this will impact both food and beverage expenses and labor expenses. Olive Garden food and beverage expenses as a percent of sales is the lowest of our brands, so their growth initiative drives improvement in that line item. In contrast, Olive Garden’s labor expense as a percent of sales is among the highest of our brands, so its increasing share of our business puts pressure on that line item. However, the key takeaway is that these items net favorably for Darden with Olive Garden’s growth, since Olive Garden’s operating margins are the highest of our brands.

The second structural impact is that of labor expenses that have been rising due to the increased FICA tip expense, resulting from the higher level of tip reporting by our employees. As we mentioned before, Darden benefits at the tax line since the FICA tip expense becomes a credit to taxes.

We estimate that the big business mix shift resulting from Olive Garden’s growth contributes about 10 basis point favorability to Darden’s food and beverage expense as a percent of sales, and about 5 points of unfavorability to Darden’s labor expense as a percent of sales.

We also estimate that the FICA tip expense contributes approximately 10 basis points of unfavorability to our labor expense as a percent of sales, but lowers the effective income tax by that same 10 basis points.

Now let’s turn to the detailed margin analysis for the first quarter.

Food and beverage expenses were 107 basis points lower than last year on a percentage of sales basis, primarily because of savings on commodities, menu mix changes at Red Lobster, and business mix changes resulting from Olive Garden’s growth.

First quarter restaurant labor expenses were 42 basis points higher than last year on a percentage of sales basis due to wage rate inflation and, about 3% or 4%, and FICA taxes on reported tips, business mix changes resulting from Olive Garden’s growth and higher benefit costs.

Restaurant expenses in the quarter were 13 basis points higher than last year on a percentage of sales basis, primarily because of higher utility expense, higher maintenance and repair costs. These expenses were partially offset by reduced worker’s comp and public liability expenses, and lower pre-opening expenses.

Selling, general and administrative expenses were 33 basis points higher as a percent of sales for the first quarter, primarily due to the adoption of SFAS-123R, or about $4.8 million. We also impaired three Smokey Bones restaurants and Olive Garden restaurant in the quarter, at a cost of approximately $4.7 million.

Our tax rate was lower than the first quarter of last year due to an increase in the number of FICA tax credits on reported tips that I previously mentioned.

We continue to have significant share repurchase in the quarter, buying back 2.3 million shares of our common stock, leaving 27.6 million shares remaining in our current authorization to repurchase shares.

As we mentioned, sales continued to improve through the first quarter, especially at Red Lobster. Thus far in September, we have seen same restaurant sales strengthen from August levels at Olive Garden. At Red Lobster, we are on pace in September to at least match the August results. As a reminder, September’s results are benefiting from the initial launch week of very strong value promotions at Red Lobster and Olive Garden in what has been a more value-sensitive environment for some time now.

For the full year, we continue to expect combined same restaurant sales growth for Red Lobster and Olive Garden to be between 2% and 4%, 2% to 4%. We anticipate that the first half of the year will be at the bottom of this range, while the second half of the year will hit the upper end of this range.

We still expect net new restaurant increase of approximately 40 restaurants, putting total sales growth for the year in the range of 6% to 7%.

With our same restaurant sales and new restaurant growth expectations, the margin improvement we expect in the third quarter and fourth quarter from better cost management, including lower food and beverage expense and selling, G&A expense, and the share repurchases we expect to make, we now anticipate that diluted net EPS growth will be 10% to 12% in fiscal 2007.

This includes the adoption of SFAS-123R on a prospected basis in the first quarter of this fiscal year 2007. Excluding the effect of adoption SFAS-123, this translates into a diluted net EPS growth of 14% to 16% in fiscal 2007, based on fiscal 2006 diluted net EPS of $2.16.

Now, before I turn this over to Drew, I would like to take a moment to comment on my upcoming retirement. As we announced yesterday afternoon, I will be stepping down from the CFO position this year in December and retiring from Darden next June.

I would like you to know I certainly thoroughly enjoyed working at Darden for the past 25 years, and I particularly enjoyed my tenure as Darden’s CFO. Over the past four years, I have had the opportunity to meet with many of you at conferences and meetings around the country, and I sincerely thank you for your perspectives and constructive feedback concerning Darden.

I leave Darden knowing that my replacement, Brad Richmond, is well qualified to take on the roll of CFO. I have worked with Brad for many years and am confident in his ability to lead the financial organization at Darden. Matthew and I look forward to introducing to you in the coming weeks and months ahead.

After December 1st, when Brad assumes this roll, I will remain as advisor to Brad and Clarence through June of next year, and then look forward to spending some more time with my family and other interests.

Now, I will turn it over to Drew to comment on our operating companies.

Drew Madsen

Thank you, Linda. We were pleased with our first quarter results in a challenging environment and believe we are well-positioned to achieve our goals over the remainder of the year.

Let’s start with Olive Garden. Olive Garden had another outstanding quarter, delivering competitively superior sales growth and solid operating profit growth while maintaining excellent returns. Their same restaurant sales growth of 2.9% during the first quarter was approximately five percentage points above the Knapp-Track competitive set, and this performance was driven by a powerful combination of two things: restaurant operations excellence and brand management excellence.

The ability of their restaurant teams to consistently deliver a competitively superior guest experience over time has helped make Olive Garden a trusted brand, with strong guest loyalty and industry-leading value, which is obviously a tremendous asset when customers are cutting back on their visits to casual dining restaurants.

Both promotions that they, or during the first quarter featured compelling new reasons to visit Olive Garden, as well as a strong value message. They are currently advertising never-ending pasta bowl at $7.95, a proven promotion featuring choice, variety in the brand’s unique spirit of Italian generosity.

As Linda mentioned, same restaurant sales have strengthened in September.

Now, stepping back from the first quarter and looking at Olive Garden more broadly, they are focused on accelerating new restaurant growth while maintaining same restaurant excellence. To that end, Olive Garden has developed two new prototypes to help accelerate new restaurant growth.

So far, 90 restaurants have been opened utilizing those new prototypes, and on average, new restaurants are exceeding their hurtle rate guest counts, hurtle rate sales, and hurtle rate returns. The team is on track to achieve their targeted savings in both capital investment and operating efficiencies, and they have established a strong pipeline of new restaurant sites. As a result, Olive Garden is well-positioned to open 30 to 35 net new restaurants during fiscal 2007, which is nearly double what they achieved last year.

Olive Garden’s strong business fundamentals, especially its brand relevance, guest satisfaction, and unit economics, combined with accelerated new unit openings, give us great confidence in their ability to maintain solid sales and earnings growth in fiscal 2007.

Our Red Lobster same restaurant sales for the first quarter of minus 2.1% were slightly better than the Knapp-Track estimate of minus 2.4% for casual dining chains excluding Darden concepts. Now importantly, as Linda mentioned, Red Lobster delivered improving results as the quarter progressed, achieving same restaurant sales growth of 1% to 2% in August, compared to Knapp-Track estimate of minus 2% for the same month.

The improving trend was primarily related to their promotion plan. During June and early July, Red Lobster advertised Summer Seafood Feast. Now, this was a contingency promotion that they had to run because of temporary product supply constraints, and our belief is that this promotion did not have sufficient news or value to drive same restaurant sales growth in the current environment.

During the remainder of July and August, Red Lobster advertised American Seafood Adventure, which featured three new regionally inspired dishes and a very powerful new commercial. Sales trends began to improve as soon as this promotion aired.

Red Lobster is currently advertising Endless Shrimp, and September same restaurant sales are trending in line with August results.

Again, stepping back from the current quarter, our plan to achieve sustainable growth at Red Lobster has three phases, and we talked about those in the past. The first phase was to strengthen our business fundamentals. The second phase is to refresh the brand to broaden its appeal and further build guest counts, and the third phase will be to accelerate new unit growth.

Phase one is largely complete. Over the past couple of years, the Red Lobster team has worked to strengthen their business fundamentals through a simply great operating discipline designed to ensure that they excel at guests want most -- what guests expect most from a seafood restaurant, which is fresh, delicious seafood, exceptionally clean restaurants, and friendly, welcoming service. They have made significant progress in all those areas.

For example, Red Lobster set another record for guest satisfaction during the first quarter this year when 72% of their guests rated their most recent visit as excellent. This is 10 percentage points above what the brand scored in the same quarter three years ago and another 2 percentage points above where they were during the first quarter last year, and they have done this, they have increased their guest experience and guest satisfaction while also boosting restaurant level profit margins to the highest levels they have been in more than a decade.

Later in the second quarter, Red Lobster will begin implementation of the second phase in their plan. More specifically, they will introduce a new menu design, several new menu items, and a program called today’s fresh fish eats, with signature preparation styles and daily chef specials. These initiatives have been thoroughly tested and significantly improved guest perception that Red Lobster offers high quality, fresh seafood and a variety of exciting new dishes. This is especially true among lapsed Red Lobster users, which we believe represents one of our biggest opportunities to increase guest counts.

Red Lobster has also developed a new advertising campaign, and tested a new advertising campaign. It was largely at parity with their current campaign on our two most important objectives -- the ability to drive promotional guest traffic in the near-term and build long-term brand equity that will further strengthen their base business over time. Given these parity results, Red Lobster plans to continue using and continue strengthening their successful Ignite The Crave campaign, while simultaneously working on a new campaign that will do even more to reposition the brand in the future.

The team at Red Lobster is proud of their tremendous progress and we are confident it will continue in fiscal 2007 and beyond.

Now, Bahama Breeze also continued to make progress on their turnaround plan during the first quarter, delivering solid same restaurant sales growth while improving their cost structure and unit economics. Going forward, our two biggest priorities at Bahama Breeze are to further strengthen guest satisfaction and restaurant level returns. Guest satisfaction improved significantly during the first quarter compared to last year, and our restaurant teams will continue to focus on their two biggest opportunities to improve the guest experience further -- hot food and attentive service.

Bahama Breeze will also continue their test of structural business model changes to reduce operating cost and complexity that do not add value for their guests. They are testing these changes now in several restaurants. Early results are encouraging, and they have also helped identify opportunities for improvement.

With continued progress in guest satisfaction and restaurant level returns, Bahama Breeze will be ready to restart modest unit growth in fiscal 2008.

Smokey Bones had a difficult quarter, with same restaurant sales that were well below the Knapp-Track chain average. The team there is working to stabilize their current business while they also transform the brand to broaden appeal and become more relevant for more dining occasions.

Our restaurant teams are focused on the things they can control every day, especially providing a great guest experience and effectively managing cost. In addition, we recently replaced our current placemat menu with a significantly redesigned handheld menu. Our research shows that the new menu does a much better job of communicating our menu variety and food quality, is easier for guests to use, and is slightly margin positive.

More importantly, we recognize the need to address the core brand positioning issue at Smokey Bones. As we discussed last quarter, we have identified a new direction that eliminates the barbeque-centric parts of the brand that are a barrier to greater occasion breadth and increased frequency. At the same time, it is a direction that will build on some of Smokey Bones’ current strengths, including good restaurant locations, a strong operations team, and a unique lodge setting that guests find extremely attractive.

Smokey Bones authentic and well-received ribs will remain part of the menu, but other things that make our guest experience stand so strongly for barbeque, will be removed.

Now, we are in the process of finalizing key elements of the repositioned brand that include name, menu, and restaurant design. We will begin a test in a new restaurant in a few months and will update you on what we learn over the remainder of the year, but at this time, for competitive reasons, we are not prepared to discuss future changes in greater detail. Clarence.

Clarence Otis

Thanks, Drew. As we look at it, with 11% net earnings per share growth after the adoption of FAS-123R, 15% excluding its impact, we had some very strong results this quarter, especially when you consider that it is a macro-economic environment that has been very challenging.

We continue to see our established brands -- Red Lobster and Olive Garden -- lead the industry and we are seeing good progress at our emerging brands, especially at Bahama Breeze, where we have been at it longer.

Linda mentioned it earlier, but I would just like to pause on just a tremendous milestone at Olive Garden -- 48 consecutive quarters of same restaurant sales growth, and that really is a tribute to Dave and his team, their ability to deliver the two things that guests value in this industry, a remarkable consistency and doing that at the same time that they deliver continuous improvement in every aspect of the dining experience that they deliver, so hats off to Olive Garden and the team for just a tremendous milestone.

I think as we step back, look at Darden as a whole, we are fully focused on running our business in a balanced manner, and that means responding appropriately to the near-term consumer dynamics that we are seeing, but it also means doing that while we continue to build a long-term strength of each of our brands. We are confident that we are working on the right things at all of our operating companies, and we are also confident that we have the right leadership and restaurant team.

Now, due to a number of different dynamics that we are all all too familiar with, there has been considerable consumer uncertainty, and we expect the environment to remain more difficult than normal for the balance of our fiscal year.

But despite that, as Linda just shared with you, we are more confident in our earnings outlook, and that is because our teams are doing a very good job managing costs and it is because we continue to achieve competitively superior same restaurant sales growth.

There is a view that consumer spending may improve if energy prices continue to fall, and if other uncertainties continue to dissipate. We would certainly appreciate that, and if it does occur, there is obviously an opportunity for us to achieve stronger sales. But short term dynamics aside, we are confident that we can build a great company, one that continues to create superior top [core tel], S&P 500 total share over value, and one that is going to last for generations. We have that confidence because we have a proven approach to achieving sustaining success in casual dining, and Drew touched upon that earlier. That approach involves combining great people, great brand management, and great operations. It is an approach that has served us well in the past. It is an approach that we believe will serve us well in any economic environment.

I am proud of our results, but I am even prouder of the outstanding people who delivered those results. To that end, I do want to thank Linda for 25 years of dedication and service. She has been a trusted partner, trusted friend over the many years that I have been at the company. She has made a very special contribution in helping Darden develop an effective operating infrastructure, a superior technology platform, and strong fiscal discipline and financial control systems. All of us at Darden wish her the very best as she enters this new phase of her life.

I also want to welcome Brad Richmond to his new role as Darden’s Chief Financial Officer. In 24 years at Darden, Brad has made a number of very important contributions to the organization, and did that most recently as our corporate controller. I have worked with Brad for many years and I am confident in his ability to take on this new leadership responsibility.

We think that these changes strongly position us for success. They will enable us to seamlessly manage through the near-term challenges of losing a valued leader like Linda to retirement, but they will also provide some talented individuals, Brad and also Val Collins, who is taking on the responsibility as corporate controller, with greater responsibility, with the opportunity to really help us achieve increased integration and capture the long-term growth opportunity that we see in casual dining.

With that, we will pause now and take your questions.

Question-and-Answer Session

Operator

(Operator Instructions)

Our first question is from the line of Steven Kron from Goldman Sachs. Please go ahead.

Steven Kron - Goldman Sachs

Thank you. Good morning. A couple of questions, just on the margin line, they are related questions. If you look at the sales during the quarter, blended comp sales across your brands were relatively flat. You did see some P&L deleverage, which Linda, you went into and talked about. I guess as we think going forward, what sales are necessary to get to positive flow-through on those lines? Kind of related to that, if we think about food and beverage, and you talk about the mix shift going towards Olive Garden helping that line item, how much of the food and beverage decline is actually coming from that mix shift and how much is just visibility of lower commodity cost. If you could just share a little bit of color on that. Thank you.

Linda Dimopoulos

Thanks, Steve. I think, as I mentioned in my comments, it is about 10 basis points is associated with the mix of Olive Garden. Of course, that has been accumulated over -- that has continued over many years, so that has been a factor. We have commented on it. We wanted to dimensionalize it this quarter because, while relatively small in any one quarter, it does accumulate over time and we expect that to be in that range for this year as well, as we accelerate Olive Garden’s growth even more.

In terms of the other mix areas, we do expect to see continued favorability, probably not the levels we saw in the first quarter, but we do expect, as we indicated in our June call, that we would expect the favorability in food and beverage and be the significant place where we get leverage this year.

We also mentioned our sales, we would expect for the year to still be in that 2% to 4% combined same restaurant sales, and so since we have been a little short of that in the first quarter, we would expect to see more of that in the back half.

Drew Madsen

On your question, the part Steve, you talked about what is the sales threshold, I think, to get leverage on the cost side. It is certainly below that 2% to 4% range. The 2% to 4% is consistent with the earnings outlook that we talked about for this year, and really for the long term.

Operator

Our next question comes from the line of David Palmer from UBS. Please go ahead.

David Palmer - UBS

Good morning. Congratulations, Linda, on your long and distinguished career there. On the food cost side, you know, this is for -- this has been through since ’02 when you were CFO, and certainly the last five years, the food costs have really come down a lot at Darden. Some of it is just the work that you have done around eliminating food waste and certainly the mix changes at Olive Garden, but we have had something like 400 basis points if I just look at the first quarter alone.

I am wondering if you guys might give us some perspective on that line item going forward. There is obviously some aqua-cultural stuff that is going on big picture, maybe that seafood will come down over time. But perhaps you could give a sense of that not only for the next three quarters, but for the next few years. Thank you.

Clarence Otis

Let me try to begin there, and have Linda and Drew build on it. I think if you look back, there are some things that are fundamental that are going on. One of them is the increasing effectiveness of aqua-culture. So shrimp has been farmed for quite a long time. The technology continues to improve. So we have fewer ponds being taken out of service for disease and other things that we might have saw in the 90’s, and we have more farms globally than we had in the 90’s. So farming technologies have spread to other geographies. China is significant today. It was not if you go back a decade. So that is part of it.

I think the other part on the aqua-culture front is there are fin fish species that are farmed today that were not in the past, so now we have enough of an array there to offer some real choice inside the farmed component, where costs are better contained, less volatility, but also declining structurally over time with farming.

I think the other pieces are we have invested a tremendous amount in our operating infrastructure and our technology platform. A lot of that allows us to gauge food usage better than we have in the past. So that helps with waste and a lot of those things. We are continuing to make investments in inventory management at the restaurant level that we think will pay off in the future.

So those are some of the things. I think there is an attentiveness to food waste among our operators. We have a program, for example, a food harvest program where we are able to donate food that we have prepared for a day and do not use, and it comes out of our rotation, but our rotation is so much tighter than you might see in other places, so it is perfectly good food. We are able to donate that to food banks across the country. We do get tax credits for those, but just the collection of that food puts a focus on just how much food can be thrown away if it is not managed carefully, and that increases the attentiveness of our restaurant employees, our front-line employees. So there are a lot of things going on.

Drew Madsen

I would add to the aqua-culture and supply chain and technology comments that Clarence made. Increased rigor, as he said in terms of how we run restaurants and manage food costs, not just the food waste portion of it, and increased rigor in how we develop menus on the front-end to make sure that we are using a balanced score card there and putting together recipes in pricing and productivity standards that are going to contribute, David, to what you are talking about.

Linda Dimopoulos

The only other thing I might add to that would be I think there is a real benefit to being all company-owned. We are really able to go deeper into the supply chain and manage much of our product. We continue with technology and other approaches, work on that with the supply chain organization across the company.

The other thing is in the Red Lobster mix, I think we have seen historically some higher food costs associated with the type of promoting that we were doing, and those high, break-even sort of promotions did put a lot of pressure on food costs. So as we have weaned ourselves off those in the last several years, those have been brought down.

Probably the only other thing is that we have seen more pressure, as we talked about in the past, in labor costs and in further down the P&L, so our pricing has been more focused to cover those sort of things, and have in some ways benefited the food cost line because we have not seen as much inflation and other offsetting initiatives that we talked about here.

Operator

We move on, a question from the line of Jeffery Bernstein from Lehman Brothers. Please go ahead.

Jeff Bernstein - Lehman Brothers

Thank you very much, and as well, congratulations, Linda. Actually, this is a question broadly on returning capital to shareholders. I know in the past you have noted your preference for share repurchase over dividends. It seems to be similar to most peers. First, I guess, just wondering big picture, why the preference? Secondly, several of your peers have aggressively ramped up their repurchase programs. I believe you have guided to similar levels of repurchase versus last year. To think about unit growth having slowed, would you consider using additional excess cash for a more aggressive repurchase, whether in the open market or through an auction, similar to some peers? Thanks very much.

Clarence Otis

I will have start and then have Linda finish on it, but we have for a very long time really made sure that we did a couple of things. One is that we wanted to have an efficient and effective capital structure where we would minimize our cost of capital. So we focused on what is the right leverage level to achieve that.

The second thing is we want to make sure that our incremental investments are value creating, and so we pay a lot of attention to trying to make that happen. We are not always right, but we try hard, and so we are not -- we try not to invest in things that are not value-creating.

So the combination of those two things really drives our share repurchase, and we have been a fairly significant share re-purchaser over an extended period of time, and those levels continue to rise because of the cash flow strength of Red Lobster and Olive Garden. As they have risen, we wanted to make sure that we have got a good balance, really, between share repurchase and dividends. We still obviously have a significant bias to share repurchase, but we have increased our dividend because we have been averaging over $400 million of share repurchase. We had dividends that were below $15 million, and we have taken that up now over the last couple of years.

So that is how we think about it. We think that we are at a leverage level that makes sense. We tend to see ourselves minimizing our cost of capital with adjusted leverage, really looking at leases, debt equivalence of anywhere between 40% and 50%. We have been toward the middle of that range for quite a few years and we are moving toward the top of that range. That is really reflective of some of the slowdown in unit growth.

Linda Dimopoulos

I think that really very well covers it. We did mention that we are -- we did raise our dividend and we would expect to continue to stay in the competitive range with yield and payout there, so at this point, we have really no significant change in plans because we have been really pretty happy with the path we have been on for many years now.

Operator

Thank you. Our next question is from the line of John Glass from CIBC. Please go ahead. Mr. Glass, your line is open.

John Glass - CIBC World Markets

Hello? Can you hear me now? Hello?

Clarence Otis

Yes, we can hear you.

John Glass - CIBC World Markets

Sorry, sorry. The question is on Red Lobster and the turnaround and the phases you are going through. Can you remind us how long phase one took, and maybe what you anticipate the length of phase two is going to be before we start seeing re-accelerated unit growth?

Drew Madsen

Phase one, strengthening all the business fundamentals, but in particularly guest satisfaction and restaurant return on sales tend to be the two things we look at most closely. That has been going on for the last couple of years. There is opportunity to continue to improve in those areas, so I would not say it is completely finished, but they have made dramatic progress. There we will be looking less for step change improvement, more for continued improvement in both of those areas.

Brand refreshment will also be an ongoing effort but the first stages of it would be the menu items that I talked about. Later, we will talk about a new advertising campaign, and down the road, we will probably be talking about some modest, in-restaurant remodeling to make sure we have the atmosphere and environment for the new Red Lobster, if you will.

All of that is going to unfold sequentially over time. It is difficult to put an exact years on it, but if you look back at Olive Garden, a lot of that took place over two or three years. So it is not going to be a three or four quarter sort of thing.

John Glass - CIBC World Markets

Great, that is helpful. Linda, I just wanted to go back to the commodities question. You talked about 10 basis points benefit from the mix shift to Olive Garden. Is that to imply then that almost 100 basis points of the food cost savings were commodities related, or would you say there are other parts to it? For example, the fact that Red Lobster comped negatively during the quarter, or the fact that Smokey Bones is growing slower than in the past. Can you further parse out, I guess, what is truly commodity related versus any other kind of mix shift?

Linda Dimopoulos

I would say -- maybe break it into, after that, those 10 basis points, maybe a third of it is really menu and mix promotion, so that is really a different kind of promotion and a different mix of offerings at Red Lobster. As I said, we had some changes there versus the prior year. We actually had maybe a third of it which is really cost savings and decreases in product year over year, and then maybe a third just leverage from pricing.

Clarence Otis

…your question on phases. I do think the brand refreshment phase will carry out over a couple of years, but that does not mean we are going to wait to get into the third phase on new unit growth until the brand refreshment phase is completely finished. So that is more like a late fiscal 2008, early 2009 when we would start thinking about more meaningful unit growth at Red Lobster, not three years from now.

Operator

Your next question is from the line of Mark Wiltamuth from Morgan Stanley. Please go ahead.

Mark Wiltamuth - Morgan Stanley

Good morning. Just to follow-up a little bit on the food cost question. Could you just tell us if that was more seafood focused or if it came across the other commodities, and what kind of duration do you have locked in, where you are pretty confident you will have year-over-year declines in food costs?

Linda Dimopoulos

That really was across a number of commodity items, so it really was not significantly in any one specific commodity. So it was really pretty broad-based, and as I said earlier, I do not expect it to continue at this level for the remainder of the year, but we do continue to see favorability for the total year, and so it will continue to show, of a lesser extent, but favorable to the remainder of the year.

Mark Wiltamuth - Morgan Stanley

If I could just ask, as you are looking at areas where you have felt any pressure from the casual dining slowdown, can you tell if it is more centered in lower demographic areas or anything you can see across your chain?

Drew Madsen

I think it has been broad-based, I guess, is the starting statement. There are places were it is weaker than other places, geographies is what I am thinking. So in the upper Midwest, it has been weaker generally through the summer. These things bounce around a little bit, but I would say that is probably over some extended period where it has been somewhat more weak, and then New England.

Operator

Your next question is from the line of Joe Buckley from Bear Stearns. Please go ahead.

Joseph Buckley - Bear Stearns

Thank you. A couple of questions. Curious on the increased guidance for the year. Is that a function of you beating your internal expectations for the first quarter, or is that a somewhat more optimistic outlook for the remainder of the year?

Linda Dimopoulos

I would say it is really a little bit of a combination of both. You know, we went into the year with a pretty volatile consumer environment, and that continued to play out, but we fared pretty well through that, so it really is a combination of both those things.

Clarence Otis

I think as Linda said, really looking at the second half of the year in particular the third and fourth quarter, and having some confidence based on what we have planned there.

Joseph Buckley - Bear Stearns

Just a very short-term question, you mentioned that Olive Garden counts in September strengthened a little bit, Red Lobster running about the same as August. I am curious if you think the gas price decline in the last few weeks has had impact, and if so, why Olive Garden and not Red Lobster?

Clarence Otis

I would say it is hard to tell. I mean, we do not have industry data at this point past August. We have heard Malcolm Nap and some other folks talk about September, and it looks like it has improved in the industry based on what they said. We certainly see improvement in our business, as you have said, better at Olive Garden, at least as good as August at Red Lobster.

We think it has always been a combination of factors. So it is a question of interest rates settling at a place where I think people can start to budget around them. They do not see them increasing at the pace that they have been increasing. It was always, in our mind, a question not so much of absolute level, but people figuring, concerned about where will it end up. So that has played in there, gas prices.

The military action in Lebanon was clearly weighing on people’s minds, and concern about the implications of that, and so there are a number of things that have come the right way.

Drew Madsen

I would probably also add that the promotion Olive Garden is running now, never-ending pasta bowl at $7.95, is particularly relevant in the current environment, and a more overt value statement than what they were doing in July, or in August, excuse me.

Joseph Buckley - Bear Stearns

Did the endless shrimp promotion, has that just started or has that been running for a week or two now?

Drew Madsen

A couple of weeks.

Joseph Buckley - Bear Stearns

Do you see that as a value driver, or is that sort of a mix between quality and value?

Drew Madsen

Both. We think never-ending pasta bowl is a brand-building promotion that offers competitively superior value. It is unique to Olive Garden and we think endless shrimp is the same thing, because you can choose from a wide variety of different shrimp preparations, flavors, types, and it is a great value. So I would say it is both.

Operator

Thank you. Our next question is from the line of Mike Smith from Oppenheimer. Please go ahead.

Michael Smith - Oppenheimer & Co.

Good morning. Linda, you do not look old enough to retire, but…

Linda Dimopoulos

Thank you, Mike. I love you.

Michael Smith - Oppenheimer & Co.

I want to talk a little bit about Smokey Bones. I know you do not -- did you say you were in test with a newly redesigned menu, handheld as opposed to the placemat?

Drew Madsen

The new handheld menu is at all Smokey Bones restaurants for the last couple of weeks, actually. It is a menu that has some pictures in it, very different design, and does a great job of showcasing the variety that has been in the Smokey Bones menu, but our guests maybe haven’t fully realized that or appreciated it.

Michael Smith - Oppenheimer & Co.

In terms of addressing the barbeque-centric nature of Smokey Bones, are you serious about perhaps changing the name?

Drew Madsen

We are evaluating a range of options, and we will move forward with the positioning and the collection of elements that deliver that position when we have confidence that it truly is more broadly appealing than what we have today, so we are looking at it.

Clarence Otis

The thing I would add, Mike, is as we have talked about before, we have a range of performance at Smokey Bones, and it does break down geographically. So a lot of testing that we are doing are in the places where the performance is weakest. We would have to see some results in those tests that are superior to the places where it is performing well to make significant moves in those stronger regions. So I just want to clarify that.

Michael Smith - Oppenheimer & Co.

Does that mean it could end up being two brands?

Clarence Otis

That is not our intent, so we will have to really read our test and see where it leads us.

Michael Smith - Oppenheimer & Co.

You mentioned that you would probably start to open some new Bahama Breezes. Was that in late ’07, or is that an ’08 project?

Clarence Otis

Well, that is our intent, is to open a Bahama Breeze. We have growing confidence in the brand and the experience our guests are having, the viability of the business model, as Laurie and her team continue to make progress.

Having said that, we want to see further progress in some of the structural business model changes that will further increase restaurant return on sales before we begin to open new units, but the tentative timing, it would be more in ’08 than this year.

Michael Smith - Oppenheimer & Co.

I know that you always mention, you know, the chocolate sauce as being one place where you can buy as opposed to build, I guess. With those kind of changes in your preparation process, what kind of basis point improvement do you think you can drive at Smokey Bones?

Clarence Otis

You mean in Bahama Breeze? Well, as we look across the entire P&L, so including labor and food cost, we are looking for fairly meaningful improvement, and 300 plus points of improvement in the P&L. We, as Drew mentioned, tested a number of different changes in some restaurants already, and we are pretty encouraged by what we see, and we see some meaningful improvement, and we are seeing that without an erosion in guest satisfaction results. In fact, we are seeing that with guest satisfaction continuing to increase and with sales growth.

So we are having increased confidence.

Michael Smith - Oppenheimer & Co.

If you got that kind of improvement, would that make Smokey Bones competitive on a return basis with Olive Garden and Red Lobster?

Clarence Otis

Well, if we were talking Bahama Breeze, the answer is yes, it would make it competitive on a return basis. Now, we still would need to work on the investment side of the equation. We have not done any work there in the marketplace in a while, because it has been a while since we opened one. We have been doing a lot of design work to make sure that we can bring in an investment that makes sense, but we think we can do that.

Operator

Your next question is from the line of John Ivankoe from J.P. Morgan. Please go ahead.

John Ivankoe - J.P. Morgan

Thank you. Certainly the Olive Garden not only comped in traffic over time, especially this quarter has been impressive, and one of the things we talked about in previous calls are some operational initiatives that might be designed to optimize the capacity of the box even further. I was hoping today you could update, specifically some things like KDS and take out and getting the guest’s checks to the consumer faster, and maybe even some seating reconfiguration that may optimize the number of people you can serve at any one time? Thank you.

Drew Madsen

Dave and his team are pursuing a number of initiatives. First of all, just being brilliant with the basics operationally and the way they run restaurants, they are focused on eliminating any unnecessary gaps in the experience, from quoting accurate wait times to making sure we seat people efficiently, comp refills, get them their check as soon as the meal is done, those sorts of things.

In addition, we have made some investments in technology. You alluded to some of them there, but we are introducing a new point of sales system. It is in about 450 or 500 restaurants across Darden. Most of them Olive Garden, but that is helping us, helping our servers, helping our managers be more efficient, because it has expanded capability and it is just faster than the point of sale system we had before.

We have KDS, a meal pacing system, in a number of Olive Gardens. Our intent there is to verify that it does in fact increase pace of meal and efficient seating while improving the guest experience, helping us get food out hotter and faster. Early results are encouraging, and if we continue to see that, we will be in a position to expand KDS to all Olive Gardens by early in fiscal 2008.

We are also looking at different market penetration strategies for our new units to help harvest the demand as efficiently as possible, if you will, so one of the smaller prototypes that we have, we have not talked about it in a while, but it is smaller with fewer seats, lower capital investment. It would help us penetrate both small markets and fill in existing markets so we can capitalize on the demand and minimize -- on the consumer demand and minimize some of the strain on our existing restaurants. That has already begun.

Clarence Otis

I think the final thing, John, and you mentioned it, is when it comes to seating, we are looking at areas of the restaurant to see if we can increase seating, and so we are looking at the lobby and bar area, trying to determine what are the things that we can do there to increase capacity? Early days in some of that work, but it is clearly an area we are focused on.

Operator

Thank you. Our next question is from the line of Andrew Barish from Banc of America. Please go ahead.

Andrew Barish - Banc of America

Good morning. Can you give me a little bit of a timeframe on the new Red Lobster menu? Then, on the fresh fish sheets, is that expected to be gross margin neutral or helpful? Then, how do you balance the operational complexity of those daily specials, as you guys have made a lot of progress with the operating platform at Red Lobster, which has clearly helped.

Clarence Otis

Both the new menu and today’s fresh fish sheets will be coming to a Red Lobster near you relatively soon. We do not want to say exactly when, but certainly it is going to be this quarter, in the second quarter, as we said.

In terms of what the impact is, we tested it very carefully to make sure that the guest experience improved, fresh fish preference increased, and that there was no unintended consequences as it related to margin, because we are not trying to do this to build check and build margin. We are trying to do this to make sure our guests, particularly lapsed guests, understand the great variety of fresh fish, the innovative new recipes, different types of preparations that Red Lobster offers.

So they have been testing it extensively for quite some time, more than a year, actually, and introducing today’s fresh fish sheets with excellence in all the Red Lobster restaurants. It is one of the key operational priorities for Kelly [Bolt] as the new team going forward.

Operator

Your next question is from the line of Rachael Rothman from Merrill Lynch. Please go ahead.

Rachael Rothman - Merrill Lynch

This is [Ushma] on Rachael Rothman’s behalf. Last year, it appeared that the Garden, along with other restaurant companies, experienced significant increases in real estate and development costs. Can you talk about the trends in development costs that you are currently experiencing?

Clarence Otis

You are breaking up. If you could repeat the question, we did not get it.

Rachael Rothman - Merrill Lynch

Can you hear me now?

Clarence Otis

Yes.

Rachael Rothman - Merrill Lynch

This is [Ushma]. Last year, it appears as though Garden experienced significant increases in real estate and development costs, just like other restaurant companies. Can you talk about the trends in development costs that you are experiencing right now?

Clarence Otis

Yes, and the answer is that they have been increasing, and that has put pressure on unit development, because we are focused on the return on invested capital. Olive Garden is the engine right now for unit development because it has the margins to absorb those increases in real estate and construction costs and still generate appropriate returns on invested capital. We are working at Red Lobster to do two things. One is improve the margins so that it can absorb those costs as well, but the other thing is the work to bring those costs down through some of the prototype work that we have been doing. So both of those are ongoing.

The increases that we have been seeing over the last several years have moderated fairly significantly, but they certainly have not reversed themselves.

Drew Madsen

In addition to becoming more efficient in the way we design the restaurants and the capital that we invest, we are also getting smarter in how we pick sites, to make sure that the market trade areas we are going to and the specific sites we are going to increase our odds that we are going to get the return on invested capital that Clarence said.

Operator

We do have a follow-up from the line of Steven Kron from Goldman Sachs. Please go ahead.

Steven Kron - Goldman Sachs

Thank you. Question for Drew. In the spirit of phases and this might be a bit of a premature question, but I was hoping we could talk a little bit more specifically around parameters around Smokey Bones repositioning. As you start to enact some of these changes upcoming a bit more aggressively, what is the appropriate time frame that we should be thinking about for a transformation like this, that you might give this brand? What are some of the near-term and intermediate signposts you might look for, or we should be tracking?

Drew Madsen

I do not think in today’s call we are prepared to talk about specific phases and milestones. Obviously the things we will be looking for are broader consumer appeal, higher sales per unit, and more stable same restaurant guest counts over time. Those are kind of the biggest things that we will be looking for.

We are going to be opening the first test restaurant in a few months, and since it is down the road yet, I think it is just premature to get into what the specific timing is going to be on how we would expand it from there.

Obviously we are going to be careful to make sure that the new -- the repositioned Smokey Bones is superior to what we have, and Clarence mentioned we already have areas in the country where Smokey Bones does very well, so we are going to proceed more cautiously there.

But beyond that, I think it is premature to get into it today.

Operator

We have a question from the line of Donald Trott from Jefferies. Please go ahead.

Donald Trott - Jefferies & Co.

Good morning. You and other restaurant companies have experienced a somewhat meaningful increase in utility costs over the last several years. Giving effect to the recent decline in oil and related pricing, could you give us some idea how much have your utility costs gone up in the last several years and what do you see as the ongoing outlook?

Linda Dimopoulos

I would say over the last -- and we have been ramping on this for a couple of years, but I recall last year, the increase was well over $20 million, and we have seen a little bit of that ripple into this year, but we are expecting some of that to moderate throughout the year, so we are certainly hoping and not expecting the kind of continued acceleration in utilities for the remainder of this year. It is much more moderate and much more in an inflationary range. It might even come down, depending on where some of these things end up.

Donald Trott - Jefferies & Co.

Generally, how have utility costs been running as a percentage of sales, just to put it into perspective?

Linda Dimopoulos

It is about 3% in total, all utilities.

Operator

There are no further questions at this time.

Clarence Otis

Thank you, Mary, and thanks for joining us on the call today. If you have some further questions, or further follow-ups, please give us a call here in Orlando. If not, we hope to -- we look forward to perhaps seeing you around the country this coming quarter. Thank you very much.

Operator

Ladies and gentlemen, this conference will be available for replay after 12:00 p.m. Eastern time today through midnight, October 20th. You may access the replay service by dialing 1-800-475-6701, and entering access code 841725. International participants may dial 320-365-3844. Those numbers again are 1-800-475-6701 and 320-365-3844, with the access code 841725.

This does conclude our conference for today. Thank you for using AT&T executive teleconference. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Darden Restaurants F1Q07 (Qtr End 8/27/06) Earnings Call Transcript (SeekingAlpha)
This Transcript
All Transcripts