Welcome to the Darden Restaurants third quarter earnings release. (Operator Instructions) With that being said, I will turn the conference over to Mr. Matthew Stroud. Please go ahead, sir.
Thank you. Good morning, everyone. With me today are Clarence Otis, Darden's Chairman and CEO; Drew Madsen, Darden's President and COO; Brad Richmond, Darden's CFO; and Gene Lee, President of Darden's Specialty Restaurant Group. 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 statements. We wish to caution investors not to place undue reliance on any such forward-looking statements.
Any forward-looking statements speak only as of the date on which such statements are made and we undertake no obligation to update such statements to reflect events or circumstances arising after such date. The most significant of these uncertainties are described in Darden's Form 10-K, Form 10-Q and Form 8-K reports, including all amendments to those reports.
These risks and uncertainties include the impact of intense competition, changing economic or business conditions, the price and availability of food, ingredients, and utilities, supply interruptions, labor and insurance costs, the loss of or difficulties in recruiting key personnel, information technology failures, increased advertising and marketing costs, higher-than-anticipated costs to open or close restaurants, litigation, unfavorable publicity, health concerns including virus outbreaks and food safety, a lack of suitable locations, government regulations, a failure to achieve growth objectives through the opening of new restaurants or the development or acquisition of new dining brands, weather conditions, risks associated with Darden's plans to expand Darden's newer brands Bahama Breeze and Seasons 52, our ability to achieve the full anticipated benefits of the RARE acquisition, possible impairment in the carrying value of our goodwill or other intangible assets, risks associated with incurring substantial additional debt, a failure of our internal controls over financial reporting, disruptions in the financial markets, volatility in the market value over derivatives and other factors and uncertainties discussed from time to time in reports filed by Darden with the Securities and Exchange Commission.
A copy of our press release announcing our earnings, the Form 8-K used to furnish the release with 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 fiscal 2010 fourth quarter earnings and same restaurant sales for fiscal March, April and May 2010 on Wednesday, June 23, 2010 after the market close. We released third quarter earnings results yesterday afternoon. These were available on PRNewswire and other wire services. We recognize that most of you have reviewed our third quarter results so we won't take the time to go through them in detail once again, nor will we spend time on a brand by brand operating summary in an effort to provide more time for your questions.
Rather, Brad will provide some additional line item detail about the financial results for the quarter and discuss our outlook for the fiscal year. Drew will briefly review our operating performance and our company perspective in the third quarter followed by Clarence who will have some additional remarks. After that, Clarence, Drew, Brad and Gene will then respond to your questions.
Thank you, Matthew and good morning. I want to start by detailing our same restaurant sale results for the third quarter given the holiday shift and severe winter weather that impacted our sales.
Blended same restaurant sales for Olive Garden, Red Lobster and Longhorn Steakhouse increased 1.3% this quarter. This includes a positive impact of 80 basis points due to the Thanksgiving holiday week shift which moved to the second quarter this year from the fiscal third quarter last year. Excluding this effect, blended same restaurant sales results increased 0.5%.
In addition, we believe more severe winter weather this year compared to last year adversely affected our blended same restaurant sales results by approximately 60 basis points. This weather impact varied by brand according to their geographic dispersion as Longhorn Steakhouse was more impacted than Olive Garden or Red Lobster. We also had some holiday shifts that had minor effect on the quarter’s results. The bottom line though is all three brands saw very good sales momentum this quarter.
The blended same restaurant sales results for the third quarter exceeded our previous guidance issued in mid-February prior to our analyst day from the strength of Red Lobster’s Lobsterfest Glutton period promotion and less severe winter weather benefiting all of our brands in the second half of February.
For context, industry same restaurant sales as measured by Knapp-Track and excluding Darden which are not affected by the Thanksgiving holiday shift, are estimated to be down 4.3% for the quarter. So, we continued to outperform the industry by almost 500 basis points this quarter which combined with continued new unit growth in the face of slight unit growth in the industry means we are building our total market share.
Turning to each brand, Olive Garden’s same restaurant sales increased 1.5% for the quarter and adjusting for the Thanksgiving week shift same restaurant sales would have risen 0.9%. Red Lobster’s same restaurant sales increased 0.9% for the quarter and adjusting for the Thanksgiving week shift same restaurant sales would have climbed 0.1%. Longhorn had a same restaurant sales increase of 1.9% for the quarter and adjusting for the Thanksgiving week shift same restaurant sales would have risen 0.7%. The Capital Grille had a same restaurant sales decrease of 1.9% for the quarter and adjusting for the Thanksgiving week shift same restaurant sales would have decreased 4.7%.
More severe winter weather adversely affected the Capital Grille’s same restaurant sales by approximately 230 basis points in the third quarter. Bahama Breeze had same restaurant sales decrease of 0.6% for the quarter and adjusting for the Thanksgiving week shift same restaurant sales would have decreased 2.2%.
Now let’s discuss the margin analysis for the third quarter. Food and beverage expenses were 171 basis points lower than last year on a percentage of sales basis as a result of reduced food costs. This reflects the fact we benefit from declining commodity prices this quarter and we expect to continue to see additional benefits in the fourth quarter although not to the same degree we experienced this quarter. Third quarter restaurant labor expenses were 170 basis points higher than last year on a percentage of sales basis due to manager bonuses and increased benefit costs, wage rate inflation and unemployment insurance taxes partially offset by reduced employee turnover in our restaurants and lower turnover related expenses. Looking ahead we continue to expect some unfavorability as a percentage of sales in the fourth quarter but we should see some improvements compared to this quarter.
Restaurant expenses in the quarter were 54 basis points lower than last year on a percentage of sales basis because of lower utility expense and reduced repairs and maintenance expense. Looking ahead we don’t expect to see favorability in restaurant expense as a percentage of sales in the fourth quarter as we have continued to lap the prior year’s reduced energy costs.
Selling, general and administrative expenses were 17 basis points higher as a percentage of sales for the third quarter because of higher bonuses, increased media expense and increased benefit costs. In the fourth quarter we anticipate that selling, general and administrative expenses as a percentage of sales will be slightly lower than prior year. As mentioned in the press release following our review of gift card usage we adjusted our gift card redemption assumptions. This adjustment reduced this quarter diluted net earnings per share growth by approximately $0.04. We made this adjustment based on increased redemption of gift cards we have been experiencing.
The effective tax rate for the third quarter was 23.2%, increasing diluted net EPS by approximately $0.02 if compared to net earnings to what they would have been with a tax rate consistent with our annual guidance of 25%. Our year-to-date tax rate is now approximately 25% and we expect our annual effective tax rate to be the same.
With only one quarter left in our fiscal year yesterday we revised upward our annual outlook. We expect blended same restaurant sales for the fiscal year to decline approximately 2.5% which is better than previously anticipated and we also expect more favorable costs than previously anticipated. So now we expect reported diluted net earnings per share growth from continuing operations to be +8% to +10% for fiscal 2010. This compares to reported diluted net earnings per share from continuing operations of $2.65 in fiscal 2009 which included an extra fiscal week.
Now here is Drew with some additional comments.
Thanks Brad. Good morning everyone. Let me start by apologizing for my voice. I am obviously battling a cold. Hopefully everyone can understand me alright. Similar to our second quarter call I will start by sharing a few thoughts about the industry and then comment briefly on our strategy and performance by brand.
Industry same restaurant sales results improved for the second consecutive quarter going from minus 6% during the second quarter to minus 4.3% in the third quarter. Just as importantly the underlying dynamics in this 170 basis point improvement versus the prior quarter also improved with guest counts improving 40 basis points and check improving 130 basis points.
Compared to last year, the implied industry check was down only 20 basis points, the best absolute performance since the third quarter of fiscal 2009 suggesting the deep discounts so prevalent over the last four quarters at many of our competitors have eased significantly. We realize that industry same restaurant sales remain negative versus prior year and we believe some of the sequential improvement I just discussed is due to the weak year-ago industry comparison. However, we also continue to believe the fundamentals in full service restaurant are improving.
As it relates to Darden, our strategy to drive competitively superior results during the third quarter was consistent with the approach we have discussed with you throughout this fiscal year. We continue to be weary of utilizing deep discounts to combat difficult industry conditions given our concerns about what this might do to long-term brand integrity, long-term business model integrity and our related growth prospects. Our approach is to build upon the broad appeal of our brands, leverage the cost advantage that comes with our scale and utilize selected value offers across our portfolio that are profitable in the near-term and maintain the strength of our business model and integrity of our brands over the long-term.
Clearly this approach worked well for us during the third quarter. As Brad mentioned our three large brands outperformed the Knapp-Track benchmark during the third quarter by almost 5 percentage points on a blended basis after adjusting our results for the Thanksgiving holiday shift.
I want to take a minute and review the underlying dynamics in same restaurant sales at each of our three large brands which is complicated this quarter by having significantly more year-over-year differences in holidays and weather than most quarters. I don’t want to take too much time reviewing all of the details to hopefully this brief summary helps.
Olive Garden achieved same restaurant sales growth during the third quarter of 1.5%. If you account for holiday shifts and weather differences their adjusted sales growth is actually a little stronger. During the second quarter of this fiscal year the comparable adjusted same restaurant sales result for Olive Garden was approximately minus 1% so clearly momentum has improved. Olive Garden featured approachable and distinctive food news during the third quarter but had two fewer weeks of price point advertising than the prior year.
Red Lobster achieved same restaurant sales growth during the third quarter of 0.9% and if you account for holiday shifts and weather differences their adjusted sales results were slightly lower but still positive versus the prior year. During the second quarter of this fiscal year the comparable adjusted same restaurant sales results for Red Lobster was roughly minus 7% so momentum at Red Lobster has improved substantially. These strong results were driven by two very successful promotions; the $29.99 seafood dinner for two promotion started in early January and ran through mid-February. This promotion offered guests an attractive price point to directly address their need for affordability but was not a deep discount that eroded profitability or brand image.
Red Lobster followed this price fixed offer with the introduction of their signature Lobsterfest promotion during the last two weeks of February. This promotion started two weeks earlier than last year and has exceeded our expectations so far.
Longhorn Steakhouse achieved same restaurant sales growth of 1.9% during the third quarter. Their adjusted third quarter same restaurant sales performance is essentially the same. During the second quarter of this fiscal year the comparable adjusted same restaurant sales result for Longhorn was roughly minus 5% so Longhorn also had a significant improvement in momentum. They featured their signature Stuffed Filet during the holidays and they followed that promotion with a value offering featuring several Signature Grill offerings starting at $9.99 price point.
While both these promotions were similar to what they ran last year we believe they featured more compelling dishes and more compelling advertising resulting in stronger sales performance. Longhorn also benefited from increased gift card distribution and sales as part of the Darden network this year.
In addition to these successful promotions, favorable cost trends and proactive internal cost management helped operating margin increase at all three of our large brands which enabled Darden to deliver a strong increase in earnings. We believe this is further evidence of the strength of our brand portfolio, our business model and the appropriateness of our strategy to achieve consistent, profitable market share growth across these brands.
Finally, we continued to make significant progress transforming the way we run our business and the way we support our restaurants that will make our brand support platform even more cost effective in the future. In particular, three core projects targeting high expenditure areas, the automation of our supply chain, the centralization of facilities maintenance support and transformation of our in-restaurant operating practices to significantly lower usage of energy, water and cleaning supplies are all on track to meet or exceed the cost reduction targets we have discussed with you in the past.
Now I will hand it back to Clarence for a few closing comments.
Thanks Drew. We are of course very pleased with our financial performance this quarter. It reflects some encouraging industry trends for sure but it also is strong evidence that Darden is well positioned. We have great brands and we have what we think is an increasingly effective and efficient brand support platform. All of that is the case because of one thing; that is because we have exceptionally talented people and those people are working well together. These talented teams in our restaurants and in our restaurant support center are why we have successfully navigated what we all know has been just an incredibly challenging environment.
More importantly, they are why we believe that as the economy recovers and beyond that gets back to normalized growth the best is yet to come for this company. We have tremendous confidence in our business. We feel great about how we are performing today and about our strategic and tactical decisions and we are excited about the future.
With that we will take your questions. Thank you.
Question and Answer Session
(Operator Instructions) The first question comes from the line of David Palmer – UBS.
David Palmer - UBS
I wanted to ask you about your sales versus the industry. Do you see reasons why just in this next quarter and I am thinking beyond that any reasons why your gap to the industry would narrow significantly? If indeed the industry is improving do you think your headroom versus the industry will be maintained? Or aside from things like Lobsterfest timing should be roughly similar to what we have seen in the recent past?
I will start. We have talked throughout the fiscal year really about what we thought would happen in the industry. We did think we would see the industry improve through the fiscal year. That has happened. Third quarter as Drew said was much better than the second. We expect the industry to be better in the fourth than it was in the third quarter. We said all along our goal is to outperform the industry. We haven’t really framed that I guess through this period but we have maintained a very strong gap. There is volatility from quarter to quarter and month to month based upon what competitors are doing and what we are doing.
We talked about a 200 basis point gap I think as we entered the year. We did feel we would see a fair amount of discounting that might narrow the gap. Obviously that has abated and the gap has widened. So, we would expect that in a more normalized environment from a discounting perspective we would have a wider gap than that.
The next question comes from the line of Jeff Omohundro - Wells Fargo.
Jeff Omohundro - Wells Fargo
My question relates to Red Lobster and the improvements you are seeing there. I wonder if you could talk a little bit more about your thinking around the three course dinner for two. How pleased you were with that effort and whether that is sort of a value offering. Do you see that continuing through the year or further efforts along those lines?
We were very pleased with the performance of the Seafood Dinner for Two promotion. We thought it did a great job of balancing the two things we are really are striving to do in this environment. One is on a brand like Red Lobster periodically give guests the affordability they are looking for but do it in a way that doesn’t negatively impact brand image or business model. We thought this price at dinner for two at $29.99 did that very well based on the preference that promotion got in restaurants to guest satisfaction that it got in restaurant. The impact on the sales trend improvement operating margins improved. We think it did everything we were looking for it to do.
On the other hand, to put that in context as we said on the call last quarter we are going to use promotions like that selectively on a brand like Red Lobster and we don’t really want to comment further on what is going to happen in the future but we will periodically use things like that to give price certainty to their guests without deep discounts.
The next question comes from the line of Jeff Farmer - Jefferies & Company.
Jeff Farmer - Jefferies & Company
You did touch on this but after 18 months of what looks like mid single digit same store sales declines at Longhorn jumped back to positive comps is pretty remarkable. With that was there a material increase in the advertising spend and was there a big performance gap between the restaurants with and without advertising in the quarter?
There is always a material difference in the business in the restaurants that are getting more advertising support than not. We did not add incremental media or incremental coupons at Longhorn. We think the trend change we are seeing just reflects continuous improvement in the marketing and culinary teams at Longhorn in terms of developing creative, compelling new dishes and putting those in advertising in more compelling ways that really helps build the brand image as a great casual dining Steakhouse and helps drive incremental traffic and that is complementing everything else the brand has already done to improve the guest experience and so forth.
Jeff Farmer - Jefferies & Company
To follow up on one of the things you mentioned on the last call in late December you gave us some insight into what direction the December same store sales were heading. Can you provide the same commentary on March?
We would not. We have talked about what we think we are going to do for the year. Implicit in that is a fourth quarter sort of expectation. I would say as we look out that is less about what is going on in March and more about the fact we are in an environment that is still choppy. It is how would describe the overall economic environment. So again we are seeing the industry strengthen. We expect that to continue. It is fragile enough it may get some setbacks with some headlines that are adversely [not had] those kinds of headlines so far in March. But we still have two months to go in the quarter.
The next question comes from the line of Matthew DiFrisco – Oppenheimer.
Matthew DiFrisco - Oppenheimer
Following on that I was curious if you could give a little bit more detail as far as your implied guidance of the sequential slow down in comps. Is that expecting a slowdown in the back half and being conservative for the shift in lent and other things and Lobsterfest or are you already seeing that type of a slowdown now?
We are really doing our math based upon prior year comparisons which are a little more difficult for the industry. But even as we see industry improvement it is up against a stronger comp prior year. Nevertheless we do expect it to improve. We haven’t seen any reason we should change that expectation and we continue to expect our sales to outperform the industry across the board and we have talked about Longhorn. Longhorn has really been outperforming the industry for quite some time now after having lagged.
Drew talked about they have been working on a lot of things to strengthen the brand. That work started with the acquisition two years ago but a lot of those initiatives really haven’t shown up in the guest experience until quite recently. We think when you put all those together it forms a critical mass that changes how guests view the brand in a positive way. So we expect outperformance to continue at Longhorn as well as the other two large brands.
Matthew DiFrisco - Oppenheimer
Two bookkeeping questions. With respect to the $0.04 you mentioned for the gift card redemption was that completely in G&A? If you could give us any sort of an outlook for CapEx for 2011, greater than 2010, equal to 2010 context?
On the gift cards that all represents a sales deduction so that is how you should think of that. It does not affect any of our same restaurant sales performance calculations but that is where that particular adjustment occurs. In terms of the CapEx I think we detailed that pretty good our expectations at our mid-February analyst call. There has been really no meaningful update there. It does suggest obviously a significant amount of CapEx investment as we strengthen our brands around remodels both at Longhorn Steakhouse and Red Lobster as well as an accelerated unit growth pace as we look to fiscal 2011.
The next question comes from the line of John Ivankoe – JP Morgan.
John Ivankoe – JP Morgan
Your labor costs as you said were up 110 basis points on positive comps. A lot of companies now are showing labor negative comps. I was hoping you could give a little more detail on what may have been discretionary in the period; bonuses, training, other types of initiatives you may have been doing especially in the context of lower turnover which normally would lower labor costs. So that is the first point. Secondly, I was hoping now that the healthcare bill is largely complete what do you think that means for Darden?
The first part of that question, restaurant labor, really there are two key components that go into that. The front line labor, that direct cost, we do continue to see equal to or slightly better leverage on that particular line. But we are experiencing some costs in the other components of that labor around unemployment taxes we have to pay and certain benefit costs around group insurance as well as with the stronger performance we have our restaurant managers are enjoying good bonuses out of those. That is probably the real driver in that number.
I would caution while we have grown same restaurant sales, guest count which is the real driver of that still aren’t positive enough to get real leveraging out of that. So when we look at the labor we are deploying in the front lines serving the guests, we are happy where that is and we are managing that pretty darned well equal to or better than the rate we were at least year.
As you said the healthcare bill is largely completely although the reconciliation component of that hasn’t passed the Senate yet. So there still could be some additional changes. What we have done is we will study the bill in its final form and figure out really the impact on our business and our employees and we will analyze the cost implications for the business. We think that it is much like a lot of the other cost challenges we face like rising commodity costs, minimum wage increases, the costs of nutrition disclosure. We had to take time to understand the cost implications and plan for implementation.
We do have time to plan. Most of the provisions in the current legislation would be effective for us in 2014 which is really the second half of our fiscal 2013. The provisions that are effective before that are provisions that aren’t expected to have a significant impact on us. For example, our medical plans do not exclude pre-existing conditions today so that prohibition which is effective next year is not going to affect us. Again, we are working really to understand the implications. We feel pretty confident about our ability to really respond through some combination of cost management and price increase.
The next question comes from the line of Jeff Bernstein - Barclays Capital.
Jeff Bernstein - Barclays Capital
A couple of longer-term questions. One, looking beyond fiscal 2010 or using fiscal 2010 as a context it looks like you are talking about 8-10% earnings growth. Impressive considering comp is down 2-3. I am wondering as you look out to fiscal 2011 as an example if comps continue to track where they are now and unit growth seems pretty well locked in the 3-4% range. Is it fair to say we should expect earnings in the near-term above the normal 10-15% range based on the fact of the cost saving initiatives you implemented in the past 18 months and the additional $40-50 million I think you talked about of transformational in 2011. I am just trying to gauge the lasting benefits from the cost cuts and some of the benefits from incremental comps. As you look into fiscal 2011 it would seem like it would be above the normalized earnings target.
At this time we are not prepared to talk about fiscal 2011. We will of course do that on the year-end and fourth quarter call in June. I would just go back to the long-term targets we talked about at our February investor conference which is that 10-15%. We feel good about that. We think it requires all of the things we talked about which is the work we are doing to really drive the top line both from a same restaurant sales perspective and unit growth and all the cost transformation initiatives we are undertaking.
As we said those are designed to really be responsive to some of the long-term cost pressures whether those are ultimately on the food cost side as we get increasing competition for food from emerging countries or things like healthcare. So all of those things are designed to respond to the fact we think some of these cost pressures are persistent and will keep us in that 10-15% earnings per share growth range.
I would just add we talked in February about what our absolute performance was in terms of margins and all that. Now basically with the strong quarter we have now we are probably at or maybe a little above our peak margins we have been at. So from here same restaurant sales growth you can take a lot of that and convert it very efficiently and effectively into earnings growth. So the ability to achieve 10-15% earnings growth over the long-term we feel very well positioned to do that from our financial model. I think our brand strength showed itself again this quarter. That sets us up very well as we think about the longer term.
That has been our growth target for a very long term. Probably more of it being driven by operating profit growth going forward, cash flow growth and reduced share base. So very strong growth. We think it is one validation of the acquisition. Brad talked about peak margins. We have new targets for peaks at this point. A lot of that has to do with the cost synergies we saw from the acquisition with the kind of top line growth that we expect given the addition of two proven, yet growing brands in Longhorn and Capital Grille.
Jeff Bernstein - Barclays Capital
I think you alluded to it in the comments and I know in the press release you talked about ramping up share repurchase with the excess cash. Given you have done $16 million year-to-date and talking about $75 million, most of which is coming this fiscal fourth quarter. How should we think about that for fiscal 2011 with the debt pay down modest? Is it reasonable that kind of accelerated pace to continue or is it still greater relative boost to the dividend is the focus for 2011?
Again we will get into fiscal 2011 when we get into our June call. What I would say is we have worked our [debt mix] to a level we feel very comfortable with in this environment. As we look to go forward the strong cash our businesses generate will allow us to return more to our shareholders both through the form of dividends and share buyback. I think we have been pretty light on that this year compared to our historical trends. I would say there is a good likelihood there will be more there but in terms of clarifying or defining that I think we will wait until June when we get this year taken care of.
The next question comes from the line of Nicole Miller Regan – Piper Jaffray.
Nicole Miller Regan – Piper Jaffray
I was hoping you could give us some kind of conversation on Capital Grille and what is happening on the higher end to aid the recovery? Also could you comment on traffic, price and mix trends as it relates to Capital Grille?
We are experiencing a broad based sales improvement across all geographies and in our central business districts and our suburban areas. We are experiencing larger gains on Monday through Thursday night primarily being driven by business entertainment. We are experiencing from a guest count standpoint our guest counts are growing. We are still seeing a little bit of negative check in the Capital Grille business. That is primarily being driven by lower wine expenditures. We are seeing a little bit of trade down there. Not a whole lot in food but more in alcohol.
The next question comes from the line of John Glass - Morgan Stanley.
John Glass - Morgan Stanley
First on the [breakage] question. I presume this is due to the fact that consumers during the recession go through their desk drawers, pull out the old gift certificates or gift cards, use them at a greater frequency. Could you talk about has that been a benefit to comp in the last couple of quarters? Is it meaningful? Can you talk about this must have a detriment to margins as you are lowering revenue without taking any offsetting cost reductions?
I think you said it pretty good. I think what we are seeing right now is consumers are going through their drawers and finding all the old gift cards and everything they can for our businesses and probably others. We have seen a pattern that has changed as we do with any of our accounts where there is a [fair amount estimated to] have routinely go through to assess those. We have seen that redemption rate has gone up. I think you are correct it has been one of the things that has helped our sales as well. We have strong brands. You can use these cards at over 1,800 different restaurants. I think it has been a little bit of a plus to our same restaurant sales performance. I would say in the magnitude of things it is really hard to measure that. It is not that significant of a number there.
What I would say is as you do pick up on nuance there our margins are a little bit stronger than the published reports would indicate because this is treated as a sales deduction. So I think that number is maybe 40-50 basis points better than reported numbers show. That would appear a little bit on every line item of the P&L. So the individual line it is not significant. I do think it has helped us bring more guests into our restaurants.
John Glass - Morgan Stanley
You mentioned a goal for new peak margins and internal thoughts and I am sorry if you mentioned this and I have forgotten but have you talked about what you think those new peak margins are? What the order of magnitude you are going to pick up in this new cycle?
I would go back to our business model we talked about in February. We continue to strengthen that. I think the more we can drive through same restaurant performance, AUV’s in our restaurants is the highest returning and biggest margin building sales growth we have. Historically if you go back a few years ago that is how we were driving most of our business and we didn’t have high unit growth vis a vie the industry. Now we have a model that is a much better mix between same restaurant sales growth and unit growth. So I think the value possible if you will is looking at those two components and seeing how you can grow your business between those measures.
Also we have talked about the transformative cost initiatives we have out there. Those to the degree we don’t incur an increasing cost environment can be converted to lower pricing which could help drive unit volumes and/or some combination of improving margins and driving earnings that way in addition to growing average unit volumes.
John Glass - Morgan Stanley
Prior peak though was 10.3%. Do you think you can exceed that?
The next question comes from the line of Brad Luddington - Keybanc Capital Markets.
Brad Luddington - Keybanc Capital Markets
I did want to see…one less week of lent in this quarter. Maybe two less actually I think. Should that have some significant impact on Red Lobster and alternatively maybe on Capital Grille and Longhorn as well on same store sales?
It is a very meaningful impact for Red Lobster in the quarter and I think in the press release if you look at February we detailed that a little bit. It is a little bit of a drag on Longhorn’s performance although pretty insignificant. Really we don’t measure much of an impact on Capital Grille but to your point those impacts net/net helped the third quarter a little bit and then hurts the fourth quarter a little bit particularly with the strong results Red Lobster has had with their Lobsterfest promotion.
Brad Luddington - Keybanc Capital Markets
To follow-up on international development in the coming years. Have you given any color on which brands will be focused on for international development?
We have not talked about it publicly but it is safe to say the large brands will be probably the bulk of the focus.
The next question comes from the line of David Tarantino - Robert W. Baird.
David Tarantino - Robert W. Baird
A question on the pricing strategy at least here in the near-term. What are your thoughts as it relates to taking pricing in this environment and what might you take as you start to cycle some of the increases you made in spring and summer of last year?
We have talked in the past about the fact that when it comes to pricing the thing we try to do is be as consistent as we can. When we see short-term spikes or declines in cost we tend to absorb the spikes and benefit from the decline and not move the pricing around a lot because as you look over the long term 2-3% is where we tend to be. Occasionally we might get below that or slightly above it but in that 2-3% range. We are obviously more toward the bottom of that through a more affordability sensitive period like that. We are at the bottom of that range given what has happened in commodity costs inflation and inflation in general to help build margins. But we absorbed some inflation that was above that range coming into this recession and took a little bit of a margin hit. So it all nets out I think over the long term is how we think about it.
One follow-up, while it has helped build margins we are very conscious of value perception and usage across all demographic groups and the value ratings have remained very strong.
The next question comes from the line of Joseph Buckley - Banc of America.
Joseph Buckley - Banc of America
I want to ask a follow-up on the implicit fourth quarter sales guidance. I just want to confirm that basically you are looking for comps to be down about 2% in the fourth quarter. Just kind of curious if there are any nuances around that in terms of when pricing might be running a little off or even in the year-over-year comparison with the 14-week quarter from a year ago. Any wrinkles beyond the obvious Easter Lent shift that we should be thinking about?
I would say 2% sounds a little heavy. I think we are lighter than that. Probably more like 1%. There are a few wrinkles having to do with the extra week that technically put pressure on the comp. I guess I will let Brad try to walk you through that wrinkle.
Basically the 53rd week last year that traditional last week of the fiscal year is a weaker and lower volume weak so we have excluded last year. We are comparing the same 13 weeks that last year’s results were reflecting. This year we moved that 13th week or that weaker week back into our quarterly computation. So it is some of the impact. It is really not too dramatic though. It does put more downward pressure.
I think more when I look at it and then at the fourth quarter we are wrapping on much stronger comparisons to last year in the fourth quarter than we were in the second quarter. We had the Red Lobster Lobsterfest promotion has moved two weeks out of the fourth quarter and into the third. Then to go back to Clarence’s earlier comments about just looking at where the industry is, where the consumers are we do expect it to improve modestly. We expect we will outperform the industry performance but we also look at a consumer that is still in a fragile state right now and we need to continue to see their household economics strengthen. We need to see more employment as well to really drive the industry and our business.
A last comment, I would reiterate one of the things I said earlier which is that is a look at the entire quarter. It is not a comment on quarter to date. Right? So we are forecasting what we think the quarter may be based upon the two unknown months as opposed to the known months. So it really reflects a perspective the environment remains fragile as opposed to anything we are seeing in the business currently.
Joseph Buckley - Banc of America
A question on gift cards as well. The change in redemptions was it more based around gift cards you sold this year during the holiday period or was it more people finding the gift card in the drawer? Then if you would just give the year-over-year comparison for gift card sales in the February quarter.
Gift cards, a lot of those redeem fairly quickly within the first 90 days. Maybe 70% or so of those. You would be surprised. They have a very long development period that we have a lot of activity on these cards into the second year and even past the second year. So you do have to look at a fairly long development period. It does reflect what has been happening recently but you have to look at longer periods to do that. I think consumers are digging pretty deep in that.
I think the other thing we see is our sales of these through third parties. Those sales channels we have had meaningful increases over the past couple of years in those sales channels. Those cards typically have a slightly higher redemption rate if you would than what we sell in our restaurants.
In terms of our overall performance on our gift card sales we really don’t get into the details of that. We have been very pleased with the program we have had for a number of years. We have had meaningful increases in that. It helps drive sales right after typically the Christmas holiday season period there that we find beneficial. We see that also helps expose more consumers to our brand. They get these as a gift and they come in. I think we have seen a lot of that benefit in this particular quarter with Longhorn. They now were able to use the Darden network so we got a lot more of their cards out there for consumers to see. I think that is one of the advantages of the acquisition beyond the cost synergies we have talked about to help them grow their total sales base as well. So we are pretty pleased with all of that.
The next question comes from the line of Larry Miller – RBC Capital.
Larry Miller – RBC Capital
Two quick follow-ups on that peak margin discussion. Do you need to see G&A and labor leverage to run at that peak? Also what kind of comp would you need to see to run that north of 10.3% margin?
I would say on the G&A line we actually invest in trying to get more cost efficient. So a lot of the investments show up on the G&A line the benefit of those investments may show up on other lines; labor, food, marketing, all of those things. So the G&A line is probably not the appropriate way to look at leverage because again those investments take place there, the benefits come in all the other places. I don’t know if that is one I would focus as much attention on.
I would agree with Clarence there because we do make at different times meaningful investments there to help drive the high average unit volumes that our brands enjoy and help avoid some of the costs that come along. But if you look at new unit growth that leverages our support structure that we have here so we do get some leverage on that part of our G&A. As Clarence said we invest at different times for different initiatives.
Same restaurant sales in our existing restaurants meaningfully leverage all of the lines on our P&L that we have there. So to your point, you do expect to see a bit of leveraging on virtually all the lines. Very little though on cost of sales and year-over-year and quarter-over-quarter it may vary on what we are doing on G&A. You see most of the leverage coming though in the restaurant expense, depreciation and restaurant labor.
I think the last part of your question about same restaurant sales and what does it take to grow our margins, obviously you can look at the recent history or this year and see that we are growing those margins pretty significantly on a down traffic and down sales. I don’t think that is a longer term norm but we have made really meaningful progress on our business model here. I think historically we have said we needed close to 2% same restaurant sales to maintain our margins. I would say by looking at where we are today somewhere in the low 1% range is all it would take in a normalized environment to maintain our margins. Anything above that you would add to our margins and accelerated earnings growth.
When we look at that long-term target we talk about 2-4%. That 2-4% would build margins and push us to new levels which we would expect. So we look at margin growth annually on a normalized basis depending on where we are investing of 20-50 basis points a year. That is what we tend to be in.
The next question comes from the line of Robert Derrington – Morgan Keegan.
Robert Derrington – Morgan Keegan
A quick follow-up on the gift card piece for a second. I assume this adjustment in this past quarter for the gift card redemption I think you said it was worth 40-50 basis points if you X that out. Is it reasonable we shouldn’t expect to see another adjustment in that redemption as we go forward?
I would say first we always review this but I think we have seen a meaningful change in the consumer’s behavior. We have seen our sales channel mix grow more in certain areas. So barring major changes from those I think we have everything adjusted that we need to and wouldn’t expect any future adjustments. I would say we are always looking at this and should consumer patterns or behaviors change that might be there but it is not anything that I would anticipate. We believe the entire gift cards we have outstanding we have adjusted for those.
Robert Derrington – Morgan Keegan
If we look at the depreciation line it was up at about 9.7%, considerably higher than revenue and a higher increase year-over-year than some of the prior quarters, can you kind of walk us through what is going on in that depreciation line and how that has affected the remodel program? Are we going to benefit from the remodel program in other lines and increased sales?
I think this is more reflective of a year’s worth of same restaurant sales challenge there. Average unit volumes were down a little bit. When we look at the programs we modeled our new restaurants we are very pleased with where they are. I think it is just a result of the sales leveraging impact that is going on there. Nothing else particularly that is driving that. You have to remember that many of the units coming online recently were units that were in the works 1.5-2 years ago so they do have a little bit higher investment base there than what we have with units going forward. So that is a bit of pressure on that line. There is nothing else significant or meaningful that is going on there.
The next question comes from the line of Keith Seigner - Credit Suisse.
Keith Seigner - Credit Suisse
On Longhorn, obviously traffic improved a lot this quarter but so did mix. I was wondering given you still have somewhat of a value promotion in place for part of the quarter where did the mix improvement come from? Was it just an easier competitive environment with less promotions? Was it lapping initial value offers from last year? Did the gift card push at Longhorn actually help to drive a little bit higher mix? If you could help us on that it would be helpful. The second question is you mentioned marketing was up in the quarter but it wasn’t up at Longhorn so I was wondering if you could tell us maybe where the increase in the spending in the quarter was located?
On the first part of the Longhorn question, we think the mix change is really being driven primarily by higher interest in our new Signature Dishes. So the stuffed filets in particular the crab stuffed filet over the holidays were more popular than the new dishes we had last year. That is what I meant by the culinary team and marketing team gaining traction on developing popular new dishes that are compelling and then just a higher percentage of people buying that.
What was your second question?
Keith Seigner - Credit Suisse
About the marketing spend being up but not up at Longhorn so wondering where the increase was located.
We didn’t increase our advertising dollars at Longhorn but the marketing as a percent of sales was up and I think they had one extra week of TV during the quarter. They had more points.
The next question comes from the line of Steve Anderson – MKM Partners.
Steve Anderson – MKM Partners
Maintenance is initial [inaudible]. Do you have any guidance on full year interest expenses?
We haven’t really detailed that particular line item out. It is more incorporated in our overall guidance. We are enjoying a very strong cash flow. We ended the quarter with no draw against our revolvers so all we have out there is our bonds. That is definitely helping our interest expense on a year-over-year basis. That is probably about all of the detail on that particular line item.
The next question comes from the line of Tom Forte – Telsey Advisory Group.
Tom Forte – Telsey Advisory Group
With the improving environment for casual dining and having a large number of brands you are adding units on I was wondering if you could take a moment to talk about the real estate environment if you are seeing any change in rents or tenant improvement allowances and things of that nature?
We have seen a shift in the real estate environment in a couple of areas. Maybe the most important is that our brands are able to secure higher quality sites than they might have been able to in the past for a variety of reasons. One, our brands are broadly appealing. They attract a lot of traffic. They are very differentiated. Second, the financial strength of Darden is obviously appealing in this environment. So one meaningful trend is being able to access higher quality sites which is a great thing long-term.
Second, we have seen across the country building costs come down about 10%. Even though there are very few new developments to be constructed now because of all of the challenges with existing tenants. We are seeing rents come down also probably more in the 5% range.
We would like to thank everybody for joining us on the call this morning. We appreciate your interest in the story here at Darden Restaurants. We look forward to speaking with you again in June. If you have any further questions please get a hold of us here in Orlando. Thank you and have a great day.
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