Darden Restaurants F2Q07 (Qtr End 11/26/06) Earnings Call Transcript

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 |  About: Darden Restaurants, Inc. (DRI)
by: SA Transcripts

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Darden Restaurants second quarter earnings release. For the conference today, all the participant lines will be in a listen-only mode. However, there will be an opportunity for your questions and instructions will be given at that time.

(Operator Instructions)

I would now like to turn the conference over to the Vice President, Investor Relations, Mr. Matthew Stroud. Please go ahead.

Matthew Stroud

Thank you, John. Good morning, everybody. With me today are Clarence Otis, Darden’s Chairman and CEO; Drew Madsen, Darden’s President and Chief Operating Officer; and Brad Richmond, Darden’s CFO. We welcome those of you joining us by telephone or on 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 and 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. 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 Smoky 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 statements made by or on behalf of the company.

A copy of our press release announcing our earnings, the 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 December 2007 during the week beginning January 1st. We plan to release same restaurant sales results for fiscal January 2007 during the week beginning January 29th. We plan to release fiscal 2007 third quarter earnings and same restaurant sales for the fiscal February 2007 on Tuesday, March 20, after the market close.

We are holding an analyst meeting on January 11 and 12, 2007 in Orlando. If you have not signed up yet, please do so by contacting us as soon as possible.

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

Second quarter net earnings were $61.6 million, and diluted net EPS was $0.41. This represents a 17% 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 approximately $0.02, or six percentage points of growth in the second quarter. Absent the adoption of SFAS-123R, diluted net earnings per share grew 23% in the second quarter.

Olive Garden had a competitively superior quarter, with solid sales and operating profit growth.

Red Lobster also had a competitively superior quarter with solid sales and operating profit growth. These results represent new second quarter records for sales and operating profit at Red Lobster.

Bahama Breeze had modest sales growth during the quarter, but solid operating profit growth as they continued to strengthen their business model.

Smoky Bones continues to have some challenges, but the team remains focused on making the brand more appealing for a broader range of dining occasions, and they took another step this quarter to reposition the brand.

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

Brad Richmond

Thank you, Matthew, and good morning. Darden’s total sales increased 4.5% in the second quarter to $1.39 billion, driven by same-restaurant sales growth at Olive Garden and Red Lobster, and our operation of 45 more restaurants than in the second quarter of the prior year.

To give you some context, industry same-restaurant sales, as measured by Knapp-Track, and excluding Darden, were down approximately 1% for the quarter.

Olive Garden’s same-restaurant sales were up 2.9% for the quarter, its 49th consecutive quarter of same-restaurant sales growth, and its total sales increased 7.1%.

Red Lobster had a same-restaurant sales increase of 0.7% for the quarter, and a total sales increase of 1.4%.

Same-restaurant sales at Bahama Breeze increased 1/10 of a percent for the quarter, as did total sales. This represents the fifth consecutive quarter of same-restaurant sales growth at Bahama Breeze.

Smoky Bones had a same-restaurant sales decrease of 5% for the quarter, while total sales increased 5% with the addition of 12 net new restaurants.

Let’s turn to margin analysis for the second quarter. Operating profit margins were five basis points lower than last year on a percentage of sales basis, including the impact of SFAS-123R. Excluding this impact, operating profit margins would have increased 32 basis points over the prior year.

Food and beverage expenses were 18 basis points lower than last year on a percentage of sales basis, primarily because of savings on commodities at Olive Garden and Red Lobster.

Second quarter labor expenses were 44 basis points higher than last year on a percentage of sales basis due to wage rate inflation and FICA tips on additional reported tips. Absent the FICA taxes on tips, which we receive in offsetting income tax credit, labor expenses were approximately 25 basis points higher than last year. FICA taxes on additional reported tips is recognized as a restaurant labor expense and increased that line item as a percentage of sales by 20 basis points in the second quarter.

A corresponding tax credit equal to approximately 130 basis points on the effective tax rate is recorded, fully offsetting the higher restaurant labor and leaving net margins unchanged. This will occur again in the third quarter, and begin to lessen in the fourth quarter as we begin to wrap on the higher tip reporting in the fourth quarter of last year.

Restaurant expenses in the quarter were 46 basis points lower than last year on a percentage of sales basis, primarily because of reduced workers’ compensation expense and lower pre-opening expense due to nine fewer new restaurant openings.

Selling, general and administrative expenses were 30 basis points higher as a percentage of sales for the second quarter. This increase was due entirely to the adoption of SFAS-123R.

Our tax rate was lower than the second quarter of last year due to an increase in the amount of FICA tip credits on higher reported tips that I mentioned earlier and the resolution of prior year tax matters.

Our year-to-date tax rate of 30.6% is in line with our annual guidance of 31%. Current tax accounting requires recording within the quarter any new developments to income taxes. In the past, these adjustments were made to the annual provision and smoothed in over the current and remaining quarters. The first quarter reflected such an adjustment, resulting in a higher tax rate of 32.2%.

We continued the repurchase of shares in the quarter, buying back 1.6 million shares of our common stock, leaving 25.9 million shares remaining in our current authorization to repurchase shares.

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%. We anticipate that the second-half of the year will be at the upper end of this range. We still expect a net new restaurant increase of approximately 40 restaurants, putting total sales growth for the year in the range of 5% to 6%.

We continue to anticipate that diluted net EPS growth will be 10% to 12% in fiscal 2007. This includes the adoption of SFAS-123R on a modified perspective basis in the first quarter of this fiscal year, which reduces anticipated diluted net EPS growth by approximately 4 percentage points.

Excluding the effect of adopting SFAS-123R, this translates into diluted net EPS growth of 14% to 16% in fiscal 2007, based on fiscal 2006 diluted net EPS of $2.16.

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

Andrew H. Madsen

Well, we were certainly pleased with the operating performance our teams delivered in the second quarter, as well as the progress achieved on the strategic priorities that will drive our future success. Let’s start with a look at Olive Garden.

Olive Garden had another strong quarter, delivering competitively superior sales growth and solid operating profit growth while maintaining excellent returns. Now, their same-restaurant sales growth of 2.9% during the second quarter was approximately 4 percentage points stronger than the Knapp-Track estimate for casual dining chains excluding Darden concepts. When you combine that with revenue from 27 net new restaurants, total sales at Olive Garden grew 7.1%. We would expect to see a similarly balanced approach to growth from both new units and same-restaurant sales going forward.

This competitively superior sales performance at Olive Garden has been driven by a combination of strongest loyalty, industry-leading value, and compelling news. The ability of their restaurant team to consistently deliver a competitively superior guest experience over time has helped make Olive Garden a trusted brand with very strong guest loyalty, and guest satisfaction remains strong during the second quarter this year.

On the advertising side, Olive Garden began the second quarter with their very successful, Never-Ending Pasta Bowl, priced at $7.95. This is certainly a guest favorite. It features choice and variety and the brand spirit of Italian generosity. The Never-Ending Pasta Bowl was followed by a promotion with two new dishes, Chicken Roma and Asiago Chicken, that have been well-received by guests and are still available through the holidays, so if you hurry, you can still try those dishes at an Olive Garden near you.

As we have discussed previously, Olive Garden is focused on accelerating new restaurant growth while maintaining same restaurant excellence. They have developed and successfully opened three new Tuscan farmhouse prototypes. They have established a strong pipeline of new restaurant sites as well, so as a result, Olive Garden is well-positioned to open 30 to 35 net new restaurants during fiscal 2007, nearly double what they achieved last fiscal year.

Importantly, their new restaurants on average are exceeding hurtle rate guest counts, sales, and returns. Olive Garden’s strong business fundamentals, combined with accelerated new unit openings, give us great confidence in their ability to maintain solid sales and earnings growth for the remainder of fiscal 2007.

Red Lobster same-restaurant sales for the second quarter of plus 0.7% exceeded the Knapp-Track estimate of minus 1% for competitive casual dining chains, although it was somewhat below our expectation.

For most of the second quarter, Red Lobster featured their signature Endless Shrimp promotion. This is a proven promotional concept that offers their guests both variety and value. We ran the same event in the prior-year period. Going forward, this will be even more effective with stronger product news than was advertised this year.

Red Lobster is currently featuring their Big Seafood promotion. You may recall that this event was very successful for us during the first quarter last year. It features distinctive items like Rock Lobster Tails, King Crab Legs, and this year, a new Jumbo Garlic Shrimp Scampi. This is a seasonally appropriate promotion at a time when guests are looking for something special and it is off to a great start so far this month.

In addition, I should note that Red Lobster has built a very strong culinary team and has fully implemented our discipline promotion development process, putting them in a position to feature compelling food news in the majority of their future promotions.

Stepping back from the current quarter, our plan to achieve sustainable growth at Red Lobster has three phases. The first phase was to strengthen business fundamentals. The second phase is to refresh the brand, broaden its appeal, and further build guest counts. The third phase will be to increase new unit growth.

Phase one is largely complete. In particular, the team at Red Lobster has made significant progress over the last two years improving guest satisfaction and restaurant level profit margins to their highest levels in more than a decade, and both of those fundamentals improved further during the second quarter.

Phase two began in October. The primary objective of this phase is to accelerate guest count growth by addressing the outdated brand image Red Lobster has with many lapsed users and the perception that it serves primarily frozen seafood. In late October, Red Lobster introduced a new menu design, new menu copy, and several new menu items. In addition, they introduced today’s fresh fish sheets. Now, these sheets are printed twice daily in each restaurant and showcase five to seven fresh fish choices, along with several preparation styles and signature chef specials.

These changes have been enthusiastically received by our guests and clearly reinforce that Red Lobster offers high-quality fresh seafood in a variety of exciting new dishes.

Additional initiatives to refresh the Red Lobster brand will be introduced later this fiscal year and during the first-half of next year. The team at Red Lobster is proud of their tremendous progress and we are confident that the business will continue to improve in fiscal 2007 and beyond.

During the second quarter, as Brad already mentioned, Bahama Breeze delivered their fifth consecutive quarter of same-restaurant sales growth but just as importantly, Bahama Breeze also continued to make significant progress on their two most important strategic priorities -- improving the guest experience and increasing restaurant level returns.

Guest satisfaction has improved enough over the last two years that Bahama Breeze now ranks near the top of casual dining in our research, and it will continue to get better as their teams focus on further improving their biggest opportunity areas -- attentive service and hot food.

At the same time, Bahama Breeze has been working to eliminate cost and complexity from their business model that does not add value to the guest experience, and these structural business model changes have meaningfully increased restaurant level profitability.

Also in the second quarter, Bahama Breeze introduced a new streamlined menu that remains very distinctive but has fewer items and can be executed more consistently. We believe this menu will continue to help build both guest satisfaction and restaurant level returns.

Now, based on all this progress, Bahama Breeze is now ready to restart modest new unit growth. They have approved one new site, which should open late in fiscal 2008, and are now working to establish a pipeline of additional sites.

Smoky Bones had another difficult quarter, with overall business dynamics similar to what we have discussed in the past. Their same-restaurant sales decline of minus 5% was significantly below the Knapp-Track chain average in total. However, there is still meaningful variation by region. For instance, restaurants in Florida, New England, and the mid-Atlantic have significantly higher average unit volume than the chain average and have outperformed the Knapp-Track average from a same-restaurant perspective.

Our strategy for Smoky Bones remains the same. We need to stabilize the existing base business, especially in regions of relative strength, while we work to transform the brand in a way that will broaden appeal and make it more relevant for more dining occasions. We said last quarter that we were about to test a new direction for the business that builds upon our existing assets, including good locations, a strong operations team, and a lodge setting that guests find extremely attractive, yet replaces the barbeque-centric parts of the brand that we believe are a barrier to greater occasion breadth and increased frequency.

Rocky River Grill House is the name of the restaurant testing this new direction, and the first Rocky River Grill House opened a few weeks ago in Cuyahoga Falls, Ohio. We describe Rocky River Grill House as a casual restaurant with the getaway spirit of the great outdoors, specializing in a variety of fire-grilled favorites.

The interior of the restaurant plays off the exterior lodge promise, with comfortable seating, warm lighting, prominent fireplaces and some natural rock décor. There are no televisions in the dining room and only a couple of televisions at the bar.

The menu is what you would expect to find in this type of environment, including a variety of fire-grilled steaks, fish and chicken dishes that are differentiated with bold, fresh flavors, and yes, Rocky River Grill House has barbequed ribs.

The service is designed to be friendly and attentive in keeping with the atmosphere in cuisine. We are pleased that sales have been strong the first few weeks. However, we also realize that we have much to learn and much more work to do. We will provide a more thorough briefing on Rocky River Grill House at our analyst day in January, including our thoughts about future testing, but are not prepared to elaborate further today. Clarence.

Clarence Otis

Thanks, Drew. With the end of the second quarter, obviously we are through the first-half of our fiscal year. When we step back and look at it, we are very pleased with where we are. We are achieving industry-leading performance. That is certainly reflected in the 17% diluted net earnings per share growth we had in the second quarter after the adoption of FAS-123R, and the 23% growth that we had in the quarter excluding the adoption of FAS-123R. We have done that in an industry environment that has been challenging.

We also feel good that even as we do what is necessary to successfully navigate through this environment, we are building the long-term strength of each of our brands. We believe the success that we are having is because of our proven approach to business, and that is an approach that, as we have said before, is anchored in combining strong brand management and great operations. Guided by that approach, we are confident that we are working on the right things at each of our brands.

But what ultimately drives our ability to create sustainable, leadership level value for our shareholders is having great people. That continues to be what we are really proud of. We are proud of our results, but we are even prouder of the outstanding people we have in our restaurants, in our restaurant support center who are delivering those results. That continues to be our number one priority -- attracting, retaining, developing and inspiring great people. We believe with that, we will continue to be successful regardless of the environment.

Now we are prepared to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions)

First, we will go to John Glass with CIBC. Please go ahead.

John Glass - CIBC World Markets Corp.

Thanks, good morning. Could you talk a little bit about minimum wage pressure in ’07? I guess both just framing it in the context of your current labor pressures and maybe what you expect in ’07 from the current minimum wage increases and tip credit increases that you have seen, and maybe what the result would be if the federal government were to take action on minimum wage.

Clarence Otis

I will start and then hand it off to Brad for more quantitative. I would say that minimum wage pressure is something that we have been dealing with for the last several years. If you look at the states, and especially the larger states where we have the most restaurants, we have had action in Florida, we have had action in California, we have had action in Illinois, New Jersey, so it is not new.

I am not sure that the federal change is going to make a whole lot of difference to us. There are additional states that continue to come on board with increases, with some having tip credit and some not. We have been facing this pressure all along, even as we strengthen our margins over the last several years, and so we feel pretty good about our ability to continue to manage through it.

Brad, if you want to talk more specifically.

Brad Richmond

Just a couple of points to add to Clarence’s, is that the -- this is in the context of our fiscal year, so I would phrase that, which goes through May, that the increase that we are seeing with the latest round of state actions is approximately the same that we have had in the previous fiscal year, so they are not changing dramatically for us. They are generally in the range, for the company, of $0.05, maybe as high as $0.10, which is a range that we can reasonably price for without putting undue pressure on the check averages to our guests.

In terms of a federal minimum wage increase, it is really kind of hard to say right now exactly what they may do. I would point out though that for many of our employees, they are above that minimum wage rate so again, clearly it will have some impact, but the magnitude of it probably would will not be too significant for us to price for.

Clarence Otis

I will just clarify -- $0.05 to $0.10 per guest, Brad was referencing.

John Glass - CIBC World Markets Corp.

That was very helpful. Could you just elaborate on your rationale for suggesting comps should strengthen in the second-half? It sounds like the current promotion at Red Lobster is doing well. Is there any, other than easy comparisons, is there anything that guides you to the higher end of the range in the second-half?

Clarence Otis

Comparisons are never easy, from our perspective. It is always a battle to get them, but I will let Drew answer that question.

Andrew H. Madsen

I think we are going to benefit first from a lot of the great work that Red Lobster has already done with their simply great operating discipline and improving all the fundamentals, improving the guest experience. That will be further leveraged with a promotion pipeline that has been more rigorously tested with more compelling news going forward.

Operator

We will go to Mike Smith with Oppenheimer. Please go ahead.

Michael Smith - Oppenheimer & Co.

Good morning. You are going to increase the number of Olive Gardens that you are opening this year. Could you characterize where you are locating those, what kind of prototypes you are using, and what type of impact do you think that might have on same-store sales growth going forward?

Clarence Otis

As I said, we are opening 30 to 35 this year, net new restaurants. We are going really in a couple of different locations. We are filling in in existing markets with a smaller prototype and we are going to new markets, smaller markets that we have not yet been able to penetrate effectively. I guess we are pursuing a balanced approach from that regard.

All the new restaurants in total are exceeding their hurtle sales and guest counts in returns. Because we are filling in in some areas, the average unit volume is slightly lower than the chain average but still very strong and still value creating.

So far, we have not seen a lot of impact, but as we manage the business for accelerating total sales growth and accelerating operating profit growth at a return level that exceeds our cost of capital, we think that balanced approach, we would be willing to have slightly slower comp growth if that was the tradeoff.

I would say, given what Drew said, Mike, 35 restaurants or so, half of those in existing markets, we are not expecting any meaningful effect on a system as big as Olive Garden’s.

Michael Smith - Oppenheimer & Co.

Thank you. I guess my follow-up question would be to go to the other concept, Red Lobster, and see whether you could characterize what kind of success you have had with the fresh fish that you have introduced.

Clarence Otis

Well, it is a little early to characterize. It has been about a month, six weeks since it has been out, but I would say the objective again is to strengthen the brand image at Red Lobster, let people know that they have a variety of great fresh fish options prepared with culinary expertise.

In testing, it did help us strengthen that perception and over time, we think it is going to attract some lapsed users that will help us build guest counts overall, but it is a little too soon to reach that conclusion.

We are very excited about it. We think it is going to help Red Lobster a great deal, but it is a little early to declare victory with it, I would say.

Operator

Next, we will go to the line of Jeffery Bernstein with Lehman Brothers. Please go ahead.

Jeff Bernstein - Lehman Brothers

Thank you very much. Just a question on the broader consumer sentiment, just looking at Darden versus some of your more mature peers. Some of those peers have seen traffic trends much softer than Darden for an extended period. Darden has been more resilient, a bit more volatile over the past couple of quarters. I know you mentioned Red Lobster came in a little bit light recently. I just wonder if you could talk about your view of the traffic trends and what you are seeing when you dig into the granularity.

As a follow-on, it seems like the comp trends have been a little light lately. You seem more confident in the second-half of the year, but yet it seems like you tweaked down the overall top line revenue growth for the full year. I am just wondering if that is due to lower productivity from existing units or perhaps maybe comps coming in more at the lower end of the 2 to 4. Thank you.

Clarence Otis

I would just say, and I will ask for Drew’s spin on this, but as we look at the total industry, certainly we have seen sales growth come down, if you look over the last six to eight months compared to the 12 months before that but nevertheless, we still see sales growth. So the more visible chains are a little weaker than the total industry, I guess is our first thought, but nevertheless, the total industry has softened up a little bit. We do think that consumers over that six- to eight-month period have been more cautious and we have a lot of hypotheses.

We read some of the hypotheses from some of the folks who publish, and some of our thoughts are consistent with that, but we think we have a more cautious consumer, so we have been managing the business with that in mind and nevertheless, trying to make sure that we continue to do the things we need to do to strengthen these brands for the long term, because environments change. They come and they go and we do not want to do short-term things that affect long-term viability.

We still see vibrancy in casual dining. There are brand-specific issues, I think, as you look at some of the larger players in the industry that may make them look a little bit weaker than what we see when we look at the overall data.

Andrew H. Madsen

I would just add that casual dining inherently is a variety seeking category. When visits slow down somewhat, guests raise the bar on what they expect. They are going to go to the brands that they trust most.

I think the first thing that you have to look at is which brands have really demonstrated consistency and competitively superior guest experiences over many, many years that build that sort of loyalty, which is not something you can do very quickly in the short-term.

I think second, you have to stand out in this kind of environment and give people a special reason to come on top of that loyalty, which is why we focus and work so hard on having compelling news that offers a great value, but do it in a way, as Clarence said, that does not change what we stand for, does not change the brand positioning, does not change the promised experience you are going to get. It just gives people a new reason to come.

Clarence Otis

I think, as you talked about our sales outlook, I would say we have talked bout 2% to 4%. We still think that makes sense. The first-half of the year was a little lighter than we thought coming into the year. The environment is a little tougher, but we do think, as Drew said, that we have been doing some work to really strengthen our brands and we expect that to pay off, even in this environment, in the second-half of the year. So we continue to think 2% to 4% makes sense.

We have come down in that range, but primarily because the first-half was a little bit lighter than we would have anticipated, as we talked to you in June.

Operator

Next we will go to the line of Jason Whitmer with Cleveland Research. Please go ahead.

Jason Whitmer - Cleveland Research

Good morning. I wanted to get back to Red Lobster briefly, especially with your shift toward fresh and seemingly getting a little bit more sophisticated. Are you trying to make sure you are balancing your core users with the lapsed users? Do you think you can still drive incremental traffic into the restaurant base without alienating your base customer?

Clarence Otis

I agree with everything you just said. We have a $2.5 billion, slightly bigger, business at Red Lobster that we love. It is a very trusted brand. It dominates the seafood category. The guests that come today love Red Lobster and we are absolutely going to make sure that they continue to Red Lobster going forward.

The balance that we need to strike is maintaining an experience that is relevant for them while broadening appeal to some of the lapsed users who have stopped coming over time, because we are still 5% to 10% below even relatively recent highs in guest counts.

It was the same challenge Olive Garden faced in the late 1990s of continuing to offer an experience that their core guests love but over time gradually, through a variety of different actions, broadening appeal to people who hadn’t been there for a while. So it has to be done in a thoughtful way, in a disciplined way.

One of the earlier opportunities we believe we have is letting people know that Red Lobster has for quite some time offered a variety of high quality fresh fish that is prepared in a number of different fashions. We have been doing that for quite some time. We are just reminding people of that fact.

Red Lobster has also introduced some menu items that are a little more innovative and have a little bit different flavor profile than maybe some of the core items on their current menu, so we are going to evolve the business. We are not going to fundamentally change the business, for the reasons you mentioned.

Andrew H. Madsen

I would just add, because this is an important question. This goes to the heart of it. What we would expect to do and we saw this at Olive Garden, is as we broaden the appeal over at Lobster, we will make Red Lobster more exciting for their core guests. So sticking with menu for a moment, we think about a menu strategy, there are certainly the core favorites and those are the things our core guests order most of the time. But they are looking for variety, so if we can add around that additional things that are exciting and compelling, we would give core guests reason to come more often, even as we give lapsed users a reason to come again. That really is the strategy.

It starts with making sure that we can enrich the experience for core guests and as we do that, we will make it broadly appealing.

Jason Whitmer - Cleveland Research

My follow-up question is more on restaurant level profits, and maybe has something to do with potential investments needed down the road. Maybe you could talk to that, but overall, you had a really good run. Basically, this is the fourth consecutive year of increasing restaurant level profits and up about 150 basis points in sum, getting close to this 23% mark. Do you have a long-term goal on that? Do you think you are getting close to a peak? What is the right sales pace you need to get some leverage on a normalized basis?

Andrew H. Madsen

I would say that our long-term goal is to improve our margins every year. The reason why sales growth is so important is because in this business, we have a lot of fixed and semi-fixed costs, and those costs are inflating every year. We cannot simply price through to cover those costs, because one of the category benefits is really every day price accessibility.

So the way to mitigate that is really to grow sales and get the leverage, leverage those fixed and semi-fixed costs. We get more leverage out of same-restaurant sales growth but we also leverage a lot of our fixed and semi-fixed costs with new unit growth, and so both of those are playing to it and over time, we expect operating profit margins to improve.

We have a target for improvement. We will go into more detail on that in January. This year, we are probably above that long-term run-rate, but that long-term run-rate is an improvement, for sure.

On an operating company level, we do have a rough target of mid-teens, 14%, 15% at the restaurant level margin. Olive Garden, as we have told you in the past, is north of that. Red Lobster has achieved that and will continue to strengthen it as guest counts grow.

Operator

The next question is from the line of Jeff Omohundro with Wachovia. Please go ahead.

Jeff Omohundro - Wachovia Securities, Inc.

First, I wonder if maybe you could give us just a little bit more color on the Rocky River Grill House. In particular, if you see a shift in check average and the targeted consumer expected to frequent this versus Smoky Bones.

Clarence Otis

We would expect, just given the protein on the menu, that the check would be a little bit higher than Smoky Bones today. I do not know that the consumer is going to be substantially different, but the occasion for which they come could be different. We think Rocky River Grill House is going to be more broadly appealing for the core visits in casual dining, everyday meals with family, planned adult dinners, going to be used more frequently by the same types of guests who are coming to Smoky Bones today.

I think it is less a shift in the guest. I think it is more a shift in how they view the brand and how they use it in terms of occasion and frequency. It might be a little bit higher in check.

Andrew H. Madsen

I would say that is absolutely right, and we feel comfortable that the higher check is a good place to be, because the value ratings that we get out of Smoky Bones are quite high. The customer that is coming to Smoky Bones today at the margins skews a little bit higher income than Olive Garden and Red Lobster, so we feel pretty good about that.

Jeff Omohundro - Wachovia Securities, Inc.

Just one more question on the whole Olive Garden acceleration, just an update on the pipeline really as you are beginning to look out, I guess, into the next fiscal year, as it sounds like you are in good shape on this year.

Clarence Otis

Yes, as I said, this year is 30 to 35. We would expect that to increase some next year. We will talk more about that in a few months, but the pipeline for next fiscal year is already established. We feel very good about our ability to do that in fiscal 2008.

Operator

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

David Palmer - UBS

Good morning. You have done a really nice job of controlling costs over the last three years. I think your food costs are down about 200 basis points since ’03, and they look to be about the lowest in the industry. However, just looking at your G&A margin, that has not really budged too much lower, even after adjusting for options. Your guidance certainly implies some nice change to your sales curve in the second-half, so you seem optimistic.

But I am wondering -- if you were to go back to the type of same-store sales growth that we saw in this last quarter, the 1% to 2% blended type numbers, could you maybe deliver double-digit EPS growth anyway, perhaps with the help of overhead cost reductions or leverage on G&A that we really have not seen yet?

Clarence Otis

I would say a couple of things. First of all, we really look at the net operating profit margin improvement because we will invest, for example, on the G&A line to drive down the labor and food cost line, so we have a very we think competitively superior supply chain. A lot of those costs show up in G&A. A lot of the benefits show up in cogs and labor, the same thing with technology. So that is the first thought.

That said, we do think that we can continue to operate much more efficiently. We have a very strong restaurant support platform that we can leverage as we scale up, and so we would expect to see some margin improvement on that line, but we tend to look at the net margin improvement as opposed to individual lines.

Operator

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

Mark Wiltamuth - Morgan Stanley

Good morning. I wanted to ask some questions on Red Lobster. You indicated your phase three is to eventually move to restaurant growth. What are the milestones you are looking for to reach that level? Are you also contemplating some smaller prototypes, as you have done with Olive Garden?

Clarence Otis

The biggest milestone is for us to continue to improve guest satisfaction, really sustain guest count growth that will help increase average unit volume and take that restaurant level return even a little higher than the mid-teen range I was talking about, so that we have higher confidence that our new restaurants will be value creating. That is really the biggest milestones and that is why refreshing the brand, phase two, is so important, to broaden appeal to build guest counts.

Will we have more than one prototype? Probably. Probably a couple of different prototypes that reflect differing investment opportunities in different sized markets.

Mark Wiltamuth - Morgan Stanley

Switching over to the Rocky River Grill House, are you going to run a test for a period here before you decide to re-brand all the Smoky Bones, or are you already committed to re-branding the Smoky Bones? Just how much will that cost?

Clarence Otis

We will be talking about that a lot more January 11th and 12th at our analyst day, but we are going to test more than just one Rocky River Grill House before we make that kind of decision, and that will include remodeling some existing Smoky Bones units.

Operator

Our next question is from Rachael Rothman with Merrill Lynch. Please go ahead.

Rachael Rothman - Merrill Lynch

The share count during the quarter came in a bit higher than we had been thinking. Obviously with your pretty strong free cash flow, could you talk about what your priorities for allocating that are --

Clarence Otis

Rachael, you are breaking up. If you could get just a little bit closer to the microphone.

Rachael Rothman - Merrill Lynch

Sorry, apologies, can you hear? Is that any better?

Clarence Otis

Yes.

Rachael Rothman - Merrill Lynch

Okay, thanks. Could you just talk about your priorities for allocating your free cash flow going forward, given that you have pretty sustainable and substantial free cash flow?

Clarence Otis

I think we talked about really looking at the returns on the businesses, and so you see the acceleration in Olive Garden because the returns are quite strong -- strong enough to get us where we need to be despite the inflation that we are seeing on land costs and on construction steel. So we are accelerating Olive Garden.

Given the business model improvement at Bahama Breeze, we are looking to build that pipeline as well. Drew just talked about Red Lobster and some milestones that we still need to see to have incremental investment in new units at Red Lobster pay off at the level that is required, and then Smoky Bones is really a work in progress.

So in terms of our cash flow priorities, that is where they are right now on the new unit side. Really Olive Garden, Bahama Breeze, if we continue to get the kind of results that we are seeing very early out of Rocky River Grill House, then remodeling of some of the Smoky Bones will have significant return, so that would be something that we would be looking at.

Beyond that, we want to make sure that we have a capital structure that makes sense, so we feel like our leverage level today is where we need it to be, and to the extent we do not have opportunistic investment outside of our existing businesses, we would be looking to maintain that leverage level and we will do that by continuing to buy back stock.

Brad Richmond

I want to add just one additional point. When you are talking about the share repurchase, last year during the first-half of the year, we did increase our leveraging. That provided some additional share buy-back. Last year we purchased about 434 million of shares. This year our guidance is to purchase approximately the same amount as we go forward, so we expect to do that at this point.

Rachael Rothman - Merrill Lynch

Perfect. Just as a quick follow-up, that may be something that you are going to address at the meeting in January, but in past conference calls, you talked a little bit about the potential for an acquisition. Could you just prioritize that? Obviously after the growth in your existing business and your share repurchases, is that something that you are still considering at this time?

Clarence Otis

I think as we think about the mix of total sales growth going forward, we do think that we would like to see a higher percentage of that come from new restaurant growth. Given where our existing businesses are, acquiring an additional business would help that. That said, we are very return focused, so we need to have something that we think has long-term potential from a consumer perspective and that makes sense for our shareholders in terms of the price. So while we are constantly monitoring things and looking at them from a consumer perspective and really gauging strength, it is difficult to put a timeline on it, given the financial requirements.

But we are constantly doing a scan. That scan really focuses a great deal of attention on consumer appeal and durability and sustainability. I think beyond that, not a whole lot else to say.

Operator

Next we will go to Robert Derrington with Morgan Keegan. Please go ahead.

Robert Derrington - Morgan Keegan

Thank you. Clarence, if you could clarify something for me. As we look at the earnings per share growth that the company has had in the first several quarters of the year, clearly it has been competitively superior to many of your peers, and it has been averaging in that roughly 15%, 16% range in both Q1 and Q2, yet your earnings guidance for the year remains unchanged. That implies in an environment in which you expect sales to be more at the high-end of the range, the earnings per share looks to decelerate in the next several quarters. Can you reconcile that for me?

Clarence Otis

I will let Brad get into the numbers, but we have increased our earnings guidance for the year from what we outlined in June. We have also range-bound it, so I think we are pretty comfortable that it reflects our view of the business, so we are not seeing any deterioration in margins or anything like that, but we do have an environment that is choppy, so we need to have a range. That is I think pretty much our thinking.

Robert Derrington - Morgan Keegan

Great. Thank you.

Operator

We will go to Bryan Elliott with Raymond James. Please go ahead.

Bryan Elliott - Raymond James & Associates

Good morning. I wonder if you could help us get a sense of the magnitude of the benefits from the ending of the growth cycle at Smoky Bones, and obviously it has been some time for Bahama Breeze. I know there is a lot of pre-opening infrastructure costs and still in prior year numbers. If you could give us some sense of the magnitude of impact, and I believe it is all in the restaurant operating expense line, or mostly.

Brad Richmond

I think there are a couple of things to consider, and that is that one, while we are de-accelerating in Smoky Bones, we are accelerating in Olive Garden, that performance there, as well as we take the Smoky Bones business in a different direction there, there is the reinvestment there that we are incurring to launch that. On a year-to-year basis, it is going to be relatively comparable.

Bryan Elliott - Raymond James & Associates

In dollars, or percent?

Brad Richmond

Dollars.

Bryan Elliott - Raymond James & Associates

Okay. All right, that is helpful. Thank you.

Operator

Our next question is from Steven Kron with Goldman Sachs. Please go ahead.

Steven Kron - Goldman Sachs & Co.

Thanks, good morning. A couple of questions. First, as we look at the margins by brand, as your press release reads, it looks as though Olive Garden restaurant level margins seemed to decline, despite a 2.9% same-store sales increase. At the same time, Red Lobster margins, it seems like it gained with only a 0.7% same-store sales increase.

With that as a backdrop, could you just talk a little bit about what surprised you this quarter? Why margins may have declined at Olive Garden? I think in prior calls you have talked about being able to get the leverage, even at the unit level, I think, within the 2% to 4% range, so wondering whether that is food and beverage or specifically labor related that may not have trickled into the Red Lobster brand. That is my first question.

Andrew H. Madsen

To Olive Garden’s point there, part of it they have the acceleration of growth there. That is an additional cost that as they ramp that growth up on a year-to-year basis, it was a little bit of a drag on their performance.

On the Red Lobster side, without that growth and just the overall base business improvement that they are having on their sales increase, we were able to drive a higher percentage return on those sales.

Each concept has their own unique P&L in terms of other factors, workers’ comp, some of those, the benefit of that was not equal among the concepts, and so that drives some individual brand differences.

Steven Kron - Goldman Sachs & Co.

Without the acceleration of growth at Olive Garden, would you have seen margin expansion at Olive Garden, or were there other factors?

Andrew H. Madsen

We would have seen expansion in margin without the growth, yes.

Steven Kron - Goldman Sachs & Co.

Okay, secondly, Brad, just back on the minimum wage front. What percentage of the dollars that we see on the P&L on the labor line is affected by minimum wage or tip credit increases?

Brad Richmond

We may have to get back with you. What I would tell you though is that it is a very small percent that are at the minimum wage. The other point that enters into though in our business is what might happen to the tip credit rate. Our servers are basically all at that rate, and if that rate were to change, probably that would be more significant in terms of a dollar impact to us, but the actual minimum wage rate itself is not too significant.

Operator

We will next go to John Lawson with Tiburon Research Group. Please go ahead.

John Lawson - Tiburon Research Group

Thanks. You have seen a lot of improvement in your food and beverage expense the last few years. Since you have purchasing offices in foreign countries, I was wondering if you could help me understand what portion of that improvement may be currency related?

Clarence Otis

We use dollar contracts, so it really would be no impact to us.

John Lawson - Tiburon Research Group

Okay. Thanks.

Operator

We will go to Donald Trott with Jefferies and Company. Please go ahead.

Don Trott - Jefferies & Co.

Good morning. Actually, I tried to get out of queue and could not, but since I am here, you discussed before the allocation of capital between expansion of your physical facilities and share repurchases. Could you comment a little bit on how dividends fit in there? What is your ongoing dividend policy, your payout policy?

Clarence Otis

I will start it off, and we really have -- we are looking to pay a meaningful dividend in the whole context, and so our thinking is a dividend yield between 1% and 2%, essentially. We have adjusted upward, for example, recently because we had fallen below that range, but that is essentially the range that we have targeted. We constantly look at dividend policy to see are there reasons to adjust, but that is our current thinking.

Don Trott - Jefferies & Co.

Thank you.

Operator

We will next go to Paul Westra with Cowen and Company. Please go ahead.

Paul Westra - Cowen Securities Inc.

Thanks, good morning. I have a follow-up question on your promotional upcoming activity with Red Lobster. I know you do not want to share too much for competitive reasons, but I was wondering if you could add more color, specifically on the commodity cost outlook. Would that outlook maybe help lower or maybe increase the guest check or promotional price point?

Second, really on a grander scheme, I am curious about your comments about the competition, or at least your peers of the well-known brands are struggling and it seems like the competition therefore might be coming from the independents, and does that change your strategy? Has that ever happened in the past that you can recall?

Clarence Otis

I will take the second question first and let Brad answer the first one. I would say as we look at the industry numbers, chains continue to be very strong competitors, so we take a lot of visibility on the biggest national chains. But they are a small percentage of total chains, and we have increasingly strong chain competitors, so the chains, when you look at chains versus independents, continue to take share. That said, independents may be stable to declining slightly, but there is a lot of churn under that number and weaker independents get replaced with stronger independents, would be our view.

But the chains are still formidable and we pay attention to a lot of them. As I said, as part of the acquisition effort but also just as part of the competitive scan.

Paul Westra - Cowen Securities Inc.

So your earlier comments as a function of what may be that limited number of large brands and regional brands are still very strong?

Clarence Otis

I think when you look at the major, the most visible public company brands, you have the ones with the biggest systems are reporting numbers that we all see and they are not representative of total chains.

Brad Richmond

On your question on the commodities front, what I would say when you look at that for the Darden brands, we have enjoyed some fairly favorable costs so far this year, on a year-to-year comparative basis. For the products we buy, we are really not seeing too much of a change in that through the remainder of our fiscal year.

Andrew H. Madsen

As that relates to promotions, the commodity costs are relatively benign and it is not going to in any way artificially constrain what we would choose to do in the second-half of the year, from a promotions standpoint.

Paul Westra - Cowen Securities Inc.

We saw the guest check change in the first-half. It would not be too materially different in the second-half?

Clarence Otis

Well, there is tremendous seasonality and Lobsterfest, which is a very high check promotion, is part of the second-half, so I do not think the first-half/second-half difference this year is going to be much different than it has been in prior years.

Matthew Stroud

We have time for one more question.

Operator

That will be Mike Smith with Oppenheimer. Please go ahead.

Michael Smith - Oppenheimer & Co.

Well, going back to Smoky Bones, have you totally thrown away the idea that Smoky Bones could operate as a concept on its own? Considering the way I understood it, it was about two-thirds of those were what you would call successful units in terms of hitting the kind of returns you want, whereas one-third were not.

Andrew H. Madsen

I do not know that we put that fine a point on the percentages, Mike, but there are clearly regions that are performing significantly higher in a couple of the key metrics, average unit volume, same-restaurant sales, unit level economics, than the chain in total.

I think at this stage, we would say it is too early to say where we are going to net out, but we are going to be careful in evaluating the new direction with Rocky River Grill House in both restaurants that have above average performance today as a Smoky Bones, and in restaurants that have weaker performance today as a Smoky Bones. We are going to be more careful before we would convert the part of the chain that is working much better.

We will talk more about it as we learn more about Rocky River and go forward.

Michael Smith - Oppenheimer & Co.

Thank you.

Clarence Otis

We would like to thank all of you for joining us today on the call. If you have any further questions or additional follow-ups, please contact us here in Orlando, otherwise we wish you all a safe and happy holiday season, and we look forward to seeing many of you in a few weeks down here in Orlando for our analyst day. Thank you.

Operator

Ladies and gentlemen, this conference is available for replay. It starts today at 12:00 p.m. Eastern and will last until January 20, 2007 at midnight. You may access the replay at any time by dialing 1-800-475-6701, or 320-365-3844. The access code is 852564. Those numbers again, 1-800-475-6701, or 320-365-3844. The access code, 852564.

That does conclude your conference for today. Thank you for your participation. You may now disconnect.

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