An Argument for Going Long Darden Restaurants

Jan.26.11 | About: Darden Restaurants, (DRI)

Idea: Long Darden Restaurants (NYSE:DRI)

Market Cap/ Price ($): 6.54 bn/ 47.33

Target upside: 8-10% in next seven days, 13-14% in next couple of weeks with Investor day on Jan. 31 and Feb. 1 acting as catalyst. The company is likely to discuss current Same Restaurant Sales trends, which in our opinion reduce recent investment community concern over market share loss of its key restaurant brand Red Lobster.

Business Basic: Darden is the largest casual-dining restaurant company in the world, with FY10 revenues of over $7.1B. DRI's more than 1,800 restaurants are 100% company-owned and include three large brands: 727 Olive Garden restaurants, 694 Red Lobsters, and 334 LongHorn Steakhouse units. The company's smaller brands include Capital Grille, Bahama Breeze and Seasons 52.

Current Scenario: The stock price of Darden saw steep declines after it reported its earning on Dec. 20. The main reason for the decline was concern about the performance of its key brand, Red Lobster. Although Same Restaurant Sales (SRS) for the combined company was +1.4% for the quarter vs. +1% of Industry ex-Darden; Red Lobster brand SRS declined 1.6%, disappointing analyst and investors.

What is the market missing?

Much of the decline in Red Lobster’s SRS can be attributed to marketing mistakes for its Endless Shrimp promotion, although the problem was fixed promptly. Most of the damage occurred in the first two weeks of September and then things quickly came back on track once the mistake was fixed. Red Lobster SRS saw steep sequential increases from down 6.6 % (YoY) in September to up 1.8% (YoY) in October and November each.

What happened? The Endless Shrimp promotion was originally priced at $16.99 in approximately 1/3 of restaurants, and $15.99 in remaining restaurants. However, the price point of $15.99 was not advertised at all, which sent confusing messages to customers (who are still price-sensitive). In October the company established the price to $15.99 in all restaurants and featured that price point in advertising, something it had not done in the past. It also developed a new commercial with greater focus on the food and value message, which finally worked.

In addition to sequential increases in Red Lobster SRS, the company also mentioned on its Dec. 20 conference call that overall SRS for the combined company was trending positive in the month of December. This is a positive, given Knapp Track Industry SRS declined 0.8% in the month of December as it implies Darden’s out-performance within the industry increased in the month of December as compared to its last quarter. (Last Quarter’s SRS out-performance was 40 bps for the whole Fiscal Q2; December SRS was positive as compared to the industry's down 80 bps, implying at least 80 bps of out-performance in December. Of course we are extrapolating from management's comment on December trends.)

Furthermore, our channel checks suggest things have improved since the December earnings call. Exact details on December and January SRS on the investor day would lead to removal of the overhang on stock valuation.

Where can price go?

The company is currently trading at 13.5x forward PE, which is the least among casual dining peers. The stock is up 14% from September 2010 vs. S&P up 23%, with peers like Brinker International (NYSE:EAT) up 47% and Ruby Tuesday (NYSE:RT) up 51%. The stock is still down 6% from its $50.43 price on Dec. 20, while S&P and peer groups have advanced. We believe there is a good chance that the stock would be able to cover 1300-1400 bps under-performance since the Dec. start, as compared to S&P and peer groups. The majority of this recovery would come on Investor day, as some of the concerns on market share loss at Red Lobster abate.

Note: Current price and under-performance imply that the market is already pricing in most of the negatives for the stock. Knapp track down in December due to harsh weather and food inflation concerns are very well understood, and should not have any further negative impact on stock price unless something unexpected happens.

Also note that Darden’s fiscal year ends in May.

Disclosure: I am long DRI.

Additional disclosure: My clients are also long in DRI