Darden Restaurants F3Q07 (Qtr End 2/25/07) Earnings Call Transcript

| About: Darden Restaurants, (DRI)
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Darden Restaurants, Inc. (NYSE:DRI)

F3Q07 Earnings Call

March 21, 2007 8:30 am ET

Executives

Matthew Stroud - Investor Relations

Bradford Richmond - Chief Financial Officer, Senior Vice President

Andrew H. Madsen - President, Chief Operating Officer, Director

Clarence Otis - Chairman of the Board, Chief Executive Officer

Analysts

David Palmer - UBS

John Glass - CIBC World Markets

Joseph Buckley - Bear Stearns

Jeff Bernstein - Lehman Brothers

Jeff Omohundro - Wachovia Securities

Howard Penney - Prudential Equity Group

Tom Thomson - Thompson, Siegel & Walmsley

Rachael Rothman - Merrill Lynch

Glen Petraglia - Citigroup

Mark Wiltamuth - Morgan Stanley

Andy Barish - Banc of America Securities

Presentation

Operator

Ladies and gentlemen, thank you for standing by and welcome to the third quarter earnings release for Darden Restaurants. (Operator Instructions) I would now like to turn the conference over to Matthew Stroud. Please go ahead.

Matthew Stroud

Thank you, Mary. 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 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. These risks and uncertainties include the impact of intense competition, changing economic or business conditions, the price and availability of food, ingredients and utilities, labor and insurance costs, increased advertising and marketing costs, higher-than-anticipated costs to open or close restaurants, litigation, unfavorable publicity, a lack of suitable locations, government regulations, a failure to achieve growth objectives, weather conditions, risks associated with our plans to improve financial performance at Bahama Breeze and to reposition Smokey Bones, and other factors and uncertainties discussed in the company’s SEC filings.

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

A copy of our press release announcing our earnings, Form 8-K used to furbish 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 at our website, darden.com.

We plan to release same-restaurant sales results for fiscal March 2007 during the week beginning April 2nd. We plan to release same-restaurant sales results for fiscal April 2007 during the week beginning April 30th, and we plan to release fiscal 2007 fourth quarter and annual earnings and same-restaurant sales for fiscal May 2007 on Tuesday, June 19th, after the market close.

We released third quarter earnings yesterday afternoon. Results were available on PR Newswire, First Call, and other wire services.

Let’s begin by updating you on our third quarter earnings. Third quarter net earnings were $106.4 million and diluted net EPS was $0.72. This represents a 7% increase in diluted net earnings per share.

In the first quarter, the company adopted SFAS-123R on a modified perspective basis, which reduced diluted net earnings per share by $0.02, or 3 percentage points of growth in the third quarter. Absent the adoption of SFAS-123R, diluted net earnings per share grew 10% in the third quarter.

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

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

Bahama Breeze reported a solid quarter with total sales that were essentially flat and continue to make progress in strengthening their business model.

Smokey Bones continues to have its challenges but the team remains focused on making the brand more appealing for a broader range of dining occasions. As we announced last quarter, they are testing a new direction with Rocky River Grillhouse, and they have plans to convert two test restaurants in the fourth quarter.

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

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Bradford Richmond

Thank you, Matthew, and good morning. Darden's total sales increased 4.7% in the third quarter to $1.54 billion, driven by same-restaurant sales growth at Red Lobster and Olive Garden, and our operation of 38 more restaurants than in the third quarter of the prior year.

As a reference, industry same-restaurant sales, as measured by Knapp-Track and excluding Darden, were down approximately 1.6% for the quarter. Red Lobster though had a same-restaurant sales increase of 4.6% for the quarter and total sales increased 5%. Olive Garden’s same-restaurant sales were up 1% for the quarter, its 50th consecutive quarter of same-restaurant sales growth and its total sales increased 4.9%. Same-restaurant sales at Bahama Breeze fell 0.4% for the quarter, while total sales declined 0.6%. Smokey Bones had a same-restaurant sales decrease of 5.2% for the quarter and total sales fell 1.5%.

Now let’s turn to a margin analysis for the third quarter. Operating profit margins were 54 basis points lower than last year on a percentage of sales basis including the impact of SFAS-123R and the asset impairment. The asset impairment charge of $16.3 million, or $0.07 per diluted share, involved seven restaurants: one Red Lobster, one Smokey Bones, and five Bahama Breeze locations, as they strengthened their foundation and prepare for renewed growth. Excluding these impacts, operating profit margins would have increased 79 basis points over the prior year.

Food and beverage expenses were 12 basis points higher than last year on a percentage of sales basis, primarily because of menu mix related to the promotional calendars at Red Lobster and Olive Garden. The featured promotions in the third quarter were high-dollar offerings, meaning that total margin dollars per guest are higher but at a food and beverage cost percent higher than that sold last year.

Third quarter restaurant labor expenses were 25 basis points higher than last year as a percentage of sales due to wage inflation and FICA taxes on additional tip reporting. We received an offsetting income tax credit for the FICA taxes, which represented approximately 11 basis points of the increase. I will explain that in more detail in a moment. Absent the FICA taxes, labor expenses were approximately 14 basis points higher than last year.

Now, FICA taxes on the additional reported tips is recognized as restaurant labor expense and increased that line item as a percent of sales by 11 basis points in the third quarter. A corresponding tax credit equal to approximately 120 basis points on the effective tax rate was recorded, fully offsetting the higher restaurant labor and leaving margins unchanged from the increased FICA tax. The FICA tax effect will lessen in the next quarter as we begin to wrap on the higher tip reporting in the fourth quarter of last year.

Restaurant expenses in the quarter were 41 basis points lower than last year on a percentage of sales basis, primarily because of sales leveraging, reduced utility expense, and lower pre-opening expense due to having seven fewer new restaurant openings.

Selling, general and administrative expenses were 22 basis points higher as a percentage of sales for the third quarter. This increase was due to the adoption of SFAS-123R and the increase in marketing expenses associated with the start of Lobsterfest in the third quarter this year compared to the fourth quarter last year.

The effective tax rate for the third quarter of 22.8% was because of the resolution of tax matters expensed in prior years and increased FICA tip credits on the reported tips that I previously mentioned. For fiscal 2007, we are now estimating an effective tax rate of approximately 28%.

We continue the repurchase of shares in the quarter, buying back 4.3 million shares of our common stock, leaving 21.6 million shares remaining in our current authorization to repurchase shares.

For the full year, we now expect combined same-restaurant sales growth for Red Lobster and Olive Garden to be between 2% and 3%. We continue to expect to open about 40 new restaurants, combining the total sales growth for the year at approximately 5%.

We continue to anticipate that diluted net earnings per share 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 fiscal 2007, which reduces anticipated diluted net earnings per share growth by approximately four percentage points. Excluding the effect of adopting SFAS-123R, this translates into diluted net earnings per share growth of 14% to 16% in fiscal 2007, based on fiscal 2006 diluted net earnings per share of $2.16.

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

Andrew H. Madsen

Thank you, Brad. We are pleased with the operating performance our teams delivered in the third quarter, especially given the challenging environment, as well as the progress that they achieved on the strategic priorities that will drive our future success.

Now let me share a few highlights from each of our operating companies.

Red Lobster delivered strong same-restaurant sales growth in the third quarter of 4.6%, which as Brad already mentioned, significantly exceeded the Knapp-Track estimate of minus 1.6% for competitive casual dining chains.

During the third quarter, Red Lobster advertised two different promotions. Their Big Seafood Festival ran from late November until early January and featured distinctive items like roasted rock lobster tails, steamed king crab legs, and a new dish called Big Island Seafood Grill. This was a seasonally appropriate promotion that was offered when guests were looking for something special during the holidays. Their second promotion, Jumbo Shrimp, ran after the holidays and offered guests both variety and value, which was important following the holiday season.

Red Lobster is currently featuring their signature Lobsterfest promotion. This is a longstanding promotion. It started one week earlier than last year to better align with Lent. Their advertising features two new dishes, Chef’s Signature Lobsterfest Pasta and Margarita Lobster, Shrimp and Scallops.

As we have discussed before, 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 appeal and build guest counts. The third phase will be to increase new unit growth.

Phase one started approximately two years ago and has largely been completed. In particular, both guest satisfaction and restaurant level returns have improved significantly and provide a much stronger foundation to support future growth.

Phase two has begun. The primary objective of this phase is to accelerate guest count growth by addressing the outdated brand image Red Lobster has with some guests and the perception that it serves primarily frozen seafood. Phase two initiatives already taken include the successful introduction of today’s fresh fish sheets that are printed twice daily in every restaurant, and a redesigned core menu with more culinary forward copy. In addition, two new restaurants have been opened with our new design inspired by the Maine coast. Red Lobster also plans to begin the introduction of new plateware and related tabletop items starting in May.

These actions, plus continued improvement to their menu and advertising, will help position Red Lobster for phase three of their plan, accelerating new restaurant growth later in 2009.

We are certainly proud of the team at Red Lobster, given their tremendous progress and we are confident the business will continue to improve in fiscal 2007 and beyond.

Olive Garden had another good quarter, delivering competitively superior sales growth while maintaining strong returns. Their same-restaurant sales growth of 1% during the third quarter was almost three points stronger than the Knapp-Track estimate for casual dining chains excluding Darden concepts, and we are especially proud of their 50th consecutive quarter of same-restaurant sales growth. We think this is truly a remarkable accomplishment for a casual dining chain of their size.

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

On the advertising side, Olive Garden continued to feature distinctive new dishes that reinforced their strong value positioning and provided guests with compelling reasons to visit their restaurants. In December, they featured two new entrees, Chicken Roma and Asiago Chicken, that were well-received by their guests. This was followed in January by two additional new entrees, five-cheese stuffed rigatoni with either chicken or sausage, starting at $9.95.

Currently, Olive Garden is featuring their Alfredo promotion, which offers guests two new dishes to choose from; Steak and Portobello Mushroom Alfredo or Crab Alfredo Venicia.

As we have discussed previously, Olive Garden is focused on accelerating new restaurant growth while maintaining same restaurant excellence. To help do that, they have successfully developed three new Tuscan farmhouse prototypes and they have established a strong pipeline of new restaurant sites. As a result, Olive Garden is well-positioned to open approximately 35 net new restaurants during fiscal 2007 and they are planning to open approximately 40 net new restaurants in fiscal 2008.

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 2007 and beyond.

Bahama Breeze 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 restaurant 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. These structural business model changes have significantly increased restaurant level profitability. Based on this progress, Bahama Breeze is now ready to restart new unit growth. They have approved one new site which should open early in fiscal 2009 and are actively pursuing a pipeline of additional sites.

Smokey Bones had another difficult quarter, with overall business dynamics similar to what we have discussed with you in the past. Their same-restaurant sales decline of 5.2% was well below the Knapp-Track chain average in total. Our strategy for Smokey 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 told you last quarter about our test of a new direction for the business that builds upon our existing assets, and that includes 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 are a barrier to greater occasion breadth and increased frequency.

Rocky River Grillhouse opened in Cuyahoga Falls, Ohio, in November and thus far, sales have been strong and we are in the process of converting two existing Smokey Bones restaurants into Rocky River Grillhouse restaurants. The first of these four conversions opened Monday in a suburb of Indianapolis, and the second will open in April in a suburb of St. Louis. We anticipate converting several more Smokey Bones into Rocky River in fiscal 2008.

Now we are pleased that their sales have been strong in the first test location but we also realize we still have much to learn and much more work to do. We will update you on the progress of this test as appropriate going forward.

And, in a separate press release yesterday, we announced that Seasons 52 will begin the next phase of its development, which includes continuing to operate its seven existing restaurants with excellence and developing the real estate and talent pipelines for another three or so openings over the next two years.

We also announced the retirement of Blaine Sweatt, President of Darden's new business division and creator of many concepts here at Darden, including Olive Garden, Bahama Breeze, Smokey Bones and Seasons 52. In addition, we announced that Stephen Judge has joined Darden as President of Seasons 52.

Blaine has been an outstanding business and community leader for many years and we will certainly miss his insight and expertise at Darden. Stephen has earned a reputation as a very successful operator at high-end, innovative dining concepts in both luxury and high-growth hospitality venues. He comes to us most recently from MGM Grand Hotel, where he led all food and beverage operations. We look forward to his leadership at Seasons 52 as they begin their next stage of development. Clarence.

Clarence Otis

Thank you, Drew. I think it is no secret to most of you listening in that it has been a challenging last 12 months for the restaurant industry generally and for casual dining in particular. I think what excites us is we think we entered this period in very strong shape. We were working on the right things and that included operations excellence, really the fundamentals, and also further differentiating our brands, and we were doing that with very talented, very motivated people in our restaurants and here in the support center.

I think this quarter’s results to me affirm that we have been focused on the right things with the right people. Our same-restaurant sales results continue to be competitively superior. That has been driven by continued improvement in both guest satisfaction and brand image and we continue to do an excellent job of managing costs, which helps us deliver value to our guests. All of that led to strong earnings, about 7% including the stock option expense, up 10% excluding it.

We think we are in a very strong competitive position in a tough environment. I think what that means to us, being competitively strong in a tough environment, is that we have a great opportunity to really further separate ourselves and become the leader in casual dining. We are excited about that. We are excited about where our businesses are. We recognize that ultimately the reason for our success is having great people. Blaine epitomizes that. Drew talked about the transition Blaine is approaching. He has been a terrific leader for Darden, but more importantly really for the entire restaurant industry and our goal is to make sure that on a consistent basis, we can continue to develop people that have the kind of talent, the kind of leadership skills that Blaine so obviously embodies.

With that, we would be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions)

Our first question comes from the line of David Palmer with UBS Securities. Please go ahead.

David Palmer - UBS

Thanks. Good morning. At your analyst meeting, you did not seem all that optimistic about the near-term sales environment for the industry, particularly casual dining. That obviously seems to be the correct instinct. However, has your outlook really changed since then? Have you gotten darker on the outlook for the industry in particular? Is that shaping your views as to how you look out in the next one, two or three quarters?

Clarence Otis

I would say no, our view of where the industry is going to be has not changed. I think we have been, we have talked about industry, total casual dining sales growth in that 4% to 6% range. It has been closer to the bottom of that range the last couple of years than it has been to the top. We do not see a whole lot of change there.

We continue to think that 4% to 6% makes sense and we are hopeful that it will move up in that range but no, I would say no reason to have a point of view that is worse two months later. Drew, I don’t know if you have anything to add.

Andrew H. Madsen

I would just add that the reason we think that is because the fundamentals of the business, of the industry still remain strong. What guests are looking for in the industry, physical nourishment and emotional nourishment and the ability to capitalize on that is still the same.

Clarence Otis

I would say just in terms of due to frequency, I think the folks who have cut back the most -- I mean, that has happened. I do not see that accelerating going forward. They are where they are. I would expect them actually to increase frequency as things get a little bit better, so we feel pretty good about that forecast that we had just a couple of months ago.

David Palmer - UBS

Thanks very much.

Operator

Thank you. Our next question is from the line of John Glass with CIBC. Please go ahead.

John Glass - CIBC World Markets

Thanks. Good morning. Two questions; my first is I wanted to revisit the idea of recapitalization of some sort in the business, especially given your strong cash flows, your balance sheet and the stock valuation, and what at least three of your other mature casual dining peers are doing in some form or fashion. Is there anything in your view you could do from a capitalization standpoint that would, beyond the typical repurchase, that could enhance shareholder value today? Have you reexamined that issue recently?

Clarence Otis

Well, I think there are several things that go into our thinking as we think about capitalization. Certainly what does it take to make sure that we can continue to reinvest as appropriately in our current businesses. The other thing is as we sit here, in an environment which is presenting challenges to a lot of competitors, what kind of opportunities do we see out there to deploy capital to build the business by building it fundamentally, by bringing on additional brands, for example, that have strength, that drive growth.

We also think about, with all of that, where would our capitalization levels be appropriately put? We have raised our leverage level I would say over the last 12 months by a decent amount. Is there more room to do that? Well, we look at all those variables and we make judgments on a fairly ongoing basis. So all of those come into account. I do not know that we are going to do anything dramatic in the near-term. I think the opportunities that are out there are fairly significant.

John Glass - CIBC World Markets

Just to paraphrase what I think I heard you say, Clarence, is that you are saving the dry powder, if you will, for an acquisition, not a recapitalization?

Clarence Otis

I would say that we have increased our leverage level and we feel good about that because we think that we do have the strong cash flows that allow us to do that while still continuing to invest in the business and be in position to make opportunistic investments.

John Glass - CIBC World Markets

Just a follow-up, on Smokey Bones, if you were to change the concept over entirely, what kind of impairment are we looking at? How much have you impaired to date and how much remaining impairment or write-off would there be?

Clarence Otis

I think we do an impairment test every quarter, and so we feel good about the assets that we have at Smokey Bones and the value catcher that is capable with those assets, and our current balance sheet reflects that. We look at it quarter by quarter though, and we will continue to do that.

John Glass - CIBC World Markets

Thank you.

Operator

Thank you. Our next question is from the line of Joe Buckley with Bear Stearns. Please go ahead.

Joseph Buckley - Bear Stearns

Thank you. A question on the casual dining environment, why do you think it is so soft? It sounds like you think it has stabilized but I am curious if you see anything that could be an inflection point, either up or down, looking out over the next several months.

Clarence Otis

Joe, that is a good question. We have a lot of different theories and we really do a lot of analysis to try to see where those are. I think fundamentally, we do think disposal income growth is slower the last couple of years than it has been years prior to that. Some of it really has to do with fuel oil, both gasoline and heating oil prices. A lot of it has to do with mortgages. People have traded up in many cases in terms of houses and mortgages reflect that. I think the mortgages are also -- there are more adjustable rate mortgages so there is more volatility in that mortgage rate.

We do see the housing market stabilizing in the sense that the mortgages that are out there are out there. We do see interest rates flattening and so the resets are starting to stabilize as well. And then gasoline prices have been in a trading range. It has been a broad range but it has still been a range that people are starting to see as the new norm.

So those are some of the things that we have seen but we continue to investigate, explore and try to understand it.

Andrew H. Madsen

The one thing I would add to that is that we need to be careful not to generalize it by casual dining in total. Strong brands in strong segments of casual dining are still growing -- not growing as fast, perhaps, but still growing. Brands that are perhaps less distinctive or are not consistently delivering a guest experience, are not sufficiently differentiated are maybe having a more difficult time as the industry has slowed down. So it is not a universal phenomenon, I guess.

Joseph Buckley - Bear Stearns

One follow-up; there has been a lot of price point advertising just in the last few weeks by a number of your competitors. Do you see the competitive level intensifying as that occurs?

Clarence Otis

No, we think that we have seen a fair amount of price point promotion for a while now and it ultimately still comes down to what is the quality of that offer. It is not just about the price. It is about the product and the product broadly defined; the food offering, the dining experience that you are offering, and people sort through all of that. So price promotion alone does not make it happen. We have proved that to ourselves many times over our history, which is why we focus so much on the entire dining experience, on brand refresh, as Drew mentioned, for example, at Red Lobster.

Joseph Buckley - Bear Stearns

Thank you.

Operator

Thank you. Our next question is from the line of Jeff Bernstein from Lehman Brothers. Please go ahead.

Jeff Bernstein - Lehman Brothers

Great, thank you. Actually, just one follow-up question on that and then a separate question. In terms of the follow-up, I am just wondering what you guys are doing specifically at Darden to combat the recent pressures as in the prior question? I was not sure if you guys were focusing more on value offerings or perhaps some greater couponing yourself or some promotional advertising just in the near-term to offset some of the pressures, and then I have a follow-up. Thanks.

Andrew H. Madsen

I would say on that side, we continue to work hard to make sure we are balanced. So the quarter we just completed is one where you saw that balance. During the holiday season, we had offers that were a little bit more indulgent in terms of price point because that is the mood of that season. Following the holiday season, a little bit more focused on value, and so we try to really have a balanced calendar throughout the year. We will tweak it around the edges with how we advertise the offerings. So if we have a great offer that we think has a very compelling price point on it, sometimes we will emphasize that price point during a value-oriented overall environment, whereas we might not otherwise, and we will strategically use couponing. But the coupon cycle I think this year is pretty much on top of what we did last year. I do not think there are any changes.

Clarence Otis

No, specifically we have not increased our couponing or increased our price point at advertising.

Jeff Bernstein - Lehman Brothers

Great. I actually have just one other question in terms of food costs. I know you mentioned in your prepared remarks this quarter you did see some increase, higher costs at both brands, perhaps being driven by just mix shifts. I am just wondering if you are expecting further similar pressure going forward and if you could just talk about your outlook for your core commodities as we look through ’07. I didn’t know if we should expect further pressure, or perhaps that this quarter was more of an anomaly. Thanks.

Bradford Richmond

Yes, you are correct. Basically in this quarter what we saw was the promotional calendar that drove higher absolute margins and profits for us but as a percentage of sales basis was lower than the comparison to last year.

In terms of the outlook, really we are just talking about the fourth quarter and in June we will update you on our fiscal 2008, but over the course of the next quarter we really do not see any dramatic shifts from where we have been and continue to see some leveraging on that particular line item.

Clarence Otis

I would say that what you are seeing is really exclusively mix as opposed to any cost pressure. As Brad said, when we are selling more or higher priced items, the percentage cogs may go up but the dollar profitability on those items is significant, so we are pretty happy selling those.

Jeff Bernstein - Lehman Brothers

But just based on the things you had locked in at this point, you do not see any reason to believe you cannot get further leverage or see further favorable food costs going forward?

Bradford Richmond

We would really comment on that in June when we talk about the next year, but as we have said before, we have a fair amount of things locked up for varying periods of time. We will recast that for you when we get to June for fiscal 2008.

Jeff Bernstein - Lehman Brothers

Great. Thank you.

Operator

Thank you. Our next question is from the line of Jeff Omohundro from Wachovia. Please go ahead.

Jeff Omohundro - Wachovia Securities

Thanks. I wonder if you could elaborate a little bit on the impact of the fresh fish list at Red Lobster. How is the mix there tracking relative to your expectations? What impact is that having on check average and on this profit contribution versus margin issue?

Andrew H. Madsen

The primary impact of the today’s fresh fish program or the primary objective is to let guests know that Red Lobster features a variety of fresh fish species, up to six or seven in every restaurant across the country and if they are interested in fresh fish, then they can get it at Red Lobster. That is not something that is widely known.

Preference on fresh fish has increased modestly since it was introduced but it has not had a material impact on check or on margin. We think the big opportunity is to change how people think about Red Lobster and use the brand and over time, to see that expressed in the form of higher guest counts.

Jeff Omohundro - Wachovia Securities

My other question relates to Smokey Bones and how we should think about the strategy there. You mentioned that you are converting I think you said two more to Rocky River Grillhouse. Do you see a conversion strategy as the way to go or are there tweaks or learnings that you could take from Rocky River and just bring that over to Smokey Bones?

Andrew H. Madsen

We are going to be exploring both of those things. Our strategy to date to stabilize Smokey Bones has really focused on broadening menu variety to try and address the barbeque-centric nature of the menu.

On the one hand, the team, which has worked very hard to do that, has successfully added more non-barbeque variety. There is more non-barbeque items. The percentage of guests ordering non-barbeque items has increased and the guest satisfaction on those non-barbeque items is higher.

But that has not yet translated into a change in perception about Smokey Bones or a change in how they use the brand and you can see that in the guest count trend. As a result, we are going to be looking at different ways of eliminating the same barrier to pipe the frequency in but of occasion relevance. Exactly what form that is going to take will be part of our strategy going forward and we will talk more about that in the future, but there could be some learnings from Rocky River Grillhouse that would apply to Smokey Bones, unrelated to the menu.

Jeff Omohundro - Wachovia Securities

Very good. Thanks.

Operator

Thank you. Our next question is from the line of Howard Penney from Prudential. Please go ahead.

Howard Penney - Prudential Equity Group

Thanks very much. Two questions; first, what are some of the metrics that you are looking at to know that the consumers’ perception about Red Lobster is changing and the fresh fish menu is having an impact?

Second, Clarence, on the thought of acquisitions, your comments about the slowing demand for casual dining and we have had questions already this morning about price point promotions and some of the more bigger competitors that are feeling the pinch in slower traffic trends might get more aggressive in terms of sales and promotions and what not, putting pressure on some of the smaller players. Is there today, this environment, the right time to be considering acquisitions or should you wait to see where profitability ends up for some of these smaller chains?

Andrew H. Madsen

On the first question about today’s fresh fish, we will look at qualitative measures and quantitative measures. We know that the Red Lobster guest base, guest counts is still 5% to 10% below recent highs and the guests that have left tell us that the biggest reason they do not use Red Lobster as much as they have in the past is their perception of the menu, particularly around having frozen seafood.

So the way we are going to evaluate the impact of today’s fresh fish sheets ultimately or qualitatively we will talk to guests and see if their perception is changing over time in terms of how they think about Red Lobster, but more importantly quantitatively, we are going to look at the mix of our guest base, light users and heavy users, the demographics of the guest base. We would expect to be seeing more of the light users or non-users that have left the brand coming back into the Red Lobster business as we go forward, keeping the current guests that we have and having the combination of that drive the total up.

Clarence Otis

I think as we think about concepts, our own, the others that we see out there, what we really are focused on is how durable and sustainable is the proposition, the consumer proposition and the business model. What would it look like over time? So the current environment is really actually a pretty good environment to get a good read on that. How well is the top line holding up relative to others in this environment is something that we can get a pretty good read on. How durable is the business model at the restaurant level in this environment is something we can get a pretty good read on. Cost pressures, they are a little bit more enterprise driven, a little bit more supply chain, are those that we discount.

But how good does the fundamental business model at the restaurant level work is something you get a pretty good read on in a stress test environment. So we actually feel like this is an environment where we really can see who the winners are.

Howard Penney - Prudential Equity Group

Thanks very much.

Operator

Thank you. Our next question is from the line of Tom Thomson from Thompson, Siegel & Walmsley. Please go ahead.

Tom Thomson - Thompson, Siegel & Walmsley

Thanks very much. A couple of questions. Your restaurant expenses have been down 40 to 45 basis points for the last couple of quarters. I wonder if that sort of improvement is sustainable for the next several, and I understand the reasons for them.

Secondly, can you give us any sense of the tenor of sales so far in March?

Finally, a disclosure question; you point out in the press release the impact of the tax resolutions and the impairments on your ’07 quarterly EPS but you do not mention that you had similar sorts of items in the same quarter last year, and if you adjust for those as well, your EPS was really up about 17% year over year. I am just curious as to why you do not show apples-to-apples in that comparison. Thanks.

Bradford Richmond

Thank you, Tom. Let me start with your question on restaurant expenses. Our organization, we find plenty of opportunities and they vary from quarter to quarter, to address our restaurant expenses. We have a multitude of efforts underway to address some of those costs, so our success varies a little bit from quarter to quarter and the item that maybe you have heard us talk about in the past, about success in the workers’ comp, public liability area. In this quarter, we talked some about the impact of lower utilities.

When you look forward for those, we still see a fair amount of opportunities to keep addressing that cost line and do not really see a huge change in that. I would say we will update it again in June for fiscal 2008, but continue to see opportunities to leverage that line.

As to your comment about comparability of the numbers, of course we get into some disclosure requirements there but I would agree with your assessment when you look at the true performance, the true strength of our brands and how they are performing in a difficult environment. We very pleased, very happy with the results there.

Your other question about looking forward into March, again we typically do not lean into the month that we are in right now but we will have our same-restaurant sales release out in a few weeks here.

Clarence Otis

Tom, I would just say that your comment about year-over-year comparability, we do lay out last year in last year’s releases those moving parts and we lay them out this year, so they are there for people to do the math. We do not do it ourselves, quite candidly, because we are sensitive to being accused of whining about the quarter, so we lay out what this quarter is. We have laid out last year same quarter and encourage people to do that math.

Tom Thomson - Thompson, Siegel & Walmsley

Great. Thank you.

Operator

Thank you. Our next question is from the line of Rachael Rothman from Merrill Lynch. Please go ahead.

Rachael Rothman - Merrill Lynch

Good morning, guys. Could you talk a little bit about how much of your $350 million in CapEx we should think about as maintenance or defensive, and what portion do you see as actual growth CapEx?

Then, on the prototype, what kind of return hurtles would you look for in how many stores or in how many various markets before you would be comfortable moving forward with a larger scale rollout of any of the particular prototypes? Thanks.

Bradford Richmond

Let me address the CapEx first and when you look at our number out there, there is roughly $100 million of that that we would look at as just replacement or ongoing CapEx to keep our restaurants at the level of appearance and standards that we would expect, so that is what I would look roughly in that range for that.

Andrew H. Madsen

I would just say inside the balance of that, you have new restaurants, you have -- and those new restaurants take several forms and when we talk to this audience mostly about net new restaurant growth, but in addition to those 35, 40 restaurants we are relocating restaurants, so they do not add to the incremental number but in fact we have closed an old restaurant an built a new one and we are rebuilding restaurants where the building is not worth reinvesting in. It is still the right location and we will scrape and build a new restaurant on the same spot, so all of those are in there as well beyond the incremental net new.

The other thing that is in there that we consider growth capital is we are making some fairly meaningful technology investments to make sure that we can continue to handle with excellence the volumes that we have, that are starting to approach $5 million a year, for example, at Olive Garden, so we can continue to grow same-restaurant sales there. We are doing those same investments at Red Lobster, which also has very significant annual volumes approaching $4 million a unit per year.

Clarence Otis

I am not sure I followed the second question. Which prototype were you referring to?

Rachael Rothman - Merrill Lynch

Just generally speaking, would you think maybe if you tested three prototypes, either at Rocky River or the new prototypes that you are doing at Red Lobster, would you feel more comfortable moving ahead with a wider scale rollout of the prototypes at what percentage of units would you feel comfortable in how many different markets that you are achieving the hurtle rates that you would need to move forward with those wider-scale rollouts? Clearly you wouldn’t roll out if you just had three units in test and one of these was --

Clarence Otis

Yes, it is actually a restaurant by restaurant return on invested capital calculation, so the prototype is certainly part of that, but the other part is just the guest count projection that we have, which really depends on a lot of other factors. How good is the site that we have picked? Some are A-plus, some are B-plus. We’ll go with B-plus sites as well, so all of those things go into calculating.

The way we think about the prototype is we have a guest count hurtle, given the total investment and does that hurtle come down with the new prototype? That is a little bit on how we think about it.

Andrew H. Madsen

In addition, on Rocky River, which is new compared to Red Lobster or Olive Garden, an existing business, in the case of Rocky River, we are going to be looking to make sure that the prototype, in addition to being the right investment level, also offers the right environment for the guest experience. And then we want to make sure that all the pieces of the business model fit together before we would start to aggressively roll something out. So we have a lot to learn still there.

Rachael Rothman - Merrill Lynch

Thank you.

Operator

Thank you. Our next question is from the line of Glen Petraglia from Citigroup. Please go ahead.

Glen Petraglia - Citigroup

Good morning. I did have a follow-up question regarding Red Lobster and then another one of my own, but Drew, you made the comment about trying to get lapsed users back at Red Lobster by changing their perception of their opportunity to get fresh fish. I am curious to know how you are communicating that to lapsed users. I did see one advertisement that may have had the fresh fish tag on the back-end of it, but I am curious to know if you have come up with a new advertising strategy or maybe I am just not watching the right programming because I have not seen a lot of discussion around fresh fish.

Andrew H. Madsen

Well, what Red Lobster is doing initially is presenting today’s fresh fish sheet personally to every guest as they sit down at the table and explaining that they offer six fresh fish species that could be prepared in a number of different ways. So the initial focus was on letting all the guests, which is a substantial number, in their current restaurants know about what they have.

Second, they have been testing today’s fresh fish advertising and early results were encouraging but they are going to be looking on how to build on that going forward to get the word out more broadly. But they have not done that in a significant way yet.

Glen Petraglia - Citigroup

Okay, so are we still several months away, do you think?

Andrew H. Madsen

Yes.

Glen Petraglia - Citigroup

Okay, and then just following up from some earlier comments about the casual dining environment, traffic has been down the last couple of months at both Red Lobster and Olive Garden, while mix has been favorable. I am just curious to know if you think that is a function of you are losing the bottom-end consumer or is there something else going on there?

Andrew H. Madsen

Well, what we look for typically is about 1% guest count growth and a couple of percent, 3% same-restaurant sales. In terms of while our brands are growing slower than they have in the past, they are still growing at a competitively superior rate. It is difficult to say whether in the short-term, in a couple of months, the guest base has changed materially in terms of lower-income guests or not. That is one of the things that we talk about because we know there is more pressure financially on that guest demographic.

But it is difficult to piece out in a two- or three-month, four-month period.

Glen Petraglia - Citigroup

Thank you.

Clarence Otis

The reason why it is difficult is the visit cycle for that guest is quarterly at best to our restaurants. They are going to a handful of restaurants quarterly, so probably once a week, twice a week, but in our restaurants it is a quarterly cycle at best.

Glen Petraglia - Citigroup

Thank you.

Operator

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

Mark Wiltamuth - Morgan Stanley

I just wanted to follow up on what was really driving the average check for Red Lobster. The check was really strong all quarter and I just wanted to get a sense of that. Then, if you could really give us a little sense on how long do you think this phase two for Red Lobster will last and are you working on the real estate pipeline now in anticipation of entering phase three?

Andrew H. Madsen

The check increase for Red Lobster was partly promotional. Not just Lobsterfest but some of their earlier promotions, and it was partly some guests at lunch ordering more dinner entrees -- just choosing to order more dinner entrees.

In terms of phase two, that is going to be a couple-year process. It is not going to -- and these phases, by the way, are not things that completely stop. They are still working on strengthening the fundamentals, which was phase one, at Red Lobster, but phase two is going to continue with new menu items, improved advertising, some amount of actual restaurant refreshment inside the unit, and that is going to take a couple of years until all of that is done. But there is going to be continuous improvement on those items step by step as we go forward. Just like it was at Olive Garden in the late 90s.

In terms of pipeline, yes, we are looking at building a pipeline of sites, assuming success on phase two and assuming success with the new prototype that we mentioned has opened already, one in North Olmstead and one in Inglewood.

Mark Wiltamuth - Morgan Stanley

Thank you.

Operator

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

Andy Barish - Banc of America Securities

Can you give us a sense first of all on the rollout of the small wares at Red Lobster, kind of cost-wise and how long that lasts? And then secondly, just where you are on the new food and innovation pipeline, also at that brand -- how far out is the team there?

Andrew H. Madsen

On the small wares side, plateware, flatware, napkins, those sorts of things, we are beginning that rollout in part of Red Lobster at the end of this fiscal year in May. As we build inventory of plates, flatware, et cetera, we will gradually expand it to the rest of the Red Lobster restaurants over the course of the year. So it is not going to be something that is finished quickly in May or June. We think that is the most efficient way to do it, as well as the most effective way to do it.

In terms of changes to the menu, or changes to food, I would think about that in two ways. Number one, changes to menu items on the core menu, the menu that is there every day as well as changes to the types of food items they advertise, and we think we are making substantial progress in both of those areas but do not really want to elaborate on the specifics. But that is a big part of their plan for next year.

Bradford Richmond

I would just add that as we do talk about rolling these in in phases, you really will not see a dramatic impact on the P&L at all because a lot of it will be just normal replacements, so its impact in terms of expenses reflected on the P&L will be smaller amounts but throughout the year.

Andy Barish - Banc of America Securities

Thank you.

Operator

(Operator Instructions)

There are no further questions. Please continue.

Matthew Stroud

Great. Thank you, Mary. We will wrap up the conference at this point. We appreciate everybody that joined us on the call today. If you have further questions, of course we are hear to answer them in Orlando. We look forward to seeing you as we are out and about this quarter at various conferences and we will talk to you again in June. Thank you very much.

Operator

Thank you. Ladies and gentlemen, that does conclude our conference for today. Today’s conference will be available from 12:00 p.m. Eastern Time today through midnight April 21st. You may access the replay service by dialing 1-800-475-6701 and entering the access code 866292. International participants may dial 320-365-3844. Those numbers again are 1-800-475-6701 and 320-365-3844, using the access code 866292.

Again, thank you for using AT&T Executive Teleconference. You may now disconnect.

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