Darden: Limited Margin Of Safety At Current Levels

Summary

• Darden released its fiscal Q1 2022 results last month, reporting 51% revenue growth year-over-year and significant EBITDA margin expansion with strong sales in nearly every segment.
• This was driven by high double-digit same-store sales growth and the addition of 34 net new stores in the period.
• While this has set up Darden for robust earnings growth, I don't see much of a margin of safety here, with Darden trading at 20.5x FY2022 estimates.
• So, while I continue to see Darden as one of the top buy-the-dip candidates in the sector, I believe it makes sense to wait for a dip below $130.00 before starting new positions.

Erik Gonzalez Garcia/iStock Editorial via Getty Images

It's been a solid year thus far for the restaurant sector, and Darden (NYSE:DRI) continues to outperform its peers, up ~31% year-to-date, lapping a 9% return in a difficult year for the industry. The continued outperformance can be attributed to the company's exceptional operating results, with Darden coming off a quarter of ~47% same-store sales growth, with all segments reporting record Q1 profits. However, with Darden currently trading at 20.5x FY2022 earnings estimates and approaching its upper channel line from a technical standpoint, I don't see enough margin of safety to rush in and buy at current levels. So, while I see Darden as one of the best buy-the-dip candidates sector-wide, I believe it will pay to be patient before starting new positions.

Darden's Brand Portfolio, Company Presentation

Darden released its fiscal Q1 2022 results last week and had yet another blow-out quarter, reporting revenue of ~$2.31 billion, up 51% on a year-over-year basis. On a two-year basis, revenue was up more than 8% (fiscal Q1 2020: $2.13 billion), and fiscal Q1 2022 revenue was just shy of record levels in fiscal Q3 2020 ($2.35 billion). This is quite encouraging given that while capacity restrictions have eased, the company has seen some capacity limitations at Olive Garden due to staffing, with the company noting that it can lose up to eight tables per night due to staffing constraints. The good news is that the company's labor situation is improving, with over 1,000 team members added per week. Let's take a closer look at the results below:

Darden Margins, Company Presentation

As shown in the chart above, fiscal Q1 2022 was quite robust across all brands, with Fine Dining and LongHorn Steakhouse performing exceptionally well. On a year-over-year basis, Fine Dining saw same-store sales growth of 84.6% and two-year segment sales up 24%, with fiscal Q1 2022 sales of ~$169 million. Meanwhile, LongHorn Steakhouse's sales were up 47% year-over-year, helping to push Darden's consolidated same-store sales growth to 47.5% in the quarter. Combined with the addition of 34 net new stores in the period, Darden managed to come in just shy of record sales figures. The only negative in the period was Olive Garden, which saw weekly sales down just over 1% relative to pre-COVID-19 levels. However, on a consolidated basis, Darden's average weekly sales were up nearly 5% to $96,200 per store.

Darden, Company Presentation

While the softness on a relative basis at Olive Garden may be a little disappointing, it's important to note that Darden continues to deal with COVID-19 related exclusions, which can make it more difficult to properly staff restaurants. This has forced the company to impose capacity limitations at some restaurants, which has led to losing up to eight tables per night. After adjusting for these capacity limitations and the fact that some consumers are still not comfortable dining out relative to pre-COVID-19, the Olive Garden results are quite encouraging. One area that has continued to help is off-premise sales, which remains sticky, with off-premise sales at Olive Garden coming in at 27% of total sales, and over 50% of orders being digital. Darden continues to invest in digital to make To-Go more seamless and drive guest satisfaction, with the company adding Apple Pay (AAPL), Google Pay (GOOG), and PayPal (PYPL) payment options for customers.

Darden Revenue Growth, Company Filings, Author's Chart

While the steady growth in segment sales is very encouraging, the most exciting news was the material boost in profit margins, with LongHorn Steakhouse up 250 basis points year-over-year on a two-year basis, Fine Dining up 490 basis points on a two-year basis, and Other up 360 basis points. Similar to segment sales, Olive Garden lagged the group but still posted 220 basis points of profit margin expansion, helping to push restaurant-level EBITDA margins to 20.9% on a consolidated basis, up 290 basis points vs. pre-COVID-19 levels. This helped Darden report quarterly earnings per share [EPS] of $1.76, up 214% year-over-year and just shy of record quarterly EPS of $2.03 in fiscal Q4 2021. This is quite impressive given the challenging labor situation and commodity cost inflation.

Digging into commodity cost inflation a little closer, Darden noted that food & beverage costs were up 150 basis points on a two-year basis. This was exacerbated by the company having to purchase some of its proteins in the spot market, with these prices well above contracted prices. The reason for having to go into the spot market was that sales were stronger than expected. The good news is that labor expenses were down 110 basis points year-over-year, mostly offsetting the food inflation, driven by hourly labor improvement due to efficiencies gained from operational simplifications. It's also worth noting that food & beverage expenses would have been lower as a percentage of sales. However, Darden has noted that it wants to remain competitive from a pricing standpoint, aiming to ensure that its average customer is not priced out of the casual dining market. For this reason, the company has been very cautious about making price increases at Cheddar's and Olive Garden. Let's take a look at the earnings trend:

Darden Earnings Per Share, YCharts.com

As shown above, Darden continues to be a powerhouse from an earnings growth standpoint, set to enjoy a full recovery relative to FY2019 levels based on current FY2022 estimates. In fact, FY2022 annual EPS is projected to increase more than 30% from FY2019 levels ($7.60 vs. $5.82), and this growth is expected to continue into FY2023 and FY2024. This is expected to be driven by robust margins, a stickier than expected to-go business, and low single-digit unit growth. Based on FY2022 estimates of $7.60, Darden currently trades at just below 21x forward earnings estimates and sports an impressive ~16% compound annual EPS growth rate (FY2015-FY2022 estimates).

So, is the stock a Buy?

While there's no disputing that Darden continues to be a name to keep a close eye on in the space given its strong growth, the stock is now trading at a premium multiple relative to its normal PE ratio of ~16x earnings. It's also trading well above the mid-point of its historical range of 10x - 26x earnings. This doesn't mean that the stock can't go higher, but generally, the best time to buy Darden has been on dips closer to 17x earnings like Q3 2017, Q4 2018, and the massive outlier in Q1 2020 during the COVID-19 Crash. Currently, the stock is well outside its low-risk buy zone, as evidenced by the below chart, with a conservative fair value of ~$137.00 based on its normal PE ratio.

Darden Valuation, FastGraphs.com

Looking at Darden's PE ratio over the past 20 years, this corroborates this view, with the chart below showing Darden's PE ratio from 2000 to pre-COVID-19 levels. As we can see, a forward earnings multiple of nearly 21 places Darden in the higher end of its historical range and more than 20% above the ideal buy zone of 17x earnings or lower. This doesn't mean that Darden has to go below 17x earnings, and one could argue that Darden would trade at a slight premium to its 5-year average given the margin outperformance. Having said that, even if we assume a low-risk buy zone of 17.5x earnings or lower by assigning a premium multiple, this would still translate to a low-risk buy zone of $133.00 relative to FY2022 estimates of $7.60. In summary, while Darden isn't overly expensive, it's not offering much margin of safety here.

Darden Valuation, YCharts.com

Finally, if we look at the technical picture, we can see that Darden is currently trading only 5% from its upper channel line, suggesting that some caution is warranted. Previous tests of this upper channel line have led to sharp corrections in the share price, with the recent tests coming in June 2007 and September 2018. These were not ideal times to be buying the stock, with Darden posting negative one-year and two-year forward returns in both instances. Obviously, this time could be different, but if Darden were to rally above $175.00 before year-end, I would view this as an opportunity to take profits into this overthrow above the stock's upper channel line. In addition, this suggests some caution before jumping into the stock, with patience likely being the best move here, until the stock trades in the bottom half of its current channel at closer to $130.00 per share.

Darden Price Chart, TC2000.com

Darden had an incredible fiscal Q1 2022 report, and we should see continued strength based on the FY2022 guidance of up to 40 new restaurants, up to ~30% same-store sales growth year-over-year, and $9.5 billion in sales. However, with the stock rallying towards its upper channel line and trading at a slight premium to historical valuation metrics, I don't see enough of a margin of safety to rush into the stock here above $156.00. In summary, while I think Darden is a top-5 name in the sector that can be bought on sharp corrections, I think there is better value out there in the market currently. One name that looks more compelling is Newmont Corporation (NEM), trading at ~14x FY2022 earnings estimates, with a dividend yield of more than 4.10%.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of NEM either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: Taylor Dart is not a Registered Investment Advisor or Financial Planner. This writing is for informational purposes only. It does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Taylor Dart expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.