Why did Darden restate its financial statements, and how much did it change earnings?

Following a December 2004 review of lease accounting practices cited in other restaurant companies' 8-K filings, Darden changed how it recognizes rent expense and depreciates leasehold improvements. Rent is now recognized straight-line over the expected lease term, including cancelable option periods where failing to exercise them would create an economic penalty. For fiscal 2004, net earnings fell $4.3M to $227.2M, reducing diluted EPS by $0.02 to $1.34. The fiscal 2002 and 2003 EPS reductions were $0.03 and $0.04. Cumulative retained earnings were reduced by $70.3M, and the deferred rent liability rose by $114M. The company states that the restatement did not affect cash flows, sales, same-restaurant sales, or covenant compliance.

Is the Red Lobster slowdown a serious concern for investors?

It is the most important operating concern in the filing. Red Lobster, the largest casual dining seafood chain, saw U.S. same-restaurant sales fall 3.5% in fiscal 2004, driven by a 6.5% decline in guest counts that was partly offset by a 3.0% increase in average check. Its 23-quarter streak of same-restaurant gains ended. Management points to improved operating efficiency, better labor management, and a less disruptive promotional strategy, and is developing a new advertising plan and $10-$15 entrees. New Red Lobster openings are being limited in fiscal 2005 to focus on improving returns, which signals a more cautious growth posture for the concept.

How strong is Darden's balance sheet and how is it returning capital to shareholders?

The balance sheet is solid for a company of this size. Long-term debt is $653M and short-term commercial paper is $14.5M. Debt to total capital is 36%, and the lease-adjusted ratio is 46%. The company has a $400M credit facility that expires in October 2008, and its publicly issued debt is rated Baa1 (Moody's), BBB+ (S&P), and BBB+ (Fitch). It repurchased 10.7 million shares for $235M in fiscal 2004, with 109.2 million of the 115.4 million share authorization used to date, and paid $13M in dividends ($0.08 per share). Capital expenditures were $354M, and management expects roughly $360M in fiscal 2005. The company also disclosed $72.5M in standby letters of credit tied to workers' compensation and general liability accruals.

What risks does the filing flag, including legal and impairment exposures?

The main risks are intense competition in casual dining, cost pressures (seafood, labor, utilities, insurance), negative publicity around food safety, the importance of locations, and the regulatory environment (alcohol licensing, minimum wage, and ADA compliance). Fiscal 2004 included $41.9M in asset impairment and restructuring charges, mostly for Bahama Breeze, and management says it will keep reviewing sites to limit future impairments. On the legal side, two California class actions and one Washington action allege meal and rest break violations. Management does not believe these, or other pending claims, will have a material adverse effect. The restatement itself was not attributed to any misconduct or material non-compliance with securities laws.

DRI 10-K FY2004 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K/A filed January 7, 2005. Cited figures are marked; the original filing is the authoritative source.

Darden Restaurants (DRI) filed this 10-K/A for fiscal 2004 (ended May 30, 2004, a 53-week year) to restate its financial statements for fiscal 1996 through 2004 and Q1 fiscal 2005.

The restatement stems from a change in lease accounting: rent expense is now recognized straight-line over the expected lease term, including cancelable option periods where failure to exercise would carry an economic penalty. The change is non-cash in aggregate and does not affect cash flows, sales, or same-restaurant sales. Fiscal 2004 net earnings were restated to $227.2 million^a ($1.34 diluted EPS) from $231.5 million ($1.36 as originally reported), a reduction of $0.02 per diluted share.

Cumulative retained earnings were reduced by $70.3 million^b and the deferred rent liability increased by $114 million. Operationally, Darden is the largest publicly held casual dining company in the world, with 1,325 company-operated restaurants at year-end (680 Red Lobster, 543 Olive Garden, 32 Bahama Breeze, 69 Smokey Bones, and one Seasons 52). Sales rose 7.5% to $5.00 billion, though the 53rd week contributed about $90 million; on a 52-week basis, growth was 5.5%.

Olive Garden was the clear bright spot, with U.S. same-restaurant sales up 4.6% and operating profit up double digits. Red Lobster's 23-quarter streak of same-restaurant sales gains ended, with U.S. same-restaurant sales down 3.5%. Bahama Breeze was restructured, with six closures and four write-downs, and fiscal 2004 carried roughly $38 million^c of pre-tax impairment and restructuring charges.

For investors, the key points are a stable balance sheet (debt-to-total capital of 36%, adjusted for leases of 46%, investment-grade ratings), continued share repurchases ($235 million^d in fiscal 2004), and management guidance for fiscal 2005 of 8-12% diluted EPS growth, 50-60 new restaurants, and 1-3% same-restaurant sales growth at Red Lobster and Olive Garden. The restatement is a non-cash accounting correction, but it does lower reported earnings and book equity, and the Red Lobster sales slowdown is the primary operating concern.

02—Key points

Key Highlights

Restatement: Fiscal 1996-2004 financials restated for straight-line rent expense over expected lease terms; FY2004 net earnings reduced by $4.3M to $227.2M, diluted EPS $1.34 vs. $1.36 previously reported; cumulative retained earnings down $70.3M; no cash flow impact.
Sales of $5.00B (+7.5%; +5.5% on a 52-week basis) driven by 54 net new restaurants and Olive Garden same-restaurant sales growth of 4.6%.
Red Lobster U.S. same-restaurant sales fell 3.5% as guest counts dropped 6.5%, ending a 23-quarter streak of gains; the concept's expansion has been limited for fiscal 2005.
Olive Garden remains the strongest concept, with 39 consecutive quarters of U.S. same-restaurant sales growth, record operating profit, and record return on sales.
Bahama Breeze restructuring: six restaurants closed and four others written down in Q4, with $38M pre-tax impairment and restructuring charges; expansion postponed pending evaluation of a lower-cost prototype.
Balance sheet and capital returns: $235M of share repurchases and $13M in dividends in FY2004; debt-to-total capital of 36%, adjusted leverage of 46%, and investment-grade ratings (Baa1/BBB+).
FY2005 guidance: 8-12% diluted EPS growth, 50-60 new restaurants (including 30-40 Smokey Bones), and 1-3% combined same-restaurant sales growth for Red Lobster and Olive Garden.

03—Questions

Frequently Asked Questions

Why did Darden restate its financial statements, and how much did it change earnings?
Following a December 2004 review of lease accounting practices cited in other restaurant companies' 8-K filings, Darden changed how it recognizes rent expense and depreciates leasehold improvements. Rent is now recognized straight-line over the expected lease term, including cancelable option periods where failing to exercise them would create an economic penalty. For fiscal 2004, net earnings fell $4.3M to $227.2M, reducing diluted EPS by $0.02 to $1.34. The fiscal 2002 and 2003 EPS reductions were $0.03 and $0.04. Cumulative retained earnings were reduced by $70.3M, and the deferred rent liability rose by $114M. The company states that the restatement did not affect cash flows, sales, same-restaurant sales, or covenant compliance.
Is the Red Lobster slowdown a serious concern for investors?
It is the most important operating concern in the filing. Red Lobster, the largest casual dining seafood chain, saw U.S. same-restaurant sales fall 3.5% in fiscal 2004, driven by a 6.5% decline in guest counts that was partly offset by a 3.0% increase in average check. Its 23-quarter streak of same-restaurant gains ended. Management points to improved operating efficiency, better labor management, and a less disruptive promotional strategy, and is developing a new advertising plan and $10-$15 entrees. New Red Lobster openings are being limited in fiscal 2005 to focus on improving returns, which signals a more cautious growth posture for the concept.
What is driving Darden's growth, and what does management expect for fiscal 2005?
Growth is driven mainly by Olive Garden, which had 4.6% U.S. same-restaurant sales growth and an 11.1% revenue increase, and by new units in Smokey Bones, which opened 30 restaurants in fiscal 2004 and is planned to open another 30 to 40 in fiscal 2005. Management guides to 8-12% diluted EPS growth in fiscal 2005, 50-60 net new restaurants, and 1-3% same-restaurant sales growth at Red Lobster and Olive Garden combined. It expects Bahama Breeze to be accretive to earnings and Smokey Bones to be dilutive for most of the year, turning accretive in the second half. Management notes that quarterly results can vary and that these projections are forward-looking statements subject to the risks listed in the filing.
How strong is Darden's balance sheet and how is it returning capital to shareholders?
The balance sheet is solid for a company of this size. Long-term debt is $653M and short-term commercial paper is $14.5M. Debt to total capital is 36%, and the lease-adjusted ratio is 46%. The company has a $400M credit facility that expires in October 2008, and its publicly issued debt is rated Baa1 (Moody's), BBB+ (S&P), and BBB+ (Fitch). It repurchased 10.7 million shares for $235M in fiscal 2004, with 109.2 million of the 115.4 million share authorization used to date, and paid $13M in dividends ($0.08 per share). Capital expenditures were $354M, and management expects roughly $360M in fiscal 2005. The company also disclosed $72.5M in standby letters of credit tied to workers' compensation and general liability accruals.
What risks does the filing flag, including legal and impairment exposures?
The main risks are intense competition in casual dining, cost pressures (seafood, labor, utilities, insurance), negative publicity around food safety, the importance of locations, and the regulatory environment (alcohol licensing, minimum wage, and ADA compliance). Fiscal 2004 included $41.9M in asset impairment and restructuring charges, mostly for Bahama Breeze, and management says it will keep reviewing sites to limit future impairments. On the legal side, two California class actions and one Washington action allege meal and rest break violations. Management does not believe these, or other pending claims, will have a material adverse effect. The restatement itself was not attributed to any misconduct or material non-compliance with securities laws.

04—Continue

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