How strong was Darden's core profitability in fiscal 2006?

Strong. Total costs fell to 91.6% of sales from 92.0% a year earlier, pre-tax margin rose to 8.4% from 8.0%, and net margin reached 5.9% versus 5.5%. Gains came mainly from lower food and beverage costs (29.6% of sales vs. 30.2%) and leverage on higher sales, partly offset by higher restaurant labor (32.3%) and restaurant expenses (15.5%).

What are the main risks to the Smokey Bones and Bahama Breeze investments?

Both concepts have not yet proven long-term viability. Smokey Bones same-restaurant sales fell 3.7%, several restaurants were impaired or closed, and the brand's new direction is untested; further losses, impairments or a costly repositioning are possible. Bahama Breeze, after a 2004 impairment of $37 million, has seen improving same-restaurant sales (+1.7%), but growth is postponed until restaurant-level returns improve.

How is Darden financing growth and returning capital to shareholders?

Operations fund most of the business. In August 2005 Darden issued $300 million of senior notes (4.875% due 2010 and 6.000% due 2035) to repay maturing debt. It had $44 million of commercial paper outstanding and no borrowings under its $500 million credit facility. Share repurchases of $434 million and dividends of $59 million were funded from operating cash flow and debt. The board added 25 million shares to the buyback authorization in June 2006, bringing unused capacity to about 29.9 million shares.

How significant is the FTC gift-card matter and the wage-and-hour litigation?

The FTC matter is the most notable open legal item. Its opening demand of $31 million in equitable relief, plus suspension of dormancy fees on existing cards, could affect results if a consent order is reached, though the company believes its practices comply with the law. The California overtime cases were tentatively settled for up to $11 million, of which $9 million was expensed in fiscal 2006. Management says the broader litigation is not expected to have a material adverse effect.

DRI 10-K FY2006 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed July 28, 2006. Cited figures are marked; the original filing is the authoritative source.

Darden Restaurants (NYSE: DRI), the largest publicly held casual dining company in the world by U.S. company-restaurant revenue, closed fiscal 2006 (ended May 28, 2006) with record results.

Sales rose 8.4% to $5.72 billion^a, driven by a net addition of 46 company-owned restaurants and U.S. same-restaurant sales gains at Olive Garden (+5.5%), Red Lobster (+4.9%) and Bahama Breeze (+1.7%). Net earnings grew 16.4% to $338 million, and diluted EPS rose 21.3% to $2.16, helped by lower food and beverage, SG&A, and D&A costs as a percent of sales and a shrinking share count from buybacks. Operating cash flow reached $717 million against $338 million of capital expenditures.

The filing also flags clear pressure points. Smokey Bones same-restaurant sales fell 3.7%^b and management is repositioning the brand, which may require further investment or a name change, and it has limited new openings to five locations. Bahama Breeze remains a turnaround with growth postponed.

Restaurant labor rose to 32.3% of sales and restaurant expenses to 15.5%, and the company faces an FTC staff finding (July 26, 2006) that its gift-card dormancy fee disclosures violated Section 5, with a proposed $31 million^c equitable monetary relief demand still under negotiation. Management expects fiscal 2007 diluted EPS growth of 9-10%, including roughly 4 points of drag from adopting SFAS 123R, and plans 39-45 new restaurant openings.

For investors, the story is a strong Olive Garden and Red Lobster franchise-like core generating solid cash flow and returning capital through buybacks and a higher dividend ($0.40^d per share, up from $0.08), offset by execution risk at the newer concepts and a meaningful but unquantified legal and regulatory overhang. Leverage is moderate: adjusted debt-to-capital was 47%, and the company maintains investment-grade ratings (Baa1/BBB+/BBB+).

02—Key points

Key Highlights

Fiscal 2006 sales rose 8.4% to $5.72 billion; net earnings increased 16.4% to $338 million, and diluted EPS grew 21.3% to $2.16.
Olive Garden (market share leader in casual Italian) posted 5.5% U.S. same-restaurant sales growth, its 47th consecutive quarter of comparable-sales gains, with sales of $2.62 billion.
Red Lobster sales reached $2.58 billion with 4.9% same-restaurant growth and seven straight quarters of comparable-sales increases, reflecting improved operating efficiency.
Smokey Bones struggled, with same-restaurant sales down 3.7%, a $4 million impairment on two restaurants, and a planned brand repositioning that could require further investment or a rename.
Operating cash flow was $717 million and capex was $338 million; the company repurchased 11.9 million shares for $434 million and raised the annual dividend to $0.40 per share from $0.08.
Fiscal 2007 guidance calls for 9-10% diluted EPS growth (including about 4 points of SFAS 123R expense drag) and 39-45 new restaurant openings, with 2-4% same-restaurant sales growth expected at Olive Garden and Red Lobster.
The FTC staff concluded on July 26, 2006 that gift-card dormancy-fee disclosures violated Section 5 of the FTC Act and proposed an opening settlement of $31 million in equitable monetary relief; the company disputes the allegations and has not yet decided a course of action.

03—Questions

Frequently Asked Questions

How strong was Darden's core profitability in fiscal 2006?
Strong. Total costs fell to 91.6% of sales from 92.0% a year earlier, pre-tax margin rose to 8.4% from 8.0%, and net margin reached 5.9% versus 5.5%. Gains came mainly from lower food and beverage costs (29.6% of sales vs. 30.2%) and leverage on higher sales, partly offset by higher restaurant labor (32.3%) and restaurant expenses (15.5%).
What are the main risks to the Smokey Bones and Bahama Breeze investments?
Both concepts have not yet proven long-term viability. Smokey Bones same-restaurant sales fell 3.7%, several restaurants were impaired or closed, and the brand's new direction is untested; further losses, impairments or a costly repositioning are possible. Bahama Breeze, after a 2004 impairment of $37 million, has seen improving same-restaurant sales (+1.7%), but growth is postponed until restaurant-level returns improve.
How is Darden financing growth and returning capital to shareholders?
Operations fund most of the business. In August 2005 Darden issued $300 million of senior notes (4.875% due 2010 and 6.000% due 2035) to repay maturing debt. It had $44 million of commercial paper outstanding and no borrowings under its $500 million credit facility. Share repurchases of $434 million and dividends of $59 million were funded from operating cash flow and debt. The board added 25 million shares to the buyback authorization in June 2006, bringing unused capacity to about 29.9 million shares.
How significant is the FTC gift-card matter and the wage-and-hour litigation?
The FTC matter is the most notable open legal item. Its opening demand of $31 million in equitable relief, plus suspension of dormancy fees on existing cards, could affect results if a consent order is reached, though the company believes its practices comply with the law. The California overtime cases were tentatively settled for up to $11 million, of which $9 million was expensed in fiscal 2006. Management says the broader litigation is not expected to have a material adverse effect.

04—Continue

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