Why did Darden's net earnings fall so sharply in fiscal 2007 even though operating performance improved?

Net earnings dropped to $201.4 million from $338.2 million because of $175.7 million in after-tax losses from discontinued operations, primarily impairment and closing charges for the Smokey Bones, Rocky River Grillhouse and nine Bahama Breeze restaurants. Earnings from continuing operations actually rose 7.2% to $377.1 million.

What is happening with the Smokey Bones concept?

Darden concluded Smokey Bones was not a meaningful growth vehicle and announced on May 5, 2007 the closure of 54 Smokey Bones and both Rocky River Grillhouse units. It intends to operate the remaining 73 Smokey Bones restaurants while seeking a buyer, and the outcome of the sale process could lead to further losses or impairments.

How strong is the Olive Garden and Red Lobster business?

Olive Garden is the largest casual dining Italian brand in the U.S., with 614 restaurants, 2.7% U.S. same-restaurant sales growth, and average annual sales of $4.7 million per restaurant. Red Lobster, with 680 restaurants, grew sales 0.9% to $2.60 billion, but same-restaurant sales rose only 0.2% as guest counts fell 2.5%.

Is the higher leverage target and dividend increase a concern for investors?

The dividend increase signals greater cash returns to shareholders, and the company says it will preserve flexibility for acquisitions and buybacks. However, raising the target debt-to-capital range to 55-65% from 40-50% increases financial risk. Current adjusted debt-to-capital was 50%, and the company remains rated investment grade (Baa1/BBB+/BBB+).

What are the main risks to the outlook?

Key risks include intense competition from casual dining chains and supermarket meal offerings, rising food, labor and insurance costs, and sensitivity to energy prices and consumer spending. Darden also faces execution risk in Bahama Breeze and Seasons 52, which have not yet proven long-term viability, and uncertainty in selling the Smokey Bones units. Pending class-action wage and server-banking lawsuits in California and Washington add litigation risk.

DRI 10-K FY2007 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed July 19, 2007. Cited figures are marked; the original filing is the authoritative source.

Darden Restaurants (DRI) reported fiscal 2007 (ended May 27, 2007) with continuing-operations sales up 4.0% to $5.57 billion^a and diluted EPS from continuing operations up 13.0% to $2.53, driven by Olive Garden's 51 consecutive quarters of same-restaurant sales growth and Red Lobster's continued growth.

However, reported net earnings fell to $201.4 million^b ($1.35 diluted EPS) from $338.2 million ($2.16) because of $175.7 million in after-tax losses from discontinued operations, primarily $236.4 million in pre-tax impairment charges tied to the decision to close 54 Smokey Bones and two Rocky River Grillhouse restaurants and to sell the remaining 73 Smokey Bones units. Nine underperforming Bahama Breeze restaurants were also closed and classified as discontinued. Management guided to fiscal 2008 diluted EPS growth from continuing operations of 10% to 12%, expects roughly 40 net new restaurants, and projects same-restaurant sales growth of 2% to 4% at Olive Garden and Red Lobster.

Capital allocation is shifting toward shareholder returns: the quarterly dividend moves to 18 cents (an indicated annual rate of 72 cents, up more than 56%), and the target debt leverage range is being raised to 55-65% of adjusted capital from 40-50%. The company repurchased $371.2 million^c of stock in fiscal 2007 and holds 20.5 million shares of remaining authorization.

Investors should weigh the strong core Olive Garden and Red Lobster performance against the ongoing execution risk in Smokey Bones' exit, the unproven Bahama Breeze and Seasons 52 concepts, and rising labor costs (restaurant labor rose to 32.5%^d of sales). Balance sheet metrics remain solid, with an investment-grade rating (Baa1/BBB+/BBB+) and an adjusted debt-to-capital ratio of 50%, though the planned leverage increase will raise financial risk.

02—Key points

Key Highlights

Continuing-operations sales rose 4.0% to $5.57 billion; Olive Garden sales reached $2.79 billion (up 6.6%) with U.S. same-restaurant sales up 2.7%, its 51st consecutive quarter of same-restaurant growth.
Diluted EPS from continuing operations rose 13.0% to $2.53, but reported diluted EPS fell to $1.35 from $2.16 due to $1.18 per share of losses from discontinued operations.
Discontinued operations included $236.4 million of pre-tax impairment charges and $13.7 million of closing costs tied to closing 54 Smokey Bones and two Rocky River Grillhouse restaurants and offering the remaining 73 Smokey Bones for sale.
Fiscal 2008 guidance calls for 10% to 12% diluted EPS growth from continuing operations, about 40 net new restaurants, and 2% to 4% same-restaurant sales growth at Olive Garden and Red Lobster.
Quarterly dividend increased to 18 cents per share (indicated annual rate of 72 cents, up more than 56%) from a semi-annual 23-cent payment, and the target debt leverage range was raised to 55-65% from 40-50%.
Share repurchases totaled $371.2 million (9.4 million shares) in fiscal 2007, leaving 20.5 million shares of authorization remaining.
Restaurant labor rose to 32.5% of sales from 32.2%, partly due to higher wage rates and FICA tax on reported tips, while food and beverage costs fell to 29.0% of sales from 29.3%.

03—Questions

Frequently Asked Questions

Why did Darden's net earnings fall so sharply in fiscal 2007 even though operating performance improved?
Net earnings dropped to $201.4 million from $338.2 million because of $175.7 million in after-tax losses from discontinued operations, primarily impairment and closing charges for the Smokey Bones, Rocky River Grillhouse and nine Bahama Breeze restaurants. Earnings from continuing operations actually rose 7.2% to $377.1 million.
What is happening with the Smokey Bones concept?
Darden concluded Smokey Bones was not a meaningful growth vehicle and announced on May 5, 2007 the closure of 54 Smokey Bones and both Rocky River Grillhouse units. It intends to operate the remaining 73 Smokey Bones restaurants while seeking a buyer, and the outcome of the sale process could lead to further losses or impairments.
How strong is the Olive Garden and Red Lobster business?
Olive Garden is the largest casual dining Italian brand in the U.S., with 614 restaurants, 2.7% U.S. same-restaurant sales growth, and average annual sales of $4.7 million per restaurant. Red Lobster, with 680 restaurants, grew sales 0.9% to $2.60 billion, but same-restaurant sales rose only 0.2% as guest counts fell 2.5%.
Is the higher leverage target and dividend increase a concern for investors?
The dividend increase signals greater cash returns to shareholders, and the company says it will preserve flexibility for acquisitions and buybacks. However, raising the target debt-to-capital range to 55-65% from 40-50% increases financial risk. Current adjusted debt-to-capital was 50%, and the company remains rated investment grade (Baa1/BBB+/BBB+).
What are the main risks to the outlook?
Key risks include intense competition from casual dining chains and supermarket meal offerings, rising food, labor and insurance costs, and sensitivity to energy prices and consumer spending. Darden also faces execution risk in Bahama Breeze and Seasons 52, which have not yet proven long-term viability, and uncertainty in selling the Smokey Bones units. Pending class-action wage and server-banking lawsuits in California and Washington add litigation risk.

04—Continue

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