Risks to the investment thesis include Darden underperforming its historical averages, but current strategies show signs of mitigating these risks and stabilizing performance.
When we think of Darden Restaurants, Inc. (NYSE:DRI), Olive Garden is the logical thing that comes to mind. In addition to being Darden's largest brand, it is one of the largest full-service restaurant brands in the United States, with approximately 920 locations spread across nearly every state and territory in the country.
In Texas alone, the company has around 111 locations, with 12 locations in Houston alone. In other key states such as California and Florida, Olive Garden has 79 and 77 restaurants respectively. That's definitely quite a footprint. When compared to other FSR brands that compete with Darden's brands, while some are growing rapidly, few brands have such a large footprint.
We can look at other casual restaurants that serve Italian and Italian-American food, and we can see that in this regard Olive Garden dominates by a wide margin. Carrabba's Italian Grill, owned by Bloomin' Brands, Inc. (BLMN) and a direct competitor to Olive Garden in Florida and Texas, does not have nearly as large a footprint, about 4.5 times smaller than Olive Garden's. Another direct competitor, Maggiano's Little Italy, a brand owned by Brinker International, Inc. (EAT) that has a similar concept, also has a footprint almost 17 times smaller than Olive Garden's.
However, not even its privileged position at the top of mind when it comes to casual restaurants serving Italian food has allowed Olive Garden to perform well in a scenario of increasingly price-sensitive guests. Last quarter, I wrote an article called "Darden Restaurants: Multi-Brand Strategy Failing To Adapt To The Market" highlighting how Darden's core brands like Olive Garden and Cheddar's Scratch Kitchen were underperforming in the casual dining segment.
On the other hand, Longhorn Steakhouse, Darden's second-largest brand with 575 locations, has maintained a solid performance despite not engaging in promotional activities. I've also written about this "perceived value" phenomenon in the restaurant industry and how some restaurants are using it to offset weak traffic in my August 5th bottoming article, "Taking Advantage Of The Selloff: 2 Full-Service Restaurants I'd Like To Buy On The Dip" and my latest First Watch Restaurant Group, Inc. (FWRG) article, "First Watch Restaurant: A Non-Traditional Recipe For Dealing With Traffic".
Since I believe I have exhausted this subject in the last few articles, I strongly recommend reading it to understand the great advantage of restaurants that can convey value to customers without resorting to promotional environments. However, as I wrote previously, this reality is for the few. Those who cannot do so need to shout about it through value promotions.
The restaurant industry is tough, this is nothing new to anyone. To paraphrase a comment of mine to a reader here on Seeking Alpha:
It's an industry with a barrier to entry limited mainly by scale, often pressured by substitutable products (taking the role of convenience stores, bakeries, etc.), and with very high competition. This all culminates in an industry where perennial advantages are sustained by copiable factors. Margins are shrinking and returns are scarce As our good old Porter said.
This reality tells us that adapting is crucial to maintaining stable comparable sales during lean times. Few restaurants can maintain positive traffic or successfully offset it with a higher check per guest. When this happens, it means you have a competitive advantage, as guests continue to come to your restaurant even when their paychecks are under pressure or when you increase your menu prices.
To understand how this affects Olive Garden, we need to do a quick recap of the last quarter. First, let's take a look at the company's comparable sales compared to both the casual dining industry and other direct competitors:
Note that by the end of 2023, Olive Garden had managed to outperform the Full-Service Restaurant Index, as had Maggiano's. Meanwhile, until Q3 2023, Carrabba's had been underperforming its peers and the index, and as time went on, its comps became less difficult, which helped the company maintain healthy levels.
In addition to giving us a broad sense of performance, I recommend breaking comparable sales down into two smaller components: traffic and average check per guest. Below I've compiled this data for the restaurants we discussed above and an average for the FSR segment:
Note that Olive Garden's traffic in 2023 is already slow, but it still exceeds the Casual Dining Traffic Index. However, this scenario began to change at the turn of the year. This is the same relationship we see with the growth of the average check. In 2023, Olive Garden was still able to increase menu prices with some leeway in relation to traffic, but everything changed during Q1 2024.
I recently explained how the composition of the average check per guest works and how the interaction between the product mix and the quantity per transaction works. In the case of Olive Garden, we can assume three situations regarding these components, since they are not widely disclosed:
We know that this ability to increase the average check per guest is difficult to achieve, especially when guests are exhausted from this increase that has remained especially high in recent years. Traffic needed to be compensated somehow, but how?
To get around this situation, management initially understood that it should not go headlong into promotions, but rather control price increases (which is why we also saw a more moderate increase in the average price of the mix) and maintain a 'daily value' stance.
We know that on the opposite side of casual restaurants like Dine Brands Global, Inc.'s (DIN) Applebee's, which has a huge portion of LTOs in its promotional mix and ends up making the mistake of selling down, there are restaurants that prefer to stay away from promotional environments and maintain an everyday value positioning. Without getting into the merits of the substantiality of 'perceived value', these restaurants generally have a strong base of occasional guests and a high dependence on menu innovation and operational consistency.
Furthermore, especially in fast-casuals and QSRs, daily value comes with some hook and build leverage. After all, restaurants that prioritize daily value need to build customer loyalty so that they make frequent visits and, if they don't get some benefit for doing so, they may end up being hooked by value offers like the $5 deals that have been popping up around.
However, what we are seeing in the industry is that most restaurants that initially adopted a strategy focused solely on daily value are giving up their margins a bit to offer value offerings, as a hybrid model. I personally like this model and think it is much more balanced than just offering LTOs focused on aggressively driving traffic and losing a lot of the average check by selling down or taking a purist view of not offering value meals and thus suffering from poor traffic.
To enhance my argument, I will insert some examples of what I am talking about:
We could give other examples, but I think you get my point. Sometimes giving up a premium pricing position and adopting a promotional strategy that is more suited to the new times is much more advantageous than maintaining a premium pricing without considering traffic or market share data. Often, others are on the move, and changing strategies is more interesting than sticking with a poorly optimized strategy for a long time.
I'm giving you these examples to show you that yes, Olive Garden is shifting its positioning toward value offerings. Plus, new traffic data from Placer.ai is showing that these initiatives are driving traffic.
Like the companies I mentioned earlier, Olive Garden sought to reshape its promotional mix for its brands that were suffering from declining comparable sales. Keep in mind that this does not include Longhorn Steakhouse and fine dining restaurants.
In an effort to communicate value, Olive Garden continued to offer the option to create your own pasta for $12.99 and highlighted its offering of unlimited breadsticks and soup or salad with every entrée. However, it deepened its initial value proposition by introducing the 'Never-Ending Pasta Bowl', which consists of offering all-you-can-eat pasta for $13.99.
The 'Never-Ending Pasta Bowl' was initially scheduled to run from August 26 to November 17, but depending on guest acceptance and the boost it provides to traffic, it could continue for longer.
Unlike some other promotions that have risen from the ashes to the challenging environment, such as Restaurant Brands International Inc.'s (QSR) Popeyes' 'Big Box' which is back at $6.99 instead of $6 (the price it was last on my list) or even Outback's 'Aussie-3-Course' which was previously $16.99 and is now $14.99, Olive Garden's newly revamped promotion will cost exactly the same price as it did in 2022.
The promotion also includes upselling levers with the addition of $4.99 to add endless toppings (also the same price as in 2022), totaling 80 different combinations, requiring greater expertise from the back of the house. Pastas are: Fettuccine, Spaghetti, Rigatoni, and Angel Hair; sauces are: Creamy Mushroom (vegetarian), Traditional Marinara (vegan), Five Cheese Marinara (vegetarian), Traditional Meat Sauce, and Alfredo (vegetarian); and toppings are: Meatballs, Italian Sausage, and Crispy Chicken Frittata.
However, even before the 'Never-Ending Pasta Bowl', daily value initiatives appeared to have had some positive impact, which was further compounded by the launch of the value promotion in August. Take a look at this new data from Placer.ai and notice how traffic appears to have improved overall when compared to Q1 2024:
Note that during the months of April, May, and June (which would be Darden's fourth fiscal quarter) traffic was slightly higher than what the company had reported in the fiscal year, highlighting the positive performance during the month of May. For the next quarter (which comprises the months of July, August, and September) the company started off on the wrong foot, but recovered with the 'Never-Ending Pasta Bowl' in August, appearing to continue this traffic improvement through September.
Will this lead to Olive Garden posting positive traffic during the next quarter compared to the same period last year? Probably not, but it does allay my initial fear that there was some chronic problem with Olive Garden's average guest, much like there is at Cracker Barrel Old Country Store, Inc. (CBRL). In that case, it would require more than a few tweaks to the promotional mix, but rather a complete overhaul of the company, as the latter is already doing in its five-pillar turnaround plan. I wrote more about this in my article called "Cracker Barrel: The Road To Relevance Goes Through Five Pillars".
In line with expectations and no surprise to me, Longhorn Steakhouse continues to perform very well and maintained particularly high traffic in May, June, and August. In addition, the brand performed better in all months compared to other months. Cheddar's also performed similarly to Olive Garden, but with greater volatility in weak months, such as April and July.
If you bought Darden when the market bottomed out as I pointed out in my August 6th article titled "Taking Advantage Of The Selloff: 2 Full-Service Restaurants I'd Like To Buy On The Dip" you probably succeeded in buying Darden Restaurants at the best possible time at a price of approximately $141.
Since then, the stock price has risen over 13% to $160, making things a bit more complicated. However, some quantitative models infer that when we make new assumptions based not on poor performance by Olive Garden, but on stable/positive performance, the target price may not be fully realized yet. This all depends on ROA and, consequently, internal growth. In this buy thesis, Darden will succeed in obtaining a satisfactory return on the assets related to Olive Garden and will obtain an ROA in line with the historical average of 9%. In this sense, we can run the NPVGO Model that we used previously and obtain the following answers: For fiscal year 2024, Darden expects an EPS of $9.50. Of this, approximately 41% will be retained in the company.
Darden's ROA is approximately 9%, which results in an internal growth rate of approximately 3.96%. If the retention per share is $3.90, the growth from the retention will be $0.38. Therefore, our NPV for year 1 will be $4.28 ($0.38 + $3.90) divided by the discount rate, which is $1.45 per share. The value of Darden stock under this method is the perpetual growth of NPVGO ($47.14) plus the value of the stock as a cash cow ($135.14), i.e., $182.28. If in the last measurement the upside potential was approximately 30%, now it would be 13%.
We can look at other metrics, such as the DDM Models, such as the Gordon Model, SPDDM and DPDDM. The Gordon Model considers the perpetual cash flows provided by dividends discounted to present value. It is great for valuing mature companies that pay good dividends. Therefore, what is essential here is to make realistic assumptions about dividend growth. Therefore, I am considering an annual payout of $5.60 growing at a rate of 3.5%, in line with the industry average. This gives us a target price of approximately $170. However, this model is highly sensitive to the growth rate used and when we use other constant growth rates such as g=4% and g=3% we get $200 and $140 respectively.
The situation is a little different when we look at SPDDM and DPDDM. Considering the same discount rate for the shareholder and two cash flows, the first being the dividend of $5.60 paid in year 1 and the second being the sale price of the stock (exit price) at an estimated P/E of 16.9 and an EPS of $9.48, resulting in a cash flow of $160.21. Discounting all of this to the present value we arrive at a value of $155.28.
However, I believe that perhaps the P/E estimates are a little biased. When we use the 5-year average P/E of 19.94 we obtain an exit price of $189.03 and a purchase price of $182.27. While both scenarios remain credible (given that market perception of brand developments in the current environment will determine the valuation and premium/discount at which this stock will trade in the market), we can average the two scenarios to arrive at a more balanced conclusion. This occurs at a price of $169.
Looking at the DPDDM we also find a similar scenario. Considering the dividends for year 1 as the same ($5.60), the dividends for year 2 as $6.20 (estimated EPS of 2025 x Payout rate) and the sale price in year 2 (exit price) as $160.30 (EPS of $10.41 and projected P/E of 15.4) we obtain a purchase price of $151.70 when we bring all this to the present value. Let's use the average P/E of 5 years and average it in the same way we did with the SPDDM. This gives us a target price of $193.90 and an average of $172.80.
Note that several metrics indicate that Darden's price could rise to an estimated range of $170-$180 depending on both the expected P/E at the time of sale and the ROA reaching their historical averages. That is, if Darden achieves its average performance, the stock price is discounted by a considerable amount, and this was exacerbated when Mr. Market pushed Darden to the $140 range during the August selloff.
Note that the risk to the thesis is that Darden underperforms its historical average. As we saw earlier, Olive Garden is showing signs of improvement by adopting value promotions and leveraging traffic, and Longhorn remains firm. I believe that in this scenario, the risks inherent to the thesis tend to dissipate while Darden performs at stable levels.
However, as we saw in the Gordon Model, there is still a good window for buying if you intend to use the stock as a kind of instrument for a perpetual stream of cash flows. I recommend that you take a look at Darden's 'Dividend Growth' tab here on Seeking Alpha and see why I consider my growth estimates to be extremely conservative.