DRI - Darden Restaurants: Should Continue To Outperform The Industry

2024-01-16 06:34:26 ET

Summary

• I reiterate my buy rating due to the normalizing operating environment, reduced build costs, and deflating food costs driving growth and increasing margins.
• Darden Restaurants continues to outperform the industry in same-store sales and is capturing market share.
• DRI is expected to continue momentum with positive sales in November and strong holiday bookings.

Overview

My recommendation for Darden Restaurants ( DRI ) stock is a buy rating, as I expect the normalizing operating environment, reduction in build costs, and deflating food costs to drive topline growth and increase margins. As DRI continues to sustain its outperformance against the industry, the market should continue to value DRI at the current forward EBITDA multiple. Note that I previously rated DRI with a buy rating, as I expected the valuation to rerate higher when the market realized the DRI had been performing much better than peers. This played out nicely with valuation (forward PE) trading up from 14x to 17x and the share price going up from ~$135 to $161 today.

Recent results & updates

DRI did very well in 2Q24 , with EPS coming in at $1.84, beating consensus estimate of $1.73. Driving the strong EPS performance were both topline and restaurant-level profits. At the topline, sales grew 9.7% to $2.72 billion, which is tracking well against my FY24 10% growth assumption. As for restaurant-level margins, DRI reported margins of 18.8%, which led to a consolidated adj. EBIT margin of 10.7% (vs. 9.4% in 2Q23) and an adj. EBTIDA margin of 14.3% (vs. 13.3% in 2Q23). As I noted previously about DRI performing better than the industry, DRI continued this outperformance streak in 2Q24, where SSS (same-store sales) was reported at 2.8%, outperforming the industry by 410 bps. Even more notable is that DRI outperformance was driven by traffic instead of pricing; DRI outperformed the industry traffic by 370 bps, suggesting that DRI is capturing market share and that the underlying performance trends remain consistent.

I expect DRI to continue this momentum in the coming quarters as the industry continues to normalize (after getting impacted by COVID and the weak macro environment). This is probably going to be the case in the very near future (3Q24), as management mentioned that SSS remained positive in November, with record sales for each brand on Thanksgiving and strong holiday bookings into 2H24. Over the medium term, I see the current trend continuing as well as a higher income cohort (>$200k household income) mix that is improving, albeit still below pre-covid levels, suggesting room for growth to be above normalized levels (recovery + organic growth). Management also commented that the business is gradually reaching pre-covid demographic levels, which I take as a sign that the operating environment for DRI is almost back to normalized levels. Aside from demand normalization, the visibility of unit growth has also increased dramatically, as management mentioned that build cost inflation has peaked and construction costs are coming in line with budgeted expectations. I believe this is an indication that DRI can finally go back to its historical pace of unit expansion. In particular, management pointed out that while 5–10 units annually have previously been abandoned due to cost environments and expectations that were higher, the current moderation in build costs and permitting should continue to promote greater development visibility. I take the upward revision of FY24 CAPEX guidance to $600 million from $550 million to $600 million as a clear indication that management is going to step up on unit growth in the near term.

Our data shows we're gradually moving back to our pre-COVID demographic mix, which -- with a bigger change in Q2 and moving back to pre-COVID demographics gets us to feel like we're getting closer to what normal is. 2Q2024 earnings call

Apart from growth, I also think margin should improve from here as food costs continue to trend favorably where chicken prices are fully covered for the rest of FY24 and that other food costs (except beef) are expected to see deflationary actions. This dynamic was also well reflected in the latest results, where restaurant-level margin expanded by 220 bps to 18.8%. mainly driven by food costs (190 bps contribution), as most items excluding beef saw deflation. As such, from here out, only 55% of the food cost (beef) is likely going to continue seeing major inflation, which means food cost growth should decelerate from the 3% we saw in 2Q24 unless beef prices surge by a huge margin. Lower food cost growth coupled with the 3% price increase should lead to a modest increase in restaurant level margin.

Sure, Chris. I'll say -- let's start with our pricing. I think, we mentioned at the beginning of the year, the pricing carryover from actions last year is about 3% on the full year, and our guidance talks about 3.5% to 4%. from: 2Q2024 earnings call

DRI’s balance sheet also remains strong, as it exited the quarter with $200 million in cash and ~$3 billion in gross debt, or less than 2x FY24e EBITDA. If DRI continues to perform as I expected, it should be able to generate more FCF in the coming quarters. Based on consensus expectations for FY24 and FY25, DRI is expected to generate around $2 billion of FCF; as such, I don’t see any risk to the balance sheet. From a yield perspective, the $2 billion FCF represents 11% FCF yield.

Valuation and risk

According to my model, DRI is valued at ~$176, representing a 12% upside. With the operating environment normalizing on a per-store level, building costs trending downward, and food costs deflating, my new model assumptions are that growth will accelerate in FY25 and the EBITDA margin will expand (vs. the 15% assumption I made previously). Over the past few months, the market has reacted very positively to DRI outperformance relative to the industry. With my expectation that DRI can continue to sustain its current performance, I believe the market will continue to value DRI at the current 11.5x forward EBITDA multiple.

A potential risk is that DRI’s fine dining segment might cause a bigger than expected drag on overall performance as it is still facing headwinds from weakening consumer sentiment. Also, despite the rise in rates, US unemployment is still near its all-time low, which is putting pressure on wages. If wages were to continue increasing, it could limit how much margin can expand in the near term.

Summary

I reiterate my buy recommendation for DRI. With the normalization in operating environment, reduced build costs, and deflating food costs, I expect DRI's growth momentum to persist. DRI should continue to outperform the industry, which will support its current valuation. DRI also maintains a strong balance sheet that should allow it to easily pay down the debt if needed, and to pay out dividends.

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