Darden's Pricing Discipline Set to Drive Full-Service Share Gains, but Industry Headwinds Linger

Equity Analyst

Sean Dunlop

Revenue segments as reported by the company.

Olive Garden

LongHorn Steakhouse

Fine Dining

Other Business

Revenue Segments

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Gross Profit, Operating Income, and Net Income as a percentage of Revenue

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An operating expense is an expense a business incurs through its normal business operations. Often abbreviated as OPEX.

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As Darden Restaurants emerges from the COVID-19 pandemic, we expect its playbook to remain largely the same, with the restaurant operator leaning into scale-driven cost advantages, embracing datacentric decision-making, trying to attract and retain employees with a compelling culture, and providing a differentiated dining experience, consistent with management's back-to-basics strategy. While we view this approach as strategically sound, we expect any success at Darden to come in spite of, rather than propelled by, aggregate industry results, with the full-service industry posting anemic average annual sales growth (1%-2%) over the past decade, well behind limited-service peers' 3%-4% clip.

In our view, scale has allowed Darden to flex its muscle through favorable procurement costs, efficiency-enabling operational investments like its to-go platform and Cheddar's point-of-sale and kitchen layout revamp, and judicious marketing support. While competitors have seen restaurant-level margins fall well below figures from the early 2010s (to the low to mid-teens from the mid-20s), Darden has been able to launch a value-oriented menu and generate margin through transaction volume, underpinning consolidated restaurant margins around 20%.

A value-oriented menu figures to be disproportionately important in the near term, with consumers seeking out relative value against a tough inflationary backdrop. Darden's cautious approach to pricing, consistently raising menu prices below inflation, reflects the firm's experience in the aftermath of 2007-09, when aggressive price increases drove declining traffic and ultimately an intercession by activist investor Starboard Value. With consumers visiting full-service restaurants only a few times per year, outpricing the core customer doesn't become immediately apparent, justifying such conservatism.

We think the firm's success will be dictated by its ability to cater to younger consumers, with strategic menu innovation, the convenience value proposition, and compelling value continuing to feature heavily in purchase decisions.

Business Strategy & Outlook

The U.S. restaurant industry is intensely competitive, with creative destruction and often irrational promotional activity rendering it difficult for operators to carve out an economic moat. Those that do so, in our view, have often developed a brand intangible asset that conveys trust, drives traffic, and imparts pricing power, or they otherwise benefit from a scale-driven cost advantage. In practice, these moat sources often arise in tandem, with a strong brand allowing restaurant chains to quickly develop new units, expand beyond regional or national borders, and generate leverage over procurement costs, general and administrative expenditures, and investments in the brand through regional or nationwide marketing. Absent the hallmarks of traditional intangible asset-driven moats, including robust comparable sales performance, international concept replication, or relative strength during periods of economic stress, we maintain our prior view that an intangible asset moat source is inappropriate for Darden. However, we do believe the firm’s procurement scale and leverage over advertising, technological, and administrative expenditures offer a durable cost advantage over peers. Our rating suggests that Darden is able to retain efficiency gains (in both general and administrative expenditures and hourly labor) that have materialized over the last three to five years as it flexes its national scale in procurement, benefits from lower last-mile delivery costs associated with larger drop sizes, and diffuses necessary marketing and technology costs across a larger base of system sales. Our 10-year average return on invested capital forecast of 15.5% (inclusive of goodwill) embodies this stance, outpacing our cost of capital estimate of 8.8%.

In our view, Darden’s brand cachet has been diminished by competition from younger, more technologically adept upstarts (particularly fast-casual restaurants, whose rapid ascendency in the aftermath of the 2007-09 recession permanently altered the trajectory of the industry), while consumer demands for convenience, accentuated by on-demand omnichannel ordering capabilities pulled forward by COVID-19 investments, appear likely to diminish the “everyday” dine-in experience for the foreseeable future. The U.S. casual dining industry remains under intense pressure, with a declining core demographic, overindexation to struggling suburban shopping centers, and the ascendance of convenience-oriented concepts stymieing industry growth in the aftermath of the Great Recession (with Darden seeing flat or negative comparable sales growth in five of seven years between 2008-14). While Darden is one of the best operators in the space and has astutely evolved its menu to better cater to both lower-income and higher-income clientele through barbell menu options and the acquisition of upscale concepts like The Capital Grille, sluggish industry growth would suggest that Darden’s growth aspirations will increasingly come at the expense of category peers, resulting in heightened promotional activity and limited pricing power. Nonetheless, we believe that Darden’s scale-driven cost advantage is enduring, while recognizing the company finds itself on the wrong side of demographic trends, with younger millennials and Gen Z customers continuing to increase their share of aggregate spending, and with a softening value proposition, as restaurant goers favor polished casual and fine dining restaurants for special occasions.

We’re impressed by management’s actions since the nadir of the post-Great-Recession-driven industry crisis, with the firm continuing to generate leverage through technological adoption in the supply chain, streamline restaurant operations, and generate efficiencies in restaurant support and services. While these benefits can be difficult to definitively trace, a couple of factors suggest value in managing a portfolio of smaller restaurants (to the extent that their operations don’t distract management from more important brands in the portfolio)—including $20 million-$25 million in general and administrative expense savings at Cheddar’s following its 2017 acquisition, or 3.8% of 2018 segment sales, and 320 basis points of restaurant margin improvement in the “other businesses” segment (disproportionately represented by Cheddar’s and Yard House) during 2021, despite a pandemic-driven mid-single-digit decline in same-store sales. The latter benefit was driven by investments in kitchen layouts at Cheddar’s, the adoption of an off-premises channel (which sees lower labor costs per order), and a unified point-of-sale system, offering customer ordering data that had previously been inaccessible and representing investments that are difficult for smaller chains to swallow. Even as management has targeted 10-30 basis points of annual operating margin improvement since the firm’s 2014 turnaround, median comparable sales growth has meaningfully recovered (to 2.4% for 2015-22 from negative 0.5% for 2008-14), alleviating concerns that cost savings are coming at the expense of investments in the brands or the firm’s competitive standing. We expect Darden’s portfolio to emerge from the pandemic stronger than before, with sales leverage, menu rationalization, a meaningfully larger off-premises business, and marketing efficiencies underpinning stronger operating margins and defending high-teens restaurant margins despite an extremely challenging inflationary backdrop in 2021 and 2022.

Further, we believe that Darden benefits from a scale-driven advantage in food procurement costs, attributable to its scale as the tenth-largest chain restaurant company in the United States in 2022 (per Euromonitor data and our estimates), as well as lower delivery costs, with larger drop sizes at restaurants offering leverage over expensive last-mile delivery. Of the 25 largest full-service restaurant operators in the U.S. in 2022, Darden posted the fourth-highest unit volume and generally sees consolidated average unit volume clock in around 5 times higher than the full-service industry average (our calculations, Euromonitor data). With $1.35 million in food costs per store before COVID-19, which outpaces the sales of many QSR concepts, Darden generates substantial leverage over last-mile delivery costs, with larger drop sizes helping blunt the impact of the most expensive component of the delivery value chain.

We see the evidence of Darden’s cost advantage manifest in three key data points.

First, the materially lower operating margins at U.S. food distributors for chain restaurant segments (with narrow-moat Sysco reporting operating margins about 6 percentage points lower in its chain restaurant business than for aggregate U.S. food service), which points to bargaining power and a reduced dependence on distributors for auxiliary services.

Second, through a strong edge in restaurant margins, general and administrative expenses, and operating margin relative to publicly traded peers, which already tend to outperform independent concepts. Darden’s restaurant-level margins, which, inclusive of marketing costs, clocked in at 18.7% before COVID-19, healthily outpaced competitors Brinker (8.5%), Texas Roadhouse (17.3%), and The Cheesecake Factory (15.7%). With restaurant margins accounting for differences in cost of food goods, paper products, labor, rent, utilities, and marketing expenditures, we view them as a useful if insufficient proxy for a cost edge over peers, discouraging price competition and irrational discounting, as Darden represents the low-cost operator in the space. Further, Darden’s normalized (2019) G&A expenditures, at 4.8% of system sales, clock in level with Brinker (Chili’s, Maggiano’s), 90 basis points better than Texas Roadhouse, and 200 basis points better than The Cheesecake Factory, resulting in structurally higher operating margins (10% at Darden against 7.2%, 7.7%, and 4.2%, respectively). That gap appears to have widened as the industry emerges from the shadow of COVID-19, with Darden posting a meaningfully higher 12.6% operating margin in its most recent quarter.

Finally, while the lines in food service are blurring, with customers often frequenting restaurants across the spectrum from fast food to fine dining, full-service concepts generally compete for a slightly different customer occasion than do fast casual and fast food. Disproportionate independent restaurant representation (with independents generating roughly 60% of full-service sales, compared with 25% of limited-service sales in the U.S., per Euromonitor), low industry concentration, and consumer preference for trying different concepts would suggest that the appropriate competitive set is all full-service restaurants (or perhaps all restaurants), rather than just the largest chains, supporting our cost advantage argument.

We view a narrow (not wide) moat rating as appropriate, with comparable sales falling below inflation across brands by our terminal-year forecasts and recognizing that natural limits prevent Darden from squeezing G&A operating leverage out of the system ad infinitum. While we expect the firm to maintain its 2022 operating margin gains, we foresee only modest incremental leverage as we consider low-single-digit comparable store sales growth and the gradual return of somewhat normalized marketing expenditures. Meaningful price competition or slower-than-expected growth could drive further deleverage, particularly if Darden is forced to lean more heavily into discounts or marketing to drive traffic moving forward, reducing our confidence in excess returns through the 20-year horizon implied by a wide moat rating.

Narrow

Economic Moat

Darden Restaurants

Darden Restaurants, Inc. is a full-service restaurant company, which engages in the provision of restaurant services. It operates through the following segments: Olive Garden, LongHorn Steakhouse, Fine Dining, and Other Business. The Olive Garden segment is the largest full-service dining Italian restaurant operator. The LongHorn Steakhouse segment includes the results of the company-owned LongHorn Steakhouse restaurants. The Fine Dining segment consists of the premium brands that operate within the fine-dining sub-segment of full-service dining and includes the results of its company-owned The Capital Grille and Eddie V's restaurants. The Other Business segment aggregates the remaining brands and includes the results of its company-owned Cheddar's Scratch Kitchen, Yard House, Seasons 52 and Bahama Breeze restaurants, and from franchises and consumer-packaged goods sales. The company was founded by William B. Darden in 1938 and is headquartered in Orlando, FL.

Earnings data Q1 2023

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