Darden: the unthinkable LONG case

DARDEN: THE UNTHINKABLE LONG CASE

MARCH 14, 2013

© HEDGEYE RISK MANAGEMENT 2

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with the State of Connecticut.

• Hedgeye Risk Management is not a broker dealer and does not make investment recommendations. This presentation does not constitute an offer to sell, or a solicitation of an offer to buy any security.

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COMPANY OVERVIEW

• Largest casual dining chain, roughly 2,000 units

• 1,016 locations are on own sites, 978 are on leased sites

• Large portfolio of brands – leading in Italian and seafood

• Strong cash flows and balance sheet

• Generous dividend yield

• Consensus estimates – NTM EBITDA: $1.1bn

– Net debt/NTM EBITDA: 1.8x

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RECAP OF OUR PRIOR STANCE

• We initiated a short call, “The Unthinkable Short Case”, on DRI on July 19th, 2012

• Headwinds we outlined included: – Accelerated unit growth masking other issues

– Cash burn

– Waning ability of Darden to be all things to all people (buyback, dividend, growth, fortress balance sheet)

– Secular macro headwinds were changing the industry’s operating environment

– Leverage outlook was set to impede future growth

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RECAP OF OUR PRIOR STANCE (CONT’D) THE INVESTMENT THESIS THAT WE OUTLINED ON 7/19, FORTUITOUSLY, WAS ADDITIVE TO MANY OF OUR CLIENTS’ PERFORMANCE IN 2012 AND 2013-TO-DATE.

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PEER GROUP PERFORMING WELL THE PEER GROUP HAS PERFORMED WELL SINCE OUR INITIAL DRI SHORT CALL

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CURRENT SETUP

• Stock price depressed but dividend yield highly supportive • Unit growth is being reined in (albeit modestly) • Secular nature of industry change being acknowledged • Guidance is for EPS to decline 11% in FY13 and little-to-no

earnings growth in FY14 • Promotions underperforming • Underinvestment in Olive Garden showing in results • Declining ROIIC • LongHorn no longer a jewel in the crown • Significantly lagging peers in international expansion efforts • Self-evident that managing portfolio is proving difficult

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UNFORCED ERRORS HAVE HURT INVESTORS

Source: Bloomberg

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CAPITAL ALLOCATION IS ONE OF THE SINGLE MOST IMPORTANT METRICS FOR A CASUAL DINING BUSINESS

WHY?


GROWING PAINS

Despite competitors and many industry commentators highlighting the need for more conservative unit growth and a focus on restaurant-level performance, in the FY12 Annual Report, Darden was focused on a new unit growth rate of 5% despite decelerating same-restaurant sales growth

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SELF-INFLICTED WOUNDS

The situation Darden finds itself in today, given the decision to focus so intently on growth in a poor operating environment for the industry, can only be described as self-inflicted

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POOR BANG FOR CAPEX BUCK

The situation Darden finds itself in today, given the decision to focus so intently on growth in a poor operating environment for the industry, can only be described as self-inflicted

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ROIIC SCORECARD NOT ENCOURAGING

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DRI HAS BECOME AN INVESTMENT BANKER’S / PE FIRM’S DREAM!


BROAD & VARIED PORTFOLIO

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• This company has over 2,000 restaurants spread among 8 separate concepts

•Olive Garden and Red Lobster account for roughly 75% of total revenues

Clarence Otis became CEO in November 2004 and his biggest achievement has arguably been the tremendous growth he has overseen

The question is:

Has it become too large?


TOO BIG, TOO COMPLEX, TO PERFORM?

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THE IMPORTANT QUESTION

• What can be done to add shareholder value?

• A breakup of the portfolio may add value

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WHAT IS LEFT TO PUSH THE STOCK LOWER?


ON THE BRIGHT SIDE... • The investment community has become far more

bearish on the stock

• Room for improvement with the “Big 3” (Olive Garden, Red Lobster, LongHorn) same-restaurant sales growth is lagging the benchmark (Knapp Track) by 340 bps

• Management is outwardly admitting past mistakes and the reality of the environment it is operating in

• Potential changes within the C-Suite could greatly improve the company’s prospects – can current roster turn things around?

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DRI TRADING AT A DISCOUNT

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INDUSTRY-LEADING?

Darden has industry-leading AUV’s, and the largest system in casual dining, but the company’s largest brands – Olive Garden, Red Lobster, and LongHorn Steakhouse – are hemorrhaging share

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LOW-HANGING, BOUNTIFUL, FRUIT • Tremendous cash flow potential

• Huge real estate value

• Non-core, under-utilized assets that can be sold at rich valuation

• Core assets represent a classic reorganization opportunity

• Market’s valuation of the whole is far below what we believe the

sum of the parts would represent in a reorganization/breakup

• G&A rationalization opportunities

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WIN-WIN

In the event of another guide-down, we expect the Board to shake things up at the leadership level We also believe that Darden is increasingly becoming a potential target for an Activist Investor

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SUM OF THE PARTS

Source: Company filings, Hedgeye Estimates

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PUTTING IT ALL TOGETHER • The current outlook is dire

• Continuing deterioration will bring intervention in one form or another

• Our original short thesis is now common knowledge

• The dividend is being preserved at the expense of growth

• We believe that the board/investment community is unlikely to sit by while any further mistakes are made

• Further underperformance versus the broader equity market is unlikely

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DON’T TAKE OUR WORD FOR IT The missteps that have been made are likely to have consequences: the recent downgrading of Darden’s debt by Standard & Poor’s is an example

“Our level of indebtedness could have important consequences. For example, it may: require a portion of our cash flow from operations for the payment of principal of, and interest on, our indebtedness, thus reducing our ability to use our cash flow to fund working capital, capital expenditures and general corporate requirements; and limit our ability to obtain additional financing to fund working capital, capital expenditures, additional acquisitions or general corporate requirements, particularly if the ratings assigned to our debt securities by rating organizations are revised downward.”

– DRI FY2012 10-K

We believed that the acquisition of Yard House, as an expensive addition to an already-too-complex portfolio, was a mistake and the recent Analyst Meeting highlighted the extra strain that this acquisition has put on the company’s debt ratios

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AN ATTRACTIVE SECTOR FOR ACTIVISTS • MCD 2006: Real estate was the fulcrum of Bill Ackman’s thesis but better operating performance

(new management) and capital allocation decisions were real drivers of returns. Sold off non-core assets

• WEN 2008: Real estate was, again, the anchor of the thesis but the business was undervalued. The company, no doubt under the influence of Trian Fund Management’s Nelson Peltz, sold off non-core assets

• APPB 2006: Breeden Capital Management threatened a proxy contest at the 2007 Annual Meeting of Stockholders which ultimately was settled with two board seats being opened up for the activist entity. The company was sold following a period of lackluster returns

• CBRL 2005: Nelson Peltz, again, held the real estate central in his thinking on taking the company private. In 1Q06, the company’s board authorized the use of proceeds from a sale of Logan’s Roadhouse to fund a modified “Dutch Auction” tender offer for $250mm of the company’s common stock (roughly 35% of common shares outstanding)

• CBRL 2011: Biglari Holdings has contested two proxy battles but has failed to secure any board seats. Pressure from Sardar Biglari has led to the CEO of CBRL being replaced. The stock price has appreciated significantly; BH first took a stake in October 2011 when the stock was in the area of $45. The stock is currently at $77 per share

• DIN 2012: Marcato Capital Management suggested a dividend payment in order to maximize its equity value. The company announced a $0.75 quarterly dividend and a $100m share repo (8% of equity value). Richard “Mick” McGuire of Marcato was previously an analyst at Bill Ackman’s Pershing Square Capital Management

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RISKS TO OUR THESIS

• The core business has not been fixed

• Industry environment is challenging

• Entrenched management

• Still growing new units too fast

• Timing could be a factor in this call to buy the stock

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THANK YOU

For more information and a complete listing of research please visit: www.hedgeye.com

or email: [email protected]

This presentation was prepared by: Howard Penney and Rory green

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Darden: the unthinkable LONG case