達登餐飲 (DRI) 2006 Q2 法說會逐字稿

Welcome to Darden Restaurants second quarter earnings release conference call. [OPERATOR INSTRUCTIONS] As a reminder today's conference is being recorded.

I will now turn the conference over to Vice President of Investor Relations Mr. Matthew Stroud.

Please go ahead.

Good morning, everybody.

Thank you.

Good morning, everybody.

With me today are Clarence Otis, Darden's Chairman and CEO;

Drew Madsen, Darden's President and COO; and Linda Dimopoulos, Darden's CFO.

We welcome those of you joining us by telephone or the Internet.

During the course of this conference call Darden Restaurants officers and employees may make forward-looking statements concerning the Company's expectations, goals, or objectives.

These forward-looking statements could address future economic performance, restaurant openings, various financial parameters or similar matters.

By their nature forward-looking statements involve risks and uncertainties that could cause actual risks to materially differ from those anticipated in the statements.

These risks and uncertainties include the impact of intense competition, changing economic or business conditions, the price and availability of food, ingredients and utilities, labor and insurance costs, increased advertising and marketing costs, higher than anticipated costs to open or close restaurants, litigation, unfavorable publicity, a lack of suitable locations, government regulations, a failure to achieve growth objectives, weather conditions and other risks and uncertainties discussed in the Company's SEC filings.

Because of these numerous variables you are cautioned against placing undue reliance on any forward-looking statement made by or on behalf of the Company.

A copy of our press release announcing the earnings, the Form 8-K used to file the release with the Securities and Exchange Commission, and any other financial and statistical information about the period covered in the conference call including any information required by Regulation G is available under the heading Investor Relations on our website at Darden.com.

We plan to release same restaurant sales results for fiscal December 2006 coring the week beginning January 2.

We plan to release same restaurant sales results for fiscal January 2006 during the week beginning January 30.

We plan to release fiscal 2006 third quarter earnings and same restaurant sales for fiscal February 2006 on Tuesday, March 21, after the market close.

We released second quarter earnings yesterday afternoon.

Results were available on First Call, PR news wire and other news sources.

Let's begin with some highlights from the second quarter.

Second quarter net earnings were $55.1 million, and diluted net EPS was $0.35.

This represents a 35% increase in diluted net earnings per share compared to last year.

Olive Garden and Red Lobster had an outstanding quarter with strong operating profit growth at both companies led by industry leading same restaurant sales growth at Olive Garden.

Bahama Breeze made good progress as well posting solid same restaurant seams growth.

Smokey Bones had a more challenging quarter as same restaurant sales fell short of our expectations.

Also, yesterday we revised upward our guidance for sales and earnings growth this fiscal year.

We now expect diluted net earnings per share growth for fiscal 2006 in the 15% to 20% range and that is based on our new expectation of combined U.S. same restaurant sales growth of roughly 4 to 5% for Red Lobster and Olive Garden.

We expect new unit growth of approximately 4% for fiscal 2006.

Linda will now provide detail about our financial results for the quarter, Drew will discuss the operating Company's business performance, and then Clarence will offer some final comments.

We'll then respond to your questions.

Linda.

Thanks, Matthew.

Darden's total sales increased 7.8% in the second quarter as a result of the same strong restaurant sales growth at Olive Garden and Red Lobster that Matthew mentioned and our operation of 55 more restaurants in the second quarter of the prior year.

Olive Garden same restaurant sales growth for the quarter was 6.4% and this was its 45th consecutive quarter of increasing same restaurant sales, this is well above the second quarter net estimate of 0.8% which excludes Darden concepts.

Olive Garden's total sales increased 9.6% in the second quarter and as a result of strong sales leverage and cost management Olive Garden had a record second quarter operating profit representing a double-digit rate of increase over last year.

Red Lobster had a same-restaurant sales increase of 2.7% for the quarter and total sales increase of 3.4%.

Red Lobster also had strong sales leverage and cost management which drove a strong double-digit percentage increase and operating profits over last year.

Bahama Breeze reported a solid increase, 1.9%, in same-restaurant sales and we continue to expect Bahama Breeze to be roughly break even to earnings in fiscal 2006 as they continue to invest in positioning the business for successful renewed growth.

Smokey Bones opened seven restaurants during the quarter and we expect to open between 25 and 30 restaurants in fiscal 2006.

While Smokey Bones had modestly higher restaurant earnings compared to prior year at the restaurant level, that's excluding SG&A and D&A, earnings increased 40%.

Same-restaurant sales were much weaker than anticipated.

We now believe that Smokey Bones brand positioning needs further refinement to make it relevant for more dining occasions.

And given the unexpected sales weakness we now anticipate only a modest contribution to Darden's overall earnings growth coming from improvement in Smokey Bones operating results this fiscal year.

In terms of margin analysis in the second quarter food and beverage expenses were 54 basis points better than last year on a percentage of sales basis.

Cost savings on various products, notably seafood and better waste management contributed to savings.

In fiscal 2006 we expect food and beverage cost as a percentage of sales to be slightly favorable to fiscal 2005.

Second quarter restaurant labor expenses were 68 points higher than last year on a percentage of sales basis with sales leverage at Olive Garden and Red Lobster offset by increased benefits, costs, wage rate inflation and higher restaurant-level bonuses.

FICA taxes on reported tips were also higher but these were significantly offset as credits at the income tax line.

Restaurant expenses in the second quarter were 22 basis points better than last year on a percentage of sales basis.

Sales leverage and favorable Workers' Comp and general liability costs were partially offset by higher utility expense and increased pre opening expenses at Olive Garden and Red Lobster.

Selling, general, and administrative expenses were lower as a percentage of sales by 66 basis points, due primarily to sales leverage at Olive Garden and Red Lobster and are net of a roughly $2 million contribution that are mostly hurricane related.

The effective tax rate for the second quarter of 31.9% was slightly below our previous annual guidance of approximately 33% primarily due to the increased FICA tax credit, our reported tips that I mentioned in the labor discussion.

For fiscal 2006 we are now estimating an effective tax rate for the year of approximately 32%.

During the quarter we repurchased over 1.7 million shares of our common stock, leaving approximately 11 million shares in our current repurchase authorizations.

As Matthew mentioned, for fiscal 2006 we now expect combined same-restaurant sales growth for Red Lobster and Olive Garden of between 4 and 5% probably closer to the lower end of this range than the higher and of course depending on whether winter which we've already felt some impact for but this is an increase from our previous guidance of 2 to 4% same-restaurant sales growth.

We are targeting a net new restaurant increase of approximately 4% in 2006.

With these same-restaurant sales and new restaurant growth expectations we revised upward our diluted net EPS growth goal to be in the 15 to 20% range for fiscal 2006.

I'll now turn it over to Drew to comment on our operating companies.

We were delighted with the operating results and the strategic progress that we achieved this quarter.

Olive Garden led the way with another quarter of exceptional performance.

Their sales and operating profit results were very strong, as Linda already mentioned, and in addition to that, their operating returns put them in the top decile of casual dining and the top quartile compared to the S&P 500.

The key drivers of this performance have been in place for some time, and we've talked about them before.

A powerful combination of brand management excellence, restaurant operations excellence and a superior business model.

As we look ahead to the second half, Olive Garden will further strengthen their guest experience with a particular emphasis on improving pace of meal and server attentiveness.

They've also done a great job of developing and testing a strong pipeline of exciting new promotional dishes and new advertising.

Now obviously Olive Garden started ramping on some big year ago numbers this month but we're confident that plans are in place to deliver solid same-restaurant growth going forward.

Olive Garden has also made good progress developing a stronger pipeline of high quality sites and a portfolio of new prototypes that will help them accelerate new restaurant growth.

Two of these new prototype designs will open in the fourth quarter this year.

Olive Garden plans to open 25 to 30 new restaurants next year which is an increase of 10 versus this year.

Red Lobster also had another quarter of strong performance.

Same restaurant guest counts increased nearly 1.5%, and same-restaurant sales were up approximately 3%.

And this is the fifth consecutive quarter that both measures have exceeded our NAP track competitive average.

Red Lobster also delivered very strong double-digit increase in operating profit.

Red Lobster's momentum over the last several quarters has been driven by their simply great operating discipline, which has really helped them improve the consistency of their execution while also improving operating efficiency, and the benefits of that focus can be seen in several areas.

Most notably, in record guest satisfaction, profitable guest count growth, and record profit margins.

The improving performance trend at Red Lobster also demonstrates the inherent strength in what their brand stands for and what their business model is capable of delivering as their top line continues to grow.

Looking ahead, Red Lobster has the opportunity for further growth in guest counts that returns them to their historic norms, roughly 10% above where they are today, and as they do that, their profit growth opportunity is also very significant, given how efficiently they are operating.

To sustain profitable guest count growth Red Lobster will further strengthen the appeal of their brand by excelling at what consumers want most from a seafood restaurant.

Fresh, delicious, seafood, friendly welcoming service, and an exceptionally clean restaurant.

Smokey Bones same-restaurant sales were much softer than we anticipated this quarter as Linda and Matthew already said.

Comps for the preceding four quarters had been nearly flat so we were surprised by the 8.5% decline that we experienced during the second quarter.

Now, while it was a difficult economic environment, these results further emphasize our need to broaden the appeal of Smokey Bones.

As we've discussed in the past, the Smokey Bones team has been working to broaden the appeal of their menu beyond barbecue.

Several new items were introduced this month after successful in-restaurant testing to help do just that, including a new mahi-mahi sandwich, portobello chicken entree, an Oregon pear and spinach salad, plus a Kansas City flat iron steak.

We also recognize the need to examine other key elements of the guest experience beyond the menu more fully in the future.

Given the absolute level of our business results entering this year at Smokey Bones, combined with this recent sales softening we've reevaluated our new restaurant opening strategy, and more specifically we will focus future openings in areas where we have demonstrated business strength in order to ensure that we deliver an appropriate return on capital while we work to broaden the appeal of Smokey Bones.

That means our pace of new restaurant openings will slow down from 25 to 30 this fiscal year to approximately 10 to 15 new restaurants in fiscal 2007.

Fortunately, we start with very strong guest satisfaction among our current guests at Smokey Bones that still ranks at the top of all Darden brands.

We need to build on this foundation in a way that broadens our occasion relevance and visit frequency beyond what is today too barbecue-centric, and we will.

Finally, Bahama Breeze delivered same-restaurant sales growth of 1.9% during the second quarter.

Key business fundamentals, including same-restaurant sales, have begun to improve since we began our focus on delighting guests with a more approachable Caribbean escape last year.

Improving guest satisfaction and several new approachable but distinctive dishes introduced over the last few months, like fresh fish Havana, oak grilled pork chops, coconut shrimp, and margarita chicken will help maintain the same restaurant sales trend.

At the same time Bahama Breeze continues to eliminate cost and complexity from their business model that does not add value to their guests.

While more progress is required before we are prepared to restart new restaurant growth, Bahama Breeze looks to be on the right path.

Clarence.

Thanks, Drew.

You heard Matthew say it, you heard Linda say it, you heard Drew say it, but I'm going to say it again, we're delighted with the results that we had in the second quarter, 35% our earnings per share growth, in an environment that we all know is a little mixed, is just terrific.

And it really reflects strong operating momentum across most of our businesses, good industry-leading sales growth at Red Lobster and Olive Garden, good progress at Bahama Breeze although as Drew mentioned we do have more work to do at Smokey Bones.

We think the key to it all really starts with a strong foundation.

We've got great people throughout our organization at every level, and we also have a great culture, and it's grounded in strong values, it's grounded in a motivating shared purpose, and we take that, and we apply it with an approach to the business that we have great deal of confidence in.

Drew mentioned it.

It's really about combining brand management, excellence, and restaurant operating excellence.

And Olive Garden really best reflects the power of that combination when you look at its results.

At Red Lobster they've got great leadership, strong operations, and they're improving the brand.

And that brand development, as Drew mentioned, means real good upside potential on the guest front.

And then that approach, that proven approach, is really what we're applying at both Bahama Breeze and Smokey Bones, and so we have great confidence in our ability to get those brands to where they need to be.

But I'd sum it up by just saying we've got great momentum going into the second half.

That is what's driving us to increase our annual earnings guidance.

We believe that when you put it all together we've got a business that's well positioned to thrive in this environment, and really in any environment, and we know that that's critical in our business, because it's a very dynamic business.

But it all comes down to just a terrific team.

We've got the right people working on the right things.

And with that we'll take your questions.

[OPERATOR INSTRUCTIONS] Our first question is from the line of David Palmer from UBS.

Please go ahead.

Hi, guys.

Congratulations on a great quarter there.

I guess I'll keep it to one question, and it focuses on the Olive Garden earnings, which I mean, you don't really say exactly what the profit growth is, but you just say double digit, which, to me, and it seems like in the past you've tended to be 15%, not the 20%-plus that you did on a consolidated basis, and I'm wondering if you did some reinvestment in that business given the fact that you had right around 10% revenue growth with the big 6% plus same-store sales growth in the quarter.

Is that -- am I right in assessing that you did reinvest actively in this business?

Hey, David, it's Drew.

We invest in all our businesses where we believe we're going to get an appropriate return over time.

And at Olive Garden this quarter, as in past quarters, we had very strong growth in all the key fundamentals, same restaurant guest count, same-restaurant sales, operating profit, and our operating profit margins at the restaurant level.

So there was differential growth there as well.

There's opportunities for us to continue to manage costs effectively going forward, but we were very pleased overall with the sales and profit growth and the returns that we got at Olive Garden.

And I would say that in this plan year, we clearly are investing a lot of time and attention and resources in making sure that we build a platform so that we can accelerate new restaurant growth at Olive Garden and do that successfully, and successfully means strong new restaurants, put in the right places, opening at the right volumes, but also it means doing that while making sure that we continue to have same restaurant excellence.

And so there has been some investment.

You see it most clearly in the development area in putting together stronger pipeline and putting together the array, the portfolio of prototypes, but that's a specific area.

And could I ask one follow-up question?

It's really more for Linda, and it's on share count.

What contribution to EPS growth over the next couple years, lets just stretch it out, do you anticipate from diluted share count reductions?

Well, we've been experiencing probably anywhere from 2 to 4% of our EPS improvement coming from share buyback, and we would, at our current levels and our current cash flows and where we see capital spending, expect to still be in that range, perhaps on the upper side of that range, in this year and the foreseeable future.

Thank you very much.

Next question is from the line of Mark Kalinowski from Buckingham Research.

Please go ahead.

Hi, I was just looking at the gross margins, and just tremendous gross margins in the fiscal second quarter.

According to my model, which goes back to fiscal '99 on a quarterly base, best quarter over that time period.

Leads me to wonder if there's still more in the bag of tricks there so we might see further improvement in gross margins or rather whether the Street should be thinking that a lot of the improvement has already been had and from here on out we're not likely to see a meaningful improvement going forward.

Thanks.

Hi this is Linda, and we have made a lot of progress and a lot of meaningful improvement, especially at Red Lobster.

They are rolling at really historical highs since we've been a public company, so appreciate you tracking us for all this period of time, and they are very strong now.

As we've said though, we are not at our historical highs from a guest count perspective.

So as we see this business continue to improve on the top line, there clearly is more of a sales leverage piece that attributes and flows from that.

So your variable pieces, the food and labor stays more fixed, but we would continue to expect to see more margin expansion coming from sales leverage and certainly from improving performance of our emerging businesses as well.

I would just add that at Red Lobster, in fact, if you just look back three or four years, we're probably down roughly 10% from where those guest counts were.

And so we would be looking to recapture that over the next three to five years, and there's tremendous profit power in doing that, given where they're operating today.

Thanks for your help.

Your next question is from the line of Bob Derrington from Morgan Keegan.

Please go ahead.

Question, Linda, I was scribbling as fast as I could, you went over G&A and the composition of what factors affected G&A.

It only increased about 1% year-over-year.

Did you mention there was some kind of recovery?

No, I think that's where you see a fair amount of our sales leverage does show up in G&A.

While we are making some investment for growth really the biggest contributing factor is sales leverage.

I did mention that we had made some contributions associated with hurricane relief, and so that was the other factor in there that I had mentioned, but the bulk of it, there's some plusing and minusing from this year and last year, but for the most part the leverage is coming from sales.

Okay.

So should we expect that if you pull out that contribution you made for the hurricane situation, would you assume -- it looks as though G&A would have been actually, on a dollar basis, less than last year.

Should we expect that going forward?

G&A is where there is a more variability, more event-driven, impairment shows up there, one-time sort of charges, the timing of when we have our general manager meetings and that sort of thing, but directionally this is where we would expect to continue to see leverage as we improve our top line, and that's where some of this margin expansion will come from.

Okay.

Fair enough.

Follow-up.

On the -- you gave a sales guidance on both Red Lobster and Olive Garden, can you kind of give us what's implied in the earnings guidance for Smokey Bones and what their sales expectation is?

Yes.

I mean I would say certainly nothing heroic from really either business.

We would -- certainly are expecting Bahama Breeze to maintain roughly slightly positive sort of momentum throughout the year and building and certainly improving trends at Smokey Bones.

But as we said, I'm not expecting anything significant on the earnings contribution piece so we really want to make sure we take the time to get this positioning nailed.

So down mid single digits kind of sounds implied?

Yes.

Okay.

Thank you.

Next question is from the line of John Glass from CIBC World Markets.

Please go ahead.

Could you update us on your growth plans for Olive Garden?

I know this was a transitional year, and perhaps you were going to look to an uptick '07.

If you've got a sharper numbers on that.

Also, have you changed your view of the growth of Olive Garden given the slowing of the Smokey Bones units?

Our plans at Olive Garden this year, new openings were 20 to 25, going up to 25 to 30 in '07, up to 35 to 40 the year after that, and it's being driven by the things that Clarence mentioned and that I mentioned in my overview comments, working harder on a bigger pipeline of high quality sites and prototypes that will help us capture different market opportunities in different trade areas than we were able to do in the past.

Our growth strategy for Olive Garden is really predicated on what we think the opportunity is for that business, which is substantial.

It's very broadly appealing, it's got a great brand, a great guest experience, a tremendous business model, and that's the opportunity we're going to capture so the two really aren't linked together.

Got it.

Just on Smokey Bones, what's the timetable roughly for some of the measures you're going to take, and do you think it's the box itself that needs to be altered?

Do you think it's simply a brand positioning menu at this point that needs to be altered?

I don't think it's the box.

I think it's more the experience that Smokey Bones offers and making that experience relevant for a wider set of occasions and more frequent usage.

Part of that is the menu, but we're going to look at all the guest touch points, like I said, and don't want to leave you with the impression that it's only the menu.

And in terms of timetable it's a little premature for us to get into that now, but it's not going to be a next quarter sort of thing.

We're going to step back from this and understand why it became a little more barbecue-centric than we would have liked, and how we want to broaden that while importantly maintaining a very unique and differentiated position in the marketplace.

So it's not going to be a next quarter sort of thing.

Got it.

Thank you.

Thank you.

Our next question is from Steven Kron with Goldman Sachs.

Go ahead please.

I had a couple of questions back on the margin front.

You talk about in your release record margins at Red Lobster and Olive Garden.

I was just wondering if you can quantify the drag that the negative 8.5% comps at Smokey Bones may have had on overall restaurant profit margins, and then secondly I think, Linda, you talked about the food and beverage costs being slightly favorable for the year.

If I heard that correctly, I guess by my estimates here in the first half of the year, I think that line is better by 70 to 80 basis points.

I was just wondering what we should be thinking for the second half, given that slightly favorable guidance.

Okay.

Let me take the margin question first.

We didn't really have a significant drag on margins from Smokey Bones, because last year we were doing an advertising test, and so that was probably a couple million dollars, and so the net of that, their performance versus last year, is actually slightly positive to contribution margin.

On the food and beverage, yes, we would expect to remain favorable in the other -- the outer quarters, slightly favorable, as much as maybe 50 basis points on the year.

Back to your first response, forgetting about the year-over-year impact, if we just look at this quarter in isolation, had Smokey Bones comps been more flattish, what kind of impact would that have had to the margin line?

I don't think we would want to get into that sort of margin diagnosis at this point.

Thanks.

Thank you.

We'll now go to the line of Jason Whitmer with FTN Midwest.

I wanted to address a question on your expansion plans considering Smokey Bones pulling back a little bit, I know Olive Garden is ramping up, but if you look at your longer term goals of trying to get up to 5 to 7% growth this year looks like you're stepping down a little bit to the lower end of your previous range of 4 to 5 down to 4.

But I'm plugging in the numbers for next year, looks like more the 3 to 4 range, based upon the current assumptions.

How do you plan to continue to find the growth, fuel growth within your core concepts, new concepts and what does that possibly imply then for your interest in looking elsewhere for alternative growth such as acquisitions?

I think if you're -- the 5 to 7, if you're referring there to new restaurants, at 5 to 7, that really is what we outlined as a long-term target, and our goal all along has really been to do the work over the next three years to put ourselves in the position where we can sustain at that level.

And so that was never something that we thought we could do in the next three years, but we knew we had a lot of work to do to position ourselves to get there.

And a lot of that work has to do with just strengthening our platform, making sure that restaurants support expertise that we have as well as just the systems that we have can be better leveraged with additional restaurants, and we're doing a lot of that work.

It also meant really making sure that we buttressed our whole new restaurant development operation.

And resourced it more appropriately for those kind of growth levels, and we're continuing to do that.

We believe that Smokey Bones is a critical part of building that platform, and the work that Drew discussed will go on, and so that will be part of the story.

As we look out longer term at 5 to 7%.

Olive Garden will be as well at that 40-restaurant-a-year range when we get there.

So all of that work continues to go on.

And I don't know that it's changed our time line, as we think about what we need to do to get ourselves in a position where we can have accelerated new restaurant growth.

Then the acquisition front, any thoughts?

I think, again, we need to do a lot of work to put ourselves in position to pursue additional concepts successfully, whether they're internally developed or acquired, and so we continue to focus really on that time frame and getting that work done over the next three years.

That said, once we've done that work, and we're in position where we feel comfortable adding new concepts, acquisitions will certainly be one of the things that we take a look at, as an avenue for doing that.

Great.

Thanks.

Our next question is from Mark Wiltamuth with Morgan Stanley.

Go ahead please.

I just wanted to explore some of the drivers behind why Olive Garden has been so strong for so long especially against this backdrop where the consumer is a little soft.

Are there areas of the menu where you're really seeing some power alleys, maybe in the price value area?

I think the biggest driver of Olive Garden's growth is the new President, but beyond that, I think there is no magic bullet, there's no simple change that -- fundamental change, that's occurred this year.

I think it really is all about the magic you get when you have great people, a great brand, and operations excellence that delivers that brand promise every day.

It takes a while to get there.

There's a lot of work that has to go on in building that foundation, both with guests and inside your operating company in terms of the culture, and Olive Garden is reaping the benefits of that now.

Have you seen any shifting within the menu this year, as the consumer has been under a little more pressure?

No.

We haven't seen -- we've looked at our guest base by segment, and we haven't seen any shifts there.

And there could be a little bit of movement month to month, just in terms of what we're promoting, versus year ago, but fundamentally, we haven't seen a big shift in entree mix.

We had seen just a little bit of check management at both Olive Garden and Red Lobster, in appetizers, a month or two, in the past couple of months that could be related to value sensitivity, but in terms of the guest counts we're driving, and the guest satisfaction we're getting and fundamentally what the brand stands for and what people are buying, it's very consistent.

If you could just give us an update on those smaller prototypes you've been working on at Olive Garden, the ones that will help you get into some of those other geographies.

Well, first and foremost they're both very consistent with our brand, and they're going to deliver the same great idealized Italian family meal experience.

Second, they're going to look and feel similar to the Tuscan farmhouses that we have today.

So there won't be a disconnect there.

But they are smaller.

Two of the prototypes we're looking at at least ,are smaller.

And so the capital investment is a little lower, and they're laid out in a way that we believe is going to be operationally easier to run day to day as well.

And that's going to lower the guest counts that we need to get to make it a viable investment, and it's going to lower it substantially.

I don't know that we want to get into the number of guests that it would reduce, but it's a meaningful reduction.

Both of those will be open -- two of those new prototypes will be open, as I said, in the fourth quarter.

When we talk -- when we use a sentence, and we have guest counts and reduced in the same sentence, I'll clarify and make sure, we've got a hurdle that we need to get over from a return perspective, and the number of guests that we need to meet that hurdle is lower what these prototypes would be.

Right.

Okay.

Thank you very much.

More guests are good.

Thank you.

We'll go to the line of Jeff Omohundro with Wachovia.

Go ahead please.

Thanks.

Two or three quick questions on labor costs.

I thought that with the comp momentum you might have gotten a little bit more labor leveraging.

Sounds like maybe there's some bonuses in there.

Just wondering, I know you did talk a bit about labor, but if you could isolate maybe some of the drags on labor leveraging.

Sure.

The biggest piece by far is certainly the inflation, the wage rate inflation, and that's coming somewhat from, as we talked about really last quarter, pressure on minimum wage is specifically, and we've priced for some of that on a dollar basis, but it doesn't give us as much of leverage on that.

We also mentioned pressure around insurance and specifically FICA taxes, and this is something we've been trying to help you understand.

As our sales increase, our tips are increasing, and we're also encouraging more of our employees to report these tips, and as a result, there is more FICA tax on this line.

However, there is an offsetting credit in the tax line, and that's part of what brings down that tax rate.

So there is a bit of a variability between this level and operating profits and after-tax profits that are impacting us here.

That's helpful.

And utility costs, I know they were up.

Previously you had talked about buying forward or hedging strategies around that.

Is there any more update on that front, or is it still pretty much on track?

It's pretty much on track.

We certainly are beginning to feel the benefits from that.

We've hedged significantly in natural gas, and that has already been benefiting us in the second quarter.

We certainly expect it to be from what we believe expectations will benefit us even more in the third and fourth quarter.

Electricity, we can't hedge as much.

We've hedged with as many states as we can, but -- so we clearly have felt higher utility costs, probably in the tune of about 7 million in the second quarter over the previous year, and at those levels are probably our expectation for the remaining two quarters.

Very good.

Thanks a lot.

Yes.

Thank you.

Our next question is from Mike Smith with Oppenheimer.

Go ahead, please.

Good morning.

Well, a couple of things.

About the expansion going forward, Clarence, I think you were talking about Smokey Bones, and you were going to locate in areas where you knew that the brand would work on your next few openings.

Did you mean that you're going into existing markets or existing areas of the country, or what exactly did you mean there?

Mike this is Drew.

We do mean going into existing regions where the business is performing at a higher level today, so Florida and New England, for example, are areas that are very strong.

It could be in existing trade areas, could be new trade areas, but we were more referring to regions where we've seen consistently stronger performance.

And in terms of the smaller Olive Garden prototypes that you're going to expand with, will those be mostly fill-in markets, or will you be going to smaller geographies?

Both.

And we're looking, as our guest counts continue to increase, and that puts pressure on pace of meal and those sorts of things, filling in with a smaller prototype in existing markets is a way to relieve some of that pressure, obviously.

At the same time, there's parts of the country that we haven't been able to get into yet that a smaller prototype, where you just need one Olive Garden and a smaller prototype would be great, so we're looking at both.

Thank you.

Our next question is from Larry Miller from Prudential.

Please go ahead.

Thank you.

Hi.

Most of my questions have been answered.

I just wondered if you could put some color around this.

Could you share any consumer research with us around Smokey Bones that gives you confidence that broadening the appeal for that brand is the right way to go?

Then I just have one small question on depreciation.

Okay.

Well, Smokey Bones has a wonderful foundation to build on.

In a couple of ways.

One, the average unit volumes, while not where we want them to be, are substantial, probably in the 3 million, 3.1 million range.

And the guest satisfaction for the people who are coming today for the experience we offer is very high.

So it's not like we are talking about a radical change that moves us into a different segment.

We're talking about building on strengths that we have today that includes the experience we offer with barbecue today.

And just refining building off of that.

So not a -- not a wholesale change, if that's what you were trying to get at.

Yes, I was just trying to get if there was something a consumer was saying to you that says, hey, this is why I don't come, and it's specifically--.

I think, Larry, it is -- what they're telling us is, is we love it, and this is the frequency with which we use it, and they think of it as a barbecue restaurant, and it's a frequency with which they use barbecue.

And so broadening out from that, it's a nice platform, given how much they like it and how well they've responded to it, but it's insufficient from a frequency perspective.

Have you tested any of that new menu in terms of how it might cannibalize a Red Lobster or Olive Garden?

I know a lot of them are located very closely together.

Well, we've tested all the new menu items in restaurant, and in Smokey Bones, and they're performing well so far.

It's too early to say whether it would have any material impact on Olive Garden and Red Lobster.

We don't anticipate that it will because those brands are broadly appealing and very strong in their own right.

We just think it's going to increase the occasion relevance and frequency for Smokey Bones.

Okay.

Last question on bones.

I think you were working on reducing some investment costs.

Are you still on track with that?

Yes.

And then depreciation as a percent of sales have been dropping over the past several quarters.

Can you just put some color around that?

Should I expect that run rate to continue, and does that mean that you are making significant -- or enough investment back in the existing facilities to support continued sales growth there?

Yes, I think you can expect to see continued leverage there.

We are going to be roughly at the same level of capital spending as we were last year, so in terms of new capital versus last year we're in roughy that same level, so this line is heavily sales leveraged, but we do regularly reinvest in our existing restaurants.

We have a very focused program.

We've talked about it impacting somewhat more on the P&L line in the last couple of years, especially at Red Lobster.

We've been working to -- they end up more in the P&L in terms of repair and maintenance in terms of improving our facility.

Probably the biggest factor we don't have any major remodeling going on on either of our big businesses at this point, and while we continue to consider and look at some things, we don't have any near-term plans to accelerate those efforts and have been very focused on keeping the current facilities just up to date and in good repair.

Thank you very much.

I think that's worth pausing on, I've been here almost 11 years and we've never heard a question that even implied that we were underinvesting our building.

It's usually been the exact opposite of that, and we certainly don't want to get to the position where we are underinvesting, but we are very careful about making sure that we keep our facilities where they need to be, but not guild a cage, either, and put in dollars that aren't necessary for consumers.

Thanks, Clarence.

Your next question is from Joe Buckley from Bear Stearns.

Please go ahead.

Thank you.

I have a couple of follow-up questions for Linda just to try to fill out some of your remarks.

Just share with us first what the wage rate inflation has been.

It's been in the 2% range, and it's a little bit higher above that this year.

So why wouldn't you get leverage on that with comps up so strong?

We didn't necessarily price for all of that.

I mean, we are getting sales leverage from traffic, and from sales.

It's just we didn't price for percent leverage at the labor line.

One of the -- this is Drew.

One of the questions that was asked earlier, regarding Olive Garden, and any investments we're making there, we touched on the things we need to do to strengthen the new restaurant pipeline as well as the prototypes, but another area that we are always very cautious on with Olive Garden is our pricing strategy and the need to maintain broad price point accessibility and a great value equation.

So as Linda was saying we're pricing to capture dollars on minimum wage and some other things but we're very careful of maintaining our value equation.

Are there any servers or staffing initiatives behind the higher labor expense?

No, we really have not seen -- I mean, every once in awhile we'll have shortages in some parts of the country but there's certainly no widespread labor shortages.

Oh, no, that's not what I meant.

I meant are you increasing the staffing or doing some things to improve the service?

Are you allocating more labor dollars per restaurant?

Yes.

I think at Red Lobster, for sure, they are being very focused on making sure that they've got the right levels of labor to operate at a very high level.

And so in terms of bussers, all those sorts of things, a little bit of that going on, yes.

Linda, on SG&A, I mean, ex the $2 million hurricane donation, you would have been down in dollars.

You mentioned the timing of different things.

Can you be as explicit as possible what might have been in last year's second quarter not in this year's, and if there's anything you know of already that we should think about for the third and fourth quarter in that SG&A line?

Let's see.

There was some specific litigation settlements that were in this quarter last year that we did not have this quarter this year, which is probably the most meaningful piece.

We talked some about the marketing that we spent and Smokey Bones last year that we are not spending this year.

Those are probably the two most significant ones.

There's a little bit in development activity which is related to impairment of restaurants and that sort of thing in this year versus last year.

As you look out into the third and fourth quarter, is there anything you know of now that would kind of skew those numbers around one way or the other?

In the fourth quarter?

Third or fourth.

Not significantly, no.

Just ongoing sort of business.

They come as discrete sort of charges, but there's nothing of significance that we were expecting at this point.

Okay.

Then just on Smokey Bones, I'll just ask a couple of questions quickly.

How much do you think the lack of advertising might have played in the comp performance in the quarter verse advertising a year ago, and then, as you look at the concept, do you need to close units, and I know you said it will have less of a boost to EPS.

Will it still be dilutive on a full-year basis?

Okay.

I'd say the sales impact of the advertising last year was about 1%, a little over 1%, so certainly impacted it, but not the biggest share of the impact of that.

I probably want to clarify a little bit about Smokey Bones.

When we talked in June, we have talked in general about our businesses needing to perform at the restaurant return on sales level of mid teens, and that Olive Garden was well above that and Red Lobster was well in that zone, and Smokey Bones and Bahama Breeze needing to get into that level, and they were -- specifically, Smokey Bones was closer to the 10% level, and in the first quarter they, in fact, did make some progress against that in the first quarter.

So this -- what has taken place in the second quarter -- and they continue in the second quarter to make progress on the variable pieces of cost of sales and labor, but with this kind of a top-line performance it's really certainly impacted their restaurant level returns, and causing us to certainly step back and revisit it.

So it is clearly a near-term, a very immediate sort of challenge, and we've been on a good path of improvement there.

We had -- we had expected them to still be absolutely dilutive for the year, but a meaningful part of the improvement, and so we now saying there's not going to be a meaning part of the improvement, or not an expected meaningful part of the improvement in this year's guidance.

Okay.

Do you think you need shrink the concept?

I mean there are regions where the volumes are so low you'll give up?

Well, we really -- and Drew can talk a little about certainly looking at the brand.

We're not prepared to do that at this point.

Having said that though, again, when we talked to you back in June, we said there were some of these restaurants that, upon further reflection, we would have taken a different strategy on in terms of their location and some of the population markets, but we really think the bigger opportunity is in looking at the broader brand.

Okay.

Thank you.

Yes.

Our next question is from the line of Andrew Barish from Bank of America.

Please go ahead.

Good morning.

A question on Red Lobster.

Really the comp turn here so far has been really ops driven.

Can you give us sort of a time line as to when you sort of transition from this blocking and tackling improvement to more new product news, new advertising, kind of an update in terms of where you see those lines crossing?

Sure.

So far -- the strategy we're taking on Red Lobster is very similar to what we used with Olive Garden, and we've talked about it in broad terms before, but think about it in three phases.

The first phase is all about strengthening the fundamentals, the blocking and tackling, as you said.

And we should see that most immediately in guest experience, and operating efficiency.

And the guest experience most -- would most likely lead to an increase in frequency, from current guests, and that is what we're seeing.

The second phase, which is where Red Lobster is now is reenergizing the brand.

Not changing the brand, but just adjusting advertising, adjusting menu, potentially some amount of restaurant remodel that just makes it more relevant today to a broader group of customers.

And those are all the things Red Lobster is working on right now for next year.

And we wouldn't get into timing on today's call, but that is exactly the next phase.

And then ultimately the third phase, once the fundamentals are strong and the brand is clear, is to accelerate new restaurant growth.

And that's not going to be in the near term, but that is up side in the future.

I would go back to the advertising for a second.

They've got a campaign now called "ignite the craving," which is demonstrating the same improvement in blocking and tackling, if you will in fundamentals of advertising and promotion that the operation side of the business is seeing.

So it is clearly more effective than the advertising they've had in the past, but it does have an opportunity to broaden with a more relevant message in the future, and that's what they're working on for '07.

Is there a -- it seems kind of a comfort level in where you are or else, or at least from my read you would be moving a little bit quicker on kind of new menu items and sort of the new news that obviously is working out there in casual dining right now.

Can you sort of address that, and is that a people issue with Sally Sedit just having come over in the last couple of quarters to the Red Lobster brand?

It's probably more a timing question and an opportunity for the future, but it's also a conscious sequencing that said what we want to do first is make sure the restaurant fundamentals and the guest experience are strong before we start doing some of the other branding things.

We don't want to promise something in our advertising that we're not ready to deliver when people get to the restaurant.

In terms of new news and product news that is going to be an opportunity going forward with Sally, working with Kelly Baltis and Kim Lopdrup and the rest of the team, but to make sure we do it right to make sure we have dishes that fit the brand, that guests love, that our operators can deliver consistently in restaurant there is a process that we go through that has proven at Olive Garden and that Red Lobster is using and it just takes time, a little time to make sure.

Thanks.

Our next question is from John Ivankoe from JP Morgan.

Thanks very much.

The question is on Smokey Bones, and this is a perception that I have, and I want to ask how you guys feel about it.

It does seem that broadening the menu and, I guess, broadening the occasions, if you will, is moving the brand towards varied menu bar and grill, which is obviously a very competitive and heavily advertised category.

Could you just give some indications of where you see the Smokey Bones brand going and what competitive set you see that brand entering, and also I have a follow-up on Olive Garden.

I would say that as we mentioned earlier, it is viewed today in a more barbecue-centric way than we would like, although there's a substantial number of guests that love that, we do need to broaden the appeal.

Broadening the appeal is not going to be limited to broadening the menu number one.

And second, when we talk about broadening the menu, it isn't with the intention of making Smokey Bones a bar and grill competitor.

That's not an area of casual dining that we intend to steer Smokey Bones to.

Barbecue will remain an important part of the menu and an important part of the experience, but it won't be what Smokey Bones ultimately stands for in the future.

It won't be what defines the brand and the guest experience going forward.

We have some ideas about where we want to go, and we're going to be evaluating those ideas appropriately, and so now is not the time to get into it on the conference call, but we're not moving in the direction of bar and grill.

Okay.

Fair enough.

And secondly, Drew, I know you mentioned it in your prepared remarks, the table time management, I forget exactly the words that you used, at Olive Garden, could you give us a sense of how that's being rolled across the system and if there's anything new that's coming up that we can look forward to that might help you on a throughput perspective at that brand?

Thanks.

Our meal pacing system -- the equivalent of KBS, I guess, is an important part of the infrastructure that we're looking at for all our brands.

All of our Smokey Bones restaurants have been opening with this system.

We're testing it at an Olive Garden and a Red Lobster now, and it is -- it's early, but it is leading to lower ticket times, hotter food, our operators are very encouraged so far, but it is still in the test phase, and is something that would be a bigger part of our plans next year going forward.

But it would help with pace of meal and ultimately throughput, not just at Olive Garden, but at Red Lobster as well.

And you would decide on that by the end of this fiscal year whether to roll that out across the system?

Yes.

Thanks very much.

Next question is from Jeff Bernstein from Lehman Brothers.

Please go ahead.

Great.

Thank you very much.

Just had a couple of questions on pricing and traffic.

First, on menu pricing, it seems like you've been slowly returning to price increases at Red Lobster while pricing has been more stable at Olive Garden.

Just wondering if you could talk broadly about your ability to take pricing in each brand relative to where you see each brand in terms of the consumer value equation, then I have a follow-up.

Well, we tend to take pricing -- typically we take broad-based pricing once a year, and then we respond to changes that we think are structural and are going to stay over time.

We respond to those periodically, like minimum wage in certain states.

Our pricing strategy for both brands is to make sure we do a couple of things.

That we keep them positioned distinctly in the market, in a way that's broadly appealing and accessible, because that's at the heart of what both of those brands stand for, and that means having a variety of price points.

Second, we want to make sure that in combination with active cost management, that we're maintaining our margins over time.

And given the rising guest experience that we've got at Red Lobster as well as at Olive Garden we feel like we've got the room to do what we need to do with pricing, but we're mindful of keeping the balance between those first two points.

We're not looking at pricing as a way to build margin.

And I would just add that as we do our competitive research, Olive Garden value is clearly a very important part of the brand.

Olive Garden among major casual dining brands is the value leader, and Red Lobster has really put an effort on improving its brand from a value perspective, and we've seen tremendous improvement in the last couple of quarters at Red Lobster.

We have time for one more question, please.

Okay, great.

Our next question is from Jonathan Waite from Keybanc Capital Markets.

Please go ahead.

Yes, good morning.

Wondering on Smokey Bones with the lowered unit growth in '07, where does that CapEx go to that you had planned?

Then I have some follow-ups, too.

Okay.

We would expect in the current year to have a slight impact in the current year.

As I mentioned earlier, we would guess our CapEx expenditure would more likely be close to last year's level at this point, and the excess of cash would now go to share repurchase, was what we do to maintain roughly our leverage ratios for the business.

So that's how that would work.

And then on Smokey Bones -- well, actually, let me go to Bahama Breeze.

Have you been able to increase the frequency of the guest that goes to Bahama Breeze fhrough new menu changes?

Well, I'm not sure if it's just through the menu changes, but we are increasing frequency and making the occasion a little more accessible, whether it's through adding lunch at all the restaurants or serving dinner on the deck at most restaurants.

It is making Bahama Breeze more approachable and more relevant for a wider variety of occasions.

The menu items that we talked about will help do that as well.

That's a little bit more recent.

But we do think we're getting a frequency improvement from all those things.

And then just so that we can have comfort that we're not having an instant replay here with Smokey Bones as we did in Bahama Breeze, it seemed like that took a long time for you to kind of rectify the situation, Bahama Breeze, and cut all the expansion and all that.

How do we get the comfort that we're not seeing the same thing happening at Smokey Bones with disparate AUVs and a need to retool the menu?

Well, I think at Bahama Breeze we had a couple of issues.

One was, just top-line trend.

And then underneath that, the restaurant level cost structure was well short of where we needed it to be.

At Smokey Bones, as we've said, it really is about making sure that we have a strong trend on topline.

From a restaurant level cost perspective we feel pretty good about where we are.

So it's a different order of magnitude of issue there.

And at 3.1 million AUV, is that not enough to get you guys excited about Smokey Bones and expanding it?

It's very much enough, but we need to have the sales trend be positive and not negative.

So it's more about trend than absolute level.

So it's more kind of camp issue then.

Oh, sure, absolutely.

Okay.

Thanks.

Well, thank everybody for joining us today on the conference call.

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