達登餐飲 (DRI) 2007 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the Darden Restaurants second quarter earnings release.

For the conference today all the participant lines will be in a listen-only mode, however, there will be an opportunity for your questions and instructions will be given at that time. [OPERATOR INSTRUCTIONS] As a reminder, today's call is being recorded.

I would now like to turn the conference over to the Vice President, Investor Relations, Mr. Matthew Stroud. Please go ahead.

Thank you, John. Good morning, everybody.

With me today are Clarence Otis, Darden's Chairman and CEO, Drew Madsen, Darden's President and Chief Operating Officer, and Brad Richmond, Darden's CFO. We welcome those of you joining us by telephone or on 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 and various financial parameters or similar matters.

By their nature forward-looking statements involve risks and uncertainties that could cause actual results 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, 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, risks associated with our plans to improve financial performance at Bahama Breeze and to reposition Smokey Bones, and other factors 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 our earnings, the Form 8-K used to furnish the release to 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 Web site at darden.com.

We plan to release same restaurant sales results for fiscal December 2007 during the week beginning January 1st. We plan to release same restaurant sales results for fiscal January 2007 during the week beginning January 29th.

We plan to release fiscal 2007 third quarter earnings and same restaurant sales for the fiscal February 2007 on Tuesday, March 20th after the market close. And we are holding an analyst meeting on January 11th and 12th, 2007 in Orlando. If you've not signed up yet please do so by contacting us as soon as possible.

We released second quarter earnings yesterday afternoon. Results were available on First Call, PR Newswire and other wire services.

Let's begin by updating you on our second quarter earnings. Second quarter net earnings were $61.6 million and diluted net EPS was $0.41. This represents a 17% increase in diluted net earnings per share.

In the first quarter the Company adopted SFAS 123R on a modified perspective basis which reduced diluted net earnings per share by $0.02, or 6 percentage points of growth in the second quarter. Absent the adoption of SFAS 123R, diluted net earnings per share grew 23% in the second quarter.

Olive Garden had a competitively superior quarter with solid sales and operating profit growth. Red Lobster also had a competitively superior quarter with solid sales and operating profit growth and these results represent a new second quarter records for sales and operating profit at Red Lobster.

Bahama Breeze had modest sales growth during the quarter but solid operating profit growth as they continued to strengthen their business model. Smokey Bones continues to have some challenges but the team remains focused on making the brand more appealing for a broader range of dining occasions and they took another step this quarter to reposition the brand.

Brad will now provide detail about our financial results for the second quarter. Drew will discuss the operating company's business results followed by Clarence with some final remarks. We'll then respond to your questions.

Thank you, Matthew, and good morning.

Darden's total sales increased 4.5% in the second quarter to $1.39 billion driven by same restaurant sales growth at Olive Garden and Red Lobster and our operation of 45 more restaurants than in the second quarter of the prior year.

To give you some context, industry same restaurant sales as measured by Naptrack and excluding Darden were down approximately 1% for the quarter. Olive Garden same restaurant sales were up 2.9% for the quarter, its 49th consecutive quarter of same restaurant sales growth and its total sales increased 7.1%.

Red Lobster had a same restaurant sales increase of .7% for the quarter and a total sales increase of 1.4%. Same restaurant sales at Bahama Breeze increased one-tenth of a percent for the quarter as did total sales. This represents the fifth consecutive quarter of same restaurant sales growth at Bahama Breeze.

Smokey Bones had a same restaurant sales decrease of 5% for the quarter while total sales increased 5% with the addition of 12 net new restaurants.

Let's turn to margin analysis for the second quarter. Operating profit margins were 5 basis points lower than last year on a percentage of sales basis including the impact of SFAS 123R. Excluding this impact, operating profit margins would have increased 32 basis points over the prior year.

Food and beverage expenses were 18 basis points lower than last year on a percentage of sale basis primarily because of savings on commodities at Olive Garden and Red Lobster. Second quarter labor expenses were 44 basis points higher than last year on a percentage of sales basis due to wage rate inflation and FICA tips on additional reported tips.

Absent the FICA taxes on tips, which we receive an offsetting income tax credit, labor expenses were approximately 25 basis points higher than last year. FICA taxes on additional reported tips is recognized as a restaurant labor expense and increased debt line item as a percentage of sales by 20 basis points in the second quarter.

A corresponding tax credit equal to approximately 130 basis points on the effective tax rate is recorded, fully offsetting the higher restaurant labor and leaving net margins unchanged. This will occur again in the third quarter and begin to lessen in the fourth quarter as we begin to wrap on the higher tip reporting in the fourth quarter of last year.

Restaurant expenses in the quarter were 46 basis points lower than last year on a percentage of sales basis primarily because of reduced worker's compensation expense and lower pre-opening expense due to nine fewer new restaurant openings.

Selling, general and administrative expenses were 30 basis points higher as a percentage of sales for the second quarter. This increase was due entirely to the adoption of SFAS 123R.

Our tax rate was lower than the second quarter of last year due to an increase in the amount of FICA tip credits on higher reported tips, that I mentioned earlier, and the resolution of prior year tax matters. Our year-to-date tax rate of 30.6% is in line with our annual guidance of 31%.

Current tax accounting requires recording within the quarter any new developments to income taxes. In the past these adjustments were made to the annual provision and smoothed in over the current and remaining quarters. The first quarter reflected such an adjustment resulting in a higher tax rate of 32.2%.

We continue the repurchase of shares in the quarter buying back 1.6 million shares of our common stock leaving 25.9 million shares remaining in our current authorization to repurchase shares.

For the full-year we continue to expect combined same restaurant sales growth for Red Lobster and Olive Garden to be between 2 and 4%. We anticipate that the second half of the year will be at the upper end of this range.

We still expect a net new restaurant increase of approximately 40 restaurants putting total sales growth for the year in the range of 5 to 6%. We continue to anticipate that diluted net EPS growth will be 10 to 12% in fiscal 2007.

This includes the adoption of SFAS 123R on a modified perspective basis in the first quarter of this fiscal year which reduces anticipated diluted net EPS growth by approximately 4 percentage points. Excluding the effect of adopting SFAS 123R, this translates into diluted net EPS growth of 14 to 16% in fiscal 2007 based on fiscal 2006 diluted net EPS of $2.16.

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

Well we were certainly pleased with the operating performance our teams delivered in the second quarter as well as the progress achieved on the strategic priorities that will drive our future success.

Start with a look at Olive Garden. Olive Garden had another strong quarter delivering competitively superior sales growth and solid operating profit growth while maintaining excellent returns.

Now their same restaurant sales growth of 2.9% during the second quarter was approximately 4 percentage points stronger than the Naptrack estimate for casual dining chains excluding Darden concepts, and when you combine that with revenue from 27 net new restaurants, total sales at Olive Garden grew 7.1%. We would expect to see a similarly balanced approach to growth from both new units and same restaurant sales going forward.

Now this competitively superior sales performance at Olive Garden has been driven by a combination of strong guest loyalty, industry leading value, and compelling news. The ability of their restaurant teams to consistently deliver a competitively superior guest experience over time has helped make Olive Garden a trusted brand with very strong guest loyalty and guest satisfaction remains strong during the second quarter this year.

On the advertising side, Olive Garden began the second quarter with their very successful Never Ending Pasta Bowl priced at $7.95 and this is certainly a guest favorite, features choice and variety and the brand spirit of Italian generosity. Never Ending Pasta Bowl is followed by a promotion with two new dishes, Chicken Roma and Asiago Chicken that have been well received by guests and are still available through the holidays, so if you hurry you can still try those dishes at an Olive Garden near you.

As we've discussed previously, Olive Garden is focused on accelerating new restaurant growth while maintaining same restaurant excellence. They've developed and successfully opened three new Tuscan farmhouse prototypes.

They've established a strong pipeline of new restaurant sites as well so as a result, Olive Garden is well positioned to open 30 to 35 net new restaurants during fiscal 2007, nearly double what they achieved last fiscal year. And importantly, their new restaurants on average are exceeding hurdle rate guest counts, sales, and returns.

Olive Garden's strong business fundamentals combined with accelerated new unit openings give us great confidence in their ability to maintain solid sales and earnings growth for the remainder of fiscal 2007.

Red Lobster same restaurant sales for the second quarter of plus .7% exceeded the Naptrack estimate of minus 1% for competitive casual dining chains although it was somewhat below our expectation.

For most of the second quarter, Red Lobster featured their signature Endless Shrimp promotion and this is a proven promotional concept that offers their guests both variety and value. We ran the same event in the prior year period. Going forward this will be even more effective with stronger product news than was advertised this year.

Red Lobster is currently featuring their Big Seafood promotion. You may recall that this event was very successful for us during the first quarter last year. It features distinctive items like rock lobster tails, king crab legs, and this year, a new jumbo garlic shrimp scampi.

This is a seasonally appropriate promotion at a time when guests are looking for something special and it's off to a great start so far this month. In addition, I should note that Red Lobster has built a very strong culinary team and has fully implemented our disciplined promotion development process, putting them in a position to feature compelling food news in a majority of their future promotions.

Stepping back from the current quarter, our plan to achieve sustainable growth at Red Lobster has three phases. The first phase was to strengthen business fundamentals.

The second phase is to refresh the brand, broaden its appeal, and further build guest counts. The third phase will be to increase new unit growth.

Phase 1 is largely [complete]. In particular, the team at Red Lobster has made significant progress over the last two years improving guest satisfaction and restaurant level profit margins to their highest levels in more than a decade and both of those fundamentals improved further during the second quarter.

Phase 2 began in October. The primary objective of this phase is to accelerate guest count growth by addressing the outdated brand image Red Lobster has with many lapsed users and the perception that it serves primarily frozen seafood.

In late October, Red Lobster introduced a new menu design, new menu copy and several new menu items. In addition, they introduced today's fresh fish sheets. Now these sheets are printed twice daily in each restaurant and showcase five to seven fresh fish choices along with several preparation styles and signature chef's specials.

These changes have been enthusiastically received by our guests and clearly reinforce that Red Lobster offers high quality fresh seafood in a variety of exciting new dishes. Additional initiatives to refresh the Red Lobster brand will be introduced later this fiscal year and during the first half of next year.

The team at Red Lobster is proud of their tremendous progress and we are confident that the business will continue to improve in fiscal 2007 and beyond.

During the second quarter, as Brad already mentioned, Bahama Breeze delivered their fifth consecutive quarter of same restaurant sales growth but just as importantly, Bahama Breeze also continued to make significant progress on their two most important strategic priorities: improving the guest experience and increasing restaurant level returns.

Guest satisfaction has improved enough over the last two years that Bahama Breeze now ranks near the top of casual dining in our research and it will continue to get better as their teams focus on further improving their biggest opportunity areas, attentive service and hot food. At the same time, Bahama Breeze has been working to eliminate cost and complexity from their business model that does not add value to the guest experience, and these structural business model changes have meaningfully increased restaurant level profitability.

Also in the second quarter, Bahama Breeze introduced a new streamline menu that remains very distinctive but has fewer items and can be executed more consistently. We believe this menu will continue to help build both guest satisfaction and restaurant level returns.

Now, based on all this progress, Bahama Breeze is now ready to restart modest new unit growth. They have approved one new site which should open late in fiscal 2008 and are now working to establish a pipeline of additional sites.

Smokey Bones had another difficult quarter with overall business dynamics similar to what we have discussed in the past. Their same restaurant same sales decline of minus 5% with significantly below the Naptrack chain average in total, however, there is still meaningful variation by region.

For instance, restaurants in Florida, New England and the mid Atlantic have significantly higher average unit volume than chain average and have outperformed the Naptrack average from a same restaurant perspective.

Our strategy for Smokey Bones remains the same. We need to stabilize the existing base business, especially in regions of relative strength, while we work to transform the brand in a way that will broaden appeal and make it more relevant for more dining occasions.

We said last quarter that we were about to test a new direction for the business that builds upon our existing assets, including good locations, a strong operations team, and a lodge setting that guests find extremely attractive, yet replaces the barbecue centric parts of the brand that we believe are a barrier to greater occasion breadth and increased frequency.

Rocky River Grillhouse is the name of the restaurant testing this new direction and the first Rocky River Grillhouse opened a few weeks ago in Cuyahoga Falls, Ohio. Now, we described Rocky River Grillhouse as a casual restaurant with a getaway spirit of the great outdoors, specializing in a variety of fire grilled favorites.

The interior of the restaurant pays off the exterior lodge promise with comfortable seating, warm lighting, prominent fireplaces and some natural rock decor. There are no televisions in the dining room and only a couple of televisions at the bar.

The menu is what you would expect to find in this type of environment, including a variety of fire grilled steaks, fish, and chicken dishes that are differentiated with bold, fresh flavors, and yes, Rocky River Grillhouse has barbecued ribs. The service is designed to be friendly and attentive in keeping with the atmosphere in cuisine and we are pleased that sales have been strong the first few weeks, however, we also realize that we have much to learn and much more work to do.

We will provide a more thorough briefing on Rocky River Grillhouse at our analyst day in January including our thoughts about future testing but are not prepared to elaborate further today.

Clarence?

Thanks, Drew.

Well, with the end of the second quarter, obviously, we're through the first half of our fiscal year, and when we step back and look at it, we're very pleased with where we are. We're achieving industry-leading performance.

That's certainly reflected in the 17% diluted net earnings per share growth we had in the second quarter after the adoption of FAS 123R and the 23% growth that we had in the quarter excluding the adoption of FAS 123R and we've done that in an industry environment that's been challenging.

We also feel good that even as we do what's necessary to successfully navigate through this environment, we're building the long-term strength of each of our brands, and we believe the success that we're having is because of our proven approach to the business, and that's an approach that, as we've said before, is anchored in combining strong brand management and great operations.

And guided by that approach, we're confident that we're working on the right things at each of our brands. But what ultimately drives our ability to create sustainable leadership level value for our shareholders is having great people, and so that continues to be what we're really proud of.

I mean we're proud of our results but we're even prouder of the outstanding people we have in our restaurants, in our restaurant support center who are delivering those results. And so that continues to be our number one priority, attracting, retaining, developing, inspiring great people and we believe with that we'll continue to be successful regardless of the environment.

And now we're prepared to take your questions.

[OPERATOR INSTRUCTIONS] First we'll go to John Glass with CIBC. Please go ahead.

Thanks. Good morning.

Could you talk a little bit about minimum wage pressure in '07? I guess both just framing it in the context of your current labor pressures and maybe what you expect in '07 from the current minimum wage increases and tip credit increases that you've seen and maybe what the result would be if the federal government were to take action on minimum wage?

I'll start, John. This is Clarence and then hand it off to Brad for more quantitative.

But I would say that minimum wage pressure is something we've been dealing with for the last several years. If you look at the states, and especially the larger states where we have the most restaurants, we've had action in Florida, we've had action in California, we've had action in Illinois, New Jersey, so it's not new, and I'm not sure that the federal change is going to make a whole lot of difference to us.

There are additional states that continue to come on board with increases with some having tip credit and some not, so we've been facing this pressure all along even as we've strengthened our margins over the last several years and so we feel pretty good about our ability to continue to manage through it.

But Brad if you want to talk more specifically.

Just a couple points to add to Clarence's is that, and this is in the context of our fiscal year is how I would phrase that which goes through May, that the increase that we're seeing with the latest round of state actions is approximately the same that we've had in the previous fiscal year, so they're not changing dramatically for us.

They're generally in the range for the Company of $0.05, maybe as high as ten, which is a range that we can reasonably price forward without putting undue pressure on the check averages to our guests.

In terms of federal minimum wage increase, really kind of hard to say right now. It's exactly what they may do. I would point out though, that for many of our employees they're above that minimum wage rate so, again, clearly we'll have some impact but the magnitude of it probably would not be too significant for us to price for it.

I would just clarify, $0.05 to $0.10 per guest. Brad was referencing.

Got you. That's very helpful.

And then just can you just maybe elaborate on your rationale for suggesting comps should strengthen in the second half? It sounds like the current promotion at Red Lobster is doing well.

Is there any, other than these comparisons is there anything that that guides you to the higher end of the range in the second half?

Well, comparisons are never easy. From our perspective, it's always a battle to get them but I'll let Drew answer that question.

I think we're going to benefit, first, from a lot of the great work that Red Lobster's already done with their "Simply Great" operating discipline and improving all the fundamentals, improving the guest experience and that will be further leveraged with a promotion pipeline that has been more rigorously tested with more compelling news going forward.

We'll go to Mike Smith with Oppenheimer. Please go ahead.

Good morning.

You're going to increase the number of Olive Gardens that you're opening this year. Can you kind of characterize where you're locating those and what kind of prototypes you're using and what type of impact do you think that might have on same-store sales growth going forward?

Well, so as I said, we're opening 30 to 35 this year net new restaurants and we're going really in a couple different locations. We're filling in in existing markets with a smaller prototype and we're going to new markets, smaller markets that we haven't yet been able to penetrate effectively.

So, there's I guess we're pursuing a balanced approach from that regard. All the new restaurants in total are returning or exceeding their hurdle sales and guest counts and returns.

Because we're filling in in some areas, not the average unit volume is slightly lower than the chain average but still very strong and still value creating. And so far, we haven't seen a lot of impact, but as we manage the business for accelerating total sales growth and accelerating operating profit growth at a return level that exceeds our cost to capital, we think that balanced approach, we'd be willing to have slightly slower comp growth if that was the tradeoff.

And I would say, I mean, given what Drew said, Mike, 35 restaurants is still half of those in existing markets we're not expecting any meaningful effect on a system as big as Olive Garden's.

Thank you.

And second, I guess, my follow-up question would be to go to the other concept, Red Lobster, and see whether you could characterize what kind of success you've had with the fresh fish that you've introduced?

Well, it's a little early to characterize it. It's been about a month, six weeks since it's been out, but I would say the objective, again, is to strengthen the brand image at Red Lobster, let people know that they have a variety of great fresh fish options prepared with culinary expertise.

In testing, it did help us strengthen that perception and over time we think it's going to attract some lapsed users that will help us build guest counts overall, but it's a little too soon to reach that conclusion. We're very excited about it. We think it's going to help Red Lobster a great deal but it's a little early to declare victory with it I would say.

And next we'll go to the line of Jeffrey Bernstein with Lehman Brothers. Please go ahead.

Great. Thank you very much. Just a question on the broader consumer sentiment.

Just looking at Darden versus some of your more mature peers and that those peers have seen traffic trends much softer than Darden for an extended period. Seems Darden's been a bit more resilient, a bit more volatile over the past couple quarters and I know you mentioned Red Lobster came in a little bit light recently.

Just wondering if you could talk about your view of the traffic trends and whether you're seeing, you know, what you're seeing when you dig into the granularity?

And just as a follow-on, it seems like comp trends have been a little light lately. You seem more confident in the second half of the year but yet it seems like you tweaked down the overall top line revenue growth for full-year.

I'm wondering if that's due to perhaps a little lower productivity from existing units or perhaps maybe comps coming in more at the lower end of the 2 to 4. Thanks.

I would just say and I'll ask for Drew's assistance on this but as we look at the total industry, certainly, we've seen sales growth come down if you look over last six to eight months compared to the 12 months before that, but nevertheless, we still see sales growth and so the more visible chains are a little weaker than the total industry, I guess is our first thought, but nevertheless, the total industry has softened up a little bit.

We do think that consumers over that six to eight-month period have been more cautious, and we've got a lot of hypothesis. We read some of the hypothesis and some of the folks who publish and some of our thoughts are consistent with that, but we think we've got a more cautious consumer and so we've been managing the business with that in mind, and nevertheless, trying to make sure that we continue to do the things we need to do to strengthen these brands for the long-term because environments change and they come and they go and we don't want to do short-term things that affect long-term viability.

But we still see vibrancy in casual dining and there are brand specific issues, I think, as you look at some of the larger players in the industry that may make them look a little bit weaker than what we see when we look at the overall data.

Yes, I would just add that casual dining inherently is a variety seeking category and when visits slowdown somewhat, guests raise the bar on what they expect and they're going to go to the brands that they trust most. So I think the first thing that you have to look at is which brands have really demonstrated consistency and competitively superior guest experiences over many, many years that build that sort of loyalty which is not something you can do very quickly in the short-term.

I think second, you have to stand out in this kind of environment and give people a special reason to come on top of that loyalty, which is why we focus and work so hard on having compelling news that offers a great value but do it in a way, as Clarence said, that doesn't change what we stand for. It doesn't change the brand positioning, doesn't change the promised experience you're going to get. It just gives people new reason to come.

And I think as you talked about, our sales outlook I would say we've talked about 2 to 4%, we still think that makes sense. First half of the year was a little lighter than we thought coming into the year. Environment's a little tougher, but we do think, as Drew said, that we've been doing some work to really strengthen our brands and we expect that to pay off even in this environment in the second half of the year and so we continue to think 2 to 4% makes sense.

We've come down to that range but primarily because the first half was a little bit lighter than we would have anticipated as we talked to you in June.

Great. Thank you.

And next we'll go to the line of Jason Whitmer with Cleveland Research. Please go ahead.

Hi. Good morning.

I wanted to get back to Red Lobster briefly especially with your shift toward fresh and seemingly getting a little bit more sophisticated. Are you trying to make sure you're balancing your core users with the lapsed users and do you think you can still drive incremental traffic into the restaurant base without alienating your base customer?

I agree with everything you just said. We've got a $2.5 billion, slightly bigger business at Red Lobster that we love. It's a very trusted brand. It dominates the seafood category.

The guests that come today love Red Lobster and we are absolutely going to make sure that they continue the Red Lobster going forward. So the balance that we need to strike is maintaining the experience that's relevant for them while broadening appeal to some of the lapsed users who have stopped coming over time because we're still 5 to 10% below even relatively recent highs in guest counts.

It was the same challenge Olive Garden faced in the late 1990's of continuing to offer an experience that their core guests love but over time, gradually, through a variety of different actions, broadening appeal to people who hadn't been there for a while. So it's got to be done in a thoughtful way, in a disciplined way.

One of the earlier opportunities we believe we have is letting people know that Red Lobster has, for quite some time, offered a variety of high quality fresh fish that's prepared in a number of different fashions and we have been doing that for quite some time. We're just reminding people of that fact.

We've also, Red Lobster's also introduced some menu items that are a little more innovative and have a little bit different flavor profile than maybe some of the core items on their current menu, and so we're going to evolve the business. We're not going to fundamentally change the business for the reasons you mentioned.

If I could, I would just add because this is an important question. I mean, this goes to the heart of it. What we would expect to do when we saw this at Olive Garden is as we broaden the appeal [over at] Red Lobster, we will make Red Lobster more exciting for their core guests.

And so sticking with menu for a moment, we think about a menu strategy, there's certainly the core favorites and those are the things our core guests order most of the time, but they are looking for variety and so if we can add around that additional things that are exciting and compelling, we would give core guests reasons to come more often, even as we give lapsed users a reason to come again and so that really is the strategy. It starts with making sure that we can enrich the experience for core guests and as we do that, we'll make it broadly appealing.

Good.

And my follow-up question, more on restaurant level profits and maybe it has something to do with potential investments needed down the road and maybe you could talk to that. But overall you had a really good run basically this fourth consecutive year of increasing restaurant level profits and up about 150 basis point in some, getting close to this 23% mark.

Do you have a long-term goal in that? Do you think [inaudible] getting closer to a peak, maybe what's the right sales pace you need to get some leverage just on a normalized basis?

I would say that our long-term goal is to improve our margins every year. I mean, the reason why sales growth is so important is because in this business, we have a lo of fixed and semi- fixed costs, and those costs are inflating every year, and we can't simply price through to cover those costs because one of the category benefits is really every day price accessibility, and so the way to mitigate that is really the gross sales and get the leverage, leverage those fixed and semi-fixed costs.

And we get more leverage out of same restaurant sales growth but we also leverage a lot of our fixed and semi-fixed costs with new unit growth. And so both of those are playing to it and over time, we expect operating profit margins to improve.

We've got a target for improvement. We'll go in more detail in that in January. This year we're probably above that long-term run rate but that long-term run rate is improvement for sure.

And [at an] operating company level, we do have a rough target of mid teens, 14 to 15% at the restaurant level margin. Olive Garden, as we've told you in the past, is north of that, Red Lobster has achieved that and will continue to strengthen as guest counts grow.

The next question is from the line of Jeff Omohundro with Wachovia. Please go ahead.

Yes. I guess first, I wondered maybe you could give us just a little bit more color on the Rocky River Grillhouse? In particular, if you see a shift in check average and the targeted consumer expected to frequent this versus Smokey Bones?

Well, we would expect just given the protein on the menu that the check would be a little bit higher than Smokey Bones today. I don't know that the consumer is going to be substantially different but the occasion for which they come could be different.

We think Rocky River Grillhouse is going to be more broadly appealing for the core visits in casual dining, every day meals of family planned adult dinners, going to be used more frequently by the same types of guests who are coming to Smokey Bones today.

So I think it's less a shift in the guest. I think it's more a shift in how they view the brand and how they use it in terms of occasion and frequency, and it might be a little bit higher in check.

I would say that's absolutely right and we feel comfortable that the higher check is the good place to be because the value ratings that we get out of Smokey Bones are quite high. The customer that's coming to Smokey Bones today at the margin skews a little bit higher income than Olive Garden and Red Lobster, so we feel pretty good about that.

And then just one more question on the whole Olive Garden acceleration. Just an update on the pipeline. [Inaudible] as you're beginning to look out, I guess, into the next fiscal year as it sounds like you're in good shape on this year.

Yes. As I said this year is 30 to 35. We would expect that to increase some.

Next year we'll talk more about that in a few months but the pipeline for next fiscal year is already established, so we feel very good about our ability to do that in fiscal 2008.

Our next question is from the line of David Palmer with UBS. Please go ahead.

Good morning.

You've done a really nice job of controlling costs over the last three years. I think your food costs are down about 200 basis points since '03, and they look to be about the lowest in the industry, however, in just looking at your G&A margin, that's not really budged too much lower even after adjusting for options.

Your guidance certainly implies some nice same-store sales growth in the second half so you seem optimistic but I'm wondering if you were to go back to the type of same-store sales growth that we saw in this last quarter of the 1 to 2% blended and type numbers, could you maybe deliver double-digit EPS growth anyway perhaps with the help of overhead cost reductions or leverage on G&A that we really haven't seen yet?

Well, I would say a couple of things. First of all, we really look at the net operating profit margin improvement because we will invest, for example, on the G&A line to drive down the labor and food cost lines, and so we've got a very, we think, competitively superior supply chain.

A lot of those costs show up in G&A. A lot of the benefits show up in COGS and labor. Same thing with technology. So that's the first thought.

That said, we do think that we can continue to operate much more efficiently. So we've got a very strong restaurant support platform that we can leverage as we scale up, and so we would expect to see some margin improvement on that line but we tend to look at the net margin improvement as opposed to individual lines.

Okay. Thank you.

Your next question is from the line of Mark Wiltamuth with Morgan Stanley. Please go ahead.

Hi. Good morning.

Wanted to ask some questions on Red Lobster. You indicated your Phase 3 is to eventually move to restaurant growth. What are the milestones you're looking for to reach that level and are you also contemplating some smaller prototypes as you have done with Olive Garden?

Okay.

The biggest milestone is for us to see, continue to improve guest satisfaction, really sustain guest count growth that will help increase average unit volume and take that restaurant level return even a little higher than the mid teen range I was talking about so that we have higher confidence that our new restaurants will be value creating.

That's really the biggest milestone and that's why refreshing the brand, Phase 2, is so important to broaden appeal to build guest counts.

Will we have more than one prototype? Probably. You know, probably a different, a couple of different prototypes that reflect differing investment opportunities in different sized markets.

Okay.

And I guess switching over to the Rocky River Grillhouse, are you going to run a rest for a period here before you decide to rebrand all the Smokey Bones or are you already committed to rebranding the Smokey Bones and just how much will that cost?

Well we'll be talking about that a lot more January 11th and 12th at our analyst day, but we're going to test more than just one Rocky River Grillhouse before we make that kind of decision and that will include remodeling some existing Smokey Bones units.

Our next question is from Rachael Rothman with Merrill Lynch. Please go ahead.

John, the share count during the quarter came in a bit higher than we had been thinking and, obviously, with your pretty strong free cash flow can you talk about what your priorities for allocating that are?

Rachael, you're breaking up. If you could get just a little bit closer to the microphone.

Sorry. Apologies. Can you hear? Is that any better?

Yes.

Okay. Thanks.

Can you just talk about your priorities for allocating your free cash flow going forward given that you have produced sustainable and substantial free cash flow at this point?

Well, I think we talked about really, [inaudible] returns on the businesses and so you see the acceleration in Olive Garden because the returns are quite strong. Strong enough to get us where we need to be despite the inflation that we're seeing on land cost and on construction steel, and so we are accelerating at Olive Garden.

Given the business model improvement at Bahama Breeze we're looking to build that pipeline as well. Drew just talked about Red Lobster and some milestones that we still need to see to have incremental investment in the units that were at Red Lobster pay off at the level that's required and then Smokey Bones is really a work in progress. And so in terms of our cash flow priorities that's where they are right now.

On the new unit side, really Olive Garden, Bahama Breeze, if we continue to get the kind of results that we're seeing very early out of Rocky River Grillhouse, then remodeling of some of the Smokey Bones will have significant return and so that would be something that we'd be looking at.

Beyond that, we want to make sure that we have a capital structure that makes sense, and so we feel like our leverage level today is where we need it to be and to the extent we don't have opportunistic investments outside of our existing businesses, we'd be looking to maintain that leverage level and we'll do that by continuing to buyback stock.

Rachael, Brad here.

Wanted to add just one additional point when you talk about the share repurchase. Last year during the first half of the year we did increase our leveraging that provided some additional share buyback.

Last year we purchased about 434 million of shares. This year, our guidance is to purchase approximately the same amount as we go forward, so we'll be expected to do that at this point.

Perfect.

And just as a quick follow-up that maybe something you're going to address at the meeting in January, but in past conference calls, you've talked a little bit about the potential for an acquisition. Can you just prioritize that, obviously, after the growth in your existing business and your share repurchases, is that something that you're still considering at this time?

I think as we think about the mix of total sales growth going forward, we do think that we'd like to see a higher percentage of that come from new restaurant growth. And so given where our existing businesses are acquiring an additional business would help that.

That said, we are very return focused and so we need to have something that we think has long-term potential from a consumer perspective and that makes sense for our shareholders in terms of the price. And so while we're constantly monitoring things and looking at them from a consumer perspective and really gauging strength, it's difficult to put a timeline on it given the financial requirements.

But we are constantly doing a scan. That scan really focuses a great deal of attention on consumer appeal and durability and sustainability and I think beyond that, not a whole lot else to say.

Next we'll go to Robert Derrington with Morgan Keegan. Please go ahead.

Yes. Thank you.

Clarence, if you could clarify something for me. As we look at the earnings per share growth that the Company has had in the first several quarters of the year, clearly, it's been competitively superior to many of your peers and it's been averaging in that roughly 15, 16% range in both Q1 and Q2, yet your earnings guidance for the year remains unchanged.

So that implies in an environment in which you expect sales to be more at the high end of the range, the earnings per share looks to decelerate in the next several quarters. Can you reconcile that for me?

I'll let Brad get into the numbers but we have increased our earnings guidance for the year from what we outlined in June. And we've also range bound it and so I think we're pretty comfortable that it reflects our view of the business so we're not seeing any deterioration in margins or anything like that, but we do have an environment that's choppy and so we need to have a range and that's, I think, pretty much our thinking.

Great. Thank you.

And we'll go to Brian Elliott with Raymond James. Please go ahead.

Good morning.

I wondered if you could help us get a sense of the magnitude of the benefits from the sort of the ending of the growth cycle at Smokey Bones and, obviously, it's been some time for Bahama Breeze. I know there's a lot of pre-opening infrastructure costs and still in prior year numbers and maybe if you can give us some sense of the magnitude of impact and I believe it's all in the restaurant operating expense item or [mostly].

Brian, Brad here.

I think there's a couple things to consider in that is that one, while we are decelerating in Smokey Bones, we are accelerating in Olive Garden, that performance there, as well as we take the Smokey Bones business in a different direction there. There's the reinvestment there that we're incurring to launch that, so on a year-to-year basis, it's going to be relatively comparable.

In dollars or a percent?

Dollars.

Okay. All right. That's helpful. Thank you.

And your next question is from Steven Kron with Goldman Sachs. Please go ahead.

Thanks. Good morning. A couple questions.

First, if we look at the margins by brand, as your press release reads, it looks as though Olive Garden restaurant level margins seem to decline despite a 2.9% same-store sales increase. At the same time Red Lobster margins seems like it gained with only .7% same-store sales increase.

I guess just with that as a backdrop, can you just talk a little bit about maybe what surprised you this quarter, why margins may have declined at Olive Garden? I think in prior calls you've talked about being able to get the leverage even at the unit level I think, and within the 2 to 4% range so wondering whether that's food and beverage or specifically labor related that may not have trickled into the Red Lobster brand. That's my first question.

To Olive Garden's point there, part of it they have the acceleration of growth there, that's an additional cost as they ramp that growth up on a year-to-year basis, was a little bit of a drag on their performance.

On the Red Lobster side, without that growth and just the overall base business improvement that they're having on their sales increase, we're able to drive a higher percentage return on those sales, and then each concept has their own unique P&L. In terms of other factors, workers comp, some of those, the benefit of that was not equal among the concept and so that drives some individual brand differences.

Without the acceleration of growth at Olive Garden would you have seen margin expansion at Olive Garden or were there other factors?

We would have seen expansion in margin without the growth, yes.

Okay.

And then just secondly, Brad, just back on the minimum wage front. What percentage of the dollars that we see on the P&L on the labor line is affected by minimum wage or tip credit increases?

You know, I may have to get back with you. What I would tell you, though, is that it's a very small percent that are at the minimum wage.

The other point that enters into our business is what might happen to the tip credit rate. Our servers are basically all at that rate and if that rate we're to change would be probably [inaudible] more significant in terms of a dollar impact to us, but the actual minimum wage rate itself is not too significant.

And next we'll go to John Lawson with Tiburon Research Group. Please go ahead.

Hi. Thanks.

You've seen a lot of improvement in your food and beverage expense the last few years. Since you have purchasing offices in foreign countries I was wondering if you could help me understand what portion of that improvement may be currency related?

We use dollar contracts, so really it would be no impact to us.

Okay. Thanks.

And we'll go to Donald Trott with Jefferies & Company. Please go ahead.

Good morning.

Actually I tried to get out of the queue and couldn't but since I'm here, you discussed before the allocation of capital between expansion of your physical facilities and share repurchases. Could you comment a little bit on how dividends fit in there, what your ongoing dividend policy is? Your pay out policy?

Yes, I'll start it off, and we really have, we're looking to pay a meaningful dividend in the whole context, and so our thinking is a dividend yield between 1 to 2% essentially and so we've adjusted upward, for example, recently, because we'd fallen below that range but that's essentially the range that we've targeted. We constantly look at dividend policy to see are there reasons to adjust but that's our current thinking.

Thank you.

And next we'll go to Paul Westra with Cowen and Company. Please go ahead.

Hi. Thanks. Good morning. I had a follow-up question on your promotional upcoming activity with Red Lobster.

I know you don't want to share too much for competitive reasons but I was wondering if you could add more color. Specifically on the commodity cost outlook, would that outlook maybe help lower or maybe increase the guest check or promotional price points?

And second really in the grander scheme I'm curious about your comments that the competition, or at least your peers of the well-known brands are struggling, and it seems like competition therefore might be coming from the independence and does that change your strategy and has that ever happened in the past that you can recall?

Well, I'll take the first question. Or the second question first and let Brad answer the first one.

I would say as we look at the industry numbers, chains continue to be very strong competitors and so we take a lot of visibility on the biggest national chains, but they are a small percentage of total chains and we've got increasingly strong chain competitors. And so the chains, when you look at change versus independents, continue to take share.

That said, independents may be stable to declining slightly but there's a lot of churn under that number and weaker independents get replaced with stronger independents would be [inaudible]. But the chains are still formidable and we pay attention to a lot of them. As I said, as part of the acquisition effort but also just as part of the competitive scan.

So your other comments is a function of maybe that limited number of large brands and regional brands are still very strong?

I think when you look at the major, the most visible public company brands, you've got the ones with the biggest systems are reporting numbers that we all see and they're not representative of total chains.

On your question on the commodities front, what I would say, when you look at that for the Darden brands, we have enjoyed some fairly favorable costs so far this year on a year-to-year comparative basis and for the products we buy, we're really not seeing too much of a change in that through the remainder of our fiscal year.

And as that relates to promotions, the commodity costs are relatively benign and it's not going to in any way artificially constrain what we would choose to do in the second half of the year from a promotion standpoint.

If we saw the guest check change in the first half wouldn't be too materially different in the second half?

Well, there's tremendous seasonality and Lobster Fest, which is a very high check promotion, is part of the second half, so I don't think the first half-second half difference this year is going to be much different than it has been in prior years.

So we've got time for one more question.

That will be Mike Smith with Oppenheimer. Please go ahead.

Well, this question, going back to Smokey Bones. Have you totally thrown away the idea that Smokey Bones could operate as a concept on its own considering the way I understood it was about two-thirds of those were what you would call successful units in terms of hitting the kind of returns you want whereas one-third weren't.

Well I don't know that we put that fine a point on the percentages, Mike, but there are clearly regions that are performing significantly higher in a couple of the key metrics, average unit volume, same restaurant sales, unit level economics, than the chain in total, and I think at this stage we would say it's too early to say where we're going to net out, but we're going to be careful in evaluating the new direction with Rocky River Grillhouse in both restaurants that have above average performance today as a Smokey Bones and in restaurants that have weaker performance today as a Smokey Bones.

And we're going to be more careful before we would convert the part of the chain that's working much better, and we'll talk more about it as we learn more about Rocky River and go forward.

Thank you.

Thanks, Mike.

Well we'd like to thank all of you for joining us today on the call. If you have any further questions or additional follow-ups, please contact us here in Orlando. Otherwise we wish you all a safe and happy holiday season and we look forward to seeing many of you in a few weeks down here in Orlando for our analyst day. Thank you.

Ladies and gentlemen, this conference is available for replay. It starts today at 12 p.m. Eastern, will last until January 20, 2007 at midnight.

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That does conclude your conference for today. Thank you for your participation. You may now disconnect.