達登餐飲 (DRI) 2012 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by.

Welcome to the second quarter earnings release conference call.

At this time all participants are in a listen-only mode.

Later we will conduct a question-and-answer session.

Instructions will be given at that time.

(Operator Instructions) As a reminder this conference is being recorded.

I would now like to turn the conference over to our host, Mr.

Matthew Stroud.

Please go ahead.

Thank you, Ernie.

Good morning, everyone.

With me today are Clarence Otis, Darden's Chairman and CEO; Drew Madsen, Darden's President and COO; Brad Richmond, Darden's CFO; and Gene Lee, President of Darden's specialty restaurant group.

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.

Forward-looking statements are made under the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995.

Any forward-looking statements speak only as of the date on which such statements are made, and we undertake no obligation to update such statements to reflect events or circumstances arising after such date.

We wish to caution investors not to place undue reliance on any such forward-looking statements.

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

The most significant of these uncertainties are described in Darden's Form 10-K, Form 10-Q, and Form 8-K reports including all amendments to those reports.

These risks and uncertainties include food, safety, and foodborne illness concerns; litigation; unfavorable publicity; federal, state, and local regulation of our business including healthcare reform, labor and insurance costs; technology failures; failure to execute a business continuity plan following a disaster; health concerns including virus outbreaks; the intensely competitive nature of the restaurant industry; factors impacting our ability to drive sales growth; the impact of indebtedness we incurred in the RARE acquisition; our plans to expand our newer brands like Bahama Breeze and Seasons 52; our ability to successfully integrate Eddie V's restaurant operations; a lack of suitable new restaurant locations; higher than anticipated costs to open, close, or remodel restaurants; increased advertising and marketing costs; a failure to develop and recruit effective leaders; the price and availability of key products and utilities -- food products and utilities; shortages or interruptions in a delivery of food or other products; volatility in the market value of derivatives; general macroeconomic factors including unemployment and interest rates; disruptions in the financial markets; risks of doing business with franchisees and vendors in foreign markets; failure to protect our service marks or other intellectual property; a possible impairment in the carrying value of our goodwill or other intangible assets; a failure of our internal controls over financial reporting or changes in accounting standards; and other factors and uncertainties discussed from time to time in reports filed by Darden with the Securities and Exchange Commission.

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 website at Darden.com.

We plan to release fiscal 2012 third quarter earnings and same restaurant sales for fiscal December, January, and February 2012 on Friday, March 23, 2012, before the market opens with a conference call shortly after.

Also, we plan to hold our fiscal 2012 analyst and institutional investor meeting on Friday, February 24, 2012, in New York City.

This meeting will also be webcast for those unable to attend in person.

We released second quarter earnings results this morning.

These results were available on PR newswire and other wire services.

We recognize that most of you have reviewed our second quarter earnings results, so we won't take the time to go through them in detail once again in an effort to provide more time for your questions.

We will offer a line item summary of the P&L and discuss our financial outlook for fiscal 2012, as well as briefly discuss our brand by brand operating performance summary.

To begin, Clarence will provide an overview of the quarter and fiscal year, Brad will provide detail about our financial results for the second quarter, Drew will review our operating performance of the larger brands, and Gene will discuss the specialty restaurant group.

We will then respond to your questions.

Clarence?

Thank you, Matthew.

And good morning, everyone.

I'm going to take just a couple of comments upfront to put our results for the quarter into context, then I'll hand it over to Brad, Drew, and Gene.

And let me start with Olive Gardens performance, which is something that Drew is going to discuss in further detail in a moment.

Now, many of you followed us for some time and I think one of the things you've observed over time is that we are not afraid to make changes.

In fact, in an industry as dynamic as ours, we think that our willingness to change is one of the biggest reasons why we've enjoyed success over time.

And we've certainly demonstrated that we're prepared to change when things are not working well.

And I think you see that in our multi-year effort, for example, to refresh the Red Lobster brand, to address an extended period of inconsistent results.

You also see it in the work that we're doing in response to negative traffic trends to more crisply articulate LongHorn's brand positioning and then to incorporate that positioning into every (inaudible) point from menu offerings and menu design to advertising to the look and the feel of the restaurants.

I think we've also demonstrated that we're prepared to do something that's much harder.

We're prepared to change when things are working well.

And I think you see that in our multifaceted effort to transform a support platform rather that's already more cost effective than most in the industry, and to move that to be run that's even more cost effective.

And as we've discussed with you before, of course, that effort involves big change to big things.

It includes further automating our supply chain, significantly reducing water and energy usage in our restaurants, centralizing the maintenance of our facilities so we can lower those costs; and then optimizing the cost of labor in the restaurants as well.

Now, Olive Garden's a case where things were working well.

They were working well so much so that Olive Garden's been taking significant market share for the past decade; and at this point, enjoys some of the highest unit volumes and returns in full-service dining.

And even though things were, in fact, working well, we were indeed making improvements.

And those improvements included meaningful investments, for example, in national Hispanic advertising and digital marketing.

They included a table management system that enables us to offer more accurate quote times on waits and get guests in and out of the restaurants on their timetable.

And they also included the introduction of Panini sandwiches at lunch, and those build on Olive Garden's signature soup, salad, and breadsticks offer for that day point.

In retrospect though, the improvements that we're making at Olive Garden weren't bold enough.

They weren't bold enough in light of the scale and scope of the changes that were taking place at other brands, including Red Lobster and LongHorn.

And they weren't bold enough given the changes that were taking place in consumer circumstances and consumer expectations.

So you have our commitment that going forward, there will be much more meaningful change, and Drew is going to touch upon that in a little bit more detail in a minute.

Now, that change is not going to add up to a radical departure from where Olive Garden is today and that's because that kind of departure just isn't warranted given Olive Garden's consumer and financial strength.

But you should note that from a guest perspective, there will be noticeable change.

The second point that I'd like to make is about the strength of our portfolio.

It's a portfolio that's built to deliver solid results even when a single brand is having brand specific challenges, like Olive Garden's having today.

That collective strength did not show through in the first half of the year.

And it didn't show through for one very specific reason, there was an abnormal spike in the cost of our single most important food product category and that's seafood.

And we chose not to jeopardize the progress that Red Lobster's been making by passing that increase along to guests.

Now fortunately, as we've worked to reestablish value leadership at Olive Garden, we don't expect that in the second half of the year and then beyond that that we're going to have that kind of headwind in terms of seafood costs.

And Brad's going to give you some perspective about our outlook for seafood and for other costs as we go forward.

But to give you a sense of what we've experienced to date, in the first half, seafood costs, which are 31% of our total food costs, were 20% higher than the prior year, a remarkable increase.

And had seafood costs risen just 4%, which would have still been a meaningful increase by historical standards and nothing else about performance changed; instead of declining 11% for the first half of the year, diluted net earnings per share would have been flat to prior year.

That's just to give you a sense of the portfolio and the business model.

And with that, let me turn it over to Brad.

He's going to walk you through the financial details for the quarter.

Thank you, Clarence.

And good morning, everyone.

Darden's total sales from continuing operations increased 6.1% in the second quarter to $1.83 billion.

This strong top line performance compares to an estimated 1.8% total sales growth for the industry excluding Darden as measured by Knapp-Track.

So as you can see, we had meaningful market share growth.

On a blended same restaurant sales basis, the results for Red Lobster, Olive Garden, and LongHorn Steakhouse were up 1.8% in the second quarter.

And this compares to the industry same restaurant sales as measured by Knapp-Track and excluding Darden that are estimated to be up 0.6% for the quarter.

And we also saw combined continued strong same restaurant sales gains in our specialty restaurant group with a 3.9% same restaurant sales growth.

Year-over-year, traffic gains at Red Lobster and LongHorn Steakhouse this quarter were strong again, driven by successful promotions, remodeling, and other brand enhancements.

On a blended same-restaurant traffic basis, results for Red Lobster, Olive Garden, and LongHorn Steakhouse were up 1.3% in the second quarter.

This compares to industry same restaurant traffic as measured by Knapp-Track excluding Darden that is estimated to be down 2.0% for the quarter.

Notably, Olive Garden's trends strengthen as well with its traffic improving 120 basis points sequentially from the first quarter to the second, while the industry experienced 140 basis point deceleration from the first quarter to the second.

Now, food and beverage expenses for the second quarter were approximately 260 basis points higher than last year on a percentage of sales basis.

About 75% of that unfavorability was expected based on the inflationary food cost environment and our decision to price below inflation.

The balance, or about 60 basis points, was due to greater than anticipated check management by our guests.

This occurred primarily at Olive Garden and LongHorn Steakhouse.

More specifically, at both brands fewer than expected appetizers, drinks, and desserts were purchased; and at Olive Garden, there was higher preference for the promotional offers compared to last year.

Clearly, consumers are still dining out, which shows in our strong blended traffic results in the second quarter and is an indication of how much they value the experiences; but they are choosing to reduce their total spend per visit.

In terms of our purchasing strategy, we continued to lock in forward contracts we believe are favorable and avoid those where there's a large premium to our expectations of future prices.

For the past year, this strategy has been successful because we've purchased products in the cash market at levels that provide meaningful savings compared to what we would have contracted for in the futures market.

For the second quarter, restaurant labor expenses were approximately 70 basis points lower than last year on a percentage of sales basis due to sales leverage and improved wage rate management.

The favorability for the quarter was consistent with our expectations.

Restaurant expenses in the quarter on a percentage of sales basis were essentially flat to last year primarily because of sales leveraging offset by higher pre-opening expenses and some increased repairs and maintenance expense.

Selling, general, and administrative expenses were approximately 20 basis points lower than last year as a percentage of sales due to sales leverage that more than offset higher media levels and media inflation.

Depreciation expense in the quarter was approximately 20 basis points higher on a percentage of sales basis compared to last year because of remodels at Red Lobster and LongHorn Steakhouse.

For the quarter, operating profit as a percentage of sales was 5.3%.

That's about 200 basis points below last year; and again, that's due almost exclusively to higher commodity cost on a year-over-year basis that we chose not to fully price for and some continued consumer check management.

For the full fiscal year, we expect combined same restaurant sales growth for Red Lobster, Olive Garden, and LongHorn Steakhouse of approximately +2% to +3%.

And we continue to expect net new restaurant increase of approximately 80 to 90 restaurants, and that's excluding the purchase of the Eddie V's restaurants, which is about a 4.5% unit growth on our current base and approximately 4% growth in operating weeks or capacity for fiscal 2012 given the timing of those unit openings.

With these same restaurant sales assumptions and new restaurant growth plans, we now anticipate total sales increase for the year of between +6% and +7%.

For the full fiscal year, we expect a decrease in our operating profit margins or operating profit return on sales of approximately 40 to 60 basis points.

For the fiscal year, we now anticipate food and beverage cost inflation to be approximately 6%.

We experienced nearly 8% food and beverage cost inflation in both the first and second quarter.

We anticipate approximately 6% food and beverage cost inflation in the third quarter and less than 3% food and beverage cost inflation in the fourth quarter.

We have approximately 50% of our total food spend contracted through the end of the fiscal 2012.

We believe some commodities will experience further cost declines from the current elevated levels, and we want to be in a position to benefit from that decline; so we've opted not to contract all of our planned usage.

Category by category, shrimp is our highest volume protein, and we have approximately 50% of our usage covered through fiscal 2012 at prices higher than fiscal 2011.

We anticipate increased supply in calendar 2012 and moderating prices from that that we experienced in fiscal 2012.

Crab is contracted or purchased at prices higher than fiscal 2011 with approximately 80% coverage through the end of fiscal 2012.

And lobster is contracted or purchased at prices lower than fiscal 2011 with approximately 70% covered through the end of our fiscal 2012.

Beef prices are higher on a year-over-year basis, and we have approximately 25% of our usage covered through the end of the fiscal year.

Chicken or poultry, we have contracted 100% of our usage through calendar 2012 at prices lower than calendar 2011 costs, even though the market prices are slightly higher on a year-over-year basis.

Wheat prices are higher on a year-over-year basis, and we have approximately 50% of our wheat products covered through fiscal 2012 at prices slightly higher than our fiscal 2011 costs.

Dairy prices are higher on a year-over-year basis.

We have approximately 30% of our dairy products contracted through fiscal 2012 at prices slightly higher than our fiscal 2011 cost.

Energy costs are expected to be unchanged on a year-over-year basis at least through calendar 2012.

We have contracted nearly 100% of our natural gas and electricity in the deregulated markets in which we operate for fiscal 2012 at prices slightly higher than fiscal 2011.

We continue to expect savings of approximately $65 million to $75 million from our four transformational cost initiatives of supply-chain automation, sustainability, facilities maintenance centralization, and labor optimization.

These savings helped offset some of the food cost inflation, and we have and will continue to experience this fiscal year.

And today, we also affirm that we anticipate reported diluted net earnings per share growth from continuing operations for fiscal 2012 will be between 4% and 7%.

This outlook implies double-digit earnings growth in the third and fourth quarters.

Our outlook also reflects a tempered, but nevertheless improving, same restaurant sales trends at Olive Garden, continued sales momentum at the other brands, Red Lobster, LongHorn and the specialty restaurant group, more normalized year-over-year commodity costs along the lines I just mentioned in the second half of the fiscal year, and continued though modestly moderating check management and the related menu mix impact.

And now I'll turn it over to Drew to comment on Red Lobster, Olive Garden, and LongHorn Steakhouse.

Drew?

Thank you, Brad.

As I mentioned on our call last quarter, the fundamental strategic challenge we faced this year is how to address the growing need for affordability that's demanded by our guests while also protecting our margins, given significant commodity cost inflation.

Our enterprise strategy to address this challenge remains grounded in two important choices.

First, we've chosen to maintain our annual price increases in the historical range of roughly 2% to 3%.

This will allow us to protect the guest value equations we believe are fundamental to long-term brand vibrancy.

At the same time, we will leverage the impact of the four transformational cost savings initiatives that both Clarence and Brad mentioned to protect our profit margins.

Essentially, we are pricing to cover the net inflation in our business after accounting for the impact of our cost savings initiatives.

During the first half of the year, however, our cost reduction initiatives did not fully cover the shortfall in our pricing versus inflation due primarily to unusually high shrimp inflation at Red Lobster.

In contrast, for the second half of the year, we expect pricing to be equal to inflation with our cost reduction initiatives contributing to margin expansion.

And for the full year, we continue to expect pricing to be equal to inflation net of our cost savings initiatives.

Second, this year we have chosen to elevate the emphasis on affordability in our promotions at all three large casual dining brands.

These promotions feature new dishes designed to offer our guests compelling brand-appropriate price points with a food cost that is consistent with sustainable value creation.

The contribution of promotions to growth in total sales and total earnings will be driven by more guests paying a little less.

Now, we're very pleased with the results of this promotion strategy during the second quarter at both Red Lobster and LongHorn, however, we did not make as much progress at Olive Garden as we anticipated.

Olive Garden same restaurant sales were down 2.5% during the second quarter, roughly 310 basis points below the full service restaurant industry benchmark.

During the second quarter, Olive Garden had two promotions that both featured brand-appropriate affordability.

Their signature never ending pasta bowl priced at $8.95 continued during September and through the first week of October.

In the second week of October, they launched stuffed rigatonis with sausage for $9.95 or stuffed rigatonis with chicken for $11.95, and both price points were featured in their advertising.

The preference on both promotions was higher than expected and guest count performance improved meaningfully from lagging the industry benchmark by 160 basis points during the first quarter, to exceeding the industry benchmark by 100 basis points during the second quarter; however, neither promotion drove as many guests as anticipated, and there was more trading to the lower-priced promoted entrees than we have seen historically.

This trading, combined with lower add-on sales as guests continue to manage their check, resulted in negative menu mix for the quarter.

The key learning we take from this is the need to evolve our promotion constructs to highlight Olive Garden's value and affordability in a more compelling way, one that motivates more incremental guest visits.

Now, stepping back from the most recent quarter, we continue to see compelling evidence that the brand relevance and business model at Olive Garden remain competitively strong.

For instance, at $4.7 million, Olive Garden enjoys the broadest appeal and highest average unit volume of any nationally advertised brand in casual dining.

Olive Garden also had the highest future visit intent of any of the large casual dining brands in our continuous tracking study over a majority of the past 52 weeks.

Although Red Lobster recently moved to the number one spot with Olive Garden a close second.

Restaurant level returns at Olive Garden remain in the upper teens, and new units continue to significantly exceed our sales and earning hurdles for value creation; however, we also know that same restaurant sales have clearly softened over the last year and remain below our expectations.

We believe the primary cause of our same restaurant sale softness is a narrowing in the value leadership advantage Olive Garden enjoys versus other large brands in the industry.

In hindsight, we did not evolve our guest experience and communication fast enough during the last couple of years to stay fresh and relevant in the eyes of consumers and superior to an improving competitive set.

This is especially true for our promotion constructs, our core menu, and our advertising.

As a result, Olive Garden is a beloved but somewhat expected brand today.

In addition, we also did not recognize fast enough a structural industry change coming out of the financial crisis related to guest's need for increased affordability.

This elevated need for affordability is most pronounced in households with incomes below $50,000.

Olive Garden held onto these guests during the recession better than the industry.

But coming out of the recession, as these guest experienced more persistent economic pressure than we had anticipated based on prior recessions, and as competitors made bolder moves to improve affordability, Olive Garden is seeing some erosion in this guest segment.

As a result, during the second half of this year, we plan to feature three uniquely constructed promotions to deliver news and value in a more differentiated manner.

In addition, our new bridge advertising will build on the core brand equities of generosity, warmth, and family in a more genuine and authentic manner while also effectively showcasing the crave and value elements of our promotional offers.

And we plan to add several more affordable items to our core menu as well.

We believe that in combination, these steps will help gradually drive improving same restaurant sales.

We're also working on even more meaningful improvements.

Their introduction and full impact will take longer to realize given the lead times associated with each initiative.

This includes a completely new advertising campaign with a more relevant communication of the idealized Italian family meal promised by Olive Garden, a new core menu featuring greater everyday affordability to ensure we maintain relevance for more economically challenged guests, as well as some distinctive dishes with slightly higher prices to ensure we offer competitive and relevant dishes for guest segments where the what you get part of our value equation is the more important dimension.

In addition, these bolder improvement initiatives also include a remodel that updates and refreshes the dining atmosphere in Olive Garden's 430 non-Tuscan farmhouse restaurants.

The Olive Garden operations team is also working on initiatives to reduce false rates, empower servers to enable greater personalization of meal pacing and elevate manager presence and ownership in the lobby.

Olive Garden opened six new units during the second quarter and is on track to open 35 to 40 net new restaurants this year.

And as I mentioned, these new Tuscan farmhouse units continue to significantly exceed their sales and earnings hurdles.

Red Lobster same restaurant sales increased 6.8% during the second quarter, 620 basis points above the full-service restaurant industry benchmark.

Red Lobster has delivered competitively superior same restaurant sales since October last year when they began emphasizing craveable new seafood dishes and price certainty in their promotions, and that momentum continued during the second quarter.

They began the quarter advertising the final week of their Crabfest promotion and then featured the endless shrimp promotion for 10 weeks.

This year, endless shrimp was featured at a $15.99 price point for the entire promotion; while last year, the price point was not advertised for the first four weeks of the promotion.

They maintain this price point in order to emphasize affordability despite, as Brad referenced previously, a nearly 25% increase in shrimp costs year-over-year.

Preference for endless shrimp was significantly stronger than prior years indicating increased consumer appeal for the promotion.

That was followed by a new surf-and turf-promotion during the last two fiscal weeks of November and features three new steak and seafood entrees priced under $20.

We also believe the new ad campaign introduced in the first quarter called Sea Food Differently continues to communicate these compelling promotions while also building brand relevance and guest engagement more effectively than the prior campaign.

In addition, the VIP service initiative introduced last year designed to make guests feel valued and important through more personalized service continues to help drive improving guest satisfaction.

Red Lobster remodeled 48 restaurants during the second quarter, and is on track to complete more than 150 remodels this fiscal year.

Remodelled restaurants continue to exceed their guest count and earnings growth hurdles.

LongHorn same restaurant sales increased 6% during the second quarter, 540 basis points above the full-service restaurant industry benchmark.

LongHorn same restaurant sales have now exceeded the industry benchmark for 12 consecutive quarters.

These competitively strong results during the second quarter were driven by two successful promotions, increased advertising weight, lift from their remodel program, plus a new lunch menu introduction.

The quarter began with the steakhouse dinner for two for $29.99 promotion.

This was followed in October by their stuffed filets promotion that featured their new lobster stuffed filet and white cheddar and bacon stuffed filet.

LongHorn has a significant long-term opportunity to grow their lunch business; and in October, they launched a new lunch menu featuring several new combination dishes that start at $7.99, and that are contributing to meaningful incremental guest count growth.

During the second quarter, LongHorn also completed the rollout of the table management system currently operating at Olive Garden.

This technology enables more accurate wait time quotes and better guest count throughput during peak demand periods.

The roadhouse to ranch house remodel program was completed during the second quarter, so now all of the restaurants with just a few exceptions have their ranch house look.

New units at LongHorn continue to significantly exceed their sales and earnings hurdles as well.

They opened 10 net new restaurants during the second quarter and are on track to open 30 to 35 net new units this fiscal year.

And excluding the incremental preopening expenses during the second quarter compared to last year, LongHorn delivered earnings growth and increased returns.

Now, Gene will discuss our specialty restaurant group.

Thanks, Drew.

In the second quarter, the specialty restaurant group delivered solid performance and successfully completed the acquisition of Eddie V's.

Total sales for the quarter were $137 million, which was 19.1% above prior year, representing 21% of Darden's overall sales growth.

This sales performance includes two weeks of Eddie V's sales.

Total sales growth was driven by strong blended same restaurant sales growth of 3.9%, which represents increases of 5.7% to Capital Grille, 0.5% at Bahama Breeze, and 2.9% at Seasons 52.

New restaurant growth of 13.4% and 1.8% of growth from the Eddie V's acquisition also contributed to total sales growth in the fourth quarter -- excuse me, second quarter.

This is now our seventh consecutive quarter of blended same restaurant sales growth, and our trailing 12 month average at unit volumes are $6.6 million at the Capital Grille, $5.5 million at Bahama Breeze, and $6.4 million at Seasons 52.

Our team also continues to manage costs effectively despite the difficult cost environment, which has led to further restaurant level margin expansion.

The specialty restaurant group plans to open six restaurants in the second half of fiscal '12; three Bahama breezes, two Seasons 52s, and one Capital Grille.

We've completed the Eddie V's acquisition on November 14, and are very excited about adding this unique fine dining brand to our portfolio.

Eddie V's gives us additional exposure to the luxury consumer and provides the specialty restaurant group with an additional high volume brand that has a strong business model, national appeal, and solid growth potential.

Eddie V's has a strong culinary platform offering guests top-quality seafood and prime steaks.

The restaurants also feature a lively bar area called The V Lounge, which has live entertainment nightly and offers guests a different experience, broadening the brand's appeal.

In addition, Eddie V's has a well-trained and tenured service team that provides -- prides itself on providing impeccable service, enabling them to develop a growing and loyal guest base.

We're very pleased with the Eddie V's entire brand leadership from the President through the management teams and chefs in the restaurants have stayed with the brand through the move to Darden.

Not only will this help achieve a smooth transition and allow for consistently excellent execution during this period, but it also enhances the specialty restaurant group's overall operational talent base.

The addition of Eddie V's gives us even greater confidence in the specialty restaurant group's ability to meaningfully contribute to Darden's overall growth.

Now, I'll turn it back to Matthew.

Thanks, Gene.

Ernie, we'd like to open up and take questions for the balance of the half hour here.

Thank you.

(Operator Instructions) And please limit yourself to one question and one follow-up question.

(Operator Instructions) We do have our first question from the line of David Palmer with UBS.

Please go ahead, your line is open.

Thanks.

Hey, guys.

Clients that we talked to, and I think this is pretty true about investors right now, they're wondering if your guidance which implies double-digit growth certainly a significant improvement in trends in the second half of the year in profit, they're wondering if this guidance is low enough -- at least low enough for new value buyers to come into the stock; and if you like to think that the near-term has been derisked as we wait for the new menu stuff to come about in the summer; and frankly, it seems like a lot of this next six months will hinge on the performance of limited time offers at Olive Garden working better than some of the recent marketing news at Olive Garden.

And for some quarters now, we've heard about limited time offers or temporary marketing at Olive Garden, maybe not hitting the way you expected it to hit.

So could you comment on maybe why you feel comfortable that this guidance is realistic and with a particular emphasis on why the limited time offers that you're going to come up with in the next six months might be more effective than what you've had in maybe the last nine months?

Thanks.

Sure.

And I'll start, this is Clarence.

I would say as we look at the rest of the year and think about how it will evolve, the more important factor for us actually on the trend change is on the cost side.

So we talked about the kind of cost inflation that we experienced in the first half, and we will see it significantly lower in the second half.

And so the savings that Brad talked about, the $65 million or so from the big cost savings initiatives that we've got on the table show through a lot more with the food costs being much better contained in the second half.

We do think we'll continue to see solid performance from Red Lobster and LongHorn, so that'd certainly reflected in our outlook.

But we would expect still challenges at Olive Garden, so we're not looking to see a big turnaround there.

We do think that we'll see comps improve from the first half, where they were down 2%, 2.5%.

We don't expect that.

We see improvement.

And they might turn positive, but our guidance doesn't depend on any significant positive turn at Olive Garden.

Okay.

Thank you.

We will go to the next question from Michael Kelter with Goldman Sachs.

Hey.

I wanted to ask first off about the remodel plan.

Can you talk about the 400 or so units you're going to remodel, what's the timeline to that?

How much you're going to spend per unit?

And do you have a history of what the changes to the stores generally do to traffic trends?

And then as a quick separately unrelated follow-up, on your guidance in the back half part of it I'm curious about is, in the SG&A line item I know compensation is a pretty good part; what's your anticipation -- in your guidance, what's your anticipation of the dollar change in compensation in the third and the fourth quarter versus the prior year?

Thanks.

Well, I'll start with your question on remodel.

Historically, we've seen same restaurant sales improvements.

When you get the remodel design and the remodel investment right, we see same restaurant sales lift of say, 4%; and that's about what we're getting, a little more than that at Red Lobster.

And so that range would be our target for Olive Garden.

Olive Garden's already remodeled some restaurants, they believe they've got the interior where they want it to be.

They believe a little bolder change is required on the outside of the restaurant to signal greater change to their guests.

And the combinations of those two things, we would expect would generate the same sort of guest count traffic lift that we're seeing from Red Lobster's remodel now.

So they're where they want to be on the inside, they'll work out the external design over the balance of this year, and we would expect to be in a position to expand it more aggressively next year.

And Michael, this is Brad.

On your compensation question, first off we look at managing to the total returns that we can get.

And we look at our investments in our G&A spend as a way to enable the absolute high level of volumes that we have in each of our brands, and by the industry-leading return on sales that we have.

That said, within the SG&A area, compensation is -- I don't have that exactly but it's roughly one-third or so of all the SG&A.

And for us, there is a fair amount of incentive compensation that varies with our performance.

And I would say, from a year-over-year perspective, last year we had 19% earnings growth, right?

And so compensation well above target this year with the outlook that we've got, it will be below target.

So it will be a decent year-over-year shift in the second half.

Thank you.

We'll go to the line of David Tarantino with Robert W.

Baird.

Please go ahead, your line is open.

Hi, good morning.

Just a question on Olive Garden.

I think Clarence, you mentioned that in the second half you're not expecting a big rebound in trends.

So my overall question is just given what you know today and the series of initiatives that you outlined, how long do you think it's reasonable to expect before we see the brand start to gain momentum?

In other words, how are you thinking about the pace of progress and turning around that brand as you think out over the next year or two?

Yes.

I would say -- I mean, we would expect to begin some momentum change this year.

So improving trends, and that's based on a lot of the things that we've done already and that will show up next year and some of the things that Drew outlined, but there's a sense of urgency beyond this year.

And so I think Drew mentioned that we would expect meaningful core menu changes, those will start to show up next year.

We would expect fairly significant changes in the promotion starting this year, but that will carry into next year as well.

And then we're looking at an advertising campaign -- a new advertising campaign that would kick in sometime in the first half of next year also.

And so we would expect a lot of this to get to the consumer within the next six to nine months.

Yes, and I can amplify that a little bit.

So the Olive Garden team is working on a new ad campaign now and testing a new core menu now in the direction of all the things I mentioned earlier; and as Clarence said, we would expect to be in the position to expand those nationally in the first half of next year.

But between now and then, we've also identified an opportunity to improve the impact that our promotions have in the short-term.

So I mentioned the insight we have now about needing to change our promotion constructs.

And without getting into too much detail on that, what we mean by that is our promotion construct for most of the past five or six years, which has worked very well has been centered on new dishes.

So we'd introduce two new dishes that tended to be stuffed pasta, we would occasionally have a price point on that.

And that news and the occasional price point worked very well until the second half of last year.

Given the change in the environment, the change with some competitors, what we think we need to do is evolve that concept and really emphasize a bigger, broader promotional idea, a bigger theme and not just rely on new dishes.

So for instance, never ending pasta bowl as a theme is more important than the new sauces each year.

Lobster Fest as a theme, is more important than the new lobster dishes.

Stuffed filets at LongHorn more important than the individual new dishes introduced each year.

So that's the nature of what we mean by evolving our promotion constructs to have bigger ideas that are brought to life by new dishes but bigger ideas with themes that resonate with our guests.

And I might just to add to the answer on one of the earlier questions about outlook.

And so I made mention in the opening remarks, if you think about the first half of the year down 11%, with all of our brands performing as they did including Olive Garden, as far as seafood costs, had been up 4% instead of 20%, we would have had earnings flat to last year.

So that gives you a sense of the kind of -- of the second-half outlook that it really is more about costs than anything else.

So that's another sort of add-on there.

Okay.

Thank you.

We will go to the next question from Joe Buckley with Bank of America Merrill Lynch.

Please go ahead, your line is open.

Hi, thank you.

One question, just kind of looking back at the first half and then maybe a question going forward.

Looking back, if you had to break down the earnings disappointment, is it driven more by the higher food costs, coming in higher than you expected?

Or is it driven by the sales and exchange with Olive Garden the most profitable brand, disappointing?

That's -- I would say certainly a combination.

I mean, the first half of the year we talked about because of the cost, as we looked out in June, we thought we would be up mid-single digits, maybe low single digits, so it's not like we expect it to be heroic.

And in fact, we were down.

And so that down really reflected against the expectations, the Olive Garden performance.

Because we knew where the costs were going to be.

They were essentially where we thought they'd be slightly higher.

But the performance against that expectation that we outlined in the first half of the year was really more about Olive Garden; and a little bit more trading, a little bit more check management than we'd anticipated at all the brands.

Okay.

And then looking forward, can you talk about the timing of some of the things you mentioned for Olive Garden?

You mentioned three second half promotions.

I think third quarter or fourth quarter, will there be a new core menu this year or I think you just suggested it probably will be in the next fiscal year?

And then just maybe some of the advertising marketing changes how quickly they will occur?

Yes.

The new promotional constructs, the things that we think will have broader relevance will start in January.

So we'll have those in the second half of this year.

We'll introduce some new, more affordable core menu items in the second half.

But the bigger menu change that's going to address affordability as well as quality and distinctiveness, both ends of the menu if you will, is something that we're going to spend more time developing and testing in the second half this year, and wouldn't expect to see that in the market until the first half next year.

Our advertising is going to feel different in the second half this year although it's going to be the same campaign.

So by that, I mean we're going to still be telling a story about people's relationships inside Olive Garden, but we're going to do it in a way that feels a little fresher, doesn't feel -- feels a little more genuine, doesn't feel in some cases perhaps that it's a little bit contrived.

And then get to a fundamentally different campaign in the first half of next year; and remodel as I mentioned, would begin more in the first half of next year as well.

I just -- I would just add and amplify on one of the points that Drew made, which is as we think about core menu, it's about two things.

It is about more affordable, approachable dishes; but it's also about the what you get side of the equation for some guests, and so this is about more compelling quality dishes at higher price points.

Because there is a need to compete there as well.

I mean, Red Lobster and LongHorn are doing very well there.

As you think about what they've got in the market even right now.

With the surf-and-turf at Red Lobster and lobster stuffed filets at LongHorn

Thank you.

We'll go to our next question from Jeff Omohundro with Wells Fargo.

Please go ahead, your line is open.

Thanks.

Just had a question regarding the expectations around the core menu.

When you think about the changes in the value leadership gap at Olive Garden relative to competitive set, do you expect or are you considering that the changes in the core menu would meaningfully reduce average check at Olive Garden?

And separately, when do you think and how extensively will you be testing these changes to core menu at Olive Garden?

Thanks.

Well, we do plan to carefully test and evaluate the changes during the second half of this year so we can be in a position to introduce it in the first half of next year.

We do anticipate having dishes -- a menu and dishes that feel different and feel more compelling to our guest space next year, and that's true both for guests who are seeking more affordability, it's also true as Clarence just said, for guests who can pay a little more and are looking for something a little more distinctive at Olive Garden, just like they're getting at Red Lobster or LongHorn.

So while the choice in variety is going to expand, we wouldn't expect a material check reduction next year, just broader relevance by the way we've constructed the menu.

Yes.

In terms of core menu and from a promotion perspective, probably about the same thing.

So not significant.

But we do have to have the breadth that Drew described.

Thank you.

Thank you.

Our next question will come from the line of Todd Duvick with Bank of America Merrill Lynch.

Please go ahead.

Good morning.

I had a couple questions for you on the cash flow statement and balance sheet.

It looks like free cash flow was negative in the quarter, which I think is a seasonal pattern for you.

But as a result, it looks like your short-term debt balance is up modestly.

Can you just tell us what we should expect going forward in terms of free cash flow, and if you think the short-term debt balance is going to be coming down over the next quarter or two?

Well, Todd, you're exactly right.

This is our seasonally low period because it's an opportunity where we are building inventory of many of the products that are live caught, this is the season to get those.

Plus we have a considerable amount of new unit development that goes on, and we try to get a lot of that work done before the weather sets in so we can get in close and get inside the buildings there.

As we look towards the end of the fiscal year and our expected performance here, we would see our short-term debt decreasing from the levels from where it is, just because they're strong and I'd say probably more durable and there are a lot of times we think about in terms of our cash flows.

But I would step back and say that we do know and value the importance of our investment grade credit profile, and so while we think we have plenty of room within our guidance and all that to make sure that we stay probably there.

But I would say from an adjusted debt to adjusted capital perspective, we be lower at the end of the year than we are today.

Yes, that would be true.

Okay.

That's very helpful.

Thank you.

Thank you.

Our next question is from the line of Brad Ludington with KeyBanc Capital Markets.

Please go ahead.

Thanks.

Good morning.

I just wanted to ask on what's been going on with Red Lobster and Olive Garden.

Given the success that Red Lobster and the continued strength in consumer environment, do you think there's a possibility that the strength at Red Lobster is cannibalizing Olive Garden some?

And then sort of a follow-up to that is if that's the case, your latest ads don't seem to feature price points; what's the thought process behind changing that for Olive Garden on the ads?

Thanks.

Well, Red Lobster certainly has tremendous momentum as does the LongHorn and we're delighted about that.

And I suspect that there is some impact at the margin that that momentum has on Olive Garden, but Olive Garden's got such a broad footprint that I think the primary opportunity for Olive Garden is more about becoming a less expected more relevant brand and that requires some different actions depending on the guest segment.

So we don't see that as the primary issue, we think all three brands are positioned and designed to be able to grow beyond the market when properly marketed and delivered in restaurant.

Okay.

Thank you.

And then the question on the price points being taken off the Olive Garden ads, what was the reasoning behind that?

During the holiday season, the marketing team at Olive Garden thought a little more celebratory, a little bit less emphasis on value.

A dish that was more distinctive, and they were comfortable that given the needs state of guests at that time, that this was an appropriate offer for the season.

Thank you.

And our next question is from the line of Matthew DiFrisco with Lazard.

Please go ahead.

Thank you.

I just wanted to -- looking at the labor line, it looks like the last six quarters or so you've done a pretty good job despite some of the more sluggish comp trends, you've done a good job of leveraging that line.

I wondered the sustainability of that and if you can update us on some of the initiatives you might have in the back half if you do expect labor leverage?

And then I just wanted to clarify, there's been a couple of different terms used I guess, value leadership you targeted sort of as Olive Garden needs to be addressed again.

And then you're talking about same advertising, yet a couple conference calls ago I think there was greater focus on price certainty with the analysis that you were getting back about the consumer.

Are these conflicting terms?

I'm just curious of how you're going to approach this advertising turnaround phase for Olive Garden and what type of testing you're doing to sort of remove some of the volatility that the brand has been experiencing with the changes or the different direction month-to-month with advertising?

Thank you.

And I'll start and then we'll get back to the question on labor, and Drew will follow.

When we talk about value, it's really is both parts of the value equation.

So it's what you get, what you pay, and we've got two sets of customers.

For one set of customers, some of the erosion has been more about what you pay relative to other brands that have made bolder moves on that side; and for another set of customers, it's less about that and more about the what you get given what a different set of brands that tend to be higher priced have done on that dimension; and so we need to address both.

The affordability piece is more about the what you pay side of the equation and that set of guests, but there is a quality and differentiation piece that speaks to the other guests and so it's both of those.

And I'd also say that the way we executed our promotion to address the what you pay side of the value, to address the affordability recently didn't breakthrough as effectively as we would like because we think it was a little too expected.

And that's why I'm saying we need to evolve our promotion construct a little bit less about two new dishes with an occasional price point, a little bit more about a broader idea, a bigger idea that could have embedded in it on occasion a specific affordability offer; but in some cases it won't.

So it's as much of the way we execute it as anything.

And, Matt, on your labor question, that's really a direct result of our employment -- our labor optimization that we've talked about, which deals a lot with our employment practices, the tip share implementation.

But also driven by maintaining very low turnover rates, obviously the economy is helping us some in that situation, but we do value that employee relation that we have the promise with them; and when you don't have the turnover, that allows our productivity levels to rise without changing any of our standards.

We have not cut back on the amount of service hours or anything.

We think that's very important to maintain our brand promise and to grow as we expect to in the future.

In terms of future quarter's year-over-year expectations, we did have a pretty good bump last year in the fourth quarter, so I think we'll continue roughly around the same rate that we are now, start to moderate towards the very end of our fiscal year; but probably still have some forward improvement even in the fourth quarter.

Great.

Thank you very much.

Thank you.

We have our next question from the line of John Glass with Morgan Stanley.

Please go ahead.

Thanks very much.

My question first is on Red Lobster and the same-store sales; and while you've talked about this being a successful turnaround, it seems that traffic and comps really are driven by one month of strength and then a quick fade; in fact, this quarter you saw negative traffic in the subsequent months after the promotion; so why is that a good thing?

Doesn't it increase the risk that if a promotion doesn't work then the comp suddenly disappears.

And I seem to remember this sort of ebb and flow of traffic -- more pronounced ebb and flow was a problem several years ago you were trying to get away from; so why are you back here now, I guess is my question?

Well, we think we need to do both.

We think that promotions in the near term can be a catalyst with news to bring our guests in.

But we also think we need to take steps to strengthen the base business and give people a reason to come into Red Lobster unrelated to whatever the immediate near term promotion is.

So as we look at the most recent quarter, with same restaurant sales up 13% in September, certainly very strong, but they maintained at 3% over the next couple of months as well.

And we think that's beginning to reflect some of the improvements that are being made to strengthen the base business.

So by that, I mean a new advertising campaign.

Historically, the advertising that Red Lobster focussed exclusively on product and what the promoted item.

Now, we've got a campaign that is resonating with guests more broadly in terms of improvements that have been made at the brand in terms of product quality, for instance, in fresh fish that build the business after the promotion is done.

Remodels is another example of what's helping to build the base business, even though we're only -- we're certainly not even halfway yet on that effort.

So that impact is going to continue to grow.

And Red Lobster is also testing a pretty comprehensive core menu change now that we think will contribute to base business growth in the future.

So we're pleased with the promotional impact that we're having, but with remodels, advertising, core menu service enhancements, we're also working to build the base business at the same time.

John, I'd add a finer point to that as well.

If you look at the prior year performance for Red Lobster, in September they were rolling over about a 6.5% decline while October and November were about 2% increases as well to help pull up their perspective on that.

If I could just sneak one more in on Olive Garden.

Is your goal to lower the average check at Olive Garden or simply to maintain it, not raise it any further, number one?

And number two, does it necessarily mean in this formula of higher traffic, lower check or lower mix that you're going to see lower sustained margins than in the past when you've had it both ways, you had both check increases as well as traffic increases?

No, our goal isn't to meaningfully lower the check at Olive Garden.

Our goal is to make sure that in the core menu we have a broader range of offering per guest who are seeking affordability.

But also, an improved range of offerings for those guests that can afford to spend a little bit more and today are buying stuffed filet at LongHorn or something from Red Lobster, for example.

So the combination of those two things, we think -- yes, it is going to continue to maintain the check about where it is, and we're going to have pricing each year that offsets the cost that go into the business.

And we would expect that to contribute to growth in total guest counts and total sales that leverage the fixed cost in the business and contribute to still very, very strong margins at a unit level.

Yes, and a total company level.

So if you think about the margins, you've got two.

You've go restaurant level margins very high at Olive Garden, approaching 20%, and you've got Op profit return on sales.

And ultimately, what matters most is the operating profit return on sales, the EBIT margin and driving that up.

And so that will -- that's what we focus on and we think there's continued room for growth in that margin across all our brands and across all of Darden.

Ernie, we have time for one more question this morning.

Thank you.

We'll take our last question from John Ivankoe with JPMorgan.

Please go ahead.

Great.

Thanks.

Just and it's consistent with the question I asked on the last call.

But discuss the attitude of taking pricing to offset costs, which is I think specifically what you mentioned in the prepared remarks.

At a time when there is a price sensitive customer, there is customers that are trading down.

There's customers that are much more promotionally oriented and just the overall feel is that pricing, kind of the non0-promoted menu may actually drive people down to the promoted part of the menu.

In other words, it's kind of a disconnect between what's promoted or what might be value versus what's core or more premium.

So I just wanted to get your thoughts on that, and secondly, as we think about taking pricing to offset costs, why you're only 25% contracted on beef, and you never really know what might change in these -- over the next six months or maybe even over the next 18 months, so that commodity isn't a problem for you?

I would say on the trading, I guess, so net, when you look across the entire year, because we have still even in this environment, a range of promotions.

When you think about what Red Lobster and LongHorn are promoting now and the price point on that, which is pretty high, because this is the right time for that.

Our promotions from a price point perspective are not dramatically different than our core menu at Red Lobster and Olive Garden, I think they're actually a little higher, the promotion price point than the core menu price point.

So over entire year, you'll trade from core menu to promotions is not going to depress the check, I guess, is that a fair statement?

Yes.

And I would add to it by saying for our approach to work over time, not in any individual quarter; but for our approach to work, we need to price to the net inflation in our business.

In the first half, that was not the case because costs were so elevated.

In the second half and for the year, it will be the case; but promotionally, what we need to make sure we do is run offers that attract enough total new guests that we don't have the same kind of -- that we don't have the negative menu mix that we had this quarter.

We offered a compelling price point, but we didn't attract enough new guests with it.

And as a result, we experienced more negative menu mix and than we historically do, but it's primarily because we didn't drive enough incremental traffic in.

And I would say the way we get the margin expansion is through an incremental guest as we price to inflation, and through an ever more cost effective support platform.

And so we talked again about those efforts, delivering an incremental $65 million or so this year on top of something that looked a lot like that last year.

And we'll talk more about it at our investor conference later in a couple of months, but we'd expect comparable kinds of numbers next year, and that's an ongoing process.

Regarding beef, if I may?

Just before we get to beef, we saw at Red Lobster and LongHorn, the strategy we just talked about worked very well.

It didn't work as well at Olive Garden, because we didn't get the incremental traffic and because we had more check management than anticipated.

And on beef costs, first I'd step back and say, beef costs are about 14% of our food cost basket.

And I'd go back -- we know that there's going to be pressure on beef costs just given the nature of that and the grow out cycle.

But I'd come back to the advantage that we have of our portfolio brand, so we can navigate around that without having to do undue pricing at say, LongHorn Steakhouse or at Capital Grille to deal with that and still make our earnings expectations.

And thank you, sir.

Please continue with any comments you'd like to make.

Thanks, Ernie.

And we would like to thank everybody for joining us on the call this morning.

We recognize that there are a number of you still in queue that didn't get a chance to ask questions.

Of course, we will be here to answer your questions throughout the rest of the day, so please give us a call.

We look forward to speaking with many of you at the Analyst Day in late February in New York City.

And for those who can't attend, of course, we'll webcast that event, and then those that aren't at that event, we will also come back and speak with you again in March, speaking about our third quarter results.

We wish everybody a safe and happy holidays, and a safe and happy new year.

And thank you very much for joining us this morning.

Thank you.

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