達登餐飲 (DRI) 2015 Q4 法說會逐字稿

Welcome and thank you all for standing by.

(Operator Instructions)

Today's conference is being recorded.

If you have any objections, you may disconnect at this point.

Now I'll turn the meeting over to Mr. Rick Cardenas.

Sir, you may begin.

Thank you, Angelina.

Good morning, everyone.

With me today is Gene Lee, Darden's CEO; Brad Richmond, Darden's CFO; and Bill White, Darden's Treasurer.

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

As a reminder, comments made during this call will include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995.

These statements are subject to risks and uncertainties that could cause actual results to differ materially from our expectations and projections.

Those risks are described in the Company's press releases which were distributed earlier today and in its filings with the Securities and Exchange Commission.

Today's discussion and presentations may also include certain non-GAAP measurements.

A reconciliation of these measurements is in our earnings release; in addition, we are simultaneously broadcasting a presentation during this call.

This presentation will be posted under the Investors tab on our website at the conclusion of the call.

We plan to release FY16 first quarter earnings on Tuesday, September 22, before the market opens, followed by a conference call.

Following prepared remarks from Gene and Brad, we will take your questions.

Now I will turn the call over to Gene.

Thanks, Rick.

Good morning, everyone.

We had another strong quarter across all of our brands.

Total sales grew 13.8% for the quarter, which was driven by combined same restaurant sales growth of 3.8% with positive same restaurant sales at each of our brands, the addition of 33 net new restaurants and the 53rd week of operations, which contributed 7.5% of sales growth to the quarter.

Earnings per share on an adjusted basis increased 100% to $1.08, and fourth quarter adjusted EBIT margins increased significantly.

Our Fourth Quarter capped a strong finish to 2015.

For the year, annual sales from continuing operations increased by 7.6%, to $6.8 billion, and all of our brands had positive same restaurant sales for the year.

Adjusted EBIT margins increased by 150 basis points through continued cost management, same restaurant sales growth leveraging, and the unwinding of deep discounting at Olive Garden.

As a result, our annual earnings per share on an adjusted basis were $2.63 a share, which was an increase of 54% versus last year.

At Olive Garden, business momentum continued, with 10 consecutive months of same restaurant sales growth.

The brand had sequential quarterly same restaurant sales improvement throughout the year and had its first annual same restaurant sales increase since FY11.

Our Olive Garden strategy has been to focus on our core guests and the frequency of their visits by concentrating on the following areas.

First, ongoing service and culinary simplifications that allow our restaurant teams to deliver great food and service.

Second, continued menu evolution that focus on our core brand equities.

The improving appeal of Cucina Mia provides a great everyday value option for our guests, thereby allowing us to be more balanced with our promotional offerings.

Next, with a refined understanding of our core guest demographics, we have increased our digital marketing efforts.

This enables us to reach guests with more relevant messaging through targeted online advertising, CRM, and social media engagement.

And our take-out program meets out guests growing needs for convenience and continues to drive significant growth.

We increased takeout sales by over 23% versus last year in the fourth quarter, to approximately 10% of sales.

Finally, better operations, leadership alignment on key priorities as a result of reduced management layers in the field has led to elevated execution.

This was an important year for Olive Garden and we're pleased with the progress we've made.

The improvement in our results this year tells us we're working on the right things and it underscores Olive Garden's tremendous brand equity and potential.

With that said, our work at Olive Garden is still in its early stages and we still see plenty of opportunity ahead.

LongHorn had a solid year of performance, with annual same restaurant sales of 4.4% and positive guest counts of 0.8, both of which significantly outpaced the industry.

Segment profit at LongHorn increased by 17%, despite near double digit beef inflation for the year.

This performance is a result of several factors, including growing the business by focusing on guest loyalty, leveraging the core menu and the peak season and chef showcase platforms to offer regional flavors, and evolving our marketing strategy with more effective local execution, broader use of CRM and digital advertising, and a stronger promotional pipeline that leveraged our steak expertise.

As we enter FY16, LongHorn is well positioned to improve on its same restaurant sales growth and continue to improve margins.

Now let's spend a few minutes discussing the real estate announcement we made this morning.

The Board and I had are excited about our announcement to separate a significant portion of our real estate and create a separate real estate business which can grow in its own right.

This decision was the result of a comprehensive analysis that we performed, along with the support of our advisors.

The plan is intended to optimize the value of our real estate by separating approximately 500 of our real estate properties utilizing three different steps.

First, the sale leaseback of approximately 75 restaurant properties; second, the sale leaseback of our restaurant support center in Orlando; and third, a REIT separation.

After receipt of the proceeds, we intend to pay down $1 billion of debt.

We expect this will maintain our investment grade credit profile.

We believe this plan results in a favorable outcome for all of Darden's stakeholders by strengthening our balance sheet while positioning two companies to succeed in the future.

The strategic rationale for our real estate separation creates benefits for both Darden and the future REIT.

The benefits to Darden include an improved capital structure with no funded debt maturities for 20 years, improved capital allocation that strengthens our return on invested capital, and a strong, conservative financial position that offers solid coverage for market rents.

The benefits to the REIT are a lower cost of capital than Darden, and the ability to focus on growing a real estate business through broader opportunities beyond Darden.

And finally, we expect the market to properly reflect the fair market value of real estate through the higher valuations for real estate companies compared to restaurant operating companies.

Now looking at the three elements of our intended plan.

We began conducting individual restaurant sale leasebacks in March of 2015 with 16 properties and have expanded this to a total of approximately 75 properties, consisting mostly of Olive Gardens.

We continue to be extremely pleased with the demand for our properties.

We expect an average cash capitalization rate of approximately 5.5% for all 75 properties and that EBITDAR will provide greater than three times rent coverage.

We anticipate a net book gain of approximately $50 million on the total 75 properties, with a $65 million gain being recognized over the next 15 years and a loss of approximately $15 million that we recorded in the fourth quarter of FY15.

Next, we're pursuing the sale leaseback of the restaurant support center in Orlando.

And finally, the proposed REIT transaction would consist of approximately 430 high quality owned property selected for their ability to comfortably cover market rents.

The tenant base for the REIT will stand out versus other REIT peers, and that is 100% investment grade with an initial concentration of Olive Garden properties.

And the REIT will be in a position to diversify through efficient 10-31 asset exchanges.

We have proven that our Olive Garden properties are in high demand and the REIT management can utilize some of these highly desired Olive Garden properties to exchange for other diversifying assets.

Additionally, we are capitalizing the REIT to provide capacity to support growth through acquisitions on Day 1. We anticipate this REIT will be attractively positioned immediately and, in the near future, be able to further shape its metrics to be best-in-class.

As previously noted, after receipt of the proceeds, we intend to retire $1 billion of debt.

This debt retirement will be sourced by the sale leaseback proceeds, a REIT distribution back to Darden at the separation funded by debt raised at the REIT, and cash on our balance sheet.

Retiring debt allows us to strengthen our balance sheet while almost entirely working through the existing sale leaseback basket.

We will be seeking bond holder consent to expand our current sale leaseback covenant limitation in the most straightforward manner.

We fully expect bond holders to appreciate that we are choosing to seek their consent, but we may also consider other structuring alternatives.

We expect the execution of our real estate strategy to be viewed as credit neutral to positive.

We anticipate Darden's annualized cash rent to increase by approximately $120 million per year and GAAP rent expense net of gain amortization of approximately $135 million, due to rent averaging accounting requirements.

Depreciation will be reduced by approximately 40 million and we will save approximately $45 million in interest due to debt retirement.

This implies a run rate reduction in pretax earnings of approximately $50 million.

We anticipate the combined dividends of both companies to be equal to Darden's current dividend.

Looking at our timeline.

We filed our private letter ruling request with the IRS on April 17.

As many of you may know, last month the IRS had announced a pause in issuing private letter rulings on the active trader business in transactions like we are discussing today.

However, our private letter ruling request is grandfathered until further notice from the IRS, since it was filed in April.

We have been watching developments closely and recognize that the IRS is reviewing its ruling practice in this area.

Nonetheless, we have a significant corporate business reason for the selection of our active trader business which we believe meets all applicable law.

Other highlights in our timeline include finalizing the individual restaurant sale leaseback transactions and the sale leaseback of the restaurant support center.

Between now and the end of December, 2015, we expect to identify and appoint the REIT management team and Board, file the Form 10 with the SEC, and complete the REIT financing and Darden debt retirement.

Once again, we're excited about this next step in the evolution of Darden.

Our fundamental restaurant operations and the guest experience will remain the same, but we will be separating a new real estate company which will be able to independently grow with properties outside of Darden.

And now, Brad will share our financial update and outlook for FY16.

Well, thank you, Gene and good morning, everybody.

Fourth quarter adjusted EBIT margins expanded versus the prior year at an even greater amount than in the third quarter.

This acceleration was the result of reduced discounting at Olive Garden, a more normalized commodity cost environment, greater cost savings, leveraging our positive same restaurant sales, and the contribution of the 53rd week.

Additionally, 50 basis points of the restaurant expense improvement this quarter versus last year related to improved Workers Compensation and public safety performance achieved during the year.

This quarter, we began reporting Marketing and G&A expenses individually.

Marketing as a percent of sales was below last year, due to lower but more normalized Marketing support levels.

G&A as a percentage of sales increased due to three drivers, higher incentive costs related to the strong business performance, higher equity based incentive costs that are hedged and fully offset in our tax expense, and investor costs related to cost reduction efforts that are more than offset by the identified cost savings captured in our performance.

Sales for the 53rd week were higher than we previously anticipated.

Along with our improved margins and low tax rate, the 53rd week resulted in $0.07 of additional EPS in the quarter.

I want to direct your attention to the segment level reporting we introduced this quarter which provides additional transparency into our results.

The four segments are Olive Garden, LongHorn, Fine Dining, which includes The Capital Grille and Eddie V's, and our other businesses, which includes Yard House, Seasons 52, Bahama Breeze, consumer package goods, and franchise revenues.

Now segment profit reflects sales less costs related to food and beverage, restaurant labor, restaurant expenses, and marketing expenses.

It's worth noting, this quarter's profit improved significantly for each operating segment.

Now the outlook we are sharing for FY16 today is based on our restaurant operating results and does not include the impact of the real estate transactions that Gene outlined and any related cash and capital structure activities we undertake.

We will provide additional information on those financial impacts once the timing and specific details of the proposed transactions are final.

For 2016, we anticipate adjusted earnings per diluted share of $3.05 to $3.20.

That's growth of 20% to 25% on a 52-week basis.

Improving operations performance is expected to contribute $0.45 to $0.60 of EPS growth in FY16.

In addition, we have interest rate savings of $0.04 in the first quarter from last year's debt retirement of $1 billion.

So of the total, $0.49 to $0.64 of annual year-over-year EPS growth in FY16, we anticipate two-thirds of the growth in the first half of the year and the remainder in the second half.

The front weighted growth is related to the timing of the reduced interest expense, cost savings, lapping on FY15 performance, and the benefit of the accelerated share repurchase in FY15.

Our other expectations for 2016 include 18 to 22 new restaurant openings, with LongHorn and Yard House accounting for the majority of the openings.

We expect same restaurant sales to increase for the Company between 2% and 2.5%; Olive Garden growth between 1.5% and 2.5%, an increase between 2.5% and 3.5% for LongHorn, and combined growth of approximately 3% for the Specialty Restaurant brands.

Same restaurant sales will be reported on a 52-week basis and will include several significant holiday shifts, in particular, a Thanksgiving shift that will be moving into Q2 this fiscal year compared to Q3 last fiscal year; capital spending between $230 million and $255 million, with approximately 40% of that going to maintenance CapEx, approximately 30% for new restaurant spending, and the remainder going to refresh restaurants, technology and other initiatives.

We expect an annual effective tax rate between 21% and 24%.

We anticipate FY16 to be a more normalized inflation environment, resulting in overall inflation of 1.5% to 2%, with commodity inflation of 0.5% to 1%; and we expect to price at the low end of the overall inflation range.

Total annualized cost savings identified since October of FY15 have increased to $100 million to $110 million by FY17.

That's $10 million higher than we announced in the third quarter.

We realized $35 million of that savings in FY15.

We expect $50 million to $55 million in 2016 and the remainder in 2017.

All of these savings expectations are net of any necessary reinvestments.

We continue to evaluate all areas of our business to identify additional cost savings without impacting the guest experience.

And now, I'll turn it back over to Gene for some closing remarks.

Thanks, Brad.

Before we move to Q&A, I want to share a couple final thoughts.

FY15 was a year of meaningful transition at Darden, with the election of a new Board of Directors, as well as my appointment to CEO.

We have made substantial progress towards our goal of returning Darden to a level of profitable sales growth and value creation our stakeholders expect.

An integral factor in this progress is a strong working relationship between the Board and the management team.

This allows for very open and constructive dialogue and has resulted in alignment around the key priorities that are driving our improved results.

Our back-to-basics focus, which is rooted in strong operating fundamentals around food service and atmosphere, is a key reason for our improved guest experience and business performance.

Of course, this is brought to life every day by our 150,000 team members.

As I visit restaurants across the country with our leadership teams, I clearly see their enthusiasm for creating the best experiences possible for our guests.

On behalf of the Board and the leadership team, I want to sincerely thank each and every team member for their hard work and dedication.

Lastly, I would like to thank Brad Richmond for his contributions during his 32 years of service.

From Financial Analyst to Chief Financial Officer, he's impacted all of our brands and, more importantly, he's had a positive impact on everyone he's had the opportunity to associate with.

All of us at Darden wish him the very best as he enters the next chapter of his journey at the end of July.

Now let's open it up for questions.

(Operator Instructions)

Our first question comes from Mr. Brett Levy from Deutsche Bank.

Good morning.

Thank you.

First of all, just a couple of little technical questions.

Do you have any sense as to what the square footage is for both the owned and the leased?

We'll need you to repeat that.

We couldn't hear you Brett.

Oh, I'm sorry.

I asked if you had any square footage owned and leased right now?

Do you want square footage or do you want just number of restaurants?

No, just the square footage.

I think that we have the number of units.

No, we don't have the square footage.

We can get back to you on that.

Do you have any sense as to what we can expect in terms of market rents and rent escalations on the leases?

Yes, Brett.

This is Bill White.

We're expecting rent escalations in the 1% to 2% range.

And market rents will be at the, we would say, certainly in the market range but at the more affordable level.

So there will be a range there, as well, depending on the individual markets.

Right.

Do you have an actual number that we can target for the rent, either per box or per foot?

On a square foot basis?

I would say in the $25 to $30 range.

And can you give a little bit more clarity on breaking down where the drivers were in terms of Olive Garden profits and what the actual profit growth was?

Yes, Brett.

This is Brad.

And we've aided that question some with providing the segment information that we gave there, so you can see in the broad picture.

But as we talked about for Olive Garden, the less discounting was obviously a significant portion to them improving their profitability.

Along with their same restaurant sales came some fairly meaningful leveraging of their restaurant expenses.

Their improvement in workers comp public liability was strong, as well.

And particularly, food costs getting more back to normalized level.

The first half of the year we talked about dairy being up nearly 20% to the prior year, and so that has much more normalized for them, as well.

And where are you on your contracting right now for next year?

One second here.

So really for us, we look out six months and we've got over 60% of our usage contracted.

The back half of the year -- which, the 60% is pretty typical where we are at this time of year -- and we have about 20% contracted for the back half of our fiscal year.

Angelina, can we get the next question, please?

Our next question comes from Mr. David Tarantino.

Gene, I had a question about the Olive Garden same-store sales dynamics.

And I wanted to first ask if the 2016 outlook assumes that you'll return to positive same-store traffic for that brand at some point in the year and when you might expect that to occur, if that is the case?

David, right now, we're expecting traffic to be flattish for next year, which we think is going to end up beating the market by 1% to 1.5%.

I've always said that the first barrier for us was to break through and for Olive Garden to start to beat the market.

We had a good quarter.

We beat the market by a point and a little bit more, if you add in the bulk takeout.

So we're hoping that we can get the brand back to level guest counts, maybe slightly positive, and we would expect a little bit better traction in the back half of the year than the front half of the year, as we still face some heavy discounting in the front half of 2016.

Great.

That's helpful.

And then perhaps could you provide an update on the remodel strategy for Olive Garden?

I think at one point you had considered that a critical element of the brand renaissance.

And I don't know where you stand in terms of your remodel program when you're looking at 2016 and 2017.

Okay, Dave, we got a lot going on with remodels.

I'll start off by saying the initial 13 that we did, which were pretty extensive remodels, are trending in the mid-7% range, above the system average.

So on a six-way analysis, they're performing, it's a little over 7% in same restaurant sales growth above the system.

We've done another 20 or so remodels at different investment levels that we're just starting to get a read on.

We're also, up in the Northeast, working on 20 different bar remodels, trying to figure out what we can do with that extra capacity that we have up there.

So I would say that we have a lot of tests going on.

We're really encouraged with the feedback, and we're trying to continue to hone in on what's the right investment level, is there a couple different packages out there that we can deploy so we don't end up having to do this same package in every restaurant.

I would also say that Dave and the team are starting the initial work on an Olive Garden of the future.

And we've identified a site and we're really excited about building a real what, I would call a contemporary Olive Garden, an Olive Garden that will be really competitive in today's environment.

And I'm hoping that that will be a significant inspiration into the future, as we continue to refresh our older Olive Gardens.

So a lot of activity, and I'm really excited about the initial results that we're getting from the original 13 we did.

Great.

That's helpful.

Thank you.

Our next question comes from Mr. Jeff Farmer from Wells Fargo.

Great.

The strength of Olive Garden's to-go business continues to surprise, in my opinion.

So I guess, from the outside looking in, it seems like the opportunity was always there.

So I'm just curious what the operational or strategic shift was, as you guys pursued to get that to-go business really moving in 2015?

And as you look forward to 2016, is there greater opportunity with to-go?

Yes, good question.

I think what the Olive Garden team did first and foremost was they really rebuilt their systems and ensured they had the right systems, the right packaging and the right processes in place that enabled this.

This was really -- the insight came from our consumer insights team that said to the team, listen, to-go is only going to get more and more important to our consumer.

You have products that travel extremely well.

You need to build out this capability.

And so the team's been working on this for 18 months.

They started off with the initial focus was 100% accurate and 100% on time.

When you do consumer research around take out, that's what the consumer really wants.

Enabling it through web ordering has been a big help.

We've also promoted it.

The team is getting ready to implement delivery.

We think large party delivery is a big growth outlet.

Over time, I expect, and the team expects, that 20% of Olive Garden's total sales is going to migrate to take out.

And we think that we're really well suited to take advantage of that opportunity.

Just one quick follow-up.

Do you intend to pursue that delivery with a third party or tackle that yourself?

We're looking at both options right now.

We do think that the third party dynamic is going to change dramatically over the next couple of years, and we're on top of what's happening in that space.

Okay.

Thank you.

Our next question comes from Mr. Matthew DiFrisco from Guggenheim.

Thank you.

Question with respect to the REIT structure.

And I think you say the $1 billion to pay down debt.

I wonder what you could -- how do you derive that or what is your total valuation that you're implying for the range for that 430 storefront or so?

Jeff, this is Bill White.

The best way to think about the total value is take a look at the aggregate rents that we've shared with the group.

So we're looking at essentially about $135 million of GAAP rent, or $120 million of cash rent.

That will be divided up amongst all those restaurants, both the individual sale leasebacks that Gene alluded to, as well as the 430 within the REIT.

And I think the best way to think about the value there is really think about where a dollar of rent trades within the real estate space or the REIT space versus an operating company to get a sense of what that value differential could be.

Right.

Okay.

So then the $120 million is associated with the 500 stores, not just 430 that are going to spun out to the REIT?

That's correct.

Okay.

And then also, do I have time for another one?

Go ahead, Matt.

Okay.

Thank you.

With respect to the breaking out of the Specialties brand now, the greater granularity separating them out to Fine Dining and then Other, I guess initially some of the Board strategies have been expressed before to be one of the next steps after a REIT is to spin off or consider greater monetization of the Specialties division.

Is this something now structurally that you're looking at the businesses differently than has been historic, where you bucketed them as a Specialties division and you're separating functions, as well now, in that the brands together, Capital Grille and Eddie V's, would be the better positioned stand-alone brands, where the classification of Other means that they're more akin to needing the support of Olive Garden and LongHorn, the smaller brands?

No, I would say this is really about meeting investor needs for insight to how Darden's performing and understanding our financial performance.

As we talked about, first in our priority right now is really their real estate strategy and executing on that.

And I think down the road, we'll look at the opportunity for segmentation of the brands and separations of the brands.

But that's far down our list right now, but something that we can look at.

But don't read into this particular segmentation as anything beyond just providing more clarity, more transparency into our financial performance.

Excellent.

Thank you.

Our next question comes from Mr. John Glass from Morgan Stanley.

Thanks.

Good morning.

Two questions.

First, just being on the progression of the traffic at Olive Garden.

So it declined sequentially through the quarter.

The industry was down, but didn't really decline sequentially.

Is that just a function of getting away from discounting -- how do you interpret that data, I guess, in looking at your overall comp was good, but the traffic was a weaker component than I would have thought?

Yes, John.

Well, we had -- let's start with March.

We actually had a strong promotion over a weak promotion that drove traffic.

That was our BOTO.

The Easter holiday had some effect in March/April.

When I look at those two months, I combine them.

And then we are going over some heavy $9.99 discounting in May, and we backed off that this year.

So when I looked at traffic for the quarter, I was overall pleased.

I kind of wrapped up the quarter into -- I looked at the last 15 out of 16 weeks, Olive Garden has significantly beat Knapp-Track.

And we had one week in there, which was Easter week the prior year, that was for some reason, we had a really bad week.

And that may have had more to do with promotional weights and some other timing.

But over the last 15 out of 16 weeks, Olive Garden has significantly outperformed Knapp-Track.

So I'm pleased.

I'm not caught up in these sequential trends.

We continue to move our Marketing spend to try to understand what's working and what's not.

And when you make some commitments, sometimes it takes three to four weeks to adjust after you try something that might not be working as well as you like.

Also remember, we have 50 basis points of traffic that's not accounted for in our large party take-out.

So we're not giving ourself any guest counts for pans of lasagne or big pans of Fettuccine Alfredo.

And that equates to approximately 50 basis points in additional traffic.

Thank you for the color.

If I could just follow up with a question on the REIT, in your assumption of valuations, the sale leaseback market is hot, and therefore, you get some pretty attractive cap rates.

Are you assuming that the REIT has not penetrated that favorable cap rate, in other words, a lower valuation or a higher cap rate?

And have you thrown out or are you willing to throw out any ranges you're initially assuming in that valuation that you just talked about?

Yes, John.

This is Bill White.

We wouldn't want to speculate on that.

We could just tell you that historically, there is a pretty significant value differential between restaurant operating companies and REITs, but we wouldn't want to really speculate on the specifics about valuation on the REIT.

Would you at least be willing to say that you think that a single tenant REIT trades at a much lower valuation than a diversified REIT, and that's your working assumption going in and you diversify it over time to get improved valuation?

There's a lot of other factors that go into that valuation, aside from diversification.

Some of the factors that Gene mentioned, the fact that this will be 100% investment grade tenant base, and there's really no public triple net REITs that are even close to that level.

So certainly other factors would go into that.

Okay.

Thank you.

Our next question comes from Mr. Joseph Buckley from Bank of America.

Thank you.

First operating question or two, and then a couple of REIT questions, as well.

In the overall inflation expectations for FY16, you shared the food inflation expectation.

What are you thinking on labor inflation?

Joe, this is Brad.

And we put that in the All Other.

In that 2% to 3%, I'd say the wage rate is probably in the upper half of that range.

But there's many other items that when you look at our P&L that would be bringing that overall inflation rate to the middle of that range, at this point.

Okay.

And then on the traffic, the traffic piece at Olive Garden, does that include the benefit of the to-go transactions?

I think you said to-go sales were up 23%.

So is that buried within that traffic number, so the on-site traffic numbers would be worse than what we're looking at?

Some of the to-go traffic, if we sell entrees to go, that is part of the traffic.

If we sell large party items, such as pans of lasagna, anything that's bulk, which we're doing a lot of, we're not taking any guest counts for that, Joe.

And that has a 50 basis point impact on guest counts.

Okay, and then--

Our next question comes from Mr. David Palmer of the RBC Capital Markets.

Thanks.

Just a quick question, Gene.

Just looking back and looking forward with regard to your costs, I know that there was a lot of costs that you got out of overhead by undoing a matrix type structure.

But as you look at the P&L from a restaurant perspective, how are you getting at the costs better than you did before?

Is there any real changes that are happening, even with regard to real estate?

For instance, when you break out rent costs, you shine a brighter light on the underlying real restaurant earnings.

Is that part of what you're getting out of the restaurant margins here is you're more accurately getting at the real restaurant earnings in your underlying assets?

Thanks.

David, a couple components to that.

First, I think our teams are doing a much better job from a labor cost standpoint.

We're really focusing on being able to effectively plan our volume and then from there, effectively plan the labor cost.

And we've been able to take out a lot of costs that built into the system.

Compound that with the work the team is doing to simplify operations.

For example, Olive Garden in the quarter was able to take 140 basis points of labor out and improve their overall service metrics, which to me is exciting.

I would also say that we've got teams doing zero base budgeting with restaurants.

And we're going out there in each of the brands and we're pulling, across the country, we're pulling every single invoice inside a restaurant, and we're just finding things that have creeped in over the years, from a basic restaurant operations perspective, that we're able to take out.

And so I think our team, our operating teams are doing a great job of going in and saying, for example, how many times do we really need to clean the carpets in a restaurant?

There's a protocol that you clean carpets once a month.

If you do it more than that, you end up actually destroying the carpet and really not a whole lot of benefit there.

So we found a lot of restaurants that were cleaning carpets twice a month.

So we've been able to find -- that's just one example of the costs the operating teams have been able to find over time.

And so this is really a bottoms up, back-to-basics restaurant approach to remove costs from the P&L.

Just follow-up on the REIT thing.

If you were -- would you contribute some of your debt over to the REIT, would that be how it would work that you would lever up the REIT and then borrow new money on the remain co?

How would that work in terms of setting up a capital structure in the future?

Thanks.

Yes, David.

This is Bill.

We're still working through some of those details.

Unlikely that we would do a debt for debt exchange of some kind, most likely some type of debt raise at the REIT.

But we're still working through all those specifics, and we'll have more to come in our public filings.

Thank you.

Our next question comes from Mr. Will Slabaugh from Stephens, Incorporated.

Thanks, guys.

Two quick questions, if I could.

First, on Olive Garden, can you give us any further detail around the deep discounting you talked about at Olive Garden that you noted you're in the process of removing.

What form did most of that discounting take, and then what percentage of what you would call discounting remains at the brand right now?

The majority of the deep discounting we're referring to is the $9.99 promotional platform that we were running last year.

We were running a lot of $9.99, $10.99.

11 of the 13 weeks in Q4 FY15 were what we call deep discounted.

We refer to anything below $11.99 as really deep discounting.

We're still going to have to have some value platforms across Olive Garden to drive the business.

Never Ending Pasta Bowl is not going away.

It's in the base.

It's something that we're going to need to do.

But strategically, last February, February of FY15, we went back in and we added Cucina Mia to the menu so that we could have a $9.99 price point to offer every day value to our guests.

This menu item is gaining momentum.

It's gaining momentum across a few constituents that use the Olive Garden restaurant.

We're finding that Millenials love the $9.99 Cucina Mia, because they get to customize their meal.

We also find the value seekers like that entry price point.

What's interesting is that 50% of the people who enter Cucina Mia at $9.99 do buy an add-on, and so the price does come up.

Our strategy all along was to introduce and get everyday value back on the menu, become less reliant on what we would refer to as a lot of deep discounting to drive traffic.

We want to continue to migrate over to more brand building, more advertising around the food that people really love.

We'd love to be doing stuff around our [tour of Italy], which has a lot of following.

So we've got to continue to evolve that piece of it.

Got it.

And one quick one on the REIT, if I could.

It seems like a couple of the primary benefits would be around one, the potential valuation gap which you mentioned, and then also the ability to add more leverage to a REIT and return that excess cash to shareholders through a dividend.

Can you shed any more color on longer term capital plans for the REIT?

We're really not in a position -- this is Bill.

We're not in a position to go into a lot of those details.

We've still got to work through some of those.

And again, I think we'll have more to say when we get to the point where we're filing our Form 10.

Got it.

Thank you.

Our next question comes from Mr. Chris O'Cull from KeyBanc.

Thanks, guys.

I just had a couple of questions.

First, in terms of just operations.

Gene, can you talk a little bit about how you're able to unwind deep discounting while still improving the comp, and also maybe what the margin impact of the discount reduction was?

I think I may have missed that.

I would say that I think we're getting a little bit, as I talked about in the last call, I think we're getting a little bit of help from the consumer.

I do think the consumer is looking for less discounting activity today than they were a year ago or two years ago.

We've had a lot of discussion around what we call the gas dividend that's going back to the consumer.

I think there's a lot of expectation that that was going to stimulate traffic.

And what I've been saying is we haven't seen it stimulate traffic, but we have seen it change the consumer behavior once they're in our building, and they're not seeking the deals the way they were years ago.

We're seeing the consumers buy more add-ons.

They're buying wine, desserts, apps.

So I think the environment is helping us somewhat move away from these constructs, and I think we're just not finding them to be as successful as they once were, so we're able to do that.

From a margin perspective, I would say that we're picking up probably well over 100 basis points from reducing this heavy discount mentality or strategy, and you see that in every line in the P&L.

So you have less discounts, your food cost improves, your labor cost improves.

Okay.

And then just as a follow-up, is tenant diversity more important than the single tenant with investment grade credit for this REIT?

And then can you guys discuss why the Company decided not to include the ground leases in the REIT?

Yes, this is Bill.

The first part is the question on tenant diversity, it's certainly something that we're focused on as we look at the strategy for the REIT going forward.

And we think that we've developed a strategy that will be very well positioned to allow, first of all, it's got very strong geographic diversification out of the gate, but then will be in a good position with enough excess debt capacity to be able to fund growth, as well diversify through 10-31 asset exchanges on a very efficient basis with some highly desirable Olive Garden properties.

So we've got a good strategy in place for that.

And then the second part of your question, on the ground leases, the biggest issue is certainly something we examine carefully.

The biggest issue we found with the ground leases is that they really require a commitment of locking in all of your existing option periods.

So in our case, 25-plus years of time that from an operating standpoint really constrains and restricts your operating flexibility to be able to go back and negotiate or renegotiate at those option periods, which have value to the operating Company, as well as frankly just having less value and typically not a very significant component of a REIT's portfolio.

Okay.

Fair enough.

And the three turns, or the three turns of coverage, does that include a standardized G&A allocation overhead allocation or is that the actual G&A allocation for Darden?

That would be pre-G&A.

Okay.

Thank you.

Our next question comes from Mr. Jason West from Credit Suisse.

Yes.

Thanks.

Just want to understand on the dividend, you talked about the net earnings impact, about $50 million pretax, but you've also lowered CapEx quite a bit over the last few years, and wondering if you think you'd be able to pay that dividend that you're currently paying on the Darden corporate side, even with the higher rent expense that you're looking at?

Yes.

So what we've said is that we will keep -- our plan is to keep the dividend whole between the two entities, between Darden post the separation and then within the new REIT, the absolute value.

So yes, we're very confident we can preserve that dividend and actually continue to show some nice improvement or progress with the dividend pay out ratio.

Okay.

And can you help us understand in terms of the free cash flow outlook for the Darden entity -- so I guess in terms of the operating cash flow side, it would be the higher rent expense, the CapEx -- is any CapEx going to go away when the real estate transfers and is that sort of the way to look at it in those two pieces that are changing?

A lot of that is projecting pretty far forward.

But what I can share is these are triple net leases.

So the CapEx guidance that I gave would pretty much stay in place, that we've talked about for this fiscal year.

So it would be hard to say there's any change there.

And in terms of the free cash flow, the real driver of that, and you see it in this particular quarter, as well, is the improvement in the operating performance of the business.

And then we gave you the information that when a transaction occurs, kind of what that would do to depreciation, which is a non-cash item, but also to interest and all of those.

So we're projecting pretty far forward.

but I think the thrust of the question around CapEx, things like that wouldn't change.

We have improving cash flows.

You can add what our working guidance is right now in terms of its impact for Darden to the operating company.

Okay.

And then just one quick one.

The $1 billion debt pay down, does that include paying, using the cash on the balance sheet, which is substantial right now, or is that sort of leaving that cash alone and you can still pay down $1 billion in debt?

Yes, Jason.

This is Bill.

It does include -- a portion of the majority of that debt retirement will come out of proceeds from the real estate transactions, but there will also be a component of cash coming up from Darden's balance sheet.

Okay.

Thank you.

Our next question comes from Ms. Sara Senatore from Sanford Bernstein.

Thank you very much.

I have one question about Olive Garden and then a follow-up on the real estate, if I may.

The first is on Olive Garden, just with the improvement in the profitability and the same-store sales, do you envision returning that concept to growth at some point?

I think there was a time when at least prior management thought this could be a 900 to a 1,000 unit business.

Is that something that you envision being the case, if operating margins and volumes, everything gets back to or better than peak?

So that's my first question.

And the second question, the follow-up on the real estate, I just am trying to understand the value creation a little bit better.

I understand the difference between the REIT and an operating business, but shouldn't we be comparing this to your debt?

And so I guess in the sense of creating value, is it fair to assume that you think -- is the cash cap rates that you're talking about, are those better than how we should think about the debt that you're paying down, the effective interest rate on that?

Thank you.

Sara, I'll take the Olive Garden growth and then Bill White will handle the value creation on the REIT.

As we think about Olive Garden, we've actually opened a few restaurants this year that have done extremely well.

So as we think about growth, we need to be opportunistic.

So continuing to open Olive Gardens is that they impact at least one restaurant, and sometimes up to two or three restaurants, because we're so fully developed.

We sat with our real estate team recently and looked at opportunity areas where we could build Olive Gardens and not have any impact, and they came out with Hawaii.

And I'm really not interested in opening Olive Gardens in Hawaii.

So at this point, we are looking for selective areas of the country where we may be able to open 5 or 10 Olive Gardens a year, not have major impact on our existing footprint, or if we're going to impact an Olive Garden, we need to think about it and around the whole notion of if we don't open this restaurant, someone else is going to open that restaurant and they're going to have an impact on that Olive Garden.

And so those are the filters that Dave and his team are running Olive Garden growth through.

I think over the next few years, where we've guided Dave to try to do is to open 5 to 10 great Olive Gardens a year and then we'll continue to examine what the long-term potential for Olive Garden is.

Bill?

And Sara, to your question about the repayment of debt, we would start with just sharing with you that we think the right comparison is not between the cap rate and the interest rates.

It's really between the cap rate and the cost of capital, the weighted average cost of capital for a restaurant company.

So it does come back to this notion that a dollar of rent is going to be worth more to a REIT than a dollar of rent saved at an operating company, less so about a optimal capital structure decision, more about the decision of owning real estate.

So really, paying down the debt allows us to do the size real estate deal that we desire, that we think creates the most value while not repaying the longer dated debt, and at the same time preserving the credit profile.

Thanks.

I'm sorry.

And just one last thing.

On the CFO search, I heard you say something about July.

Did I miss it?

Are you, have you identified candidates that you're very close to settling on somebody?

The CFO search is ongoing.

We're doing a thorough search and when we have more news, we'll provide you an update.

Okay.

Thank you very much.

Our next question comes from Mr. John Ivankoe from JPMorgan.

Hello.

Thank you.

Just to follow-up on the CapEx, if I may.

I think in 2016, the CapEx is guided at $230 million to $255 million, of which 30%, if I heard you, was refreshed technology and other.

So just to look at that refresh piece of that, call it, $240 million CapEx, it definitely doesn't seem like a big number relative to your own store base.

So just a little bit more color on that in terms of where you think it could go.

And certainly understand in 2015, you really put the brakes on that, and in 2016, it looks like you're studying the various options that you have.

But longer term, what is the right level of refresh CapEx that we should consider for your business for your own portfolio?

Thanks.

Well, there's two things there, John.

One, the maintenance CapEx is the amount to keep the facilities up to the standards and expectations that we have.

That amount is, when you look at the size of the unit, the traffic that they're doing, that's run pretty consistent year to year.

And in terms of the refresh opportunity, Gene touched some on the opportunities that we see with Olive Garden, but that work is still underway.

And we'll continue to evaluate that, and when we see the opportunity to invest more that produces even greater return, we're comfortable doing that.

And maybe is it the case that your maintenance CapEx, I think, is something pretty close to D&A, that's something that we should consider over time?

And this is obviously a big change relative to how Darden used to be.

Does refresh by definition not have to be as big as part of the plan as it was maybe interpreted 2 to 12 years ago, in terms of how Darden was previously run?

Well, let me be clear.

Through the process that we're going through, we aren't really cutting maintenance CapEx.

We know the importance of keeping our facilities up to the standards that we expect.

And so as we look at that over time on a per restaurant basis, particularly when you take out the Red Lobster disposition and its older base, the amount that we're spending on a per unit basis, we feel very comfortable.

It's consistent with what we've done and maintains the facilities to the high level that we need.

I do think that you're on to a point on the refresh, that we've talked about it in past and maybe have had programs and things that were more capital than we should have spent.

And that's why you see Gene and Dave George and the team there being very diligent, very cautious, taking the time to understand the money that we're putting back into the pre Tuscan farmhouse Olive Gardens and making the proper decisions there.

And so I know there will be more updates as we get further through that.

Thank you.

Our next question comes from Priya Ohri-Gupta from Barclays.

Great.

Thank you so much for taking the questions.

These are for Bill.

Bill, it sounds like you said a couple times on the call that your intent is to not look to pay down the longer dated bonds.

So if you can just confirm that you don't have plans to touch the 2035s or 2037s.

And then as you look at paying down the rest of the bonds that are in place, would you plan to do a tender or a make whole?

And then finally, just around the consent solicitation, would that be on all of the bonds that are in place or just the ones that remaining in place and what your order of operations is going to be in terms of getting the consents versus taking out the debt?

Thank you.

Yes, a lot of questions in there, Priya.

So we're actually launching the consent process today.

So our preference is to not really get into a lot of the details there.

Give us an opportunity to speak to bond holders directly, which is what we will be doing.

What I can confirm for you is that yes, we will be paying down all the debt outside of the long dated 2035 and 2037s.

The 2035s and 2037s, those are the bond holders we'll be seeking consent from and more to share about that later in the day.

And in terms of the process that we'll take to retire the debt, we're still formulating that strategy.

Our first step is to speak to the long dated bond holders and work towards getting consent with those individuals.

We should make it clear that consent is not a requirement to do what we want to do, but it's certainly the preferred route.

So what happens in the event that you don't get the consent that you seek from these long dated bond holders?

We really feel like that what we're going to bond holders with, we'll be able to get consent.

Again, it's not a requirement.

And our preference is to not go into those details at this stage of the game.

But our intent is to have a good conversation with bond holders and work with bond holders.

And then just one final one, if I could.

What's your expected ongoing leverage of the op co, or the leverage that you're targeting as a result of all of this?

Thank you.

Yes.

We would expect leverage to stay, on an adjusted basis, approximately where we are today and even improving with the improving operating performance we're delivering.

So adjusted debt to EBITDAR, we would expect to continue to show progress and improvement.

Thank you so much.

Our next question comes from Mr. Joshua Long from Piper Jaffray.

Great.

Thank you for taking the question.

I was curious if you could give us an update around technology investments, either at the store level or maybe at the above store level to support some of the off-premises sales channels that you're looking at?

I'm thinking that we've previously talked around maybe some table top technology in the restaurants and then maybe anything to support that to-go channel that we've been talking about as a long-term opportunity at Olive Garden.

Great.

Technology is a big part of our plan moving forward.

I'll start with Ziosk.

We're rolling that out in Olive Garden.

We're over 100 restaurants today.

Our guest and server feedback continues to be positive.

We're seeing similar results or better results than our initial test sells.

So we're real excited about what we're doing with the Ziosk in Olive Garden.

We're working on web ahead capabilities.

We think that that's going to be an important part going into the future.

People are going to want to be able to put their name on some sort of list ahead of time.

They want to know what the wait is.

It all building on the convenience trend that's important.

We're trying -- one of our goals in Olive Garden, because we do have a lot of over capacity on the weekend, is how do we improve the wait.

And so one of the technological things we're doing is we're putting screens in the lobby, so people can see where they are on the wait.

And the initial feedback from that has been really, really positive.

A lot of our other technological investments right now are around CRM, and we're working with a partner to continue to move that forward.

We're in the early phases, discovery phases of developing a loyalty program.

So a lot of energy and effort there.

We're also looking at, from a technology standpoint, looking at our POS systems in restaurant, trying to figure out what's the best way to go forward there.

That's really it, from a technology standpoint at this point in time.

That's very helpful.

And generally speaking, can we think of this as maybe an Olive Garden first approach, and then with a lot of these initiatives maybe being adapted to your other brands in your portfolios over time?

Well, some of the technology stuff that we're doing has to be implemented on the other brands.

Olive Garden only has so much capacity.

So we're doing a lot of the web ahead in LongHorn.

And we look at each brand and say okay, who has the capacity to do this, to run the test so we can get the results, so that the burden isn't always on Olive Garden in the testing process.

Thank you.

Our next question comes from Mr. Joseph Buckley of Bank of America.

Thank you for coming back to me.

I just wanted to ask a couple on the REIT.

Is it going to be a triple net lease structure?

And could you give us some help on the rent breakdown between the properties in the REIT and properties being done in the sale leaseback transactions?

Joe, this is Bill.

It will be a triple net structure.

And we're not quite in a position to be able to give you the breakdown yet amongst, we've given you total rent, total number of properties.

We're still formulating the exact mix and trying to take all the steps to be prepared to know what the cost structure and other things will look like for the new REIT.

So we're just not quite in a position to go into the level of detail with you yet here today.

From our seat, is it appropriate to think of it as an equal split, based on the number of restaurants in the two different transaction structures?

Or is it something unique about the sale leaseback properties that would skew that?

No, I think that's a fair assumption.

The only asset, obviously, in that mix that's slightly lumpy would be our restaurant support center.

But beyond that, I think that's a very reasonable assumption.

Okay.

And the $50 million, is that a GAAP number, the pretax impact?

It is.

Okay.

Thank you.

Our next question comes from Mr. Jason West from Credit Suisse.

Yes.

Thanks for letting us do some follow-ups.

So one, on what Joe just asked about the pretax earnings impact, are you guys planning to call out the non-cash rent as a one-time item in the earnings, or are you planning to leave that in as the adjusted earnings?

I think it's going to be on a GAAP basis, once the transactions complete.

And we again aren't sure of the exact timing of that, so it's a little ways out.

But as always the case, even today with our facilities, we have a GAAP number that's on our P&Ls, and then the cash that goes to the cash flow statements.

That will continue as we go forward.

I don't think there will be any need to call out that difference.

Okay.

And can you explain again, I'm sorry if I missed it, how the $1 billion debt pay down proceeds, we know a portion of it is the balance sheet cash, a portion of it is the sale leaseback.

And is there some expectation that you'll receive a distribution from the REIT as a portion of that, as well?

Would that be a distribution if the REIT issues securities, or are you saying if you hold on to a portion of the REIT, you'll get distributions from the dividend payments from the REIT?

Yes, Jason.

This is Bill.

No, you're right on track.

It's actually, there will be a distribution from the REIT.

The REIT will raise some debt and send a distribution back at the point of spin, or at the point of separation, that will come back to Darden and that will be one of the components.

So the timing on some of that, we would obviously expect to see some of the sale leaseback proceeds sooner; and then at the point of the separation, we'll call it in the Fall of this calendar year, that's when we'd see that distribution back from the REIT, and then addition to a component coming from Darden's balance sheet cash to satisfy that debt retirement.

Great.

Thank you.

Thank you so much.

At this time, there are no further questions on queue.

I would like to hand the call back to the speakers.

Gentlemen, you may proceed.

Well, thank you all for your time and attention today.

As a reminder, we plan to release FY16 first quarter earnings on Tuesday, September 22.

Have a great day and have a great summer.

Thank you.

And that concludes today's conference call.

Thank you all for participating.

You may now disconnect.