Fitch Ratings has placed the ratings of Darden Restaurants, Inc.
(Darden; NYSE:DRI) on Rating Watch Negative, indicating that ratings
could be downgraded or affirmed upon resolution of the Rating Watch.
The action follows Darden's announced strategic actions, the most
significant of which is the potential separation of Red Lobster, and
downward revision of fiscal 2014 earnings. Although no final decision
has been made on the form of separation, Darden expects to execute a
tax-free spin-off of Red Lobster to shareholders but may also consider a
direct sale.
The spin-off, which Fitch views as likely to be completed, is subject to
final approval by Darden's Board of Directors, confirmation of the
tax-free nature, and other customary conditions. Darden is targeting
early fiscal 2015, which begins May 26, 2014, for completion.
A full list of ratings follows at the end of this press release. At Nov.
24, 2013, Darden had approximately $2.9 billion of total debt.
KEY RATING DRIVERS
Leverage and FCF
Fitch anticipates that Darden's leverage can improve modestly following
the proposed separation of Red Lobster if the remaining entity maintains
meaningfully lower debt. Fitch also views the firm's planned reduction
in new unit growth and that senior management's compensation will be
more aligned to both SRS growth and FCF favorably. However, uncertainty
exists as to the timing of any meaningful improvement in FCF. Darden's
FCF weakened over recent years due to significant increases in its
dividend and the payout ratio is expected to remain high post
separation. Resolution of the Negative Watch will occur with additional
clarity around Darden's capital expenditures, dividends, and FCF within
one year of the transaction.
Fitch downgraded Darden's ratings to 'BBB-' from 'BBB' in October 2013
due to persistently weak same-restaurant sales (SRS), particularly at
Olive Garden, declining operating income, and because leverage and FCF
would not improve as fast as originally anticipated. Darden's current
'BBB-' ratings reflect Fitch's expectation that the firm will maintain
total adjusted debt-to-operating EBITDA (defined as total debt plus 8x
gross rent to operating EBITDA plus gross rent) of between 3.0x - 3.5x
and that FCF (defined as cash flow from operations less capital
expenditures and dividends) will approximate $100 million by fiscal 2015.
For the LTM period ended Nov. 24, 2013, total adjusted debt-to-operating
EBITDAR and FCF were approximately 3.5x and $37 million, respectively.
Fitch projects that total adjusted debt-to-operating EBITDAR and FCF
will remain near current levels for fiscal 2014.
Post Separation Credit Profile
Fitch views the separation of Red Lobster as material to Darden's credit
profile, given the chain's substantial operating earnings and cash flow.
During fiscal 2013, Red Lobster represented roughly a third of Darden's
2,138 restaurants, $8.6 billion of sales, and $1.0 billion of operating
EBITDA. Red Lobster has lower margins than Darden's corporate average,
due mainly to seafood costs, and historically has had greater SRS
volatility, due to its relatively high average per person check which
was approximately $20.25 to $20.75 in fiscal 2013.
Fitch expects the separation of Red Lobster to result in more stable
operating cash flow and higher margins and believes that Darden will
continue to benefit from a broad portfolio of brands. However, Olive
Garden continues to experience SRS pressure and will represent the
preponderance of the firm's sales and operating cash flow over the
intermediate term.
Pro forma for the transaction, Darden will have over $6 billion of
revenue, over $700 million of EBITDA, and over 1,400 units.
At Nov. 24, 2013, Darden had 834 and 445 Olive Garden and LongHorn
Steakhouse restaurants, respectively, while The Capital Grille, Bahama
Breeze, Seasons 52, Eddie V's, and Yard House (collectively referred to
as the Specialty Restaurant Group) had a total of 184 units. The firm
also had six synergy restaurants that house both a Red Lobster and Olive
Garden in the same building.
Darden expects to reduce new unit capital expenditures and maintain its
current $0.55 cents per share quarterly dividend in aggregate across the
remaining business and the new publicly traded entity following the
potential spin off. Moreover, the firm will seek to preserve its current
rating and will target a solid non-investment grade rating for Red
Lobster.
Evidence of Sustained Improvement at Olive Garden
SRS and operating profit improved at Olive Garden during the second
quarter of fiscal 2014. SRS declined 0.6% during the latest quarter,
representing a meaningful improvement versus negative 4.0% in the fiscal
first quarter and negative 3.2% during the second quarter of fiscal
2013. Operating profit benefited from lower restaurant expenses and
selling, general, and administrative (SG&A) costs.
Darden began discussing efforts to reignite consistent SRS growth at
Olive Garden in fiscal 2012 but changes to address affordability and the
guest experience are taking time to resonate with customers due to a
heightened level of competition and the slow U.S. economic recovery.
Darden's latest SRS guidance includes expectations that combined SRS
will decline 1% to 2%, representing a 1% - 2% decline at Olive Garden, a
4% - 5% decline at the soon to be separated Red Lobster, and a 2% - 3%
increase at LongHorn Steakhouse.
Fitch believes Darden is making progress with its turnaround of Olive
Garden but it is too soon to ascertain whether the recent improvement is
sustainable. Furthermore, Fitch views Olive Garden's relative maturity,
as a 30 year old U.S. brand, as somewhat of a limiting factor for
significant long-term sales and operating income growth.
Additional Cost Reductions
Darden has increased its annualized fiscal 2015 cost savings target to
$60 million from $50 million, expecting these efforts to provide it
added flexibility to regain SRS momentum. Fitch believes these savings
could also offset any dis-synergies associated with the separation.
Reductions in headcount and lower priority initiatives will be the
primary source of these cutbacks. Expenses associated with this program
are expected to approximate $10 million, all of which was incurred
during the latest quarter. Fitch believes Darden has meaningful
opportunity to improve its cost structure, given that SG&A as a
percentage of sales has grown to 9.9% during fiscal 2013 from 9.4% in
2004.
Liquidity, Maturities and Debt Terms
At Nov. 24, 2013, Darden had $84.6 million of cash and an undrawn $750
million revolver, which serves as backup to the company's commercial
paper program (CP) and expires Oct. 3, 2016. CP totaled an estimated
$324.2 at Nov. 24, 2013.
Upcoming maturities are limited to $100 million of 7.125% senior
unsecured notes due Feb. 1, 2016 and modest term loan amortization
payments. Darden's $300 million term loan amortizes annually at 5% of
principal or $15 million beginning in August 2014 until maturity on Aug.
22, 2017.
Darden's revolver, term loan, 3.79% senior notes due Aug. 28, 2019, and
4.52% senior notes due Aug. 28, 2024 subject the firm to a maximum
consolidated lease adjusted total debt to capitalization ratio of 0.75
to 1.00. Darden has remained in compliance with this covenant. At Nov.
24, 2013, the ratio was approximately 65%.
All of Darden's publicly traded notes, excluding the 7.125% 2016 and 6%
2035 notes, include change of control provisions. The firm's 6.2% senior
notes due Oct. 15, 2017 and 6.8% notes due Oct. 15, 2037 are subject to
coupon step ups if ratings fall below investment grade.
RATING SENSITIVITIES
Future developments that may individually or collectively lead to a
negative rating action include:
--Total adjusted debt-to-operating EBITDAR sustained above 3.5x due to
materially lower operating income or higher debt;
--Persistent SRS declines, particularly at Olive Garden, and higher than
expected margin deterioration concurrent with high levels of capital
expenditures;
--Negligible or negative FCF post the separation of Red Lobster;
indicating limited ability to pay down debt if operating earnings
experience meaningful declines and an inability to internally fund a
potentially still high dividend and unit growth, even at reduced levels.
Future developments that may individually or collectively lead to a
positive rating action, although not anticipated in the near-term,
include:
--Total adjusted debt-to-operating EBITDAR maintained below 3.0x due to
operating income growth and/or debt reduction;
--Consistently positive combined SRS performance, particularly for Olive
Garden following the separation of Red Lobster;
--Significantly improved discretionary FCF.
Fitch rates Darden as follows:
--Long-term Issuer Default Rating (IDR) 'BBB-';
--Bank credit facilities 'BBB-';
--Senior unsecured notes 'BBB-';
--Short-term IDR 'F3';
--Commercial Paper (CP) 'F3'.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research:
--'2014 Outlook: U.S. Restaurants - Shareholder Demands to Rise, Even as
Market Share Battle and Cost Pressures Continue (December 2013);
--'Fitch Downgrades Darden's IDRS to 'BBB-/F3'; Outlook Stable (October
2013);
--'Corporate Rating Methodology' (August 2013);
--'Short-Term Ratings Criteria for Non-Financial Corporates' (April
2013).
Applicable Criteria and Related Research:
2014 Outlook: U.S. Restaurants (Shareholder Demands to Rise, Even as
Market Share Battle and Cost Pressures Continue)
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=724335
Corporate Rating Methodology - Effective from 8 August 2012 - 5 August
2013
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=684460
Short-Term Ratings Criteria for Non-Financial Corporates
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=714415
Additional Disclosure
Solicitation Status
http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=812594
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