When will relative pricing catch up with Olive Garden?
Once the undisputed leader of national Italian restaurant chains, Darden's star property is facing pressure to sustain long-term growth.
It was priced at the low end of casual dining, perhaps above the bar and grille sub-segment, which is the traditional leader of low-end dining.
Looking at the Italian chains back then, there seemed to be a pretty well-developed pecking order: Macaroni Grill was a step up in terms of food and check, and the then-newer Carrabba's chain was another step up to the top of the segment.
Along the way, Macaroni Grill had some business missteps that let Olive Garden, whose parent is Darden Restaurants Inc. (DRI), become the undisputed No. 1 national Italian chain, with all of the economies of scale attendant to national advertising, name recognition, and share of advertising voice that follows.
One of the things that Olive Garden's marketing people have done masterfully since the 2000 recession, in my opinion, is advertise and establish a value image in the minds of its customers, while continually raising relative prices. That was our impression every time my wife and I dined at one, which was increasingly infrequently.
In the first half of this fiscal year, even as food ingredient cost-of-goods-sold increases were easing, there was investor concern for earnings growth at Darden Restaurants. The concerns mostly revolved around Olive Garden, the largest and easily most profitable chain in the company. Some of this controversy involved efforts to change advertising and "invest" in more affordable meals, such as $12.95 three-course dinners to help traffic without overly hurting margins.
At the same time, I looked at the same-store sales growth for Olive Garden, which had been weak for some time, while Carrabba's, which is privately owned, had been showing same-store sales growth for about 12 consecutive quarters -- interesting dichotomy there.
Comparing the menus, I found that the average entrée price was the same, about $17.50. Now it may well be that Olive Garden sells more lower-priced menu items than Carrabba's, but still, the comparable pricing was puzzling.
Cheesecake Factory (CAKE) has for 25 years been considered the gold standard of casual dining chains. It typically has prices at the high end of the segment. When I compared its menu to Olive Garden's, however, I concluded that the pricing was equal. Cheesecake Factory may well have tempered its increases in recent years because of the tough economy. This would be extremely discomforting to me if I owned Darden stock, especially in a pressured consumer environment where I saw private label (surrogate for pricing pressure) finally get to General Mills (GIS), the last man standing in consumer staples, or any number of other examples I could recite.
The news in February of third-quarter Olive Garden comps coming in +2% did not make a case for a turn up or down in the chain's future sales. And the weather was unusually warm. Then there was Darden's annual analyst meeting, in which management tried, with some success, to build confidence in the company's long-term growth rate, while still doing some hemming and hawing by eliminating an Olive Garden margin trend slide that had been included in former presentations.
Management did say that most of its Olive Garden operating margin leverage is expected to come from a fixed advertising budget. Maybe. But for me all of its promotions, including $12.95 meals, smacks of the sort of "hi-lo" pricing that many supermarkets have employed without success against Wal-Mart (WMT), Target (TGT), Costco (COST), and others. At some point, a customer wants to go out to eat and just look at the menu without comparative shopping. So I see Olive Garden's margins coming down longer term from a pricing level that is too high, or sustaining a loss of market share.
Beyond Olive Garden, Red Lobster (another Darden property) has had questions about how much the last two quarters' promotions have helped a comp-store sales trend that was last positive at 1% in fiscal year 2009. And Longhorn's longer-term operating margin growth will at least be somewhat challenged by a higher beef prices due to $7-per-bushel corn and its effect on gross margin percentage.
A few days ago, an Olive Garden coupon went out. Previously this has happened only when there has been traffic pressure. Again, was the weather too warm this past quarter?
Darden stock at $49, using a consensus fiscal year 2013 earnings per share of $4.10 (up 14% and assuming some decent economic recovery), discounts a future 5% five-year compound growth rate (using 7% risk discount, 4% risk free rate). I believe that's too optimistic an outlook unless Olive Garden gets some margin leverage from here.
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