Fitch Ratings affirms BBB ratings for Darden Restaurants' long-term issuer default rating, bank credit facility, senior unsecured debt; outlook negative due to incremental leverage expected from Darden's planned acquisition of Yard House USA
July 13, 2012
– Fitch Ratings has affirmed the ratings of Darden Restaurants, Inc.
(Darden; NYSE: DRI) as follows:
--Long-term Issuer Default Rating (IDR) at 'BBB';
--Bank credit facility at 'BBB';
--Senior unsecured debt at 'BBB';
--Short-term IDR at 'F2';
--Commercial paper (CP) at 'F2'.
The Rating Outlook is revised to Negative from Stable.
Fitch has concurrently assigned a 'BBB' rating to Darden's deferred privately placed $80 million of 3.79% senior unsecured notes due Aug. 28, 2019 and $220 million of 4.52% notes due Aug. 28, 2024. Proceeds from the issuance, which was announced on June 20, 2012 and is expected to close on Aug. 28, 2012, will be used to repay existing indebtedness.
Negative Rating Outlook:
The Outlook revision is due to the incremental leverage expected from Darden's planned acquisition of Yard House USA, Inc. (Yard House) for $585 million inclusive of approximately $30 million of cash tax benefits to be realized over the next two years. The revision also reflects Darden's materially negative FCF during the fiscal year ended May 27, 2012. The transaction, which will be debt-financed, is expected to close early in the fiscal second quarter ending November 2012.
Yard House is a small upscale chain of 39 casual dining restaurants serving contemporary American cuisine and 130 plus taps of imported, craft and specialty beer. The company generated $262 million of sales and $39 million of EBITDA in calendar 2011. Fitch views the acquisition as a complement to Darden's Specialty Restaurant Group (SRG) given its unique ambience and future growth potential. However, incremental debt to fund the deal will initially increase leverage to the high end of the range acceptable for current ratings.
For the fiscal year ended May 27, 2012, rent-adjusted leverage (defined as total debt plus 8 times gross rents-to-operating EBITDA plus gross rent) was approximately 2.5 times (x), up from 2.2x for the fiscal year ended May 29, 2011 due mainly to higher debt. Pro forma for the acquisition of Yard House, rent-adjusted leverage is forecast to approximate 3.0x. Darden generated approximately $100 million of negative FCF during the latest fiscal year due to elevated capital expenditures and the firm's targeted 40 - 50% dividend payout ratio. FCF is down from a positive $169 million during the prior year and well below the firm's long-term average of $200 million.
A combination of operating income growth and a commitment to less share repurchases should result in deleveraging over the next 12 to 18 months. However, a rating downgrade could occur if rent-adjusted leverage increases above 3.0x due to weaker than expected sales and operating income growth or if FCF remains negative. The Outlook could be revised to Stable if rent-adjusted leverage is maintained at or below 3.0x and FCF generation improves. Fitch expects Darden's FCF to remain below the firm's historical average in the near
term due to elevated capital spending for new unit development and the firm's high dividend payout ratio, particularly versus most restaurant peers.
Darden's ratings reflect its significant operating cash flow, which has averaged approximately $750 million annually since 2007, and its strong position in the U.S. casual dining industry, with 1,994 restaurants at May 27, 2012. Olive Garden, Red Lobster and LongHorn, Darden's core restaurant chains comprising 94% of the firm's units, hold leading market share positions in the full service Italian, Seafood, and Steak categories. The Capital Grille, Bahama Breeze, Seasons 52 and Eddie V's are smaller niche brands in the firm's SRG Group, representing the remaining 110 or 6% of total units.
Ratings consider the competitiveness and economic sensitivity of the U.S. restaurant industry but balance that against Darden's ability to outperform the broader casual dining industry on a blended same-restaurant sales (SRS) basis. Furthermore, the firm's consolidated restaurant margin is among the highest in the casual dining industry at over 18% for the fiscal year ended May 27, 2012. Essentially all of Darden's units are in North America and are company-operated.
Recent Operating Performance and Fiscal 2013 Guidance:
During fiscal 2012, Darden's consolidated sales increased 6.6% to $8 billion. The increase was due to combined SRS growth of 1.8% at Olive Garden, Red Lobster, and LongHorn Steakhouse (LongHorn), SRS growth of 4.6% for the company's Specialty Restaurant Group, and 4.7% of sales growth from new unit development and the acquisition of 11 Eddie V's restaurants. On a stand-alone basis, Olive Garden's SRS declined 1.2% while Red Lobster's and LongHorn's SRS increased 4.6% and 5.3%, respectively. Reported EBIT was flat at $740 million versus $741 million during the prior fiscal year as labor, supply chain and other cost savings initiatives offset significantly higher food costs.
In order to improve sales performance at Olive Garden, Darden is implementing a new advertising campaign and is adding more affordable core menu items as there has been a narrowing of the value leadership advantage Olive Garden once held due to significant discounting by competitors during the last recession. Fitch is encouraged by the actions Darden is taking but is concerned about the time it may take to return to sustainably positive SRS trends at Olive Garden given the weak consumer environment and the competitiveness of the industry.
During fiscal 2013, Darden expects blended SRS growth of 1-2% for its core Olive Garden, Red Lobster and Longhorn Steakhouse restaurants due mainly to pricing. The company has guided for total sales growth of 9-10% due to incremental new unit development, which will result in about $750 million of capital spending, and the acquisition of Yard House. Fitch views Darden's full year SRS guidance as conservative but anticipates volatility throughout the year due to still high unemployment and slow U.S. job growth. Darden's expectation of 0.5% - 1.5% food cost inflation during fiscal 2013, down significantly from about 6% experienced in fiscal 2012, should benefit operating income. The firm has nearly 70% of its
total fiscal year food spend contracted through the end of calendar 2012.
Adequate Liquidity, Manageable Maturities and Financial Covenants:
At May 27, 2012, Darden had $487 million of liquidity consisting of $71 million of cash and $416 million availability under its $750 million revolver expiring Oct. 3, 2016. Approximately $263 million of commercial paper and $71 million of letters of credit outstanding were backed by this undrawn facility. Darden's maturities are staggered through 2037, with $350 million of 5.63% sr. unsecured notes due Oct. 15, 2012 and no other debt maturing until 2016. Fitch expects the 2012 notes to be refinanced.
Darden remains in compliance with its maximum consolidated lease adjusted total debt-to-total capitalization credit facility covenant of 75%. Using a multiple of 6.25x minimum operating lease obligations, as defined by the agreement, this ratio was 62% at May 27, 2012.
The company's $350 million 5.63% notes due Oct. 15, 2012, $500 million 6.2% notes due Oct. 15, 2017 and $300 million 6.8% notes due Oct. 15, 2037 all contain a change of control triggering event provision and ratings-based coupon step-ups, which have never been tripped. Darden's deferred privately placed notes are pari passu with existing senior unsecured notes but unlike the firm's other notes contain a maximum consolidated total debt-to-capitalization covenant of 80%.
What Could Trigger A Rating Action?
Future developments that may, individually or collectively, lead to negative rating action include:
Rent-adjusted leverage, calculating on an 8 times gross rent basis, above 3.0x due to weaker than expected SRS and operating earnings; and/or
Multiple years of negative FCF due to weaker than expected operating cash flow, heightened capital spending, or large additional increases in the firm's dividend.
Darden's Rating Outlook could be revised to Stable if:
Rent-adjusted leverage is maintained in the 2.5x - 3.0x range due to operating income growth and/or debt reduction; and
Darden's FCF generation improves meaningfully due to growth in operating cash flow or lower capital expenditures.