CHICAGO--(BUSINESS WIRE)--Fitch Ratings has downgraded the ratings of Darden Restaurants, Inc. (Darden; NYSE:DRI) as follows:
--Long-term Issuer Default Rating (IDR) to 'BBB-' from 'BBB';
--Bank credit facilities to 'BBB-' from 'BBB';
--Senior unsecured notes to 'BBB-' from 'BBB';
--Short-term IDR to 'F3' from 'F2';
--Commercial Paper (CP) to 'F3' from 'F2'.
The Rating Outlook is Stable.
At Aug. 25, 2013, Darden had approximately $2.8 billion of total debt.
KEY RATING DRIVERS
FCF, Leverage Drives Downgrade
The downgrade is due to continued weak same-restaurant sales (SRS), particularly at Olive Garden where SRS have been negative for two consecutive years, and declining operating income. Moreover, due to Darden's disappointing earnings for the first quarter ended Aug. 25, 2013, leverage and free cash flow (FCF - cash flow from operations (CFO) less capital expenditures (CAPEX) and dividends) will not improve as fast as Fitch anticipated, causing credit statistics to remain weak for the 'BBB/F2' category.
For the latest twelve month (LTM) period ended Aug. 25, 2013, total adjusted debt-to-operating EBITDAR (defined as total debt plus 8x gross rent to operating EBITDA plus gross rent) was 3.4x, up from 2.6x at May 27, 2012. Operating EBITDAR-to-interest plus rent was 3.6x, down from 5.0x at May 27, 2012, and FCF was negative $63 million, versus an average of over $200 million prior to fiscal 2012.
Fitch currently expects total adjusted debt-to-operating EBITDAR to approximate 3.3x in 2014 and improve modestly to 3.1x in fiscal 2015. FCF is projected to exceed $100 million by fiscal 2015, after increasing only nominally in fiscal 2014.
Cash Flow, Financial Strategy
Darden's CFO has grown at a 5% compound annual growth rate since fiscal 2009 to approximately $950 million in fiscal 2013 but, after declining 14% in the fiscal first quarter, Fitch projects only modest CFO growth in 2014. Cash flow priorities include new unit growth and satisfying the firm's high dividend. Share repurchases have been completely curtailed since the end of fiscal 2012.
Darden expects moderately lower CAPEX of $600 million - $650 million in 2014, as the firm scales back on new unit openings at Olive Garden. Darden's FCF has deteriorated significantly since 2010 due to dividend increases and heightened CAPEX. In June 2013, Darden announced an additional 10% increase in its quarterly dividend even though earnings will decline. Fitch expects the firm's payout ratio to approximate 70% of net income in fiscal 2014, a level that is extremely high for an economically sensitive restaurant company.
SRS Weakness, Margin Pressure
Darden expects combined SRS to be near the bottom of its 0% - 2% guidance range for fiscal 2014. Combined SRS for Olive Garden, Red Lobster, and LongHorn Steakhouse (LongHorn) declined 3.3% during the most recent first quarter, after declining 1.3% during fiscal 2013. Individually, during last quarter, SRS at Olive Garden and Red Lobster were negative 4.0% and 5.2%, respectively, due mainly to reduced traffic, while LongHorn was positive 3.2%.
According to Fitch's records, Darden began discussing efforts to reignite consistent SRS growth at Olive Garden in fiscal 2012. Fitch believes changes aimed at increasing affordability and variety are taking longer than anticipated because of heightened competition and the slow economic recovery, which will be further impacted by the recent government shutdown. Fitch projects that Darden's operating EBITDA margin will decline to approximately 12.5% in fiscal 2014, down from 14.4% in fiscal 2012 due to a combination of weak SRS, food cost inflation, and higher labor-related costs.
New Cost Reductions Efforts
Darden expects to realize $25 million of gross annualized on-going operating support cost savings in fiscal 2014 and $50 million by fiscal 2015. Expenses associated with these efforts are expected to total $10 million in fiscal 2014.
Darden expects cost savings, which include reductions in headcount and lower priority initiatives, to provide it added financial flexibility until SRS regain positive momentum. Darden maintained its guidance that EPS will decline 3% - 5% in fiscal 2014, despite lower SRS growth and higher food costs. The firm's expectations reflect the combined benefit of cost savings and the postponement of some provisions related to the Affordable Care Act.
Investment Grade Profile
Fitch's Stable Ratings Outlook reflects its view that Darden has adequate levers to pull in order to maintain its investment grade rating, should SRS continue to decline and pressure CFO. Management's commitment to maintaining its investment grade rating has been demonstrated by its willingness to halt share repurchases and pull back on CAPEX. Maintenance CAPEX is currently about $150 million.
Moreover, Fitch believes Darden's portfolio of leading casual dining restaurant chains reduces its business risk but recognizes that its two largest brands, Olive Garden and Red Lobster, appeal to a similar consumer demographic. At Aug. 25, 2013, Darden had a total of 2,155 mainly U.S. based company-operated restaurants. Olive Garden, Red Lobster, and LongHorn represented 92% of these units with 832, 704, and 438 units, respectively. Darden's Specialty Restaurant Group, which includes The Capital Grille, Bahama Breeze, Seasons 52, Eddie V's, and Yard House, represented the remaining 8% of its units.
Liquidity, Maturities and Debt Terms
At Aug. 25, 2013, Darden had $108.9 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 $212 million at Aug. 25, 2016.
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 Aug. 25 2013, the ratio was 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.
Future developments that may individually or collectively lead to a positive rating action 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 for Olive Garden, Red Lobster, and LongHorn;
--Significantly improved discretionary FCF; such that FCF margin to sales nears 3.0% or more.
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 and higher than expected margin deterioration concurrent with high levels of capital expenditures;
--Negative FCF, indicating the inability to internally fund unit growth and high dividend pay out.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research:
--'Fitch Affirms Darden's IDRS at 'BBB/F2'; Outlook Negative (June 2013);
--'Corporate Rating Methodology' (August 2013);
--'Short-Term Ratings Criteria for Non-Financial Corporates' (April 2013).
Applicable Criteria and Related Research:
Corporate Rating Methodology - Effective from 8 August 2012 - 5 August 2013
Short-Term Ratings Criteria for Non-Financial Corporates