Company Reports

As we gear up for the release of first-quarter earnings, our top picks in the restaurant industry remain wide-moat McDonald's and wide-moat Starbucks, trading at 14% and 19% discounts to our $312 and $105 fair value estimates, respectively. While industry traffic has been depressed for two years, both brands boast strong digital platforms that allow them to defend transaction frequency without indiscriminate national discounting, and both benefit from scale-driven cost advantages that should allow them to meet the needs of the increasingly value-sensitive consumer without sacrificing financial performance. These are the two most important factors, in our view, that will distinguish the best and worst performers in our industry coverage over the coming years. The industry looks fairly priced in aggregate, trading at a 3% premium to our market-cap weighted fair value estimates. The aggregate figure masks a very bimodal return distribution: Brands like narrow-moat Wingstop (up 108% annually) and wide-moat Chipotle (74%)—which boast strong unit economics and have taken material industry transaction share—have materially outperformed brands like no-moat Wendy's (down 9%) and narrow-moat Papa John's (down 17%), which have not. Those top-performing brands are fully priced, trading at material premiums to our intrinsic valuation (163% and 52%, respectively), suggestive of meaningful execution risk.

As one final addendum to our mixed prognosis regarding narrow-moat Darden's fiscal third-quarter earnings results, we've lowered our Uncertainty Rating for the company to Low from Medium. This is reflective of the interplay between our quantitative methodology and qualitative assessment of the firm's prospects. With concept diversification that runs the gamut in the full-service restaurant industry, strong value positioning, and marketing discipline through a promotional cycle, we believe that the firm's cash flow uncertainty is low. Our forecasts remain otherwise unchanged.

Darden Restaurants' playbook strives to leverage its competitive advantages, with the restaurant operator leaning into its scale-driven cost edge, embracing datacentric decision-making, trying to attract and retain employees with compelling benefits and culture, and providing a differentiated dining experience, consistent with management's back-to-basics strategy. While we view this approach as strategically sound, we expect any success at Darden to come in spite of, rather than propelled by, aggregate industry results, with the full-service industry posting anemic average annual sales growth of just 1%-2% over the past decade, well behind limited-service peers' 3%-4% clip.

Narrow-moat Darden reported decent fiscal third-quarter results, with $2.98 billion in sales narrowly missing our $3.03 billion estimate, but with $2.62 in adjusted EPS edging our $2.55 forecast. It was disappointing to see declining traffic in the firm's Olive Garden and Longhorn segments en route to a 1% consolidated comparable store sales decline as well as to see a downward revision to full-year same restaurant sales guidance (midpoint growth to 1.75% from 3%). That said, the pressure wasn't entirely unforeseen, given a sharp 6.5% decline in full-service restaurant traffic over the past three months (BlackBox Intelligence). During the most recent quarter, restaurants that have exhibited sales softness have been thoroughly punished by the market, and a 5%-6% decline in March 21 trading suggests that Darden is no exception. After weighing the firm’s results, we expect to raise our $146 fair value estimate by a low-single-digit percentage, consistent with time value, leaving shares trading at about a 10% premium.

As we survey the U.S. restaurant landscape looking toward 2024, the largest, chained restaurants with durable cost advantages look best positioned to outperform. We expect industry growth to remain low—just 1.3% annually in real terms through 2025, versus a long-term average of 2.5%. The sharp slowdown is predominantly attributable to slowing consumption spending, with pressured U.S. consumers already limiting restaurants’ ability to further increase prices and likely driving an uptick in industry promotional activity.

Darden Restaurants' playbook strives to leverage its competitive advantages, with the restaurant operator leaning into its scale-driven cost edge, embracing datacentric decision-making, trying to attract and retain employees with compelling benefits and culture, and providing a differentiated dining experience, consistent with management's back-to-basics strategy. While we view this approach as strategically sound, we expect any success at Darden to come in spite of, rather than propelled by, aggregate industry results, with the full-service industry posting anemic average annual sales growth of just 1%-2% over the past decade, well behind limited-service peers' 3%-4% clip.

Narrow-moat Darden reported acceptable fiscal second quarter results, with net sales of $2.73 billion aligning with our estimate but with $1.84 in adjusted EPS falling well short of our $2.12 forecast. The firm narrowly missed consensus sales expectations, sending shares down 2%-3% after the release, but we expect few changes to our $11.5 billion and $8.37 GAAP EPS full-year estimates, which remain roughly in line with management's tiny downward revision to guidance (40 basis point lower sales growth and a 25-basis-point decline in comparable sales growth at the midpoints for fiscal 2024). We expect no meaningful change to our $146 intrinsic valuation, leaving shares trading at a slight premium.

The restaurant industry looks cheap to us for the first time since fall 2022, with the recent market correction creating a buying opportunity for long-term investors. Our coverage trades at a 7% cap-weighted discount to our intrinsic valuations, with wide-moat companies like Yum Brands, Starbucks, and McDonald's looking unusually alluring, each trading at a 10%-12% discount to our respective $139, $103, and $285 fair value estimates. We recognize that slowing same-store sales pose a near-term risk, but believe that large, quick-service operators with scale-driven cost advantages and strong digital touchpoints look poised to capture market share in this dynamic environment. Restaurants are more resilient than many investors realize, with companies that outperform on the basis of "value for the money" like McDonald's and wide-moat Chipotle even posting comparable-store sales growth over the course of the 2007-09 downturn. While we expect consumer spending to slow in 2024, we continue to maintain that the U.S. will avoid an outright recession and believe that investors seeking consumer cyclical exposure would do well to consider turning toward the restaurant industry at current prices.

Darden Restaurants' playbook strives to leverage its competitive advantages, with the restaurant operator leaning into its scale-driven cost edge, embracing datacentric decision-making, trying to attract and retain employees with compelling benefits and culture, and providing a differentiated dining experience, consistent with management's back-to-basics strategy. While we view this approach as strategically sound, we expect any success at Darden to come in spite of, rather than propelled by, aggregate industry results, with the full-service industry posting anemic average annual sales growth (1%-2%) over the past decade, well behind limited-service peers' 3%-4% clip.

Narrow-moat Darden Restaurants extended its full-service restaurant share gains during its fiscal 2024 first quarter ended August, outperforming the industry’s same-store sales average by over 400 basis points (Black Box Intelligence). Driven by strong same-store sales growth of 6.1% at Olive Garden and 8.1% at LongHorn Steakhouse, total sales topped $2.7 billion, matching our estimate. Against a more challenging economic backdrop, Darden’s development of more value-oriented fare continues to resonate with consumers, buoyed by its dedication to strategically pricing at a value gap to its peers (according to Darden). As for cost management, restaurant-level EBITDA margin increased 170 basis points to 19%, thanks to food and beverage pricing leverage and productivity gains, just south of our 20% forecast.

Darden Restaurants' playbook strives to leverage its competitive advantages, with the restaurant operator leaning into its scale-driven cost edge, embracing datacentric decision-making, trying to attract and retain employees with compelling benefits and culture, and providing a differentiated dining experience, consistent with management's back-to-basics strategy. While we view this approach as strategically sound, we expect any success at Darden to come in spite of, rather than propelled by, aggregate industry results, with the full-service industry posting anemic average annual sales growth (1%-2%) over the past decade, well behind limited-service peers' 3%-4% clip.

Restaurant stocks look expensive as we take the industry's pulse, with names in our coverage trading at a market-cap-weighted 10% premium to our intrinsic valuations. While demand has held up nicely to date, we're seeing weak spots, with persistent declines in traffic and items per check suggesting price-conscious consumers and a more challenging pricing environment to come. Nominal same-store sales growth remains healthy, up around 5.7% industrywide over the past three months (RMS data), but traffic (down 1.4%) and items per check (down 3.7%) remain points of concern. We expect slowing sales momentum into the first half of 2024, resulting in a more promotional environment for the industry and a three- to four-year route to normalized restaurant-level profitability. The industry's bargain bin looks sparse, but we see modest upside in Wendy's and Starbucks shares, which trade at 6% and 2% discounts to our $23 and $104 fair value estimates, respectively.

Darden Restaurants' playbook strives to leverage its competitive advantages, with the restaurant operator leaning into its scale-driven cost edge, embracing datacentric decision-making, trying to attract and retain employees with compelling benefits and culture, and providing a differentiated dining experience, consistent with management's back-to-basics strategy. While we view this approach as strategically sound, we expect any success at Darden to come in spite of, rather than propelled by, aggregate industry results, with the full-service industry posting anemic average annual sales growth (1%-2%) over the past decade, well behind limited-service peers' 3%-4% clip.

Narrow-moat Darden Restaurants continues to fire on all cylinders, with its portfolio of full-service restaurants outperforming full-service industry same-store sales benchmarks by 610 basis points during its fiscal fourth quarter. Sales of $2.8 billion and diluted EPS of $2.58 were in line with our forecasts for $2.8 billion and $2.50, respectively. We expect to increase our $143 fair value estimate by a low-single-digit percentage, consistent with time value. We also plan to adjust our Uncertainty Rating to Medium from High, consistent with our quantitative methodology. However, Darden's valuation continues to look stretched to us, with the shares trading at a 12%-13% premium to our revised fair value estimate.

We're not entirely sure why narrow-moat Darden Restaurants has elected to purchase 154-unit Ruth's Hospitality group, but at least it doesn't appear to be overpaying for the privilege. The acquisitive full-service operator intends to add the upscale steakhouse chain to its lineup at a valuation of $715 million after a planned cash offer of $21.50 per share, representing a 34% premium to the steakhouse's May 2, 2023, closing price and 9.4 times trailing EBITDA. Given the muted scale of the deal (with Ruth's clocking in at just shy of 4% of Darden's intraday market cap and at 5.2% of fiscal 2022 sales) and a reasonable multiple—PitchBook data suggests a median restaurant acquisition multiple of 12.4 times trailing EBITDA over the past five years—we don't anticipate any consequential changes to our $143 fair value estimate for Darden or to our Standard capital allocation rating. Deal closure is expected in June and without external financing.

The restaurant industry has proven surprisingly resilient despite stout macroeconomic headwinds, but between normalizing consumer spending patterns, a widening value gap with the grocery channel, and early signs of price sensitivity, we believe that 2023 is shaping up to be challenging. Despite early indications of a strong first quarter, we continue to expect a softer second half of the year, limiting near-term margin recovery as restaurants are reluctant to outprice their core customer. To this effect, traffic and items per check have declined in each of the past 10 months industrywide—through February 2023—and we continue to view exclusively price-driven comparable store sales growth as a tenuous long-term strategy. We sport a carb-heavy value menu in the industry, with wide-moat Domino's and narrow-moat Toast representing our top picks, trading at 16% and 18% discounts to our $397 and $21.50 fair value estimates, respectively.

We believe that prudent adoption of digital ordering, restaurant software, and loyalty programs can yield meaningful benefits for the restaurateurs we cover as well as for astute investors who can identify today's digital leaders. We expect investments in technology to pave the way for food-service establishments to gain share from the grocery channel, settling just north of 55% of U.S. consumer food spending, ahead of our prior 50% estimate, as technology-driven cost savings enable restaurateurs to narrow the value gap with the cheaper grocery channel. The largest chains in our coverage are poised to disproportionately benefit from technology adoption; we forecast their share of total restaurant sales to grow by 200 basis points over the next five years, with wide-moat firms like Chipotle, Starbucks, and Domino's looking particularly well positioned. Investors looking for immediate-term opportunities should consider Domino's and narrow-moat Toast, which trade at roughly 16% and 17% discounts to our $397 and $21.50 intrinsic valuations, though we'd remain eager buyers of leaders like Chipotle and Starbucks at prices below our $1,550 and $103 fair value estimates.

As Darden Restaurants emerges from the COVID-19 pandemic, we expect its playbook to remain largely the same, with the restaurant operator leaning into scale-driven cost advantages, embracing datacentric decision-making, trying to attract and retain employees with a compelling culture, and providing a differentiated dining experience, consistent with management's back-to-basics strategy. While we view this approach as strategically sound, we expect any success at Darden to come in spite of, rather than propelled by, aggregate industry results, with the full-service industry posting anemic average annual sales growth (1%-2%) over the past decade, well behind limited-service peers' 3%-4% clip.

After narrow-moat Darden outperformed industrywide traffic by 700 basis points during fiscal third-quarter 2023 (Black Box Intelligence), we're finally giving the firm credit where it's due. Darden learned its lesson after raising prices too aggressively amid the global financial crisis, and its commitment to structurally lower marketing expenses in lieu of using discounting to buy traffic is a meaningful step forward. After digesting wide industry outperformance, management suggesting long-term margin expansion, and a massive (340-basis-point) sequential improvement in its restaurant EBITDA margin to 20%, we expect to raise our $123 fair value estimate by more than 15%, leaving shares fairly valued.

We expect sluggish sales growth to represent the key issue for the restaurant industry in 2023, following a year of investor concern regarding inflated input costs and margin compression. Though we see modest upside in wide-moat Domino's and view wide-moat Chipotle shares as fairly valued, the industry trades at a 5% market-cap weighted premium to our fair value estimates, suggesting that current entry prices are less than salient.