This article was submitted for the Sohn Conference investment idea contest on April 22,2016. It was not selected as a finalist. The first half contains some of my earlier services work while the second half focuses on Darden Restaurants (DRI). I will be putting out more work on DRI and other names in the future. To be clear, this was written prior to the strong ISM NMI (services) data released on May 4,2016. #Sohn2016
Before looking at DRI, I feel it’s important to analyze the current economic backdrop and how it plays into the success of DRI. My thesis for DRI being undervalued is based on the belief that the long term strength of the consumer and the economy in general has been underestimated by the investment community. This underestimation is a function of many investor’s conservatism bias towards recognizing and accepting the strength of a services based economy. In short, conservatism bias is a term used in behavioral finance which describes why people cling to prior views and fail to update those views when presented with new information. This failure is mostly driven by the mental discomfort, or cognitive dissonance, that comes with processing new information that conflicts with an existing belief. Then compounding this bias, we have financial media constantly associating services based employment with that of “burger flippers” or low skilled and low paid positions. This association, quite frankly, is not only derogatory to a whole group of people that work very hard, but it’s also untrue. Most people don’t realize that the services jobs spectrum includes computer hardware designers, programmers, electrical and mechanical engineers, medical professionals, scientists, accountants, lawyers, architects, advertising agents, commercial drivers, CEOs, custodial arts professionals and even those very special folks that toil in financial markets. Not only are services jobs primarily high-skilled positions, they also have high earnings. Using data from the most recent nonfarm payrolls report, the table below shows how many people are employed in various goods producing and services sectors, and how much in earnings they generate.
Much to the chagrin of those in financial media, you can see that four of the top five earning industries are all in the services sector and do not include the leisure and hospitality industry.
The U.S. economy used to be a manufacturing and exporting powerhouse, which is what many people still think the economy is about today. In reality, the economy has been transitioning from a manufacturing/export base to a services/consumption base since the mid 1900’s. This transition has had significant effects not only on the composition of the workforce, but also on business cycle length. Because a services/consumption based economy is highly self-sustaining and less susceptible to exogenous shocks, the length of the average business cycle has increased. In the table below, I have adjusted NBER business cycles to include the transition from a manufacturing/exports based economy to a services/consumption based one.
The current expansion is in its 83rd month, and I would argue we have more than a year to go.
In addition to having a longer business cycle, the services based economy also has a labor force that is more resilient to recessions and is able to recover more quickly from them as the charts below demonstrate. In the charts, I have drawn a comparison between Manufacturing, Professional and business services (PBS) and Total private employment. All three data series are titled and defined by The Bureau of Labor Statistics which is the source of all data used in the charts. I chose PBS because it best represents a broad range of service industries. The charts include every recession that has occurred since 1945 as defined by the NBER. 1945 is the earliest starting point for which data was available for all three series.
The first chart shows the average number of jobs lost on a monthly basis as a percentage of its total industry. For example, in the recession of 2001, manufacturing lost an average of .81% of its workforce on a monthly basis while PBS lost just .43%. Then in the Great Recession, they lost .83% and .47% respectively.
As you can see, PBS has been more resilient to downturns than manufacturing.
The second chart shows the monthly average number of jobs recovered (or decline in job loss) in the first six months after a recession has ended.
The takeaway from these charts is that PBS has outperformed manufacturing in terms of losing fewer jobs during a recession and then recovering them more quickly after a recession. This outperformance is a function of the self-sustaining nature of services labor and suggests that a longer than average expansionary cycle is possible. It is these changes in the nature of the economy and the labor force that I believe will keep this expansion alive and take equities along with it. It’s a bull market!
Now that I’ve covered my reasons for believing why the economy will continue to provide a bullish atmosphere for equities in general, let’s take a look at DRI. Darden Restaurants is the largest full service restaurant chain in America with 1,534 domestic locations and just 39 restaurants internationally. DRI finds itself in a great position to capture consumer discretionary dollars because of its excellent brand reputation and the wide spectrum of consumers that it appeals to. Unlike typical retailers that target a specific demographic, DRI has restaurants that appeal to all income levels and provides a range of atmospheres. The table below demonstrates the brand diversification that is offered to customers:
DRI restaurants themselves are often situated in the main social structure of the locality they serve. These prime locations are what allows DRI to capture maximum consumer dollars during cycle upswings, but also allows DRI to capture dollars in a downturn by being part of the focal point of the community. The fact is, even in bad times, people still find a way to go out to eat and DRI will be there.
The greatest challenges that DRI faces come from managing its food and labor costs. While food costs can be extremely volatile, DRI is able to manage its suppliers by leveraging its significant scale. DRI has become a Walmart of the restaurant industry in its ability to manage costs through its dominant position over suppliers. As for labor, costs have risen as the economy has strengthened. To address this, in 2014 / 2015, DRI reviewed its operating structure and reduced its workforce for which it did incur termination expenses but has made the organization more long-term efficient. This leads us to the first aspect of “disruptive” technology that DRI may be able to take advantage of. Technology is currently being developed that could revolutionize labor intensive kitchen processes such as food preparation, basic cooking and cleaning. Spyce Kitchens, for example, is a company formed by MIT students which has made an entirely robotic kitchen service. Once this kind of technology is fully proven and brought up to scale, it could be an absolute windfall for DRI. Labor is roughly 30% of COGS, so just a 20% drop in labor costs would give a 50% increase to operating income. A reduction in labor costs will also allow DRI to redirect capital towards dining experience enhancing projects, thus making them that much more appealing to consumers in the long-term.
In terms of its finances, DRI is an investment grade credit with a fairly transparent balance sheet. Its long term debt is rated BBB- by S&P and Ba1 by Moody’s. While this is just barely IG, I would expect upgrades in the future as DRI has significantly reduced its leverage and continues to generate strong free cash flow. During the second and third quarters of fiscal 2016, DRI retired $1.01 billion of loans and notes, leaving just $450 million outstanding of long-term debt with overall leverage at just .5x on TTM EBITDA. The debt retirement was funded by the sale-leaseback of 64 restaurant properties and its corporate headquarters. After the sale-leasebacks, DRI still has significant real estate assets that can be used for future financing needs. The one issue on the B/S that there is, is the $1.44 billion in goodwill and trademarks that could be a problem should they incur an aggressive write down. That said, given that DRI has significant assets and minimal debt, tapping capital markets for future financing should not be an issue. This brings me to the second “disruptive” aspect of DRI which is that it operates in a nearly “disruptor” proof business. Given that the dining out experience is essentially irreplaceable and a timeless one, DRI future cash flows can be counted on. Obviously DRI’s business is still subject to normal competition, at least the risk of being “disrupted” can be almost entirely eliminated. In today’s technology driven and “disruptable” environment, the safety that DRI offers is sure to command a premium in its valuation.
While the food services industry has a history of being volatile and highly susceptible to the business cycle, I feel that DRI has built a business that will be able to rise above these risks and come out ahead. In conclusion, I think the economy is in good shape and has reached a critical mass where the expansion can keep going until we inevitably run into some kind of turbulence. That said, a great way to take advantage of this expansion is to get long DRI and in general, get long America!
(See below for ratios)