An Equity Valuation and Analysis of. As of June 1, 2007

Transcription

1 An Equity Valuation and Analysis of As of June 1, 2007 Ashley Boaz Kristie Lee Robert Tabb Nick Traweek Robert Durrant

2 Table of Contents Executive Summary...3 Industry Analysis.4 Accounting Analysis 4 Financial Analysis Forecast Financials and Cost of Capital Estimation...6 Valuations 6 Industry Analysis.8 Company Overview...8 Five Forces Model.10 Rivalry Among Existing Firms.10 Threat of New Entrants Threat of Substitute Products...15 Bargaining Power of Buyers...16 Bargaining Power of Suppliers..16 Value Chain Analysis 17 Firm Competitive Advantage Analysis...18 Accounting Analysis.21 Key Accounting Policies. 21 Areas of Accounting Flexibility...23 Quality of Disclosure 25 Potential Red Flags..43 Fixing Accounting Distortions.44 Financial Analysis Forecast Financials and Cost of Capital Estimation.45 Liquidity Analysis..45 Profitability Analysis 55 Capital Structure Analysis.64 Extended Ratio Analysis 68 Forecasting Analysis 72 Cost of Capital Estimation 80 Weighted Average Cost of Capital..83 Method of Comparables 85 Other Method of Comparables..90 Intrinsic Valuation Models 92 2

3 Credit Risk Analysis..99 Analyst Recommendation 100 Appendix..102 Works Cited 119 3

4 Executive Summary Investment Recommendation as of 6/1/07: Overvalued, Sell DRI trading Price 6/1/07: $ Week Range: $ $47.60 Revenue (5/28/06): $5,720,640,000 Market Capitalization: $6.09 B Shares Outstanding: 146,998 3-Month Avg. Daily Trading Volume:1,399,270 Percent Institutional Ownership: 81.84% Book Value Per Share: $1.29 ROE:.266 ROA:.115 Cost Of Capital Est. R2 Beta Ke Estimated Month Month Year Year Year Kd: 6.4% WACC: 10.57% EPS Forecast Ratio Comparison DRI EAT APPB Trailing P/E Forward P/E PEG P/B Valuation Estimates Actual Price (6/1/07): Ratio Based Evaluations Trailing P/E: $57.89 Forward P/E: $52.74 PEG: $24.92 P/B: $29.51 P/EBITDA: $69.02 P/FCF: $98.3 EV/EBITDA: $43.07 Intrinsic Valuations Discounted Dividends: $6.29 Residual Income: $39.23 LR ROE: $35.63 Free Cash Flows: $9.79 AEG: $61.14 Altman Z-Score Moneycentral.msn.com Moneycentral.msn.com 4

5 Industry Analysis Darden Restaurants, Inc. is the largest publicly held casual dining restaurant company in the world. (Darden K) Darden operates in the specialty foods dining industry. They target consumers that are looking for high quality prepared foods with high quality service and atmosphere. In May of 1995, Darden became a publicly traded company. Based out of Florida, the firm currently has approximately 1400 restaurants and are opening an average of about 54 stores per year. Darden is constantly growing, having a record setting year in 2006 for sales, earnings and share price. Direct competitors of Darden include Applebee s, Brinker, The Cheesecake Factory, OSI Restaurant Partners, and Texas Roadhouse. During the authoring of this report, OSI Restaurant Partners became a privately owned company which cannot be monitored on the stock exchange. Therefore there is not sufficient information to completely compare them to Darden. The specialty foods dining industry is a market that thrives on differentiation of product and specialization. There is a low threat of new entrants into the industry, but the threat of substitute products is a moderate factor in sales. The customer has a moderate amount of bargaining power with regards to price since there is a large amount of possible substitute products. Not only could the consumer easily switch to another restaurant in the specialty dining industry, but they also have other choices, such as cooking food themselves or paying less to eat at a restaurant with low differentiation among products (i.e. fast food restaurants). Threats to business and competition have many forms in multiple industries for Darden Restaurants Inc. Accounting Analysis A key factor in valuing any firm is its accounting methods. To effectively evaluate Darden, we had to take into account their accounting practices and relate them back to their key success factors. The SEC allows a great deal of 5

6 flexibility in accounting, so reporting across firms in Darden s industry may be difficult to compare. A main accounting policy that is taken into account is their pension plans. Darden uses a defined benefit plan to attract and keep high quality employees. Since defined benefit plans are considered high risk to the company, this should be a concern of the company. They are liable for future costs of these pension plans. Darden has planned for these costs, however, with a very reasonable estimated growth rate of 9%. Inventory is one area of accounting that has much flexibility. Darden must keep customers happy by absorbing the cost of bad meals and spoilage. Their financial statements do not make it clear in any way how much is written off from these comped meals and spoilage of food. Although the costs may be lumped with other liabilities, this shows a low level of disclosure for the company s financial statements. Land leases are another concern in Darden s accounting practices. Darden records their leases as operating leases instead of capital leases. This allows them to have no effect on assets or liabilities, which can understate both of these sections of the balance sheet and can cover up future obligations. Darden is clear in stating their future lease obligations in their financial reports even though they use operating leases. The amount of transparency that Darden s financial statements have help to show a true value of the company. Even though they do not break everything down completely to show as much information as possible, they further discuss all sections to adequately convey important information. Processing of Darden s accounting policies can identify red flags for the company. Although no major red flags were found for Darden, some small issues are considered later in the report. 6

7 Financial Analysis, Forecast Financials and Cost of Capital Estimation To value a firm, all future performance must be taken into account. After all, a company s stock price in the future depends on it s performance in the future. To take this into account, several ratios were first calculated to show the past performance of Darden and several of its competitors. After assessing past performance based on these ratios, we used them to forecast financial statements for Darden for the next ten years. We then estimated a beta for the company, calculated the cost of equity and debt, and finally computed Darden s cost of capital using the Weighted Average Cost of Capital method. Our ratio analysis revealed that Applebee s is at the top of the industry for liquidity. Darden has the best accounts receivable turnover, showing that the company collects on its receivables quicker than its competitors. In general, the liquidity ratios computed are slightly favorable for Darden. The profitability ratios that were computed showed that the net profit margin for Darden is about average for the industry. Gross profit margin was extremely low, which could indicate value in the company that is not recognized. Capital structure ratios showed bad trends for Darden in general. Their debt to equity, times interest earned and debt service margin are all on the low side of the industry. In short, their current capital structure is inferior compared to the rest of the industry. We used the ratios we computed to forecast Darden s financial statements for the next ten years. We forecasted the income statement based off of the past sales of the company. This growth rate was 8.4%. We used the asset turnover ratio as a base for forecasting the balance sheet. We then used other ratios and growth rates to forecast the rest of the balance sheet and statement of cash flows. Valuations Once we evaluated the three major aspects of the firm that give it value, we used several models to calculate the value of the company s share price. We 7

8 used the method of comparables and five intrinsic valuation models to valuate the company s share price. The method of comparables used information from several firms in the industry to value the company. We took statistics from each company to get industry averages for several different ratios. We then used the industry average to estimate Darden s share price. These ratios included Forward and trailing price to earnings, Price to Book Value and the PEG ratio among others. These valuations showed that Darden is slightly overvalued. These valuations are not as reliable as the intrinsic valuations, though. The formulas for the intrinsic valuations are based on financial and accounting theory, and tend to be more accurate. The intrinsic valuations we used were the Free Cash Flows, Residual Income, Long Run ROE Residual Income, Abnormal Earnings Growth, and the Discounted Dividends Models. Using these models, we found that the firm is slightly overvalued. 8

9 Industry Analysis Company Overview Darden Restaurants, Inc. operates in the casual dining industry. Their mission statement is To nourish and delight everyone we serve. (Darden s k) Darden is composed of two main restaurants, Red Lobster and Olive Garden, and two smaller units, Bahama Breeze and Seasons 52. Red Lobster was founded in 1968 by William Darden, and was later acquired by General Mills. In May of 1995, Darden became an independent publicly traded company. Today, Darden Restaurants is based out of Florida. As of May 28 th, 2006, Darden operated 1,427 restaurants in 49 states (excluding Alaska) and Canada. This was up from the previous year s total of 1,381 stores. Over the previous 5 years, Darden has opened up an average of 54 restaurants per year. (Darden k) We believe this represents a strong trend towards commitment to constant growth. Forecasts are for the firm to open up additional units during the fiscal year of This is below the firms stated goal of 5%-7% annual expansion, but Darden anticipates accelerated growth in the near future. (S&P Stock Report) The year of 2006 was a record setting year for the firm, which reported the highest sales, net earnings, net earnings per share, and share price in its history. Fiscal Year Sales 4,366,911 4,654,971 5,003,355 5,278,110 5,720,640 Costs & 4,011,476 4,317,368 4,670,579 4,854,193 5,238,122 Expenses Earnings 232, , , , ,194 EPS Stock Price $25.54 $18.70 $22.37 $32.48 $36.13 (Darden K) 9

10 Darden faces competition from many different firms in the casual dining industry. Direct competitors include Applebee s International (APPB), Brinker International (EAT), Cheesecake Factory (CAKE), OSI Restaurant Partners (OSI), and Texas Roadhouse (TXRH). Brinker International possesses the most assets of this group with just over $2.2 billion. Darden is larger than all of its direct competitors, with over $3 billion in assets. We believe the firm s aggressive expansions are intended to maintain and increase this gap. Darden also has the largest market capitalization of this group with $6.4 billion, with Brinker International the next largest, at $3.6 billion. This shows that the firm is the highest valued firm among its direct competitors. From , Darden s stock lagged behind its competitors and the market index. From 2005-present, the stock has rebounded and has outperformed the market and many of its competitors. As of June , the companies stock was at an all time high of $46.59/share. 10

11 Five Forces Model The Five Forces Model allows for an outside-in business strategy that is used to make an analysis of the attractiveness or value of an industry structure ( This method does this by the identification of five fundamental competitive forces: rivalry among existing firms, threat of new entrants, threat of substitute products, bargaining power of buyers, and bargaining power of suppliers. High competition among firms can cause for a loss in profit for a firm. With there being several different firms for a customer to choose from, a firm must differentiate itself from the competition, thereby getting more power and allow them to gain a higher profit share. These five forces are important because it shows that the average profitability is influenced by these forces on a daily basis. In other words, firms can not compete or grow sufficiently if they do not have a basic understanding of each of these five headings that we will explain below. CASUAL DINING RESTAURANT INDUSTRY RIVALRY AMONG EXISTING FIRMS: THREAT OF NEW ENTRANTS: THREAT OF SUBSTITUTE PRODUCTS: BARGAINING POWER OF CUSTOMERS: BARGAINING POWER OF SUPPLIERS: MODERATE LOW MODERATE MODERATE LOW Rivalry among Existing Firms When discussing this topic, it is only appropriate to say that the profitability of a firm is influenced the most by the rivalry among existing firms section of the five forces model. This force looks at how strong the competition between the existing firms are, looks at a firms ability to dominate over the competition, or shows if all firms are among equal size and strength. Industry growth tells us how well the industry is doing among its competitors financially 11

12 and economically. Having a well rounded industry can not only influence customer inflow but also make room for potential profits to expand. Industry Growth: By keeping up with the current restaurant industry growth levels, we can tell if these areas are expanding, contracting, or remaining stagnant. As researched, the Restaurant Performance Index (RPI), which is a monthly statistical barometer that tracks the health of the restaurant industry ( stood at 101 points in April 2007, down.9 percent from its March 2007 levels. The industry as a whole has remained above 100 points for 48 consecutive months concluding a growth within the restaurant casual dining industry. Sales have also shot up for Darden Industries, recording $5.72 billion in fiscal 2006, $5.28 billion in fiscal 2005 and $5.00 billion in fiscal 2004 (Darden 10- K). Compared to its competitors, Brinker Incorporated showed revenues for fiscal 2006 of $4.15 million, $3.74 million in fiscal 2005 and finally $3.54 million for fiscal 2004 (Brinker 10-K). This slight growth in sales each year proves that the casual dining restaurant industry is increasing slowly each fiscal year. With this said, industries will not have to take market share from each other in order to grow steadily. Concentration: If you have one company who dominates the industry and sets extensive rules to its competitors, this industry is said to have high concentration. The casual dining industry deals with a monopolistic competition atmosphere because of its many producers and consumers in its market. Sellers in this case will attempt to differentiate their products from those of their competitors instead of specifically competing on product price. This allows this industry to have a low concentration field of study. Darden Incorporated currently is the largest dining 12

13 restaurant company in the world based on market share, sales and number of company owned restaurants. The graph below proves this theory by comparing Darden s (DRI) three main competitors, Brink (EAT), Applebee s (APPB) and OSI (OSI) with the percentage change over the past two years. Clearly Darden s growth exceeds its competitors by a long shot. As you can see Darden s percent increase in the number of new restaurants overshadows the competition by at least seventy percent. Switching Costs and Differentiation: The restaurant industry differentiates their products from their competitors to gain the advantage. Since these competitors are continually changing and re-innovating their products and services, customer switching costs are reasonably high. This allows customers propensity to move from one product to another to increase. Price competition is not a main focus within these companies because they are trying to set themselves apart from one another. Since this industry consists of mostly differentiation, firms must compete mainly on customer service, restaurant layout, and product separation. 13

14 Fixed/Variable Costs and Scale Economies: Firms in every industry are continually fighting for market share and if fixed costs (Ex. utilities, rent) are higher than variable costs (Ex. cheese, bread) companies are able to reduce their prices to level out the difference. Darden reportedly increased its food and beverage variable costs in 2006 to more than 6.2% from In this case, since the competitors in this industry strive for quality and not price, fixed costs will ultimately be lower than its variable costs. Gradually, firms are opening up new chain locations nation wide. For instance, Applebee s opened up an additional 41 restaurants from 2005 to As new locations transpire, so will the overall scale of the businesses explode. This allows a restaurant to accommodate a greater number of people and increase their profit margin. Excess Capacity and Exit Barriers: Excess capacity exists when marginal cost is less than the average cost, or in other words, when the amount of inventory held exceeds the demand from customers. Knowing that the casual dining industry operates at a monopolistic level and the market demand has been steadily growing, excess capacity will most likely rise as well. The casual dining industry has been known for its little exit barriers over the past few decades. Firms are finding that the cost to leave the competition exceeds the benefits of staying. This low exit barrier dilemma reduces rivalry and makes the industry more attractive to customers. The restaurant casual dining industry is a highly competitive yet growing market. There is a low level of concentration, low fixed to variable cost ratio, high switching costs, and very few exit barriers within this industry. Each of the firms in this sector competes on a unique product, high level of quality, but at the same time focuses on low costs. 14

15 Threat of New Entrants The threat of new entrants is how easy or difficult it is for new firms to start competing with existing firms. Like all profitable industries, new entrants are drawn toward that particular market to hopefully grab at a piece of market share. There are several barriers of entry that new firms must overcome before officially claiming a name stake in an industry. These include how loyal customers are to existing products, how quickly they can achieve economies of scale, would they have access to suppliers, would government legislation prevent them or encourage them to enter the industry, switching costs, and capital requirements. It is extremely important in the restaurant industry for new entrants to be able to establish a strong customer backing and to have a good relationship with its suppliers. Economies of Scale: When new firms want to enter a competitive market, they will be forced to match the scale of size of the previous existing firms. The two largest firms in the casual dining industry are currently Darden Incorporated with 1,427 restaurants and $3,010,170 in total assets and Applebee s standing at 1,804 total locations and $935,465 in total assets. Since Darden is a top competitor and has a key influence over the market share in this industry, they are able to utilize fully the economies of scale within the market. This means that these two companies are able to set the costs for the casual dining restaurant industry as a whole. Distribution Access and Supplier Relationships: New firms trying to enter into a highly competitive market may have major barriers that they must overcome. Experienced companies have most likely established networks and relationships with distributors and suppliers that are contract based. This competitive advantage can sometimes monopolize larger 15

16 firms like Brinker or Darden Incorporated from smaller companies trying to enter into the restaurant chain business. For example, as a regulation for restaurant chains, each company must have at least $1 million in annual sales with two or more operating stores. This first mover advantage can limit entry into this industry by a significant amount. Darden currently has contracts with Jtech communications, General Mills, and 1,998 other suppliers around the world. Applebee s has partnered up with Weight Watchers, Tyler Florence (world renowned chef) and Cue Search. Brinker Incorporated has thousands of exclusive contracts currently. The relationships these firms hold puts them one step ahead in the casual dining industry allowing them to promote and sell their products at a discounted price. New entrants will have a hard time keeping up and competing with billion dollar firms with well established networks. Legal Barriers to Entry: The legal barriers to enter into the restaurant business are few and far between. Like all businesses, there are legal complications that have to be faced at some point in time. If an industry has locations in countries other then the United States, their rules of business and currency conversions are undoubtedly going to be different than that of the United States. Also, new entrants may be faced with civil lawsuits like customer injuries, or racial discrimination. Regardless of the industry, all businesses face public and private issues daily which make smaller firms that more hesitant to enter into the competition. As obvious as it sounds, new firms will have a difficult time entering a market with significantly low barriers of entry. Relationships between firms and distributors/suppliers already exist between larger firms who have been in the business longer. The majority of revenue generated and market share companies will also have higher benefits when establishing economies of scale. With this said, new entrants will find it difficult to enter into the casual restaurant dining 16

17 industry. This being so, they will have a hard time establishing themselves and will be more likely to not last long in the market. Threat of Substitute Products In any industry, companies must be aware of possible substitute products. In the casual dining industry, there is a great threat of competition from other restaurants and the supermarket industry. Because the casual dining restaurants cater to a specific type of food, a main factor effecting customer s willingness to switch products is their preference in food type. People are willing to pay a premium to eat the specific type of food they want prepared in specialty ways. Customer s that choose restaurants in this industry are also willing to pay a premium for good service, such as well trained wait staff and cooks. The supermarket industry also poses a threat by offering ingredients to make the food yourself, and also by providing quality made entrees and side dishes that are pre-made in the deli section (Darden 10-K). Price plays a role in customer s decision of eating cheaper from the supermarket or eating at a restaurant. Darden s main customer bases are those who are willing to pay extra to dine in a nice atmosphere while eating well cooked food. Bargaining Power of Buyers Customers have some control over prices in casual dining restaurants. Switching costs are low to none, so extremely high prices could easily force customers to choose alternative products. Most casual dining restaurants do have a degree of specialization and differentiation in the products sold at each restaurant. Therefore customers are less price sensitive and the business is able to charge an amount greater than other restaurants that have more generalized items on their menus. The casual dining customer base does not have much relative bargaining power because each customer represents only a small fraction of a restaurant s business. The volume of customers is high and the volume of product bought 17

18 per customer is low. If a single customer is lost, the impact on the company is minimal, so bargaining has little effect on prices. Bargaining Power of Suppliers Each casual dinning restaurant purchases food and supplies from approximately 2000 different suppliers in several countries around the world. There is little price sensitivity with respect to many of the seafood products that they buy. Seafood is shipped from around the world, and availability can be dependant on many factors of nature. Because of the specialty of some of its product, the company has little control over prices it pays. All other supplies are bought from competitive suppliers that can be replaced on short notice and with little hassle. This gives the business a lot of bargaining power with all other supplies. Value Chain Analysis Industry Classification The restaurant business is an extremely aggressive industry that competes heavily on price, cost, and the opening of new restaurants, therefore using a differentiation strategy making them a low competition firm. An industry that can execute the key success factors of this strategy can gain a competitive advantage over other industries. The restaurant with the best food selection for the price and most accessible locations will gain the majority market share. Superior Product Quality and Variety In the casual restaurant industry a company must have a superior product to offer that is of the utmost quality to gain the highest customer base. With there being a large amount of casual restaurants one must offer a variety of products of the best quality to stand above their competitors. If a company does 18

19 not provide a unique dining experience it will fall below the competition and lose all demand for its product. Superior Customer Service The restaurant business relies heavily on its customer service. The restaurant has to ensure that its customers have an enjoyable experience therefore ensuring their continued business. Customer service is the key component in surviving the restaurant industry. A customer will remember the service that they receive while dining at the establishment and that will determine if they return or not. Investment in Brand Imaging Brand imaging is a key element of a successful company. A memorable atmosphere must be created to ensure that customers have an enjoyable time and would guarantee their return. Customers associate company names with the atmosphere they have experienced. A company must have a unique distinction about them that diversifies them from their competitors. This will ensure that customers will recognize these characteristics and associate them with a certain brand. Firm Competitive Advantage Analysis Competitive Strategies Darden Restaurants Incorporated has strived to be the best casual dining, now and for generations and to nourish and delight everyone we serve since 1995 (Darden s K). They focus to give an enjoying, casual dining experience that is affordable. Through superior product quality and variety, 19

20 superior customer service, and investment in brand imaging, Darden Restaurants Incorporated has risen to the casual dining leader. Superior Product Quality and Variety According to Darden s K, the restaurant industry is intensely competitive with respect to the type and quality of food, price, service, restaurant location, personnel, concept, attractiveness of facilities, and effectiveness of advertising and marketing. Darden offers a variety of dishes to complement the atmosphere and design of the restaurant. Red Lobster, the largest casual seafood restaurant, provides fresh fish, shrimp crab, lobster, scallops, and other seafood. Olive Garden, the market share leader among casual dining Italian restaurant, imports numerous wines and coffee straight from Italy. Their menu includes appetizers; soups, salads, and breadsticks; a variety of baked pastas; sautéed dishes with chicken; seafood; grilled meats; and an assortment of desserts. Bahama Breeze mirrors their Caribbean atmosphere by offering Caribbean style food, such as seafood, chicken, and steaks, along with exotic, tropical drinks. Finally, Smokey Bones provides barbequed pork, beef, and chicken. Not only do the four restaurants of Darden supply a variety of food choices, but their food is have excellent quality because it is all fresh. Darden s ability to provide fresh and tasty food depends on their relations with their suppliers. Their purchasing staff analyzes, negotiate, and purchase from more than 2,000 suppliers in 45 different countries. One of Darden s requirements is that the suppliers must meet strict quality control standards in the development, harvest, catch and production of food products (Darden s K). For example, the seafood is tested to make sure they are microbiologically safe. Darden s variety and quality of food gives them a great advantage over their competitors. 20

21 Superior Customer Service Since Darden began in 1995, they have focused their attention of their guests having excellent food, service, and experience. They desire to nourish and delight everyone we serve, the core purpose of Darden (Darden s K). This would not be accomplished without the great customer service Darden provides. Darden believes that the customer is the top priority. For example, Olive Garden s purpose is Hospitaliano!, our passion for 100% guest delight ( When you dine at Olive Garden, you are catered to your every need. Also, Darden provides a Guest Service Satisfaction Survey in which the guests rate their customer service on a scale of one to ten. Without Darden s excellent customer service, they would not have risen to the top casual dining restaurants in the United States. Investment in Brand Imaging Brand Imaging is one of the main commitments to strengthen this multibrand casual dining company. They want to leave a lasting impression in their guests minds of the enjoyable atmosphere, the terrific food they ate, and the excellent service they received while dining with the Darden restaurants. For example, Olive Garden focuses on providing their guests with a family fun environment that is a genuine Italian dining experience, when you re here your family ( Also, Bahama Breeze focuses on the Caribbean theme by providing Caribbean-inspired food, handcrafted tropical drinks, [and a] vibrant atmosphere ( From these examples, we have concluded that Darden Restaurants does an excellent job at providing brand imaging. 21

22 Accounting Analysis In order for an analyst to properly evaluate the degree to which a firm s accounting captures its underlying business reality, he/she must conduct a thorough accounting analysis (Palepu 3-1). There are six steps to this process that must be completed. First, the analyst must identify key accounting policies. The policies are used to measure the firm s critical factors and risks. The next step is to assess the accounting flexibility of the firm that is allowed under the Generally Accepted Accounting Practices (GAAP). Third, the analyst must evaluate the accounting strategy that the firm chooses to implement. The fourth step is to evaluate the quality of disclosure. Fifth, the analyst must identify potential red flags that point to questionable accounting practices. Finally, if the accounting analysis suggests that the firm has misleading numbers, then the analyst must undo the accounting distortions by using the statement of cash flows and the financial statement footnotes. Key Accounting Policies To be able to value a firm properly, the key success factors of Darden Restaurants must be analyzed to see if they correspond with the accounting practices that they choose. Under the five forces model, we stated that Darden Restaurants key success factors include the following: superior product quality and variety, inventory management, and investment in brand imaging. These key success factors and the accounting policies chosen by Darden should be closely related. If they do not somewhat mirror each other, then red flags are identified and further analysis is needed. 22

23 Pensions One key accounting policy for Darden centers on its need for superior product quality and variety. In order to achieve this, the firm must continuously attract superior employees. One of the ways in which Darden attracts and retains these high talent individuals is by offering both a non-contributory defined benefit pension plan for their salaried employees as well as a contributory postretirement benefit plan for retirees. These funds are primarily invested in U.S., international and private equities, long duration fixed-income securities and real assets (Darden 10-K). Capital Lease vs Operating Lease Next, we will take a look at the effect of capitalizing some of the longterm leases the firm currently identifies as operating leases. It is often advantageous for firms to recognize leases as operating leases, which are treated as rent expense, because it does not recognize the liability of future obligations. However, it is also misleading, as most leases are non-cancelable. We will examine how Darden accounts for leases, as well as what effect these choices have on our perception of the company. Inventory Waste Another key accounting policy, not only for Darden but for the restaurant industry as a whole, is how firms deal with inventory losses. Two of Darden s key success factors were offering superior quality and variety and enhancing brand image. In order to do this, they must continuously offer only fresh foods and take steps to sooth any dissatisfied customers. Darden attempts to accomplish this in three ways. First, the company has a meal replacement policy. That is, if a customer doesn t like the meal they ordered, they can send it back to the kitchen and order something else, with the restaurant absorbing the cost of one of the meals. Second, the firm has a policy of compensating 23

24 customer meals to prevent an incident in a wide variety of cases. (This can include long wait times, a hair in the food, undercooked meats, etc.) Finally, the company minimizes its inventory loss due to spoilage by maintaining strict levels of inventory and observing proper storage techniques. Areas of Accounting Flexibility While there is a minimum accounting standard (GAAP in the U.S.) which all companies must conform to, there remains a large degree of flexibility in accounting methods. In an ideal world, this flexibility would be used by managers to provide a clearer picture of the economic consequences of its business activities (Palepu). However, this flexibility can also be used to manipulate the financial statements, either for the manager s personal gain or to mislead investors. Areas of flexibility in the casual dining industry include inventory valuation, pension plans, and capital and operating leases. In the following sections, we will examine how Darden utilizes this flexibility in regards to its key accounting policies. Pension Plans Defined benefit plans, by definition, represent a high level of risk for the beneficiary (in this case, Darden.) The firm is responsible for providing the necessary funds to cover future costs of providing these benefits. It is difficult to assign a particular dollar amount to this total due to the uncertainty of future economic conditions. Darden estimates their long term rate of return on these assets to be 9%. The expected long-term rate of return on plan assets and health care cost trend rates are based upon several factors, including our historical assumptions with actual results, an analysis of current market conditions, asset allocations and the views of leading financial advisers and economists (Darden s 10-K). The 9% rate represents the liability Darden books to cover its expected future pension costs. We find that a 9% rate of return is very reasonable given the company s investment strategy and previous results. 24

25 In comparison to the industry, Darden is unique among its direct competitors as the only corporation that offers a defined benefit plan. As such, it is difficult to analyze the believability discount rates, expected rate of return and estimated liabilities provided. However, it is still possible to assess these variables to some degree. The firm uses a discount rate of 5.75% (used to find the present value of future benefit obligations), a number that we believe represents a conservative estimate. However, we are dissatisfied with Darden s estimation of future health care costs. In their 10-K report, Darden assumes an 8.5% annual increase in health care expenses for 2007, and forecasts that this will gradually decrease to 5% in This does not reflect what we believe to be the current trend in rising health care costs. This concern is illustrated in the following chart depicting historic health care costs in the U.S. Year % Increase in total health care benefit cost 7.3% 8.1% 11.2% 14.7% 10.1% ( Factoring in estimates for 2005 (8%) and 2006 (12%, as estimated by the Segal Group), we find that Darden s stance on the deceleration of health care costs is misleading. Inventory Management it is how Darden accounts for these policies that we will ultimately focus on. We were not able to find any information on how the firm accounts for these losses. Given that it is possible the charges are simply lumped into some other liability, this is not necessarily an indication of aggressive accounting. It does however raise questions as to whether or not these costs are being accurately represented in the company s financial statements. We will examine 25

26 this problem further when we discuss what we see to be red flags within Darden s accounting policies. Leases Generally speaking, there are two acceptable methods for recording leases under GAAP. First, there are capital leases. A capital lease is used when the company will have the rights to use the asset for all (or close to all) of the assets useful life. When a company enters a capital lease, the entire amount of the asset is debited to assets and credited to liabilities. For this reason, it is common for companies to attempt to classify leases as operating leases. Under an operating lease, there is no effect on either assets or liabilities. Instead, the company recognizes the lease by recording rent expense charges. The problem with this is that, in general, leases are long-term, non-escapable contracts. Failing to recognize the future obligations of the company leads investors to underestimate liabilities and over-value the firm. Darden recognizes their leases as operating leases. However, the company is very open in its disclosure of future obligations in regards to these leases. The following table illustrates the amount of future obligations the company is carrying in operating leases. OPERATING LEASES (figures in thousands) Payments due in < 1 year 1-3 years 3-5 years 5+ years Amount $72876 $ $93046 $ By breaking down the costs of their future obligations, Darden acknowledges that they have a total future obligation of $425 million. We believe that this is a fairly accurate representation of the unrecognized liability facing the company. 26

27 Quality of Disclosure The quality of disclosure is an important measure of the firm s accounting quality. It helps the outsiders of a company see inside the company. The better the quality of disclosure, the more transparent the company will be. Having transparent financial reporting practices means the company allows users to get a true and fair picture of the firm. This allows analysts the ability to make a more precise evaluation of the company. Qualitative Analysis The majority of the information needed for the qualitative analysis is found in the company s SEC filing of the 10-K. This report is an annual report required by the U.S. Securities and Exchange Commission (SEC), that gives a comprehensive summary of a public company's performance.[it] includes information such as company history, organizational structure, executive compensation, equity, subsidiaries, and audited financial statements, among other information ( Overall, Darden Restaurants does a superb job at reporting its financial condition. Darden does not necessarily provide a transparent view of their assets, liabilities, and equity in their financial statements, but they do break down each segment in their 10-K to further explain. For example, they explain in depth their long-term debt and pension plans. The company did an excellent job at providing a transparent view of their long-term debt. Because they list each of the note and debentures along with their interest rates and dates to maturity, an investor has a very enlightened view of the company s long-term debt. They can clearly see how much money they owe in each category and year. 27

28 May 28, 2006 May 29, % senior notes due September 2005 $ -- $ 150, % notes due February , % medium-term notes due March , , % senior notes due August , % medium-term notes due April ,000 75, % debentures due February , , % senior notes due August , ESOP loan with variable rate of interest (5.41% at May 28, 2006) due December ,430 26, Total long-term debt 647, ,010 Less issuance discount (2,829) (763) Total long-term debt less issuance discount 644, ,247 Less current portion (149,948) (299,929) Long-term debt, excluding current portion $ 494,653 $ 350,318 # s from Darden s 10-K Darden Restaurants explain their retirement plans in detail. They break down these plans into defined benefit plans and postretirement plans. They describe what they are currently paying and also give a future forecast of what they expect to pay in each of these plans. For example, they expect to contribute about $400 to their postretirement plan during the fiscal year The company reveals the relevant information, such as the discount rates, the future discount rates, and the expected return on plan assets. This important information has a significant effect on amounts reported for defined benefit pension plans (Darden s 10-K). Despite Darden s excellent disclosure of their long-term debt and retirement plans, they give very little information about their inventory. Besides giving the amount of inventories that they hold on the balance sheet, the only information that was given about their inventory is that they consist of food and beverages and are valued at the lower of weighted-average cost or market (Darden s 10-K). We believe that they do not disclose this information because 28

29 they don t want to advertise to their competitors how much they expect of their inventory to sell in the next year. In summary, Darden Restaurants has clearly done an outstanding job in disclosing its financial performance throughout its 10-K. Despite the poor job of disclosing its inventories, we believe that the report is sufficient and helpful. Anyone can read and understand their financial status to make an informed decision about possibly investing. Quantitative Analysis Quantitative information is found using ratios in either raw form or change form. Raw form is finding the ratio using the numbers from the same year. Change form is finding the ratio by using the difference of two years. This quantitative information expresses the company s performance in number terms. In order for red flags to be identified, the ratios must be computed. Therefore, conducting a quantitative analysis is very important in valuing a firm. Sales Manipulation Diagnostics Since managers have the incentives to alter the sales numbers in order to benefit them personally, sales manipulation should be a general concern for most companies. We compared the ratios of Darden Restaurants with those of its competitors to see where DRI stands. Neither Darden nor any of its competitors disclose warranty liabilities. We believe this is due to the fact that they do not offer a guarantee that their customers will be satisfied with their purchase after five years. Therefore, a graph of Net Sales/Warranty Liabilities ratios is not available. 29

30 Sales Manipulation Diagnostics DRI Net Sales/Cash from Sales Net Sales/Net Accounts Receivable Net Sales/Unearned Revenues N/A Net Sales/Warranty Liabilities N/A N/A N/A N/A N/A Net Sales/Inventory EAT Net Sales/Cash from Sales Net Sales/Net Accounts Receivable Net Sales/Unearned Revenues Net Sales/Warranty Liabilities N/A N/A N/A N/A N/A Net Sales/Inventory OSI Net Sales/Cash from Sales Net Sales/Net Accounts Receivable Net Sales/Unearned Revenues Net Sales/Warranty Liabilities N/A N/A N/A N/A N/A Net Sales/Inventory APPB Net Sales/Cash from Sales Net Sales/Net Accounts Receivable Net Sales/Unearned Revenues N/A Net Sales/Warranty Liabilities N/A N/A N/A N/A N/A Net Sales/Inventory # s from 10-K s 30

31 Net Sales/Cash from Sales DRI EAT OSI APPB The ratio of net sales/cash from sales is computed by taking the net sales of the company and dividing it by the net sales minus net accounts receivable. This ratio helps to indicate the amount of cash collected each year from customers. If the ratio equals one, then the company collects cash from sales equal to the net sales. Each of the companies ratios are very close to one. This ratio is a measure of how well sales are supported by cash received from sales. If the ratio begins to increase dramatically, we would worry that the firm might be artificially inflating their numbers to increase net income. However, since the firm has a consistent ratio at (or close to) $1 in cash from sales for every $1 net sales, we find their sales figures to be highly reliable. 31

32 Net Sales/Net Accounts Receivable DRI EAT OSI APPB When analyzing net sales/net accounts receivable, a higher ratio is preferred to a lower ratio. A higher ratio suggests that accounts receivable make up a smaller portion of sales. If the receivables make up a smaller portion of sales, then there are higher cash sales than there are sales on account. In our case, we are attempting to deduce how reliable the firms sales figures are. Darden consistently has over $150 in sales for every $1 in accounts receivable, a number which could possibly raise a red flag in our evaluation of the reliability of the firms sales. However, since it is relatively in line with its competitors, and its sales/cash from sales ratio is near 1, we do not find this to be a significant concern. 32

33 Net Sales/Unearned Revenue DRI OSI EAT APPB When analyzing the ratio of net sales to unearned revenue, an analyst would look for a sudden decrease in unearned revenue, for this could possibly be a red flag. If there is a sudden decrease in unearned revenue, then there would be an increase in net sales making the ratios of the company increase rapidly. When this occurs, it could be caused by booking revenue prematurely, meaning they mark it in their books before they have completed the task or delivered the goods and the revenue is earned. Looking at Darden s net sales/unearned revenue, between the years 2003 and 2004, net sales increase and unearned revenue decreases. This causes the ratio to rise. However, from 2004 and on, net sales decrease and unearned revenues increase, causing the ratio to decline. 33

34 We are not able to determine what happens during 2002 since unearned revenue was not disclosed during that year. Since there are not any sudden increases in the ratio, there is no reason to be concerned about accounting fraud. When comparing the firms in the industry, there is a wide gap between them. Applebee s and OSI have very close ratios that are for the most part declining due to their declining net sales and increasing unearned revenues. Brinker has fluctuated over the past five years from having a sudden increase in the ratio to having a sudden decrease. Net Sales/Inventory DRI EA T OSI APPB When comparing net sales/inventory, a higher ratio would indicate a quicker turnover of inventory and a more efficient operation cycle. When a ratio increases, it is due to either a rise in sales or a drop in inventory, both of which are very desirable and positive situations. A dramatic rise in this ratio could be 34