Management’s Discussion and Analysis of Financial Condition and Results of Operations

Financial Review 2005

    This discussion and analysis below for the Company should be read in conjunction with our consolidated financial statements and related notes found elsewhere in this report.

    For financial reporting, we operate on a 52/53 week fiscal year ending on the last Sunday in May. Our 2005 fiscal year, which ended on May 29, 2005, and our 2003 fiscal year, which ended on May 25, 2003, each had 52 weeks. Our 2004 fiscal year, which ended on May 30, 2004, had 53 weeks. We have included in this discussion certain financial information for fiscal 2004 on a 52-week basis in order to assist investors in making comparisons to our 2005 and 2003 fiscal years.

Overview of Operations

    Our business operates in the casual dining segment of the restaurant industry, primarily in the United States. At May 29, 2005, we operated 1,381 Red Lobster, Olive Garden, Bahama Breeze, Smokey Bones Barbeque & Grill and Seasons 52 restaurants in the United States and Canada and licensed 37 Red Lobster restaurants in Japan. We own and operate all of our restaurants in the United States and Canada, with no franchising.

    Our sales were $5.28 billion in fiscal 2005 and $5.00 billion in fiscal 2004, a 5.5 percent increase. On a 52-week basis, after reducing fiscal 2004 sales by the $90 million contributed by the additional 53rd operating week, our sales increased 7.4 percent in fiscal 2005. Net earnings for fiscal 2005 were $291 million ($1.78 per diluted share) compared with net earnings for fiscal 2004 of $227 million ($1.34 per diluted share). Net earnings for fiscal 2005 increased 27.9 percent and diluted net earnings per share increased 32.8 percent compared to fiscal 2004. The net earnings increase in fiscal 2005 reflected Red Lobster’s substantial progress in some important areas. A primary driver was substantially improved operations behind Red Lobster’s new “simply great” operating discipline, which allowed the brand to simultaneously improve both guest satisfaction and operating efficiency. Red Lobster finished fiscal 2005 with three consecutive quarters of U.S. same-restaurant sales and guest count growth and year-over-year operating profit growth. Olive Garden also delivered strong performance in fiscal 2005. Driven by U.S. same-restaurant sales increases in each quarter of fiscal 2005, which resulted in 43 consecutive quarters of same-restaurant sales growth, Olive Garden had a double-digit operating profit increase, record annual operating profit and record return on sales. Bahama Breeze also contributed to net earnings growth in fiscal 2005 as a result of operating improvements in a number of areas and the closing and write-down of under-performing restaurants in fiscal 2004. Smokey Bones’ continued investment in expansion, combined with high rib costs and the write-down in the carrying value of one restaurant, resulted in a modestly greater operating loss in fiscal 2005 than in fiscal 2004.

    In fiscal 2006, we expect a net increase of between 55 to 65 restaurants. We expect combined U.S. same-restaurant sales growth in fiscal 2006 of between two percent and four percent at Red Lobster and Olive Garden. We also expect Bahama Breeze to have minimal effect on consolidated net earnings growth in fiscal 2006 as we continue to invest in positioning the business for successful, renewed growth. And, in fiscal 2006, we expect Smokey Bones to open 25 to 30 new restaurants while implementing menu enhancements to broaden its appeal. As a result, we anticipate approximately $0.04 to $0.06 per diluted share improvement in Smokey Bones’ impact on our consolidated net earnings. On a consolidated basis, we anticipate low double-digit diluted net earnings per share growth in fiscal 2006.

     Our mission is to be the best in casual dining, now and for generations. We believe we can achieve this goal by continuing to build on our historical strength as a multi-brand casual dining company, which is grounded in our commitment to combining the following:

  • A strong culture that inspires and engages our people, with firmly held values, a clear mission and a core purpose to nourish and delight everyone we serve;
  • Competitively superior leadership;
  • Brand management excellence;
  • Restaurant operating excellence; and
  • Restaurant support excellence

    From a financial perspective, we seek to increase profits by leveraging our fixed and semi-fixed costs with sales from new restaurants and increased guest traffic and sales at existing restaurants. To evaluate our operations and assess our financial performance, we monitor a number of operating measures, with a special focus on two key factors:

  • Same-restaurant sales – which are a year-over-year comparison of each period’s sales volumes for restaurants that are open more than 16 months; and
  • Restaurant operating margins – which are restaurant sales less restaurant-level cost of sales (food and beverage costs, restaurant labor and other restaurant expenses).

    Increasing same-restaurant sales can increase restaurant operating margins because these incremental sales provide better leverage of our fixed and semi-fixed costs. Same-restaurant sales increases can be generated by increases in guest traffic, increases in the average guest check, or a combination of the two. The average guest check can be impacted by menu price changes and by the mix of menu items sold. For each operating company, we gather daily sales data and regularly analyze the guest traffic counts and the mix of menu items sold to assist in developing menu pricing, product offerings and promotional strategies. We view same-restaurant guest counts as an indication of the long-term health of an operating company, while increases in average check and menu mix may contribute more significantly to near-term profitability. We continually focus on balancing our pricing and product offerings with other initiatives to generate sustainable same-restaurant sales growth.

     We compute same-restaurant sales using restaurants open at least 16 months because new restaurants experience an adjustment period before sales levels and operating margins normalize. Sales at newly opened restaurants generally do not make a significant contribution to profitability in their initial months of operation. Our sales and expenses can be impacted significantly by the number and timing of the opening of new restaurants and the closing, relocation and remodeling of existing restaurants. Pre-opening expenses each period reflect the costs associated with opening new restaurants in current and future periods.

    There are significant risks and challenges that could impact our operations and ability to increase sales and earnings. The casual dining restaurant industry is intensely competitive and sensitive to economic cycles and other business factors, including changes in consumer tastes and dietary habits. Other risks and uncertainties include the price and availability of food, ingredients and utilities; labor and insurance costs; higher-than-anticipated costs to open or close restaurants; litigation; unfavorable publicity relating to food safety or other concerns; lack of suitable locations; government regulations; and factors that could impact our growth objectives, including construction cost increases, construction delays and other factors.

Results of Operations for Fiscal 2005, 2004 and 2003

    The following table sets forth selected operating data as a percentage of sales for the 52-week periods ended May 29, 2005 and May 25, 2003 and the 53-week period ended May 30, 2004. All information is derived from the consolidated statements of earnings for the periods indicated.

  Fiscal Years
  2005 2004 2003
Sales      100.0 %         100.0 %         100.0 %   
Costs and expenses:
    Cost of sales:
        Food and beverage		   30.2     30.5     31.1  
        Restaurant labor   32.1     32.0     31.9  
        Restaurant expenses   15.3     15.5     15.3  
            Total cost of sales, excluding
            restaurant depreciation and
            amortization of 3.8%, 3.9% and
            3.8%, respectively		   77.6 %   78.0 %   78.3 %
Selling, general and administrative   9.5     9.4     9.3  
Depreciation and amortization   4.0     4.2     4.1  
Interest, net   0.8     0.9     0.9  
Asset impairment and restructuring
    charges, net		   0.1     0.9     0.1  
            Total costs and expenses   92.0 %   93.4 %   92.7 %
Earnings before income taxes   8.0     6.6     7.3  
Income taxes   2.5     2.1     2.4  
Net earnings   5.5 %   4.5 %   4.9 %

Sales

    Sales were $5.28 billion in fiscal 2005, $5.00 billion in fiscal 2004 and $4.65 billion in fiscal 2003. The 5.5 percent increase in company-wide sales for fiscal 2005 was primarily due to a net increase of 56 company-owned restaurants compared to fiscal 2004 and same-restaurant sales increases at Olive Garden. These sales increases were partially offset by the additional operating week in fiscal 2004. After reducing fiscal 2004 sales by the $90 million contributed by the additional operating week, sales would have been $4.91 billion for fiscal 2004 on a 52-week basis, resulting in a 7.4 percent increase in fiscal 2005.

    Red Lobster sales were $2.44 billion in both fiscal 2005 and fiscal 2004. U.S. same-restaurant sales for Red Lobster increased 0.9 percent (on a 52-week basis) due to a 1.9 percent increase in average check offset partially by a 1.0 percent decrease in same-restaurant guest counts. Average annual sales per restaurant for Red Lobster were $3.6 million in fiscal 2005.

    Olive Garden sales of $2.40 billion were 8.5 percent above last year. U.S. same-restaurant sales for Olive Garden increased 7.2 percent (on a 52-week basis) due to a 5.3 percent increase in same-restaurant guest counts and a 1.9 percent increase in average check. Average annual sales per restaurant for Olive Garden were $4.4 million in fiscal 2005. Olive Garden has enjoyed 43 consecutive quarters of U.S. same-restaurant sales increases.

    Bahama Breeze sales of $164 million were 7.2 percent below last year. Same-restaurant sales for Bahama Breeze decreased 1.6 percent (on a 52-week basis) for fiscal 2005. Bahama Breeze also had six fewer restaurants in operation during fiscal 2005. Average annual sales per restaurant for Bahama Breeze were $5.1 million in fiscal 2005.

    Smokey Bones sales of $269 million were 54.6 percent above last year. Same-restaurant sales for Smokey Bones increased 1.1 percent (on a 52-week basis) for fiscal 2005. Average annual sales per restaurant were $3.1 million, with appreciable variation by region. Smokey Bones opened 35 new restaurants during fiscal 2005.

    The 7.5 percent increase in company-wide sales for fiscal 2004 versus fiscal 2003 was primarily due to a net increase of 54 company-owned restaurants compared to fiscal 2003, same-restaurant sales increases at Olive Garden and the additional operating week in fiscal 2004. After reducing fiscal 2004 sales by the $90 million contributed by the additional operating week, total sales increased 5.5 percent from fiscal 2003. These sales increases were partially offset by decreased U.S. same-restaurant sales at Red Lobster. While Red Lobster’s sales of $2.44 billion were 0.1 percent above fiscal 2003, its U.S. same-restaurant sales decreased 3.5 percent (on a 52-week basis) due to a 6.5 percent decrease in same-restaurant guest counts, partially offset by a 3.0 percent increase in average check. Average annual sales per restaurant for Red Lobster were $3.6 million in fiscal 2004 (on a 52-week basis). Olive Garden sales of $2.21 billion were 11.1 percent above fiscal 2003. U.S. same-restaurant sales for Olive Garden increased 4.6 percent (on a 52-week basis) due to a 3.0 percent increase in average check and a 1.6 percent increase in same-restaurant guest counts. Average annual sales per restaurant for Olive Garden were $4.1 million in fiscal 2004 (on a 52-week basis). Bahama Breeze sales of $176 million were 28 percent above fiscal 2003. Bahama Breeze opened four new restaurants during fiscal 2004, including its new prototype restaurant in Pittsburgh, PA. Bahama Breeze also closed six restaurants during the fourth quarter of fiscal 2004 as a result of a comprehensive analysis performed during the fourth quarter of fiscal 2004 that examined restaurants not meeting our minimum return-on-investment thresholds and certain other operating performance criteria. Average annual sales per restaurant (excluding the six closed restaurants) were $5.2 million (on a 52-week basis). Smokey Bones sales of $174 million were 87 percent higher in fiscal 2004 than in fiscal 2003, its average annual sales per restaurant were $3.2 million (on a 52-week basis) and it opened 30 new restaurants during fiscal 2004.