Red Lobster 2015 Annual Report Download - page 21

DARDEN RESTAURANTS, INC. | 2015 ANNUAL REPORT 17
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
DARDEN
If the fair value of the reporting unit is higher than its carrying value,
goodwill is deemed not to be impaired, and no further testing is required. If
the carrying value of the reporting unit is higher than its fair value, there is an
indication that impairment may exist and the second step must be performed
to measure the amount of impairment loss. The amount of impairment is
determined by comparing the implied fair value of reporting unit goodwill to
the carrying value of the goodwill in the same manner as if the reporting
unit was being acquired in a business combination. Specifically, fair value
is allocated to all of the assets and liabilities of the reporting unit, including
any unrecognized intangible assets, in a hypothetical analysis that would
calculate the implied fair value of goodwill. If the implied fair value of good-
will is less than the recorded goodwill, we would record an impairment loss
for the difference.
Consistent with our accounting policy for goodwill and trademarks, we
performed our annual impairment test of our goodwill and trademarks as of
the first day of our fiscal fourth quarter. As of the beginning of our fiscal fourth
quarter, we had seven reporting units, five of which had goodwill: Olive Garden,
LongHorn Steakhouse, The Capital Grille, Eddie V’s, and Yard House. As part
of our process for performing the step one impairment test of goodwill, we
estimated the fair value of our reporting units utilizing the income and market
approaches described above to derive an enterprise value of the Company. We
reconciled the enterprise value to our overall estimated market capitalization.
The estimated market capitalization considers recent trends in our market
capitalization and an expected control premium, based on comparable recent
and historical transactions. Based on the results of the step one impairment
test, no impairment of goodwill was indicated.
Given the significance of goodwill relative to the size of the LongHorn
Steakhouse ($49.3 million), The Capital Grille ($401.7 million), Eddie V’s
($22.0 million) and Yard House ($369.2 million) reporting units, we also
performed sensitivity analyses on our estimated fair value of these reporting
units using the income approach. A key assumption in our fair value estimate
is the weighted-average cost of capital utilized for discounting our cash flow
estimates in our income approach. We selected a weighted-average cost of
capital of 10.5 percent for LongHorn Steakhouse and The Capital Grille,
16.0 percent for Eddie V’s and 13.5 percent for Yard House. A 100 basis
point increase in the weighted-average cost of capital would decrease the
estimated fair value by approximately $458.9 million, $64.8 million,
$32.1 million and $160.9 million for LongHorn Steakhouse, The Capital
Grille, Eddie V’s and Yard House, respectively. The estimated fair values of
LongHorn Steakhouse, The Capital Grille, Eddie V’s and Yard House exceeded
their carrying values by approximately 160 percent, 23 percent, 101 percent
and 34 percent, respectively.
The fair value of trademarks are estimated and compared to the carrying
value. We estimate the fair value of trademarks using the relief-from-royalty
method, which requires assumptions related to projected sales from our
annual long-range plan; assumed royalty rates that could be payable if we
did not own the trademarks; and a discount rate. We recognize an impairment
loss when the estimated fair value of the trademarks is less than the carrying
value. We completed our impairment test and concluded as of the date of the
test, there was no impairment of the trademarks for LongHorn Steakhouse, The
Capital Grille, Eddie V’s and Yard House. The estimated fair value of LongHorn
Steakhouse’s trademark exceeded its carrying value of $307.8 million by
approximately 103 percent. The estimated fair value of The Capital Grille’s
trademark exceeded its carrying value of $147.0 million by approximately
22 percent. The estimated fair value of Eddie V’s trademark exceeded its
carrying value of $10.5 million by approximately 238 percent. The estimated
fair value of Yard House trademark exceeded its carrying value of $109.3 million
by approximately 68 percent. A key assumption in our fair value estimate is
the discount rate utilized in the relief-from-royalty method. We selected a
discount rate of 11.5 percent for LongHorn Steakhouse and The Capital Grille,
17.0 percent for Eddie V’s and 14.5 percent for Yard House. A 100 basis point
increase in the discount rate would decrease the estimated fair value by
approximately $69.3 million, $20.2 million, $3.3 million and $17.3 million for
LongHorn Steakhouse, The Capital Grille, Eddie V’s and Yard House, respectively.
We determined that there was no goodwill or trademark impairment as
of the first day of our fiscal 2015 fourth quarter and no additional indicators of
impairment were identified through the end of our fiscal fourth quarter that
would require us to test further for impairment. However, declines in our market
capitalization (reflected in our stock price) as well as in the market capitaliza-
tion of other companies in the restaurant industry, declines in sales at our
restaurants, and significant adverse changes in the operating environment
for the restaurant industry may result in a future impairment loss.
Changes in circumstances, existing at the measurement date or at other
times in the future, or in the numerous estimates associated with management’s
judgments and assumptions made in assessing the fair value of our goodwill,
could result in an impairment loss of a portion or all of our goodwill or trade-
marks. If we recorded an impairment loss, our financial position and results
of operations would be adversely affected and our leverage ratio for purposes
of our credit agreement would increase. A leverage ratio exceeding the
maximum permitted under our credit agreement would be a default under
our credit agreement. At May 31, 2015, a write-down of goodwill, other
indefinite-lived intangible assets, or any other assets in excess of approximately
$1.4 billion would have been required to cause our leverage ratio to exceed
the permitted maximum. As our leverage ratio is determined on a quarterly
basis and due to the seasonal nature of our business, a lesser amount of
impairment in future quarters could cause our leverage ratio to exceed the
permitted maximum.
We evaluate the useful lives of our other intangible assets, primarily
intangible assets associated with our acquisitions, to determine if they are
definite or indefinite-lived. Reaching a determination on useful life requires
significant judgments and assumptions regarding the future effects of
obsolescence, demand, competition, other economic factors (such as the
stability of the industry, legislative action that results in an uncertain or
changing regulatory environment, and expected changes in distribution
channels), the level of required maintenance expenditures, and the expected
lives of other related groups of assets.
Insurance Accruals
Through the use of insurance program deductibles and self-insurance, we
retain a significant portion of expected losses under our workers’ compensation,
certain employee medical and general liability programs. However, we carry
insurance for individual workers’ compensation and general liability claims
that exceed $0.5 million. Accrued liabilities have been recorded based on
our estimates of the anticipated ultimate costs to settle all claims, both
reported and not yet reported.
Our accounting policies regarding these insurance programs include our
judgments and independent actuarial assumptions about economic conditions,
the frequency or severity of claims and claim development patterns and claim
reserve, management and settlement practices. Unanticipated changes in
these factors may produce materially different amounts of reported expense
under these programs.