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Source: Barron's, March 23, 2013 feature article

Feature | Saturday, MARCH 23, 2013

Can Darden Fix the Menu?


The operator of Olive Garden and Red Lobster is getting a handle on its costs and has a workable recipe for turning itself around. Its inexpensive stock merits a better review from investors.

Darden Restaurants has so successfully reduced investors' appetites that even last Friday's meager results were enough to send the company's shares modestly higher. Happily, more sustenance could be on the way.

First, the morsels that the owner of Red Lobster, Olive Garden, and LongHorn Steakhouse doled out last week: It reported that fiscal third-quarter sales rose 4.6%, to $2.26 billion, but that was due to new restaurant openings and last year's acquisition of Yard House, a beer and burger chain. Earnings fell 18%, to $134.5 million, as did earnings per share, which came in at $1.02. Same-store sales at its three biggest and best-known chains dropped 4.6%, dragging down margins and profits.

Alan Diaz/Corbis



More important, however, the company is following a new operating recipe designed to reverse the margin contraction and earnings declines that have pulled the shares down 13% from last fall's peak. In addition to cost-cutting, it wants to slow the growth of some of its more mature brands while pushing harder on its newer, faster-growing chains. Some think the company isn't going far enough and that more changes could unlock a roughly 35% gain in the stock over the next year or two.

Darden (ticker: DRI) took pains to tamp down expectations at a February analyst meeting. By last week's report, analysts expected the company to report $1.01 a share, down from the $1.13 a share they'd been anticipating prior to the sessions with the company. Similarly, analysts now project fiscal 2013 earnings of $3.16 a share, down from about $4.10 a year ago.

Encouragingly, investors chose to focus on the fact that the fiscal third-quarter results were a penny better than the lowered forecasts. They also took note when executives alluded to recent comments from industry tracker Malcolm Knapp, who has been upbeat about March results at U.S. restaurants. That would be a welcome break from February, when casual-dining restaurant sales were down 5.4% industrywide, hurt by higher payroll taxes, poor weather, and higher gas prices.


Orlando, Fla.–based Darden gets the largest share of its revenue from Olive Garden, whose 818 restaurants contribute 44% of sales. The chain's falling same-stores sales were a concern when we wrote positively about the company a year and a half ago ("Darden Offers Investors a Tasty Treat," Nov. 14, 2011), and they remain a worry today. Red Lobster, with 705 outlets, kicks in 32% of revenues, and LongHorn's 416 restaurants generate 14% of revenue. The latter have held their market positions.

Darden is working to turn around its largest brands by limiting the extent of menu-price increases and reducing the number of new restaurants. For example, Olive Garden will open 15 new stores in fiscal 2014, down from 36 this year. The company already has kicked off a cost-cutting program that has resulted in about $130 million in annual savings, which will grow to $170 million to $195 million a year.

Simultaneously, Darden wants to promote its smaller, lesser-known but faster-growing brands. In addition to Yard House, they include Bahama Breeze, Eddie V's, Capital Grille, and Seasons 52. With mostly positive same-store sales and room to open new restaurants, the specialty group now has 168 restaurants that represent about 10% of sales.

   The Bottom Line

If Darden cuts menu prices and costs, its shares could rise 35% to $66.


"We're...reshaping our portfolio to increase the size and contribution of the specialty-restaurant group, which is something that broadens our guest and occasion base," said CEO Clarence Otis on Friday's call. "We think we're well positioned as an organization, given the strength of our brands, the collective experience and expertise we have, and the operating cash flows we have, to make the changes that are needed."

There's more to do, argues Howard Penney, a managing director and restaurant analyst at Hedgeye Risk Management, who correctly called the stock's decline earlier this year and now believes that the shares are worth $66 apiece, sharply north of today's $49 share price.


Limiting the rise in prices for an average dinner isn't enough. Prices must come down, Penney argues, as well as costs. "Either the current management team makes [big changes], or I think someone will come in and force them to do so or push them out," Penney says.

Aside from posting better earnings, Darden could have other appeals for shareholders. It could be an attractive target for a private-equity investor or activist manager because it throws off strong cash flows—an estimated $950 million this year. Cash flows support a $2 a share dividend, which equates to a 4% yield, among the few payouts in the industry (see table); the company confirmed on Friday that it plans to increase the payout. Darden also owns the land and buildings for 55% of its restaurants, which Penney values at $20 a share. His sum-of-the-parts valuation concludes that the company is worth $66 a share.

Turnarounds are often messy, and they usually take longer than expected to emerge from the kitchen. But properly prepared, a transformation could make Darden shares an appetizing meal. 


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