Darden Shares Would Look Better On a Pullback

by Peter Cohan | July 5, 2011 12:44 pm

While food prices have been soaring with the rise in oil prices, Darden Restaurants (NYSE: DRI) is holding strong, and its two main chains — Olive Garden and Red Lobster — are managing to keep customer traffic high. With plenty of growth potential ahead and recent increases in dividend payouts, is it time to buy Darden?

Since 1968 when Bill Darden opened[1] the first Red Lobster in Lakeland, Fla., Darden Restaurants has grown to eight restaurant chains with more than 1,800[2] restaurants throughout North America. By number of stores, it’s the largest full-service casual dining company in the world. Though it does have a few locations outside of North America, there is still much room for it to grow globally.

Why buy Darden? Here are three reasons in its favor: 

• Newly increased dividends.  Darden has recently increased its dividend by 34% to 43 cents a share from 32 cents a shares. That gives the stock a 3.3% dividend yield.
• Its two main restaurants are market leaders. Red Lobster and Olive Garden both lead[3] the casual seafood dining and casual Italian dining markets, respectively. At the end of its 2010 fiscal year, there were 694 Red Lobsters and 723 Olive Gardens, and while this may mean that Darden will have to look elsewhere to continue expanding, it is springing from a solid base. 
• Out-earns its capital cost. Darden earns more operating profit than its cost of capital. However, it has no EVA Momentum, which measures the change in “economic value added” (essentially, profit after deducting capital costs) divided by sales. In 2010, Darden’s EVA momentum was unchanged, based on 2009 revenue of $7.2 billion, and EVA that improved from $18 million in 2009 to $49 million in 2010, using a 9% weighted average cost of capital.

There are also two reasons not to buy: 

• It only met expectations in its most recent quarter. Darden met its fiscal fourth-quarter expectations of $1 a share[4], and it was able to do just that while earning revenue of $1.99 billion, slightly exceeding expectations. The good news is that Darden expects 2012 earnings per share growth of between 12% and 15%, based on overall sales growth of 6% to 7%.
• The stock is fully priced. Darden’s price to earnings to growth ratio of 1.2 makes it fairly expensive (a PEG of 1.0 is considered fairly priced). Darden’s P/E is 15.56[5] and its earnings are expected to grow 12.9%[6] to $4.35 a share in fiscal 2013.

I would watch Darden’s stock and consider buying it should we suffer a market break during the next month of U.S. debt ceiling negotiations. I wouldn’t be surprised if Darden stock plunges in sympathy with some bad news on that front. At that point, the stock might be a better bargain.

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