by Dan Burrows | March 26, 2013 10:52 am
The market’s betting that the worst of the sales slowdown at Darden Restaurants (NYSE:DRI) is now behind the company.
But the company’s intention to test so-called “fast-casual service” in a number of locations suggests more weakness ahead.
The knock on Darden — operator of Red Lobster, Olive Garden and LongHorn Steakhouse — is that its prices are too high, given the quality of its food. And so customers are increasingly taking their hard-earned dollars to places like Panera Bread (NASDAQ:PNRA) and Chipotle Mexican Grill (NYSE:CMG), where they get better food at cheaper prices — and don’t have to tip.
Darden, meanwhile, doesn’t have much wiggle room in when it comes to cutting prices — not when the restaurant chain is struggling with higher costs that are weighing on its margins.
Thus, the decision to test out the fast-casual idea: You order at the counter, and someone brings your food to your table. Getting rid of waiters and waitresses means customers don’t have to tip — cutting 15% to 20% off their costs. Employing fewer waiters and waitresses means lower costs for Darden, too.
But that’s a pretty big downgrade of the whole experience of eating at one of Darden’s restaurants, at least for those patrons who still see it as a comfortable, sit-down — and full-service — casual restaurant. And although it doesn’t necessarily smack of panic, it does suggest that the company feels the need to take some radical steps to arrest declining sales.
Revenue for the most recent quarter rose 5% to $2.26 billion, matching analysts’ average estimate, but only because of strong sales at LongHorn Steakhouse and Darden’s specialty nameplates, like 40 Yard House. The core brands of Red Lobster and Olive Garden continued to drag on results.
Same-store sales are a critical retail industry measure because they exclude receipts from new locations. A company naturally will add more total sales as it expands its store base, but the real test is if its extant stores are still growing. That’s where companies get leverage over the costs of opening and operating all those stores.
And on that basis, Darden still is in trouble.
Same-store sales at Red Lobster fell 6.6%. Olive Garden posted a 4.1% drop in sales at U.S. locations open for at least a year. LongHorn Steakhouse fell 1.6%.
And yet shares in Darden are up 12% for the year-to-date, beating the broader market by 3 percentage points.
That’s partly because the Street sees a turnaround taking shape, and partly because the company does indeed generate a lot of cash. Cash flow is good enough to support an annual dividend of $2 a share, which makes the forward yield a mouthwatering 4%.
However, even after taking the dividend into consideration, shares simply aren’t cheap enough at current levels to reflect earnings potential and risk.
On both a forward and trailing earnings basis, Darden’s price-to-earnings ratios are at or near their five-year highs, according to data from Thomson Reuters Stock Reports. That might not make them frothy, but the market sure looks unreasonably optimistic. Indeed, the forward P/E of 16 represents a 33% premium to the stock’s own five-year average.
It’s also not clear why you’d want to pay 16 times forward earnings for something that’s forecast to grow earnings by just 5% a year over the next five years.
Furthermore, the stock is rising so fast that Darden’s price/earnings-to-growth ratio (or PEG, which shows how quickly shares are appreciating relative to earnings prospects) is now at 2.8. Consider that Darden’s own five-year average PEG is just 1.1 — and the S&P 500 has a PEG of 1.8 — and it appears that the stock has gotten ahead of itself.
Darden is attractive for its cash generation, and it very well might be in the early stages of a sales turnaround, but the stock looks to have baked in all that good news — and then some. Unless shares sell off to afford a more palatable entry point, this is a meal you can skip.
As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.
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