If You Hold Darden Stock, You Should Cheer a Corporate Split

by Will Ashworth | October 15, 2013 3:01 pm

If You Hold Darden Stock, You Should Cheer a Corporate Split

Almost a week has passed since the Wall Street Journal reported that Barington Capital — a hedge fund that, along with a group of other investors, owns 2.8% of Darden Restaurants (DRI[1]) — is pushing the multi-concept restaurant owner to split into two businesses. Darden stock has responded, pushing 10% higher in the five days of trading since the idea became public.

Investors seem to like the idea, and so do I. Here’s why:

Darden Restaurants: A Tale of Two Businesses

Barington also is looking for DRI to lower its operating costs and generate greater returns from its real estate. However, the suggested split of Darden’s business is the big attention-getter because it acknowledges that Darden stock has a growth problem.

While Red Lobster and Olive Garden are its legacy brands, their best days are behind them. In Darden’s first quarter ended Aug. 25, Red Lobster and Olive Garden’s same-restaurant sales declined 5.2% and 4%, respectively. In fiscal 2012, Red Lobster’s same-restaurant sales declined by 2.2% while Olive Garden’s were off by 1.5%.

Red Lobster and Olive Garden account for approximately 72% of Darden’s overall revenue, and they’re not going. If you’re a Darden stock holder, that’s a problem.

Barington suggests putting the two legacy brands in one business and the remaining six (LongHorn Steakhouse, Capital Grille, Eddie V’s, Seasons 52 and Yard House) in another.

Respected restaurant analyst Howard Penney believes in a much more dramatic split. Namely, he thinks the best thing Darden can do is replace CEO Clarence Otis, sell off all the real estate — which is worth approximately $15 per share[2], according to Penney — and finally separate the eight brands into three operating segments: Italian, Seafood and Steak, with Yard House spun off and Bahama Breeze sold.

Penney believes the duo, if properly managed, can be a solid business once more, but I’m not so sure. People are avoiding these restaurants because better alternatives are available. Meanwhile, dome of Darden’s specialty concepts have real potential to grow into legacy brands.

The July 2012 acquisition of Yard House was a brilliant catch[3] for DRI despite the fact it generates less than $400 million in annual revenue (about 4% of Darden’s total figure). In Q1, Darden’s five specialty brands generated $282 million, with its LongHorn Steakhouse another $325 million.

With four of the six delivering same-restaurant sales growth of at least 2.1% in the quarter, it’s not like the company isn’t experiencing growth … it is.

Just not at Olive Garden or Red Lobster.

The Sum of Its Parts

Penney values the whole of Darden stock at $84 to $89 per share. Of that, approximately $52 is for the brands, another $15 to $20 for real estate and finally $17 per share for general and administrative reductions. He believes Darden’s head office overhead is bloated, and that it could easily cut its G&A by 2 percentage points, which would add $1.10 per share in annual earnings for DRI.

Analysts polled by Thomson Reuters estimate that Darden stock will earn $3.17 per share in fiscal 2015. In other words, that extra $1.10 would provide a 35% earnings boost without even considering the sale of real estate or any type of reorganization.

While Penney’s three-pronged approach has merit, I think Barington’s idea to divide Olive Garden and Red Lobster from the rest is the simplest and most sensible.

The company currently has three billion-dollar brands, two of which aren’t growing. Yard House and Capital Grille could both be generating more than $1 billion annually within four to six years, while LongHorn already is. Providing more focus to each of its brands by separating them into two independently owned and operated companies will deliver more growth than is currently occurring.

Out With the Old

Clarence Otis and his management team have made several statements that try to paint the company lily-white, but that’s simply not the case.

As Penney suggests, Otis and his team are poor managers. Despite Darden’s restaurants having higher sales per store than its peers as well as higher margins at the restaurant level, DRI’s operating margins are much lower than Brinker International’s (EAT[4]) and the rest of its casual dining peers.

How’s that possible? Because Mr. Otis is too busy fighting the minimum wage[5] to pay attention to its legacy brands, which are floundering, and a corporate bureaucracy that’s severely bloated.

Well, I hope he’s not too busy to pay attention to the likes of Barington Capital and Howard Penney. They might come at Darden’s problems from different directions, but they both understand that its current business model is broken.

The true value of Darden stock can’t be obtained without some sort of restructuring. A split seems like the best approach, with or without Otis at the helm.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.

Endnotes:
  1. DRI: http://studio-5.financialcontent.com/investplace/quote?Symbol=DRI
  2. worth approximately $15 per share: http://app.hedgeye.com/unlocked_content/31176-flashback-dismantling-darden
  3. brilliant catch: http://investorplace.com/2012/07/darden-strengthens-its-bench-with-yard-house/
  4. EAT: http://studio-5.financialcontent.com/investplace/quote?Symbol=EAT
  5. too busy fighting the minimum wage: http://westorlandonews.com/2013/09/18/tips-for-darden-restaurant-workers-rally-for-livable-wages-benefits/

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