Shares of Darden Restaurants (DRI) are up today after the troubled restaurant operator announced plans to unlock the value of its massive restaurant property portfolio with a Darden REIT spinoff. DRI, for those unfamiliar, is the owner and operator of the Olive Garden and Longhorn Steakhouse, among other brands.
The plan, which was first proposed last spring, has been a long time in the making, so Wall Street’s reaction has been a little more muted than you might expect. But all the same, DRI stock is up more than 2% on the news.
Let’s dig into the details.
As part of its plan to reduce its debt load by about $1 billion, Darden will transfer about 430 restaurant properties to the Darden REIT, which will then lease the properties back to Darden. The deal essentially has three benefits:
- It potentially lowers Darden’s debt load by nearly two-thirds.
- It will potentially lower Darden’s tax bill. By paying rent to the Darden REIT, DRI lowers its taxable income. Meanwhile, the rental profits of the Darden REIT are not taxable at the corporate level due to the tax advantages of the REIT structure. Essentially, DRI is paying itself rent and getting a tax break in the process.
- A publicly traded Darden REIT unlocks value, as yield-hungry investors will (presumably) pay the typical REIT premium for tax-advantaged income.
So, should you consider DRI stock for the new Darden REIT? Probably not.
I’m all in favor of lowering the debt load and finding tax savings. That’s just good business. But I’m skeptical on the third point.
In a good REIT investment, you want to see low tenant concentration. Well, the Darden REIT would only have one tenant — Darden — and that tenant is struggling. The Darden REIT would be an undiversified collection of restaurant properties that probably couldn’t be re-rented quickly or easily in the event that Darden had to scale back.
With a single, weak tenant responsible for 100% of rental revenues, the Darden REIT would likely trade at a large discount to its peers. At some price and at a wide-enough discount it might be worth a stab. But I’d wait for the dust to settle first.
That said, let’s forget about the Darden REIT for a moment. What about DRI stock? With or without the REIT, might Darden itself have potential?
Darden stock has had a nice run this year, up about 18%. Sales grew 14% last quarter compared with a year earlier, with Olive Garden same-restaurant sales rising 3.4%. Yet these improvements were from depressed levels, and traffic at Olive Garden has resumed falling over the past two months.
Meanwhile, Darden is still facing some pretty significant headwinds. Middle-income Americans are trading down from full-service chain restaurants in favor of fast-casual chains like Chipotle Mexican Grill (CMG), for a number of reasons. Americans are eating healthier than they used to, yet incomes have not kept pace with inflation over the past decade. Squeezing out the waiter allows the typical cash-strapped American to eat out affordably.
Moreover, Darden’s suburban restaurant chains are stale and the brands no longer hold cachet. That’s a hard problem to fix, and a REIT spinoff certainly doesn’t address this underlying problem.
The Darden REIT spinoff is a good move, but not good enough to entice me into buying Darden stock. And probably not good enough to entice me to eat at the Olive Garden again.
Charles Lewis Sizemore, CFA, is the chief investment officer of investment firm Sizemore Capital Management. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today’s best global value plays.
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