Should Darden Stand Pat Or Spread Out?

By Stephen D. Simpson, CFA | September 28, 2011 AAA

The largest casual dining operator in the world, Darden Restaurants (NYSE:DRI), warned that it's fiscal first quarter was going to disappoint, and disappoint it did. There are bigger questions about this company than just why traffic at Olive Garden was weak this quarter. Should the company get more aggressive and add concepts in what is a weak restaurant market, or focus on maximizing what it has? Perhaps even more pertinent to investors, are Wall Street's sell-side analysts expecting too much in their models and dooming the stock to underperformance?

Investopedia Markets: Explore the best one-stop source for financial news, quotes, and insights.

A Sluggish Start to the Year
The consumer spending environment is still very price-conscious and that is hurting casual restaurant chains like Darden. With companies like Five Guys, Chipotle (NYSE:CMG), and McDonald's (NYSE:MCD) offering improved products and other quick-service rivals like Yum! Brands (NYSE:YUM) offering low prices, it is harder to draw traffic to stores with average checks in the high teens.

While Darden reported revenue growth of over 7% this quarter, core comp sales were up less than 3% while speciality comps were up a bit more than 5%. Growth was weakest at the flagship Olive Garden, where comps fell almost 3% (on lower traffic) and overall sales rose less than 1%. While Red Lobster and and LongHorn were stronger on a reported basis (each up 12%, with comps up 10.7% and 4.8% respectively), both benefited from heavy promotional activity that gives a misleading picture of real traffic.

Profitability was tough as well. When food providers like Tyson (NYSE:TSN) and Cal-Maine (Nasdaq:CALM) raise prices, that all flows through sooner or later to the restaurants. To that end, Darden reported 17% higher food costs this quarter, and gross margin dropped two full points. While the company did a laudable job of controlling corporate expenses, operating income fell about 8% and the company saw a one-and-a-half point erosion in operating margin.

How Many Levers Can Management Pull?
Unfortunately, it is not immediately clear what Darden can do to make things better in the short run. The company is not exactly in a position to shift away from seafood, steak or poultry and if the company gets too aggressive on passing through prices, at least one among rivals like Brinker (NYSE:EAT), DineEquity (NYSE:DIN), Ruby Tuesday (NYSE:RT) and a host of private operators (like OSI Restaurant Partners) will fight back on price and absorb the margin cut.

Likewise, there is not much that the company can do to change the dining experience overnight. Customers may be somewhat less price sensitive at Cheesecake Factory (Nasdaq:CAKE) or P.F. Chang's (Nasdaq:PFCB) and certainly much less sensitive at Ruth's Hospitality (Nasdaq:RUTH), but Darden is not going to change its brand image fast enough to benefit - and that is even assuming that it would be a good idea long-term (which it probably isn't).

Growth by Expansion?
Darden has been willing to do deals in the past and that could be a consideration again so long as the company doesn't have to pay cash ($1.7 billion in debt on the balance sheet today is more than enough). There are plenty of chains having tough times that could make long-term sense for Darden - names like McCormick & Schmick's (Nasdaq:MSSR), Texas Roadhouse (Nasdaq:TXRH) or the aforementioend Ruth's. Then again, maybe management has enough on its plate already.

The Bottom Line
Darden is a decent business even if there is a squeeze play on today between stressed consumer budgets and rising input costs. Unfortunately, analysts may be expecting too much. Although Darden has historically generated free cash flow margins around 1.5%, many sell-side analysts are projecting forward margins in the 7% range. Now it's fair to assume that Darden will see positive leverage from reduced capital expenditures (the existing store base suggests a slower pace of expansion in the future), but that's a big jump. Even if analysts and investors don't always pay attention to cash flow in favor of P/E and other methodologies, sagging cash flow growth could limit share price appreciation.

It's hard to argue for buying Darden on the basis of those aggressive cash flow expectations. Even if the company can boost free cash flow production to over 7% of sales, subtracting a large chunk of the debt from the valuation renders the stock undervalued by less than 20%. So, less than 20% discount to fair value on the basis of aggressive cash flow improvement in an environment of intense margin pressure - that sounds like a recipe for indigestion to me. (For additional reading, take a look at How To Analyze Restaurant Stocks.)

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

comments powered by Disqus
Related Analysis
  1. Still More Gains Ahead For Semiconductor Makers
    Stock Analysis

    Still More Gains Ahead For Semiconductor Makers

  2. U.S. Restaurants Slog Through a Weak Industry - Industry Outlook
    Stock Analysis

    U.S. Restaurants Slog Through a Weak Industry - Industry Outlook

  3. Bear of the Day: McDonald's (MCD) - Bear of the Day
    Stock Analysis

    Bear of the Day: McDonald's (MCD) - Bear of the Day

  4. Geopolitics and the Market - Ahead of Wall Street
    Stock Analysis

    Geopolitics and the Market - Ahead of Wall Street

  5. Looking Ahead to Q3 Earnings Season - Earnings Trends
    Stock Analysis

    Looking Ahead to Q3 Earnings Season - Earnings Trends

Trading Center