Improved Traffic And Menu Revamp Optimism Boosting Darden

By Stephen D. Simpson, CFA | September 26, 2012 AAA

Sit-down restaurants have come back into favor over the past year or so, and Darden (NYSE:DRI) has gone along for the ride ... even though company growth really hasn't improved all that much. Darden remains a strong player in the industry, with two of the largest concepts (Olive Garden and Red Lobster) and sustained double-digit returns on capital. Although Darden shares don't look like much of a bargain today, the market may not be through with it yet, as menu revamps could spur better traffic and earnings.

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First Quarter Results Meet Expectations
Although there was some deviation from expectations on particular line items, Darden basically delivered the sort of quarter that the Street expected.

Revenue rose about 5%, with company growth in the "big three" (Olive Garden, Red Lobster and Longhorn) actually shrinking 0.3%, while the specialty restaurant group saw 2.2% growth. Restaurant traffic generally increased through the quarter for Darden, though Red Lobster's poor performance (down 2.6%) sapped some of the momentum from Longhorn (up 3.6%). Olive Garden looks like it's still in a rut, with comps up just barely (0.3%).

Margins were solid. Restaurant-level margins improved almost a point and a half, helped by lower labor costs and lower food costs. Operating income rose more than 5%, leading to a slight improvement in operating margin.

SEE: The Top 5 Ways Restaurants Make You Spend More

Revamping Menus to Drive Traffic
The good news and bad news for Darden is that the company's two largest concepts are so well-known to diners. To a certain extent, you either like Olive Garden and/or Red Lobster or you don't; pricing can make a difference on the margin (increasing or decreasing the frequency of visits), but it's really the core menu that makes the brand.

To that end, it sounds like management is looking for a serious revamp at Red Lobster and ongoing refinements at Olive Garden. At Red Lobster, management is apparently looking to increase the non-seafood menu content to 25% (from about 8% currently). That's a big swing, and arguably a risky move, but it could help freshen and remake the brand.

For Olive Garden, it sounds like the plans are less ambitious. There's going to be some more fine-tuning on portion size, nutrition and price, but it doesn't sound like management is looking to make big changes.

Is Yard House a New Beginning?
Darden paid $585 million in cash for the 39-store Yard House chain, a somewhat more upscale concept than its largest chains. Management has said that it believes the market can support 150-200 stores, and if it can maintain Yard House's very strong unit volume (an average of over $8 million, second only to Cheesecake Factory (Nasdaq:CAKE), I believe this could be a significant future driver.

Are Diners Tired of Burgers?
Judging by the performance of the stocks in this sector, as well as the recent interest in the IPO of Outback Steakhouse operator Bloomin' Brands (Nasdaq:BLMN), investors are banking on a recovery in company growth at sit-down chains. Such a recovery isn't exactly obvious in the results at Cheesecake Factory, Brinker's (NYSE:EAT), Chili's, Maggiano's or DineEquity (NYSE:DIN), but at least the companies are positive again.

Less pressure from food and labor costs should continue to help the sector, but a wholesale improvement in traffic probably needs better job and wage numbers first. Then again, maybe diners are tired of the McDonald's (NYSE:MCD) value menu and want to go back to sit-down restaurants.

SEE: McDonalds: A History of Innovation

The Bottom Line
Perhaps Darden's menu plans will help stimulate better growth, but it already looks like the Street expects a lot of improvement. Even high single-digit adjusted free cash flow growth over the next decade doesn't lead to an appealing fair value once the company's debt is factored in. Cash flow doesn't necessarily move stocks in the short-term, however, so investors may look at Darden's single-digit EV/EBTIDA ratio and the prospects for double-digit operating income/EBTIDA growth and still think they're getting a bargain.

At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

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