An Activist Investor Declares War on Olive Garden

Back in October, Barington Capital Group disclosed a 2.8% stake in restaurant operator Darden Restaurants (NYSE: DRI  ) the owner of numerous iconic chins including Olive Garden, along with a mission to break up the company and unlock shareholder value. With management resisting any big changes, Barington released an 84-page report on Dec. 17 which lays out the problems with Darden and its proposed solution.

The arguments are compelling, and it's clear that Darden's management will have a hard time ignoring the calls to action. Brinker International (NYSE: EAT  ) and Yum! Brands (NYSE: YUM  ) have undertaken similar plans to great success, and it may be time for Darden to follow suit.

Desperation instead of a plan
It's not completely true that Darden hasn't made any big changes. The Olive Garden, one of Darden's mature restaurants, began serving cheeseburgers earlier this month. The six-ounce Italiano Burger, which sells for $9.99, is an attempt to better compete with other sit-down chains.

Source: Olive Garden

The decision to sell burgers in an Italian restaurant came after the company determined that chains such as Chili's and Applebee's were stealing away customers. Instead of improving its menu while sticking to Italian food which has allowed the Olive Garden to become as popular as it is, Darden decided to simply copy its competitors. I suppose that if Darden determined that Chipotle was stealing customers, an Italian-themed burrito would have been considered.

This reeks of desperation on Darden's part. With same-store sales on the decline, a cheeseburger is not going to right the ship. Barington believes that the lack of focus, with eight different chains under one roof, is the main culprit behind the company's current problems.

What's wrong with Darden?
A few points stand out in Barington's presentation. Darden has acquired five brands in the past six years in an attempt to fuel growth, but these new brands have complicated the situation at Darden to the point where the company is no longer competitive in the casual-dining industry. Both return on capital and return on equity have declined significantly over the past five years, with same- store-sales growth at Olive Garden and Red Lobster well below a majority of the company's peers. What's worse, Darden is last among its peers in converting advertising dollars into same-store-sales growth, with the company relying heavily on ineffective promotions.

The acquisitions, which were supposed to lead to synergies and cost savings, haven't produced any synergies at all. Selling, general, and administrative expenses have remained essentially flat as a percentage of revenue over the past five years, meaning that the addition of new brands has not produced any cost savings. One of the reasons behind this is that the eight brands operated by Darden are vastly different, catering to different target customers and offering unique experiences. Barington argues that the lack of brand focus has contributed to the declining same-store sales, and the Italiano Burger is a perfect example.

The solution
Barington believes that Darden could be worth as much as $80 per share if all of its recommendations are implemented, more than 50% above the current stock price. The plan involves splitting Darden into three new companies. "Darden-Mature" would be comprised of Olive Garden and Red Lobster, "Darden-High-Growth" would contain all of the other brands, and "Darden REIT" would be a real estate investment trust which owns all of Darden's real estate.

Darden-Mature would be able to focus on revitalizing its brands while cutting costs and paying out a large dividend. Darden-High-Growth could grow its brands without worrying about sluggish mature brands, and Darden REIT could pay out high, tax-free dividends.

Darden wouldn't be the first restaurant to spin off non-core brands to focus on the core business. Brinker International, operator of Chili's, has spent the last decade ridding itself of various brands, including Romano's Macaroni Grill and On the Border Mexican Grill. The company now operates just two brands, and this focus is no doubt the reason why the company's stock has soared in the past five years.

Another example is Yum! Brands. In 2011, Yum! sold A&W Restaurants and Long John Silver's, leaving only Taco Bell, KFC, and Pizza Hut. This has allowed the company to focus on expanding these successful brands in international markets, with China and India likely to drive growth for years to come.

The bottom line
If the best idea that Darden's management can come up with is selling a cheeseburger in an Italian restaurant, it's probably time for a change. Barington's blueprint for the future of Darden looks like a promising plan, and I expect pressure on management to only intensify from here, especially if sales remain weak. Darden is a potentially compelling turnaround story, and the high dividend yield is an added bonus.

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