What’s Really Wrong with Olive Garden and Red Lobster?

This past week, Darden Restaurants (DRI 0.46%) announced plans to either spin-off or sell Red Lobster from its portfolio of brands. In recent quarters, Darden Restaurants has underperformed industry peers like Bloomin' Brands (BLMN -0.97%) and The Cheesecake Factory (CAKE -0.51%). However, Red Lobster splitting from Olive Garden and the rest of Darden Restaurants doesn't address what's really wrong with the company as a whole.

Credit: Darden Restaurants Annual Report 2013

Darden Restaurants' earnings and spin-off announcement                   Second-quarter earnings for the 2014 fiscal year echoed recent quarters for Darden Restaurants. Earnings-per-share, or EPS, fell 42.3% from the same quarter a year ago, led by same-restaurant sales declines from its biggest brands Red Lobster and Olive Garden.

In contrast, the other six brands that make up Darden Restaurants reported same-restaurant sales increases, with the specialty restaurant group leading the way, which includes The Capital Grille and Seasons 52.

Industry peers Bloomin' Brands and The Cheesecake Factory saw EPS increases of 42.9% and 2%, respectively, in their most recent quarters.

During the conference call, a Red Lobster spin-off or possible sale was announced with the expectation of closing a deal by the beginning of the 2015 fiscal year. However, investment companies like Barington Capital Group have been pushing for a split where Red Lobster and Olive Garden would be one entity and the other six concepts would be another.

Splitting up won't fix Red Lobster and Olive Garden
Businesses that wish to streamline their operations sometimes sell or spin-off less-productive subsidiary businesses. The idea is that the spun-off company is expected to be worth more long-term because the management of the separated company(s) has an incentive since their compensation is connected to bottom-line results.

However, in this case both of Darden Restaurants' biggest restaurant concepts are underperforming. Traffic has been declining for much of the year at both Red Lobster and Olive Garden.

Additionally, Olive Garden, which has historically been described as an Italian restaurant concept, recently added a burger and fries to the menu. This decision may backfire because the $9.99 burger will now be compared with the thousands of other burger varieties customers can find from fast food all the way to fine dining.

Darden Restaurants is at a fork in the road
Whether management follows through by letting Red Lobster go on its own, or if they follow the advice of Barington Capital Group and make both Red Lobster and Olive Garden part of the same spin-off, the real problems are still not being addressed -- lackluster traffic, weaker sales than in years past, and too many restaurant concepts, as shown below:

Multiple restaurant concepts make focusing on any one brand difficult for management. Supply chain, personnel training, menu changes, and overall company logistics become too complex.

Customer price points are also affected when a restaurant owner has too many brands. During the Darden Restaurants conference call, management stated that they are planning to increase Olive Garden's attractiveness to guests who are not financially constrained via higher price points. This could alienate middle- and lower-income families in the future.

Making matters worse are recent industry trends that show quick-service restaurant visits were up 1% this year, while full-service restaurants haven't seen visit gains in several years.

What happens to Darden Restaurants in 2014?                                                                                                             Consumers are increasingly trading full-service restaurants for fast-casual options. Even without the impact of fast-casual restaurants, the total number of restaurants is now 980,000 in the U.S. This gives customers more options to try new restaurants and leaves major chains spending more on marketing and making improvements.

Credit: Bloomin' Brands Investor Presentation

It is likely that both Bloomin' Brands and The Cheesecake Factory will continue with their successes. Bloomin' Brands has seen net income rise to $153.7 million for the first nine months of 2013, compared to $40.6 million in the same time period of 2012. Likewise, The Cheesecake Factory now has 15 straight quarters of positive comp sales.

In the mean time, Darden Restaurants may see tighter margins as it goes through a transition and makes improvements on its eight restaurant concepts while structuring a spin-off or sale of Red Lobster.

Bottom line                                                                                                               The announced Red Lobster spin-off by Darden Restaurants does not address the company's problems as a whole. The company's ownership of too many concepts has affected the management of each individual concept and hurt overall earnings. While Bloomin' Brands and The Cheesecake Factory also each have several concepts, they are nowhere near the complexity that Darden Restaurants has reached. It is likely that Bloomin' Brands, The Cheesecake Factory, and other major chains will slowly take market share from Darden Restaurants as the latter restructures its business over the next year.