How to Fix Red Lobster and Olive Garden in 1 Step

Red Lobster and Olive Garden can be fixed, but a public "spin-off" is not the answer.

Feb 1, 2014 at 8:00AM

I read a great article by fellow Fool Rich Duprey yesterday which "examined this letter to management, (from activist investment firm Starboard)." The letter bucked recent requests and demanded that Red Lobster not be spun-off.

If you've been following the drama, a slew of activists have piled into Darden Restaurants (NYSE:DRI) recently, and have demanded Red Lobster and Olive Garden be spun off. This would seemingly make sense as Red Lobster and Olive Garden recently had comparable sales declines, of 4.5% and 0.6% respectively. Yet, the rest of their brands, including the up-scale Capital Grille, have done very well.

Now the activists are pushing back in the other direction.

In its letter, to quote Duprey," Starboard said: Red Lobster performs so poorly as it is that separating it will have it trade at a discount even to Darden, which itself is trading at a discount to the underlying businesses it owns and the real estate it possesses." 

So it made me wonder, what's the best solution for Red Lobster and Olive Garden? Should they spin-off, or should they stay a part of Darden?

Let's dig a little deeper.

Examining Red Lobster and Olive Garden's woes
As I'd mentioned in a recent article, restaurant trends aren't favoring casual dining right now. Securities Analyst Andy Barish, of Jefferies Equity Research, recently predicted an oversupply of casual dining restaurant locations continuing in 2014. The culprit is that diners are gravitating upward (to fine dining), or downward (to fast casual). Yet, even with that challenging macro-environment in mind, this company has failed on an operational level compared to its peers.

Three reasons explain why.

1. Copy-cat reflex

It seems like every sub-par quarter leads Darden to attempt to copy competitor Brinker International's (NYSE:EAT) menu, especially with Olive Garden.

Recently Olive Garden introduced a burger to its menu. This was introduced so it could compete with Brinker's Chili's; the idea was that traffic was being crimped by dining groups who had that "one person in the group" who wasn't in the mood for Italian food. Yet, last year the chain attempted to copy Maggiano's (also a Brinker brand), when it mimicked a promotion that allowed diners to "take a pasta dish home" when they ordered one.

Which approach is this brand taking in the long term? I couldn't tell you.

Darden's management is chasing whatever seems to be working now, and that's troubling. I think what management missed is that Maggiano's and Chili's, love them or hate them, have defined brands. I don't know what the heck Olive Garden is offering these days, do you?

2. A preference for cutting costs 

In quarters as recently as this past September, Darden has decided  to appease the street after a poor quarter by "cutting costs." Wall Street is one of few bizarre places where news such as "we're firing people," or "where cutting our food costs," are perceived as good news. 

While these measures may "bump" the stock for a few days, they're disastrous long-term strategies for any business. What is a restaurant built on, if not its people and the quality of its food?

While this move helped short-term margins, customers stopped coming back because they were getting smaller portions, worse quality, all the while paying higher prices. The math doesn't add up. 

3. Mindless dividend hikes

What is most troubling, in this on-going saga, is the slew of dividend increases that Darden has issued in recent years. The dividend has nearly doubled, being increased four times in just the past three years. In what world does it ever make sense to increase your pay (to shareholders in this case) drastically, in the face of admitted struggles and failure? 

To be fair, the aforementioned competitor Brinker has also raised its dividend an absurd amount in recent years. If Brinker was facing this type of activism, I'd be pointing this out as well, but it's not.

Is Darden hiking its dividend to "copy" Brinker and keep pace? I don't know. Yet I think, like the copy-cat tendency and the cost cutting, it signals a common theme--that management is far too concerned with appeasing investors. 

How to Fix Red Lobster and Olive Garden in 1 Step
By analyzing this troubling situation, I've come to the conclusion that neither scenario, a spin-off nor remaining part of Darden, is the right move for Red Lobster and Olive Garden.

Rather, the best move, is for a private equity firm to take Red Lobster and Olive Garden private.

It's blatantly clear that management has made decisions based on appeasing traders in the short term. These are good brands that simply have their priorities out of whack.

It reminds me of a pitcher in baseball who's given up several home-runs, and will "try anything" because his confidence is clearly shaken. The coach needs to pull Red Lobster and Olive Garden to the bench, so they can reflect on their strategy.

A private equity firm should come in and buy these brands. Their performance could be removed from the public eye, and they can focus on reinvesting to build a quality product and experience. 

You may like their biscuits, but forget about Red Lobster
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Adem Tahiri has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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