4 Reasons to Sell Darden Restaurants

Invest in Darden Restaurants? Maybe not until it gets its act together.

Mar 19, 2014 at 1:20PM

Full-service restaurant company Darden Restaurants (NYSE:DRI) includes three large restaurant chains: Olive Garden, Red Lobster, and LongHorn Steakhouse. It also includes a specialty restaurant unit containing brands such as Bahama Breeze and The Capital Grille.  Darden Restaurants faces headwinds in the form of stiff competition from fast-casual chains such as Chipotle Mexican Grill (NYSE:CMG) and Panera Bread (NASDAQ:PNRA). Investors would be wise to avoid Darden Restaurants, and here's why.

Wrong strategies
Darden Restaurants wants to either sell or spin off Red Lobster, and who could blame management for making this decision? According to Darden's latest earnings report, Red Lobster registered the worst performance ever, with same-store sales and traffic down 4.5% and 11.9%, respectively, in the month of February. Olive Garden also came in weak, with same-stores sales and traffic decreasing 2.6% and 4.9%, respectively, during the same time frame. These two chains showed weaknesses going back to FY 2013 ending last May.  A spinoff of Red Lobster would allow it to function as its own company, complete with executives devoted solely to the brand.

With that said, perhaps Darden Restaurants should also spin off Olive Garden, which suffers similarly from declining same-store sales and customer traffic. Why group Olive Garden in with LongHorn Steakhouse, which showed an increase in same-stores sales of 2.2%, with only a negligible decline in foot traffic in February, and represents the largest Darden chain showing signs of decent growth over the past two years? It truly doesn't make sense to pair these two businesses together. Darden Restaurants should probably spin off all business units as separate companies. You may argue that a spin off of Olive Garden along with Red Lobster would destroy the purchasing power of Darden's remaining LongHorn Steakhouse, which only operates 430 units. If that is the case, then maybe selling the two restaurants would be the better alternative, providing Darden Restaurants with the necessary cash to build on the success of LongHorn and its specialty units, which also showed improvement.

The Olive Garden logo change
Darden Restaurants recently changed its high-end-looking three-dimensional Olive Garden logo to a lower-quality one-dimensional logo. Darden Restaurants just disrupted one of the few remaining advantages Olive Garden possesses, a familiar brand identity that people liked and could identify with. The new design met with a great deal of jeers in the financial community, according to an article in Yahoo! Finance, and rightly so. 

Eroding fundamentals
Darden Restaurants' declining customer traffic and same-store sales resulted in declining fundamentals. According to Darden's latest form 10-Q, year-to-date sales increased 5% driven primarily by strength in its LongHorn Steakhouse and specialty restaurant segments. However, net income declined 38%. Darden's free cash flow is negative. Its balance sheet is in a lousy state, with cash and long-term debt-to-equity clocking in at 4% and 121%, respectively. Its operating income covers interest expense by only three times, while the rule of thumb for safety stands at five . Darden Restaurants paid out nearly all of its free cash flow in dividends during FY 2013, putting its FY 2014 dividend at risk.

Better opportunities elsewhere
Investors may want to consider the faster-growing fast-casual dining segment. Chipotle Mexican Grill focuses on its core competency of providing quality food from organic sources at a reasonable price and in an efficient manner. In 2013, the company expanded its store count by 185 units. Chipotle Mexican Grill grew its revenue and free cash flow 18% and 48%, respectively, during that time. The company possesses no long-term debt and holds cash equivalent to 21% of its stockholder's equity.

Restaurant investors may also want to look toward Panera Bread, which sells things like bagels, soups, and salads.  It grew its store count by 133 units in 2013. Overall, Panera Bread increased revenue and free cash flow 12% and 14%, respectively. Unlike Darden Restaurants, Panera possesses a balance sheet with no long-term debt, and cash that equates to 18% of stockholder's equity.

Things to look for
Look for Darden Restaurants to continue to struggle if it doesn't spin off the weak Olive Garden segment along with Red Lobster and keeps its stronger brands such as LongHorn Steakhouse and its specialty segment. Expect the popularity of the fast-casual dining industry to continue. Chipotle Mexican Grill plans to open 180 to 195 units in 2014. Panera Bread also plans on opening around 115 to 125 stores in 2014. Darden plans on slowing down expansion some, opening 15 to 20 units per year within its LongHorn restaurants and 20 to 25 within its specialty units, and halting its Olive Garden expansion altogether, representing a wise move on Darden's part.However, Darden Restaurants' investors would heed caution to stay away from the company right now.

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William Bias has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Chipotle Mexican Grill and Panera Bread. 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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