Betting on mega restaurant chain Darden Restaurants (NYSE:DRI) has not been a winning move lately, with its share price roughly treading water over the past 12 months. The company has been hurt by relatively poor customer traffic and sales trends due to notable weakness at its Olive Garden and Red Lobster units.
In response, Darden has implemented a restructuring plan, which includes the proposed spinoff of its Red Lobster unit. It's a move that has come under fire from major shareholders, like activist hedge fund Starboard Value. So, should investors bet on a rebound for Darden?
What's the value?
Darden has built itself into one of the largest full-service dining chains thanks primarily to a couple of factors: consistent annual store growth as well as the 2007 blockbuster acquisition of competitor Rare Hospitality Group, owner of the Longhorn Steakhouse and Capital Grille brands. While the company's increasingly large size and scale have led to slightly improved, restaurant-level profitability over the past five fiscal years, the overhead required to manage its myriad of brands has led to lower overall operating profitability.
In addition, Darden has been hurt by declining per-store sales, likely due to the rising popularity of the so-called fast-casual dining chains that have picked off portions of Darden's customer base.
As Darden's weak stock price suggests, the company's financial performance has been relatively poor in FY 2014, highlighted by lower comparable-store sales at its Olive Garden and Red Lobster units; these concepts together account for roughly 70% of its overall store base.
More notably, Darden's profitability fell sharply during the period, hurt by higher commodity and labor costs, as the company made wholesale menu and personnel changes at the restaurant level in a bid to turn around its customer outflows. The net result for Darden was lower operating cash flow. This forced the company to do an about face in its growth-oriented mind-set, highlighted by its current moratorium on new store openings at its Olive Garden unit.
Looking into the crystal ball
Management has painted the Red Lobster unit as out of sync with the remainder of its brand portfolio, hence its decision to remove the unit via a proposed public offering. However, that logic seems to be a little off base, given the similar customer profile and average check size shared by both Red Lobster and Olive Garden as well as Longhorn Steakhouse to a lesser extent.
More likely, it appears that management is hoping that a spinoff will appease its agitated shareholders who have pushed alternative ideas; these investors have generally focused on spinning off the company's real estate holdings into a publicly traded REIT.
Unfortunately, getting rid of the Red Lobster unit would seem to do little to stem Darden's falling overall comparable-store sales, a trend that has anecdotally been due to customers' preference for competitors' more health-conscious menus.While Darden has made progress in improving its fare, including the introduction of a supplemental low-calorie menu at Olive Garden, the efforts seem to have failed to gain significant traction to-date.
Sticking with what works
As such, investors looking for growth in the restaurant sector should probably stick with the fast-casual leaders that continue to gain a larger share of the dining-out pie, like Panera Bread (NASDAQ:PNRA) and Chipotle Mexican Grill (NYSE:CMG).
Panera, for its part, had a solid year in FY 2013. It reported a 12% top-line gain that was aided by an expansion of its store footprint and higher comparable-store sales, its 14th straight year of positive comps. While the company's growth trajectory downshifted versus the average of the last few years, due to acknowledged operational issues, Panera continues to use innovation to win the battle for customer market share. This has been highlighted by the recent incorporation of higher-protein sprouted grains into its baked goods.
In addition, Panera continues to benefit from a loyal customer base, evidenced by 15 million MyPanera card members; this limits the company's required advertising spending and allows it to invest those dollars in product development.
In a similar manner, Chipotle continued building on its seemingly unstoppable growth trajectory in FY 2013, posting a 17.7% top-line gain that was helped along by a double-digit expansion of its store base. Like Panera, Chipotle benefits from word-of-mouth marketing by its growing throng of satisfied customers; it's a competitive advantage that keeps its corporate overhead low and provides greater funding for store expansion and product development activities.
The bottom line
Darden likely has unrecognized value in its diverse restaurant brands and physical assets, a condition that has brought some big-moneyed investors to its door. However, with a stagnating top line and a management team digging in for a fight, the value realization process at Darden might be a bumpy ride and take an extended period of time. As such, most investors should probably steer clear of this uncertain story in favor of Darden's fast- casual peers that, while priced at above-market P/E multiples, continue to build more valuable, growing franchises.
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Robert Hanley owns shares of Panera Bread. The Motley Fool recommends Chipotle Mexican Grill and Panera Bread. The Motley Fool 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.