If Warren Buffett Is Right (and He Usually Is), Red Lobster Is in Deep Trouble

According to Warren Buffett's wisdom on turnaround plays, there's little reason to believe Red Lobster can successfully turn itself around.

Apr 29, 2014 at 6:00PM

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"Good jockeys will do well on good horses, but not on broken-down nags."

-- Warren Buffett

Red Lobster is in serious trouble. Same-store sales at the seafood chain have fallen in seven out of the last eight quarters. In fact, they haven't just fallen, they've plummeted: In the most recent quarter, sales dropped by 8.8% from the year-ago period.

In an attempt to contain the damage, parent company Darden Restaurants (NYSE:DRI) has begun spinning off the sinking ship into an independent company. According to a March press release explaining the move:

As consumer demand dynamics have changed, Red Lobster's priorities and operating support requirements have come to differ meaningfully from those of Darden's other brands, which are having greater success increasing appeal among consumers outside their core guest profiles. By establishing two independent companies, a separation will better enable the management teams of each company to focus their exclusive attention on their distinct value creation opportunities.

Never mind the question of whether Darden's others brands are actually "having greater success increasing appeal among consumers" -- customers seem to be abandoning Olive Garden as well -- the big issue is whether a spinoff will indeed be a catalyst for positive change at Red Lobster. Can an independent Red Lobster execute a turnaround once freed from Darden's control?

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Although the answer to this question ultimately boils down to price, value, and food at the presumably soon-to-be-independent chain, I think there's a more general way to approach the query. That is, how likely is it that a company such as Red Lobster can actually turn itself around?

Given Warren Buffett's unparalleled investing success and experience, particularly throughout his early career when he focused on companies that sold for a deep discount to intrinsic value, this is a question the chairman and CEO of Berkshire Hathaway has spent a lot of time contemplating. And, at least according to the Oracle of Omaha, Red Lobster's chances don't look good.

Here's what he had to say in his 1980 letter to shareholders:

We have written in past reports about the disappointments that usually result from purchase and operation of "turnaround" businesses. Literally hundreds of turnaround possibilities in dozens of industries have been described to us over the years and, either as participants or as observers, we have tracked performance against expectations. Our conclusion is that, with few exceptions, when a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.

And here Buffett is again in 1983:

We react with great caution to suggestions that poor businesses can be restored to satisfactory profitability by major capital expenditures. The projections will be dazzling -- the advocates will be sincere -- but, in the end, major additional investment in a terrible industry is about as rewarding as struggling in quicksand.

The point here is that successful turnarounds are rare. Even if they weren't, the deck is innately stacked against the company at hand. Thus, given the dozens of excellent businesses in the market today, why would investors bet on one like Red Lobster -- or, for that matter, even Darden? They wouldn't. Turnaround stories are the exclusive province of speculators willing to risk their principal in the hopes of outsized future gains.

With the latter in mind, I'll leave you with Buffett's two most important rules about investing:

Rule No.1: Never lose money.
Rule No.2: Never forget rule No.1.

The greatest thing Warren Buffett ever said
Warren Buffett has made billions through his investing and he wants you to be able to invest like him. Through the years, Buffett has offered up investing tips to shareholders of Berkshire Hathaway. Now you can tap into the best of Warren Buffett's wisdom in a new special report from The Motley Fool. Click here now for a free copy of this invaluable report.

John Maxfield has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Berkshire Hathaway. 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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