Why I’m Taking the Safe Approach to Investing in Restaurants

The casual-dining space has become a tough sector to invest in, but there are still big opportunities.

May 5, 2014 at 1:19PM

The fickle restaurant goer has really put a hurting on some of the casual-dining restaurants, and this has led some of these companies to take on new strategies. At the forefront of this transition is Darden Restaurants (NYSE:DRI), which is trying to spin off Red Lobster  in the hopes of narrowing its focus.

Private equity firms have gotten involved with the company as a result. But that's not always a buy signal. The big question is: how does a separation of its brand help address the declining traffic that the entire industry is experiencing?

Sorting out the Darden drama
Private equity got involved after Darden decided to spin off its Red Lobster brand. The idea is that Darden could spin out Red Lobster and pay off some debt. Then, another company might actually come along and buy the remaining company, primarily made up of Olive Garden.

Starboard Value is spearheading the fight against the Red Lobster spinoff. The fund owns just over 5% of the company and believes that the move enriches management, while being a negative for shareholders. The firm also believes the deal would destroy $850 million in value. That's a fairly significant number for a company that's market cap is $6.6 billion.

The overarching issue is that just spinning off Red Lobster is questionable, as it still leaves the weak-performing Olive Garden grouped together with its smaller, faster-growing brands.

Other reasons to question Darden
Fiscal second-quarter earnings missed consensus by a large margin. Over the last 30 days, analysts have lowered their average earnings-per-share estimates for this quarter, next quarter, and this year.

This comes as the company's traffic is expected to remain weak. And even if the company managed to spin off Red Lobster, it wouldn't be completed until fiscal 2015, which means that Red Lobster's weak results will continue to weigh on the company. In addition, its key brand Olive Garden also underperformed for the majority of fiscal 2013. 

The entire casual-dining space isn't weak
Despite the weakness that Darden is seeing, competitor Brinker International (NYSE:EAT), whose key restaurants include Chili's and Maggiano's, is holding up fairly well. For the first quarter, comps were up 0.7% and the company also managed to lower its costs, which is helping to offset lower traffic numbers. Brinker's innovations in its menu could also help increase traffic going forward.

Buffalo Wild Wings (NASDAQ:BWLD) is another reason that Darden is losing market share. Shares of Buffalo Wild Wings are up nearly 50% over the past 12 months, and its restaurants continue to attract consumers due to the company's focus on sports. While other restaurants remain weak, Buffalo Wild Wings expects to grow earnings by 20% in 2014. Compare that to the fact that Darden is expected to see earnings fall by 20% in 2014.

Buffalo Wild Wings hit 1,000 stores opened this year and plans to open another 700 locations over the long-term. And it's even expanding its portfolio to include other brands, such as the PizzaRev chain that it bought a stake in during 2013.

How shares stack up
One of the few positives for Darden is the fact that investors are getting a 4.4% dividend yield, which is more than double what Brinker shareholders are getting, while Buffalo Wild Wings doesn't even pay a dividend. But that enticing dividend payment by Darden is also an 86% payout of earnings, leaving little room for growth. However, Brinker's payout is only 37%.

As far as valuation goes, Darden trades at a P/E of 18 based on next year's earnings estimates. Brinker trades at a P/E of 16. Buffalo Wild Wings trades at a slight premium (P/E of 25) given its superior growth prospects. Both Darden and Brinker have sizable debt loads, while Buffalo Wild Wings carries no debt.

Bottom line
The dining-out industry has been shaken up a lot over the past couple years. The introduction of fast casual played a big part in this shakeup. But the one casual-dining company that has managed to keep traffic flowing into its stores is Buffalo Wild Wings. And it plans on increasing its store base by more than 70% in the near term. For investors looking to gain exposure to the restaurant industry, Buffalo Wild Wings is worth a closer look.

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Marshall Hargrave has no position in any stocks mentioned. The Motley Fool recommends Buffalo Wild Wings. The Motley Fool owns shares of Buffalo Wild Wings. 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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