Did Darden Restaurants Just Make a Major Error by Selling Red Lobster?

Darden shares sunk and investors cried foul when the company announced it will sell Red Lobster to a private equity firm for $2.1 billion. Here's why the deal might not be so bad.

May 21, 2014 at 4:30PM

At first glance, you might think a restaurant chain with well-known brands and a stable business model would have the hard work done for it. After all, people need to eat. And in an economic environment in which consumers spend modestly on eating out, it seems that Darden Restaurants (NYSE:DRI) should have no trouble succeeding.

But that's not what's happening. Darden's sales and customer traffic are collapsing. In response, shareholders have pressured management to spin off its underperforming chains. However, Darden has its own plan of action, which will be to sell Red Lobster, one of its most well-known brands. This sent Darden shares significantly lower after the decision was announced. In light of the market's reaction, is it clear that the company made the wrong move?

Headers

Source: Darden.com.

Darden is a tale of two companies
Ironically, Darden's two most well-known restaurants are also its worst-performing ones. Red Lobster and Olive Garden are simply crumbling. Third-quarter U.S. same-restaurant sales, which measures sales at locations open at least one year, fell 5.4% and 8.8% at Olive Garden and Red Lobster, respectively.

This is especially poor performance when compared to rival Brinker International (NYSE:EAT). The owner of Maggiano's and Chili's racked up 0.8% same-restaurant sales growth in its third quarter as well as 16% growth in earnings per share, thanks to effective cost controls.

Darden's problems are compounded by the fact that Olive Garden and Red Lobster are hugely important to the company. Both restaurants make up a huge percentage of its total sales. In fact, the two chains combined comprise more than two-thirds of the company's total revenue.

By contrast, Darden has some other restaurant chains that are actually performing well. For starters, LongHorn Steakhouse registered a 0.3% increase in same-restaurant sales. That doesn't sound impressive, but Darden is taking LongHorn on an ambitious growth strategy by rapidly opening new locations. Total sales at LongHorn jumped 9.1% higher in the most recent quarter because of this.

In addition, Darden's Specialty Restaurant group, which includes a number of brands like Bahama Breeze, The Capital Grille, and Eddie V's, collectively posted an 11.6% sales increase last quarter.

These conditions are why several of Darden's major institutional investors have called on the company to spin off its underperforming restaurants from those that are more successful. Darden finally answered the call, just not in the manner most investors expected.

Darden now flush with cash
Darden announced it will sell Red Lobster to private equity firm Golden Gate Capital for $2.1 billion in cash. This is a hefty sum, which represents one-third of Darden's entire market capitalization. Of this, $1 billion will be used to repay existing debt, and Darden will use the remaining net proceeds to buy back shares.

Some large investors pounced on management immediately. Hedge fund Starboard Value, which owns more than 5% of Darden, cried foul, saying that the deal severely undervalued Red Lobster considering its profitability and real estate assets. Unfortunately for Starboard and other investors, the deal is not subject to shareholder approval.

Shares of Darden sold off 5% after the news, but the bearishness may be premature. It's not as if Red Lobster is performing superbly. Far from it. In fact, same-restaurant customer traffic at Red Lobster fell 12% in December, 18% in January, and 12% in February. Costs are also problematic, as management noted that food and beverage expenses as well as labor costs went up in the last quarter.

Plus, Darden will be able to fortify its balance sheet and pay off burdensome debt. This will provide investors a greater margin of safety and allow the company to maintain its hefty 4.5% dividend yield. Shareholders will also benefit from the share buybacks, which will boost earnings going forward.

The bottom line
While Darden didn't fetch an exorbitant price for Red Lobster, that was very unlikely to begin with. However, it didn't get ripped off, either. Red Lobster generated about $2.6 billion in sales in fiscal 2013, meaning it was sold for about 0.8 times trailing sales. That's actually a higher multiple than Darden as a whole trades for, and it's worth noting that Red Lobster is its worst-performing restaurant.

Darden will now be able to improve its balance sheet, buy back stock, and focus on expanding its higher-growth brands like LongHorn Steakhouse and The Capital Grille. That's why the deal actually makes a lot of sense. 

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Bob Ciura 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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