After announcing on May 16, 2014 that it would be selling its Red Lobster restaurant chain to Golden Gate Capital, Darden Restaurants (NYSE: DRI ) was punished by Mr. Market, who pushed the company's shares down 4%. This downturn saw a partial recovery on May 19 when the company's shares climbed 1%, but the fact of the matter is that Darden's troubles may just be getting started. In response to the asset sale, institutional investors like Starboard Value and Barington Capital Group have attacked management for misleading investors.
Darden's transaction is tricky!
According to corporate news releases, Darden is slated to sell its Red Lobster chain to Golden Gate Capital in a transaction valued at $2.1 billion. After factoring in taxes and transaction costs that Darden will have to cough up, the company should net around $1.6 billion from the deal.
While investors may think this is a decent price for a business hit with year-over-year sales declines, some of the company's top investors aren't so sure. In addition to Starboard calling for a shareholder vote on the issue, Barington announced its "strong opposition" to the deal for the following reasons:
One of the major points of contention disclosed by Barington is the role that American Realty Capital Properties (NASDAQ: ARCP ) is expected to play. Following the completion of the transaction, American Realty will buy more than 500 (no specific number has been given) of Red Lobster's 705 real estate locations from Golden Gate for $1.5 billion that it will then lease back to the Golden Gate-owned chain. Of these locations, approximately 93.5% will be on 25-year initial term contracts, while the remaining 6.5% will have a weighted-average lease of 18.7 years.
While this kind of transaction may not make much sense at face value, there are a number of benefits that will accrue to both American Realty and Golden Gate as a result. In addition to reducing Golden Gate's purchase price of Red Lobster to $600 million on a pre-tax basis, the deal will leave American Realty holding the bag should Red Lobster ever go under. Yes, the agreement between it and Golden Gate will net American Realty an estimated 9.9% return annually, but if Red Lobster's turnaround fails, it will be American Realty that is stuck with the empty buildings.
This may be shortchanging shareholders!
Assuming that Red Lobster can turn around, both Golden Gate and American Realty stand to make some money. However, investors like Barington and Starboard fear that Darden's management team is being reckless by selling the chain for so cheap and would prefer that the company divest itself of Red Lobster and Olive Garden through a spinoff.
In its defense, Darden claims that the deal values Red Lobster at about 9 times EBITDA (earnings before interest, taxes, depreciation, and amortization), which is higher than the 6.2 times the entire company is trading for using 2013's metrics. Even better, Darden said that it will use the proceeds from the sale to reduce its $2.5 billion in debt by $1 billion and conduct a $700 million share buyback in 2015 with the rest.
Both of these data points make the deal hard to argue against; but as Barington pointed out, the company's management team is misleading investors when it comes down to its valuation of the sale. After factoring in the effects of the sale-leaseback and the estimated $120 million in cash rent Red Lobster will pay to use its locations, the company's pro forma EBITDA comes down to about $115 million. Taking Barington's estimates at face value, investors would see that Golden Gate is paying just 5.2 times Red Lobster's EBITDA, well below the 9 times boasted by Darden's executives.
Based on the data provided, it's pretty easy to see that Golden Gate and American Realty are getting a pretty good deal by acquiring Red Lobster. Meanwhile, Darden will see a pretty nice windfall, but shareholders should be concerned that it's selling the chain for far cheaper than a simple read-over of its press release indicates. On top of opening the business up to investor and legal scrutiny, the transaction could be a sign that, perhaps, the company's leadership may pose more of a long-term problem than its faltering restaurant chain.
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