How Can Darden Blow a $2 Billion Opportunity?

It may be closer to happening than anyone realizes.

Jul 15, 2014 at 5:00PM

Restaurant group behemoth Darden (NYSE:DRI) has agreed to sell Red Lobster outright for $2.1 billion. I've personally criticized the plan, as have big-shot Darden investors like Starboard Value and Barington. But really there's no point in arguing anymore--the sale is happening whether we like it or not.

And it gives rise to an entirely new issue: what will Darden do with its enormous payday? The answer will dictate Darden's future.

Darden's plan
Darden's management already outlined its spending plan. After factoring in expenses, the company hopes to be left with $1.6 billion. From that, it will spend $1 billion to retire debt and the rest will go to share buybacks.

Let's break that plan down. Currently, the company has $2.5 billion in long-term debt, so it will be able to retire about 40% of its debt load. Consider that interest expenses cost Darden over $30 million per quarter. By reducing its debt by 40%, it could save about $12 million each quarter in interest expenses.

Moving on to the second part of that plan, Darden plans to spend about $700 million to buy back shares in 2015. We don't know where its shares will trade then, but at the current price that would reduce its outstanding share count by about 12%. 

By reducing its debt and outstanding share count, Darden is working to maintain its $2.20 per year dividend. After all, the company has a reputation to uphold--it has given about $2 billion back to shareholders through dividends and buybacks over the past five years.

But what about the business?
Many investors love Darden's commitment to shareholders, evidenced by its 86% institutional ownership -- guys who need consistent returns. But you're not an institutional investor--you don't want consistency, you want a home run. And great market-beating investments only come from great businesses.

Imagine for a moment if Darden never chose to pay dividends or buy back shares. Assuming that it used that money to pay down its debt, it would now be virtually debt-free with $127 million in cash. It would also see no reason to sell Red Lobster. 

But wait, isn't Red Lobster a dying brand that needs to be booted? While it's true that Red Lobster wasn't meeting the expectations of Darden or investors, Red Lobster generated $0.91 per share for Darden in fiscal 2014. That's a pure annual profit of over $100 million. That's a lot of money to kiss goodbye.

So in summary, Darden will soon have less debt but it will also have less income. It's willing to give up $100 million per year so it can give institutional investors the buybacks and dividends they want. But we have to wonder if these moves help Darden's business at all. 

An alternative option
While the $2 billion spending spree forecast by Darden seems to weaken its overall business outlook, the situation isn't completely without hope. That's because Darden still holds one ace up its sleeve -- Yard House.

Acquired by Darden in 2012, this concept is Nation's Restaurant News' No. 2 restaurant for growth -- and it's easily apparent why. In 2013 this chain grew its sales by over 20% and increased its location count by 18%. Perhaps most impressive is its sales per unit of over $8 million.

The casual American food and beer segment is littered with players like BJ's Restaurants (NASDAQ:BJRI), Brick House Tavern & Tap of Ignite Restaurant Group (NASDAQ:IRG), and Buffalo Wild Wings (NASDAQ:BWLD)

Restaurant Sales Growth Unit Growth Sales per Unit
Yard House 20.1% 18% $8.5 million
BJ's Restaurants 9.4% 12% $5.7 million
Brick House 11.3% 33% $3.1 million
Buffalo Wild Wings 18.7%* 14%* $3 million

*At corporate owned locations

As you can see, Yard House blows the competition away on some very important metrics. But just as Buffalo Wild Wings differentiates itself from the crowd with its sports focus, Yard House also differentiates itself with classic rock. This joint carefully picks out classic tunes to blare through its state-of-the-art sound system while diners enjoy its selection of over 100 beers.

If Darden is going to dump a moneymaker like Red Lobster then it needs to pump money into growing Yard House. I have no doubt that this chain could grow into a 1,000 unit force -- comparable to Buffalo Wild Wings. But growth costs money, and with Darden already acting like money is tight, I wonder if it will spend enough to speedily grow this chain.

The payday Darden gets for Red Lobster could fund incredible growth. Even if it proceeds to pay down $1 billion in debt, reserving $700 million for expanding Yard House instead of buying back stock could easily fund the openings of over 100 restaurants -- potentially adding over $800 million to Darden's top line.

I see this as a golden opportunity to improve business, but it looks like Darden might miss this opportunity. This restaurant segment is growing quickly, and competitors are anxiously gobbling up key real estate across the country. If Darden misses out, I'll keep my eyes on BJ's and Ignite to see if they seize the opportunity.

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Jon Quast has no position in any stocks mentioned. The Motley Fool recommends BJ's Restaurants and 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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