Darden's Olive Garden. Image source: Darden Restaurants.
With shares paying out more than 4% a year, Darden Restaurants (DRI 0.08%) is one of the highest-yielding dividend stocks on the market. In fact, there are currently just 20 companies with a larger yield in the entire S&P 500.
Still, a hefty payout alone isn't enough to make a company an elite dividend stock. Income investors also look for proof that the dividend they're buying has ample earnings coverage, along with a good chance of steady and substantial growth in the future. Darden Restaurants meets none of those conditions.
Pay till it hurts
For one, the company is paying out more than 100% of earnings in the form of dividends. For obvious reasons that situation can't last long.
Darden reached this point through a combination of falling profits and escalating dividend payments. Partly to satisfy a restless shareholder base, management recently boosted the quarterly payout to $0.55 a share, twice what it was just three years ago. Meanwhile, earnings are down about 70% over the same time frame, which is one reason why shareholders aren't happy.
Put the two trends together and you get a payout ratio chart that gives income investors the jitters.
DRI Payout Ratio (TTM) data by YCharts.
Darden's business isn't generating enough cash to cover its dividend commitment. In the last quarter, for example, operating cash flow was $45 million while the dividend payment amounted to a $73 million outflow.
Most companies couldn't sustain that kind of payout gap for long, but Darden is a somewhat special case. The restaurant operator just sold off a big chunk of its business, separating the struggling Red Lobster brand for about $2 billion in cash. After devoting half of that bounty toward debt repayment, management is using dividends and stock buybacks as the preferred methods for returning the rest of the Red Lobster cash to shareholders.
Bigger than Red Lobster
But Darden's struggles go beyond a seafood chain that is now someone else's problem. Olive Garden is the company's main source of sales and profits, and that business hasn't fared much better lately. Sure, its menu reboot is helping, particularly by raising average check levels. And customer satisfaction scores have crept higher recently, helping the chain in September manage another slight increase in comparable-store sales.
But diners are still largely gravitating toward other options: Customer traffic at Olive Garden fell in each of the summer months, led by a 4.3% drop in July. Investors betting on a quick rebound at this restaurant chain should be prepared to ride out a long turnaround strategy.
The takeaway
Darden said last month that it expects earnings for this fiscal year to be roughly $1.79 per share. Consistent with recent trends, that would be significantly below the $2.22 per share it expects to pay out in dividends during the year.
If that wasn't enough to give income investors pause, the company is also fighting with activist investor Starboard Value over the basic structure of its business. Starboard has proposed, among other things, moving the company toward a franchising model. But Darden's management has warned that such a move would "dramatically reduce cash flow" and "threatens Darden's ability to maintain [its] current annual dividend."
Put all this together, and its clear that Darden's dividend, while massive right now, can't be counted on by investors seeking steady income. The payout isn't currently covered by earnings, its growth is tied to a business that continues to struggle, and it risks being cut as management does battle with its shareholder base. Dividend investors should skip this course.
