Fool on the Street: Grilling Darden Restaurants

In the beloved villages of Greece, goods salesmen travel via overloaded pickup trucks, touting their offerings over a megaphone to inspire the convenient sale to the isolated townsfolk. Executives of Darden Restaurants (NYSE:DRI), the largest casual dining chain operator in the world, based on fiscal 2007 sales, may have a more difficult sales pitch to make in their travels because of today's competitive and potentially softening marketplace. The restaurateur is on its horn nonetheless.

If you call Darden's corporate offices these days, as I did, you will find few at headquarters. You see, much of Darden's executive team is on the road, promoting its new and improved strategy for overcoming its growth issues. And in this edition of "Fool on the Street," I'll look into Darden's plan and at its outlook, considering the challenging operating environment.

Darden appears to be a company with a plan. After the company's latest presentation -- having seen one of its presentations before and having carefully analyzed the stock long ago, while later profiting from its rise -- I view the current situation as a bit less appealing.

The problem
While Darden's plan for growth keys on a more rapid expansion of its leading concept, The Olive Garden, that plan appears to be driven by necessity, not decision. In reviewing the presentation, as they say, it's like deja vu all over again. Darden's management, a well-respected group both within the industry and among analysts, harps on patience when developing a new concept. We've heard that before. With failures over the years involving a Chinese cuisine concept, and more recently, its Smokey Bones concept, I question the company's skill in identifying winning ideas. By now, the operator of nearly 1,400 Olive Garden, Red Lobster, Bahama Breeze, Smokey Bones, and Seasons 52 restaurants should be able to make a new concept work if the idea is marketable.

Darden knows enough about operating a restaurant to manage the ins and outs. So when management comes out and says it's planning to grow through further Olive Garden expansion, it seems to me that that's only because there is no other choice. In May, Darden threw in the towel on Smokey Bones, closing 56 of the barbecue and grill spots, with a plan to sell the other 73 properties. During this month's presentation, management indicated that by the time it could work out "experience" and margin issues at Bahama Breeze, it couldn't expand the concept until fiscal 2009. Nonetheless, Darden is building a property pipeline. The company's latest restaurant idea, Seasons 52, is a higher-ticket concept, and the company sees its opportunity limited to only about 100 spots nationally.

Not your garden variety
Restaurants and retailers alike are notorious for estimating a certain market size, and then when it's reached and the company becomes faced with the dilemma of what to do with capital, that number often increases. It seems Darden is no different. So, expect to see 40 new Olive Garden locations in fiscal 2008 versus 32 in fiscal 2007, which ended in May. Olive Garden was the company's main engine in fiscal 2007 also, as the segment grew sales 6.6% on 2.7% same-store growth. Darden expects that a new point of sales system, an automated meal pacing system, and menu and advertising changes will help same-store sales continue to expand this fiscal year.

Red Lobster, a cash cow yet seemingly endless renovation project, is undergoing another makeover. There's a new store prototype, and the company plans to later get around to putting the new look into existing locations as well. Red Lobster is also renovating its image, with a focus on the freshness of its seafood. The end goal is to maximize the seafood staple's brand potential and improve same-store traffic. Red Lobster's sales only rose 0.9% in the year just passed, and that included just a 0.2% contribution from same-store growth.    

Time to buy a steakhouse?
The company enjoys the cash-cow benefits of its many Italian and seafood restaurants. Darden has two clear uses in mind for its cash: to pay more dividends and to continue to seek growth. Some might argue that given what's happened with its recent new concepts, maybe Darden should accept the status of a mature business and pay out its profits in the form of dividends. In fact, Darden increased its dividend by about 56% this past year, and during the Q&A session of its presentation, declared it would likely continue to boost dividends.

Still, executives the world over are not the type to just sort of sit on their steak-filled rears, except perhaps in certain family-owned operations that miss the benefit of activist shareholder inspiration. I believe Darden could pursue the purchase of a large concept outright. This shouldn't be a surprise, though, because the company mentioned it might do as much at the conference where it gave its presentation.

In fact, Darden could take on a large operation, and thus a more proven concept. Management says it's not beyond buying into an operation of more than 100 locations, as long as it has two-thirds of its market potential still open to it. So a steakhouse like Ruth's Chris (NASDAQ:RUTH), with 107 owned and franchised stores, comes to mind immediately. High returns are an important criterion, and Ruth's return on equity measures 40%, versus 32% at Darden, based on data from Capital IQ. As for growth, analysts surveyed believe that Ruth's Chris can grow EPS at 18% per year over the next five years. That would certainly provide a boost to Darden's projection for 10% to 12% in fiscal 2008. Detractors might argue that the average ticket at Ruth's steakhouses is too high for it to offer broad appeal, but you never know.

Or maybe Darden is hungry for Chinese again. P.F. Chang's China Bistro (NASDAQ:PFCB) operates 152 Bistro units and 107 Pei Wei Asian Diner locations. As far as meeting the criteria, analysts see P.F. Chang's growing at an energizing 21% clip over the next five years. However, P.F. Chang's returns just 11% on equity, which doesn't seem like a fit. Returns are likely weighed down by Pei Wei, though. Darden would probably spin off Pei Wei if it couldn't fill the bill on return on invested capital, and Pei Wei offers a faster than casual dining-type experience anyway.

Darden is trying to please both worlds, and seems to have the luxury to do so. As management pointed out, the stock has returned 22% on average over the past 10 years. The company's shares have done OK this year, providing a 9.4% total return, and over 52 weeks, the shares are up about 31%. Even so, casual dining is coming under pressure as investors worry about consumer spending in light of expensive gasoline and other costs of living. Darden's forecast for 7% to 9% overall casual dining chain store growth in the near term represents an increase over the past five years. However, it's based on management's expectation that employment will remain stable or improve, while inflation is driven lower. This analyst disagrees, seeing instead a weakening employment situation, which is in line with the Federal Reserve's forecast, and persistent inflation, which is not.

As far as valuation goes, Darden trades like an industry leader.

The Foolish bottom line
While I think Darden has the right idea in consolidating its weaker segment operations at a challenging time, its industry outlook seems hopeful and its valuation appears lofty for the environment this Fool expects. Still, with Darden's conservative growth and stable cash cows, the shares should remain a staple in many large mutual funds. That could help moderate cash outflows from its stock. Even so, this Fool would steer clear of the chain, even if it looks to buy a steakhouse.

For further Foolishness:

• Fool on Call: A Fresh Look at Darden
• A Bland Quarter at Darden: Fool by Numbers
• Who Wants These Bones?

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Fool contributor Markos Kaminis has no ownership interest in any of the companies discussed here, but he wants to remind all his grad school pals at Pittsburgh's Katz School of Business that he recommended Darden 10 years ago in his valuation project. The Fool has a disclosure policy.