Olive Garden owner Darden Restaurants (NYSE:DRI)recently announced it would split the company in two, creating a real estate investment trust that would house the Italian restaurant chain's properties. Markets ate the news up and initially pushed the stock almost 6% higher.
While it was not an unexpected development -- activist investor Starboard Value had campaigned on the move last year in its successful drive to unseat Darden's entire board of directors -- the initial euphoria over the plan might be misguided, and investors could ultimately rue management's decision.
Real estate investment trusts are all kinds of popular these days as a quick, easy way of "unlocking shareholder value" in an otherwise stagnant business.
Activists investors have called for REITs at Dillard's department stores, McDonald's, and MGM Resorts. Canada's Hudson's Bay entered into a joint venture with mall operator Simon Property Group that will eventually see the owner of Saks Fifth Avenue split off the partnership into a REIT. Also, Eddie Lampert will ultimately house the vast majority of Sears Holdings' real estate assets in a trust.
Creating a REIT helps boost stock values in part, because it brings front and center the valuable real estate a company owns but that is mainly hidden from investor view. In the case of restaurant operators such as Darden, which owns more than 1,500 locations, being a landlord is a sideline business that distracts from its real purpose of serving food.
Additionally, REITs gain favorable tax treatment, because they are required to pay out virtually all of their profits to shareholders as dividends. Converting real estate assets into a REIT provides an immediate influx of cash that the company can use to pay down debt -- Darden itself has said it intends "to retire approximately $1 billion of its debt over time."
That all sounds good, magical even, but investors should not allow a spell to be cast over them. There are real risks involved with the proposal, and it might be the case that Darden's original opposition to the plan, in which said a REIT offered only "limited value creation," was right all along.
Here are three reasons why this REIT could be wrong for Darden and investors.
1. Its success or failure rides on Olive Garden
Darden has been working to turn around the Italian food chain, and though same-store sales were 3.4% higher in the fourth quarter and up 1.3% for the full fiscal year, they only rose as a result of raised prices and a better product mix on the menu. Traffic at the chain continues to trend downward, meaning it is still having problems attracting customers.
Because Darden said it will initially seed the REIT with only Olive Garden restaurants, the chain's performance will dictate the success of the trust as well. As a result, the REIT is likely to trade at a significant discount to peers, because it is dependent on a weaker operator for virtually all of its rental income.
2. Darden no longer controls the rent
Owning the property gives the restaurant operator stability in costs that it will lose when someone else decides what to charge for rent. While Darden said the properties leased back to it will "have attractive rent coverage ratios, fixed rent escalations and multiple renewal options at Darden's discretion," that also hints at future rising costs for a chain still in decline.
It does give Darden a quick injection of cash but at the expense of future rent payments. Moreover, the arrangement locks Darden into long-term leases that limit the company's flexibility if it comes time to exit weak markets. With declining traffic, that could be a problem.
3. It's a short-term solution to a long-term problem
As noted previously, Darden achieves several goals through this strategy, some worthwhile like paying down debt. However, the company achieved the same end by selling the Red Lobster chain last year and paying down $1 billion of debt.
This REIT is ultimately just a gimmick -- financial engineering that does not address Olive Garden's real long-term problems, including a shift in consumer sentiment away from carb-heavy foods like pasta toward healthier fare.
Darden's other major chain, LongHorn Steakhouse, is doing much better, because it can ride the rising protein trend, even though beef prices are at record highs. Its comps were about 5% higher in the fourth quarter, with both rising prices and higher foot traffic.
What it means for investors
The fact that Darden shares gave back much of their initial gains following the REIT announcement suggests investors are having second thoughts about the plan.
Of course, shares are also 68% above their 52-week low, though much of that was predicated on the activists winning seats on the board. But since that transition included the knowledge the new team would offer this REIT plan sooner or later, gains from the announcement have already been priced in. Investors need to be aware that they may have achieved all they can with Darden Restaurants stock, and that is something the REIT spinoff is unlikely to change.