Last May, in our article, “Darden Restaurants: A Generous Dividend Payer in the Restaurant Industry”, we pointed out the exceptional dividend potential in shares of Darden Restaurants (DRI), the world’s largest casual dining operator, which owns over 2,100 restaurants, mostly through its three largest chains, The Olive Garden, Red Lobster, and LongHorn Steakhouse. Indeed, the current dividend yield of about 4.4% is more than double theValue Line median for all stocks in the Survey. However, after several quarters of poor performance, the company has undertaken a plan to unlock greater value for shareholders, with institutional investors clamoring for still-bolder action.
While part of the impressive dividend yield comes from continued increases in the payout, which has risen at a 26% annualized rate over the past five years, part of it is due to a stagnant share price since 2010. The stock has been held down by a reversal of the company’s earnings trends in fiscal 2013, with full-year share net coming in below the record level set in fiscal 2012. (Fiscal Years end the last Sunday of May).
We predict a further decline in earnings per share for fiscal 2014. The earnings decline has come largely due to the drop in same-restaurant sales for the company’s three largest chains. On the bright side, the company as a whole has seen continued sales increases and the addition of new restaurants in its younger restaurant offerings, such as Yard House, Bahama Breeze, and Capital Grille. Indeed, the company expects to see a total sales increase in fiscal 2014 of between 4% and 5%, despite a decline in its three biggest chains of 1% to 2%.
Investor skepticism over the company’s longer-term outlook is likely influenced by the increased competition that the casual dining industry as a whole is facing from the booming high-quality fast-food sector, represented by fast-growing chains such as Chipotle (CMG) and Panera Bread Company (PNRA).
In December of last year, the company announced a plan of action to address shareholder concerns. The plan includes a spinoff of Red Lobster from the rest of the company, set to close during fiscal 2015. The spinoff would come in the form of a tax free, 100% pro rata distribution of Red Lobster stock to Darden shareholders, with “New Red Lobster” becoming a publicly-traded company. The “New Darden” should maintain its investment-grade credit rating, while the spun off “New Red Lobster” would aim for a strong, but non-investment grade rating, as it would leverage up somewhat to reach an optimal capital structure that reflects Red Lobster’s strong cash-flow generation. “New Darden” would expect to maintain an attractive, consistently growing dividend and increase its share repurchases, but would aim to gradually reduce the payout ratio over time, while “New Red Lobster” would aim to return capital to shareholders especially vigorously, through dividends and share repurchases, and maintain a payout ratio of about 75%, as it is already in its cash cow phase.
Another key element of the plan focuses on reduced capital expenditures and growth, and to forego further acquisitions, which addresses the concern of some investors that acquisitions in recent years have led the company to remove its focus from its core businesses. Furthermore, the plan aims for substantial cost savings and a better alignment of management compensation with results for shareholders by basing it on shareholder-friendly factors such as same-restaurant sales and free cash flow.
Institutional investors such as Starboard Value LP and Barington Capital Group have argued that these plans may not go far enough to unlock the company’s full potential, and have floated alternative proposals. One proposal has been to split the company in two, with its more-mature Olive Garden and Red Lobster chains being split from LongHorn Steakhouse and all of Darden’s smaller chains, which are still in their growth phases. Another proposal is to establish a real estate investment trust (REIT) to unlock the value of the company’s real estate, which would likely account for well over half of the company’s current market cap. Indeed, Starboard has asked for a special shareholder meeting to be held in light of the proposed spinoff of Red Lobster, arguing that the spinoff would likely be completed before the annual shareholder meeting and that shareholders should have a say in the company’s strategy going forward. Management has resisted calling a special meeting, saying that it would be an unnecessary waste of resources. However, the special meeting appears to be set to go ahead, as Starboard announced several weeks ago that it has the support of a majority of outstanding shares. The intention of the meeting would be to vote on a non-binding proposal urging the Board of Directors to delay the Red Lobster spinoff until the annual shareholder meeting, unless any spinoff transaction would require shareholder approval. While the battle among the company’s stakeholders is ongoing, it appears that management is on its back foot, and will likely be discussing alternative proposals with major shareholders.
Whatever proposals ultimately win out, the shift in strategy is likely to unlock shareholder value. Furthermore, a recovery of profitability projected out to 2017-2019, as well as the outsized dividend yield, offer total return potential well above the Value Line median over the coming 3 to 5-year stretch.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.