Darden Restaurants (DRI) is the world’s largest casual dining operator with over 2,100 restaurants including its three largest chains, The Olive Garden, Red Lobster, and LongHorn Steakhouse.
The company has had a tough run in recent quarters, with earnings for fiscal 2013 (year ends May 26th, 2013), likely to come in lower than the previous year on higher costs. However, another factor that has been weighing on the company is the damper higher payroll taxes and gasoline costs have put on discretionary income. This is compounding the economic squeeze that has been felt by Darden's middle-class consumer base since the recession of 2007-2009. Indeed, during the fiscal third quarter (ended February 24th, 2013), the company reported a significant decline in sales at The Olive Garden, Red Lobster, and LongHorn Steakhouse. Nonetheless, the share price and earnings growth have generally been quite solid since the recession, with shares rebounding from a low of $13.20 in late 2008 to over $48.50. Furthermore, the company maintained solid, near-record profitability even in 2009, the harshest year of the recession, and has posted impressive growth since then.
Profit gains stalled in fiscal 2013, and worrying long-term trends may be influencing the share price, which has declined substantially from its 2012 high of $57.90. In particular, the casual dining industry faces intense competition from the booming high-quality fast-food industry, which includes chains such as Chipotle (CMG) and Panera Bread Company (PNRA), whose share prices have strongly outperformed both Darden and the broader market of late. The rising competition from that category of restaurants could place pressure on both volume and pricing at Darden’s traditional chains. This has led the company to look to its Specialty Restaurant Group, which includes chains such as Capital Grille, Bahama Breeze, Seasons 52, Eddie V’s, and Yard House, to be the main growth driver going forward. The group generated sales growth of over 55% last year. However, most of that increase came from the 2012 acquisition of Yard House, which included 40 restaurants, for $585 million in cash. In addition to that purchase, Darden has added a net of 108 new restaurants in the past year, which has partially offset the effect of same-restaurant sales decreases from its core brands, and should drive growth over the coming years.
In its three core franchises, which still account for the vast majority of the company’s restaurants, management has focused on several strategies to get comp sales moving in the right direction. Initiatives include new menu items, different marketing strategies, and restaurant remodeling. However, a return to significant growth will likely have to wait until middle class discretionary income resumes a more-positive trajectory.
Still, these shares have considerable long-term appeal. This stock has solidly outperformed the market over the past 10 years, though there have been periods of concern. The issue’s Price Growth Persistence and Earnings Predictability scores are favorable, with earnings growth having been fairly consistent over that time period.
The most distinctive feature of these shares is the outsized dividend yield, which currently stands at around 4%. Indeed, the dividend has risen at a 38.5% rate over the last 10 years with most of that has come from the rising payout ratio. While the company paid out only 6% of 2003 earnings in dividends, we expect this year’s to account for 59% of earnings. However, a good amount of it also has come from rising earnings, which have grown at a 12% annual rate over the past decade.
Meanwhile, the long term debt burden, while sizable, is relatively manageable, with total interest covered by earnings about eight times over.
A possible risk to continued growth in the payout is that capital spending has eaten up a substantial amount of cash flow in recent years. In fiscal 2012, for example, cash flow per share was not enough to cover capital spending and dividends. If the company can’t grow cash flows without spending such a high proportion of them on capital spending going forward, either the balance sheet will suffer or dividends will have to rise at a significantly slower pace than in the recent past.
Overall, while we see significant appeal here for income-minded investors, challenges remain. Success going forward will depend on Darden’s ability to improve the fortunes of its largest chains in the face of changing trends in the restaurant industry. However, specialty restaurants ought to play an increasingly important role, which should help the company to grow, while rewarding shareholders with high dividends in the meantime.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.