Buy These Great Casual Dining Stocks

Michael is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Darden Restaurants (NYSE: DRI) and Red Robin Gourmet Burgers (NASDAQ: RRGB) both have a compelling investment story to tell. Red Robin needs no further explanation beyond its name; Darden operates a portfolio of casual dining concepts, including Longhorn Steakhouse, Red Lobster, and Olive Garden.

Both of these companies would make excellent additions to your portfolio based on your investing preference – Darden is slower-growing but safer (and it pays a dividend); Red Robin is riskier but may generate higher returns. My investment style means I favor Red Robin. Let’s dig in and take a more granular look.

Where they stand

Red Robin is trading at a price/earnings (P/E) ratio for the trailing-12 months (TTM) of roughly 30, which looks pricey when compared to Darden’s P/E ratio of 16.1. The gap narrows significantly when Morningstar estimates the forward P/E ratios; for Red Robin, it’s about 19 (indicating earnings per share growth of almost 50%), while for Darden it’s about 14. That is some enormous anticipated growth in the pipeline for Red Robin (but still great value for Darden).

Morningstar’s anticipated growth for Red Robin is no typo. If past performance predicts the future, then even the expected revenue growth could be conservative. In 2010, Red Robin earned $0.46 per share (EPS); in 2011, EPS tripled to $1.34; in 2012, that number increased by almost 50% to $1.93. First-quarter 2013 results showed a slight dip in EPS to $0.66 from $0.71 in Q1 of 2012 (due to a few things, primarily some changes in the company's fiscal calendar; according to management, this reduced EPS by roughly $0.10).

Darden runs on a June through May fiscal year, so comparisons between the two restaurants will not be perfect. Earnings grew from $2.84 per share for FY 2010 to $3.39 in FY 2011 and $3.57 in FY 2012. For the trailing-12 months, earnings were $3.27. Third quarter FY 2013 (which ended in February 2013) showed a significant year-over-year decline to $1.02 per share compared to Q3 2012, which was $1.25 per share.

Same-restaurant sales were down 6.6% for Red Lobster, 4.1% for Olive Garden, and 1.6% for Longhorn Steakhouse. Management additionally cites higher personnel costs, depreciation, administrative expenses, and poor weather for declines in profitability.

Red flags

These are red flags, but to my mind not necessarily large ones. Darden's restaurants operate at fairly high price points, so a stubbornly under-performing economy may account for the lost sales. Additionally, Darden's Specialty Restaurant Group turned in a same-restaurant sales increase of 2.3%, which partially offset the declines for the other concepts.

Darden pays a 3.7% dividend with a payout ratio of below 50% (which indicates to me a dividend that is sustainable and has room to grow). Red Robin does not pay a dividend.

One to avoid

To get a sense of where these two companies fit in the broader sector, let's compare them to a company that I would not buy - Ruby Tuesday (NYSE: RT), which operates restaurants of the same name. For Q3 FY 2013, corporate same-store sales declined by 2.8% (Ruby Tuesday operates by the same calendar as Darden). Third-quarter 2013 EPS clocked in at $0.04 per share, as compared to $0.07 in Q3 of 2012. 

Management is talking about the need to re-position the restaurant. These red flags combine to create a stock that I would not purchase, despite some positives (including its expansion into the fast-casual restaurant segment with the Lime Fresh Mexican Grill concept). If Ruby Tuesday turns around, posts positive comps, and stabilizes its earnings, I think it could become a great value play - but right now, the proof isn't there.

Innovation and expansion

Red Robin’s new “can-crafted cocktails” are interesting innovations – the Blue Moon one probably tastes better – which emphasize Red Robin’s continual menu refreshment. Personally, I’m not jazzed about this particular product, but management does a good job of adapting and trying a variety of new things.

There is a more “out of the box” feel to Red Robin’s menu updates than I experience when I look at new menu items at Red Lobster or Olive Garden. Trying out these new concepts increases the chance that Red Robin will successfully latch onto the next big thing and hit a home run for its investors.

Red Robin is also innovating and expanding its restaurants, with some new restaurants occupying smaller (4,000 square foot) spaces and the new fast-casual Burger Works units. According to the Q1 2013 earnings call, Red Robin intends to open seven of the 4,000 square foot units, 13 of the traditional larger-footprint restaurants, and several new Burger Works' locations this year. With its low debt/equity ratio (0.3, according to Morningstar), Red Robin has lots of room to finance additional construction and development.

Darden is not adjusting its restaurant footprints, although it recently added a new concept with the purchase of the Yard House chain. Darden is expanding both domestically and internationally, with 57 restaurants set to open in Brazil, the Dominican Republic, Colombia, and Panama. In total, Darden intends to open 105 new restaurants this year. The company is sitting on a fair amount of debt (the debt/equity ratio is 1.3, according to Morningstar), which may slow further growth and expansion.

Final thoughts

These are great restaurants for different investing styles. Red Robin’s continual menu and restaurant innovation will pay off with explosive growth. Darden is more established and is following a steadier growth plan. Retail depends on the economy, and these companies are no exception - so both restaurants look a lot riskier in the short term. Stay in long term, however, and the volatility will smooth out. Both companies have credible plans for further growth – follow your thesis and watch it pay off.

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Michael Douglass has no position in any stocks mentioned. The Motley Fool recommends Red Robin Gourmet Burgers. The Motley Fool owns shares of Darden Restaurants. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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