Undervalued Restaurant With Improving Fundamentals

By Federico Flom - September 28, 2012 | Tickers: DRI, MCD, YUM | 0 Comments

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I enjoy analyzing restaurant companies. As one of the investors of a famous sushi restaurant in Buenos Aires, I find very interesting to research potential picks in this sub-industry. After analyzing Starbucks, Yum and McDonald's I believe that  Darden (NYSE: DRI) is an interesting pick to research considering it is one of the cheapest stocks in the industry. The company is innovating with new concepts for its restaurantes to improve top-line growth. Also, Darden accelerated its rate of new openings with 100 - 110 net new outlets planned for 2013 against 89 in 2012. Regardless of the slow-moving economic recovery, I am encouraged by the company’s constant restaurant openings.

Shareholder oriented management team

I like companies that are shareholder oriented. Darden’s management actively handles its capital, returning much of its free cash to shareholders through share repurchases and dividends. The company repurchased more than 8.2 million of its shares worth $375 million, in 2012. In the recent recorded fourth quarter of 2012, the company bought back 0.4 million shares. In addition, Darden increased the quarterly dividend by 16% to $0.50 per share payable on August 1, 2012, to shareholders of record July 10. Darden raised its dividends by 100% over the last three years supported by its strong cash flow generation. The company will pay out approximately $255 million in dividends to shareholders in 2013, an increase from $225 million in 2012, $175.0 million paid in 2011, $140.0 million in 2010, $110.2 million in 2009, $100.9 million in 2008 and $65.7 million in 2007, respectively. Darden’s strong value offer, menu improvements, extensive advertising, and excellent unit level implementation with differentiated brands, positioned it well for growth. I am confident about the company’s capability to deliver competitively superior sales.

Remodeling is gaining strenght

Darden projects massive growth prospects over the next five years as well as expects revenue and earnings per share to grow faster. Restaurants remodeling is gaining strenght in Darden´s results. Red Lobster remodeled 148 units in 2012 and is on the way to improve 175 restaurants in 2013. Management expects completion of the remodel program by the end of 2014. Renovated Red Lobster outlets keep generating same-restaurant sales growth of 5 6% and yielding higher return than cost of capital. LongHorn completed the remodeling in the Ranch House image during the second quarter of 2012. Olive Garden is also undergoing extensive renovation. The interior or exterior of 430 outlets in the United States will get the look of farmhouses in Tuscany, Italy by the end of 2015. Olive Garden plans to reimage 20 - 25 units in the first quarter of 2013. Management stated that all revamped units continue to surpass sales and earnings target.

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Longhorn Steakhouse, International expansion and SRG will contribute to future growth

Longhorn Steakhouse will likely deliver a strong show on the back of increased media support, improved promotion and other brand enhancements including the roll-out of meal pacing and table management systems. LongHorn has a significant long-term opportunity with their lunch business. The Specialty Restaurant Group (SRG) is another brand that is emerging consistently contributing around 26.9% of Darden's overall sales growth. With the recent addition of Eddie V's Restaurants and Yard House to SRG, I believe that SRG represents a meaningful long-term growth vehicle. The deal supports the company’s strategy to provide an momentum to Specialty restaurant group as a remarkable long-term growth story. Analysts are confident in a turnaround at Olive Garden through remodel activity, new menu innovations that includes affordable lunch options, takeout and smaller plates, and marketing enhancements.

Darden’s international expansion also gives substantial expectations. The company signed franchise agreements with partners in the Middle East, Mexico, and Puerto Rico, and is looking into Asia, the Caribbean, and South America. I see this strategy favorably, as partnering with local franchisees reduces the risk and capital needs for Darden. The company’s target of $35 million-$45 million of incremental operating income input from international franchisees within five years shows an attainable goal.

Promotions are getting traction

Looking deeper into the core-brand results, I think that traffic picked up at Olive Garden during the first half of the quarter during the "two dinners for $25" promotion, especially in light of various "two dinners for $20" promotions running across much of the casual dining landscape. Olive Garden's August traffic results went down 3.7% and are a mild issues, though part of the decline can be credited to the launch of several new appetizer plates that had a positive mix impact during the month and should continue in the period to come. At Red Lobster, I am happy that the "Endless Shrimp" promotion in August provided an immediate lift to restaurant traffic trends, which improved 4.9% during the month, and that menu transformation strategy to add more non-seafood selections with price points under $15 will make the brand more accessible to a broader audience moving forward.

Management comments

Management recently announced its fiscal 2013 projections, including core-brand comparable-restaurant sales growth of 1%-2%, 100-110 new restaurant openings not including Yard House, and earnings per share growth of 5%-9% that includes acquisition-related costs also purchase accounting adjustments that suggests full-year EPS between $3.75-$3.89. I believe Darden’s core-brand position for 1%-2% same-restaurant sales growth in 2013 looks more attainable based on recent menu and promotional strategy changes as well as the impact of remodeling and advertising changes that will take place as the year progresses. Together with new outlets from the Specialty Restaurant Group and the inclusion of Yard House starting in the second quarter, I believe the top-line growth target of 9%-10% looks possible. With the impressive first-quarter restaurant margin gains and management's expectations of a 0.5%-1.5% increase in its commodities basket for the year, I plan to increase my restaurant margin assumptions for the full year to the 24% range, implying a little less than 100 basis points of improvement compared to the 22.9% posted a year ago.

Valuation and peer comparisons

My target estimate is around $58 per share based on  a more optimistic long-term revenue growth and operating margin assumptions as well as the recent acquisition of Yard House. My rfair value implies forward fiscal-year price/earnings of 14 times, an enterprise value/EBITDA of 8 times, and a free cash flow yield of 5.2%. Darden also trades at much cheaper multiples than peers Mc Donald's (NYSE: MCD) and Yum Brands (NYSE: YUM). For example, Darden trades at 0.9x sales, 15x earnings and 3.9x book in comparison to McDonald's 3.5x sales, 17.5x earnings and 6.7x book while Yum trades at 2.4x sales, 20x earnings and 14x book. In addition, Darden pays the highest dividend yield.

Conclusion

I like to invest in companies that operate businesses I can understand and are shareholder oriented. In addition I think that one of the best ways to invest is finding good companies trading at inexpensive valuations that could appreciate from improving fundamentals. Darden is one of those companies so I recommend investors to keep an eye on this stock.

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