Bullish Despite Poor Same Store Sales

By Gayatri Sharma - August 9, 2012 | Tickers: DRI, DIN, RT | 0 Comments

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Last month, Darden Restaurants (NYSE: DRI) announced an agreement to purchase Yard House, a restaurant concept with 39 units that competes in the bar & grill segment for $585 million ($555 million net of tax benefits). Funding comes through its $750 million revolver and reduced share repurchases. Darden will now repurchase only $50 million of stock in F13, vs. $200-250 million originally. We view this acquisition as a significant long term upside and believe that the remodeling of Olive garden and Red Lobster will further provide substantial future value to shareholders.

Yard House with its 130 types of beers

Yard House, as one of the most exciting growth concepts in casual dining, offers contemporary American cuisine with chef-inspired recipes and ethnic flavors along with an extensive range of premium beers targeting a younger demo. Yard House fits well in Darden’s portfolio as it has no operational impact on the core brands. Yard House currently operates 39 restaurants across 13 states. Management expressed its intention to grow the concept to over 150-200 units in the coming years. We view the deal favorably as it provides Darden a brand with high growth/returns and increased exposure to younger/wealthier consumers. Overall, we believe that the stock is likely to be weak on near-term dilution, but the longer term transaction offsets the near term dilution.

Darden’s value perception as a potential share price catalyst

We believe the disappointing SSS (-1.9% vs consensus estimate of 1.3%) in 4Q was primarily driven by SSS declines at Olive Garden (-1.8%) and Red Lobster (-3.9%). SSS growth of 3.0% at LongHorn Steakhouse provided some support. Following these disappointing results, the management understands the need to enhance everyday value positioning at Olive Garden and Red Lobster. The company is planning to overcome this issue through menu evolution involving changes to the core menu at each brand. We believe that as the new core menus are rolled out over the next few quarters, guest traffic will respond favorably.

The company is promoting a new value platform, "Two Dinners for $25" for Olive garden and “Three-Course Seafood Dinner for Two” for Red Lobster. The same approach appeared to have worked with the “Three Course Meal” for $12.95 promotion during February as it gave impressive Olive garden’s SSS of 4.3%. On top of discussed initiatives, the company has also accelerated its Bar Harbor remodel program for Red Lobster and Tuscany remodel program for Olive Garden that will attempt to break through to consumers with a fresh image. We are optimistic about refocus on Darden’s value perception as a potential share price catalyst.

Low Valuation

Darden is trading at a forward PE of 12.12x which seems to be undervalued as company is showing better revenue and EPS growth than its peer group over the past 5 years. The following table summarizes forward PE and expected growth of Darden, Ruby Tuesday (NYSE: RT) and DineEquity (NYSE: DIN) :-

Clearly despite the lowest valuation, Darden is expected to post best-in-class EPS growth among its peers. It implies that the company's superior metrics are not fully factored into the current stock price and needs an upward correction.

Additionally, management plans to maintain a dividend payout ratio of 40-50% longer term and could easily hit the higher end of its long-term sales target (7-9%) and earnings guidance (10-15%). Darden has diversification across its restaurant portfolio, which provides it with continuous long-term unit growth opportunity, SSS gains and strong unit economics. Focus on addressing Olive Garden’s and Red Lobster's value perception issues and the addition of another highly differentiated growth vehicle (Yard House) to amplify its growth profile in long-term gives this stock a bullish tone. Therefore, we rate the shares a buy.

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