It's Okay to Buy the Food, Just Don't Buy the Stock

Austin 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) recently reported third quarter metrics. Earnings per share rose by 292% from the previous quarter but fell by 18% from the same quarter last year. Total revenue climbed to $2.26 billion while same-store sales declined by 4.6%. With so much competition in the restaurant industry, are these numbers bad news for Darden and other companies?

Darden overview

Darden Restaurants operates Olive Garden, Red Lobster, and Longhorn Steakhouse in the United States and Canada. In addition to these, the company has 5 other brand name restaurants. As of December 2012 the company operated 2,000 locations. If offers affordable meals to the middle of the road restaurant goers. This is the type of company that definitely benefits as consumer spending increases. As more people go out to eat, they go to places like those of Darden Restaurants, DineEquity (NYSE: DIN), and Brinker International (NYSE: EAT).

DineEquity

DineEquity owns the Applebee’s and International House of Pancake brand restaurants. The company has 3,600 restaurants in 17 different companies, which are primarily franchised. The company pays one of the highest dividends in the industry with a yield of 4.2%. It has grown its dividend at an annual rate of 24% over the past few years. Next year, same store sales growth should be in the high single digits and may even approach 10%. This is largely due to a rebounding economy. It has a relatively high Selling, General, and Administrative (SGA) expense rate of 19.2% but has a plan to reduce this expense as it increases its franchise locations.

Brinker International

Brinker International runs restaurants under the name Chilis Grill and Bar and Maggiano’s Little Italy. The company has 1540 restaurants under the name Chilis and 45 under Maggiano’s. It operates in 32 countries. This company has a solid dividend yield, as well, coming in at 2.3%. It has also been buying shares back over the last 5 years in an effort to increase the value of its stock for investors. Its On the Border Mexican restaurant is its main laggard, but the Chilis brand brings in nearly 85% of the company’s total revenue.

Problems ahead for this industry

With new regulations with regards to healthcare requirements, restaurant companies may have to make operational changes. The CEO of Darden said the company would have to cut workers’ hours to avoid paying for additional healthcare premiums. DineEquity estimated the cost of fines for its New York locations to be at $600,000 if it does not provide healthcare policies for its workers. Otherwise insurance premium costs would be tens of millions for the company.

This industry already has extremely low profit margins. On average net profit margins in the restaurant industry are 4%. An increase in costs and a decrease in sales will lead to major troubles for this industry.

Company

Gross Margin (2012)

SGA Expense (2012)

Net Profit Margin (2012)

DRI

22.90%

9.30%

5.90%

DIN

46.10%

19.20%

14.40%

EAT

72.71%

60.06%

5.36%

Darden had already launched a new campaign to get more people in the door at their restaurants. It launched a new advertising initiative, more options on the menu, and lowered the cost of many meals. It wasn’t enough to make a difference. It has the highest food cost and very low margins.

Challenges with the margins

It is very easy to see that gross margins are very different in each of these companies.

Brinker International has the highest gross margins of the three. According to its most recent quarterly earnings, the company's margins have benefitted from an increase in menu prices and a decrease in the core ingredients it uses. The company also instituted waste management processes at its Maggiano's locations. At least some of these margins are maintainable for the future. It is difficult to predict the future volatility of produce, poultry, and dairy commodities, so it isn't certain if this will be an advantage in the future. 

Brinker International also has the highest SGA expense of the group causing it to have lower net profit margins. Labor expenses have risen recently due to health care costs. The company has been reducing its other restaurant expenses with few maintenance and repair costs and transaction costs for credit cards. So, in the future this area of expenses may decrease.

DineEquity has a plan to go to a 99% franchised operations so that total gross margins will increase. This plan will minimize the impact of food costs at its company-owned locations. One reason it doesn't have the high margins of Brinker International is that it has an offering of low-cost foods at Applebee's to attract more customers. Gross margins should increase and the total labor expense in SGA should decrease as the company continues its franchise operations. 

Darden has the lowest gross margins. One of the major reasons is management ineffectiveness. In its most recent quarterly earnings report, the company said that beef costs were much higher than anticipated while seafood costs were much lower. Darden's restaurants had the wrong menu-mix, as management called it. It had too many higher cost meals and not enough lower cost meals. This could easily carry in to the future as it is difficult to anticipate changes in commodity prices and to change a menu appropriately. 

Final thoughts

Stay away from Darden Restaurants as operating costs increase and sales decrease. Its okay to pay for the food, just don’t pay for the stock.


Austin Higgins has no position in any stocks mentioned. He is the Principal Consultant for Avant Venture Group and focuses on building businesses through innovation, growth and investment. Read his company's blog at BuildInvestGrow.com and follow him on Twitter @Austin_Higgins.

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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