Is Darden a Good Buy After a Plunge?

Anh 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) just lost nearly 9.6% of its market value within a trading day, dropping from $52.42 to $47.40 per share. It seems to be a good drop for income investors to accumulate shares of this consistent and growing dividend-paying restaurant stocks. However, in order to determine its attractiveness, investors need to factor in the potential operating performance, the balance sheet strength, and the valuation of this business.

Darden is considered to be the largest full service restaurant company globally with around 1,994 restaurants located in the US and Canada, with several famous brand names such as Red Lobster, LongHorn SteakHouse, Olive Garden and Bahama Breeze. Interestingly, Darden doesn’t follow the franchise model; all of its restaurants in the US and Canada are owned and operated by the company.  It has around 28 franchised restaurants based in Puerto Rico, Japan, and Dubai. Its business is divided into two segments: quick service and full service. 

The recent plunge in its stock price was caused by the weak guidance the company provided in the second quarter, along with the gloomy growth outlook for the full year 2013. Although the average second quarter EPS analysts expected was in the range of $0.47, the company expected only $0.26 - $0.27 EPS for the second quarter. In addition, Darden estimated the overall decline of the same-store sales in all restaurant brands, of 0.8%, with a 2.7% drop in Red Lobster’s same-store sales and 3.2% decline of LongHorn Steakhouse’s. 

Because of the company-owned business model, Darden employs a large amount of debt on its balance sheet, with the high level of goodwill and intangibles. As of August 2012, it had nearly $1.9 billion in stockholders’ equity, only $52 million in cash, but more than $2 billion in both short and long-term debt and more than $1 billion in goodwill and intangibles. The total contractual obligations including operating leases and purchase obligations totaled $45.3 billion, with nearly $1.6 billion due in less than a year. The good thing is that Darden has been generating increasing positive operating cash flow consistently over the last 10 years. Trailing twelve months, it generated nearly $900 million in operating cash flow, but only nearly $250 million in free cash flow, due to the high maintenance capital expenditure.

One of its peers, DineEquity (NYSE: DIN), the owner of Applebee’s and International House of Pancakes, has just finished its five year strategy to turn its casual dining chain into fully franchised restaurants. At the moment, the refranchising program is helping to transition itself into a 99% franchised restaurant system. It was a quite smart move for the long-term business results. Indeed, year-to-date, DineEquity has outperformed Darden and another restaurant company, Buffalo Wild Wings (NASDAQ: BWLD), drastically.

<img src="/media/images/user_14219/screen-shot-2012-12-05-at-45102-pm_large.png" />

DineEquity gained nearly 50% year-to-date in the stock market; whereas at the same time, Buffalo Wild Wings and Darden only gained 10.6% and 9.2%, respectively.

In terms of valuation, it seems that all three restaurant stocks are quite reasonable, with their PEG ratios.

<table> <tbody> <tr> <td> <p> </p> </td> <td> <p><strong>DRI</strong></p> </td> <td> <p><strong>DIN</strong></p> </td> <td> <p><strong>BWLD</strong></p> </td> </tr> <tr> <td> <p><strong>Forward P/E</strong></p> </td> <td> <p>11.6</p> </td> <td> <p>5.6</p> </td> <td> <p>19.6</p> </td> </tr> <tr> <td> <p><strong>PEG</strong></p> </td> <td> <p>0.9</p> </td> <td> <p>0.5</p> </td> <td> <p>0.8</p> </td> </tr> <tr> <td> <p><strong><span><span>Div</span></span> yield</strong></p> </td> <td> <p>3.6</p> </td> <td> <p>N/A</p> </td> <td> <p>N/A</p> </td> </tr> </tbody> </table>

DineEquity is the cheapest, with only 5.6x forward P/E and 0.5x PEG, whereas Buffalo Wild Wings is the most expensive, with nearly 20x forward earning and 0.8x PEG. Darden is the only stock that is paying a dividend, which has a yield of 3.6%.

My Foolish Take

Darden is reasonably priced after the plunge in its share price. However, the business of owning restaurants would keep Darden reinvesting substantially back into the business, which potentially eats into its growing operating cash flows. Along with DineEquity’s cheapest valuation, I would prefer the business transition into the franchise model going forward.

hoangquocanh has no positions in the stocks mentioned above. The Motley Fool owns shares of Buffalo Wild Wings and Darden Restaurants. Motley Fool newsletter services recommend Buffalo Wild Wings. 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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