2 Numbers that Worry Me
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
I'll readily admit that many times when I begin researching a company, I assume their competitive position to be stronger than it actually is. At least, such was the case with Darden Restaurants (NYSE: DRI), and its popular restaurant chains Olive Garden, Red Lobster, Longhorn Steakhouse, and others. Looking at the stock, the first thing I noticed was the company's dividend yield of about 3.5%, and analyst expectations for almost 12% earnings growth. This combination is in the sweet spot of what I personally look for in an investment, growth and income. There are two problems. First is the income isn't guaranteed. Second is the growth may not be what's expected.
To say that the restaurant business has been difficult over the past few years would be an understatement. Many chains have had to rethink both their menu and their pricing to appeal to consumers who are more careful about how much they spend. Darden Restaurants has stepped up to the challenge at its two major chains, offering unlimited soup and salad at Olive Garden, and a set price for appetizer, meal, and dessert at Red Lobster.
However, their competition has gotten wise to offering better values, and newer entrants have created a concept called fast casual dining. Years ago, an individual or family looking to eat out somewhere basically had two choices: a sit down restaurant or fast food. Today, fast casual restaurants like Chipotle (NYSE: CMG) and theme restaurants like Buffalo Wild Wings (NASDAQ: BWLD) have changed the game. This has left companies like Darden and its rival Brinker International (NYSE: EAT), which owns Chili's, scrambling to re-price their menu to continue and attract guests. Looking at Darden's most recent earnings, you can see clearly that this company is not the growth stock that it used to be.
In its most recent quarter, revenue increased just 4.64% and diluted EPS was up 9%. The company's Olive Garden chain represents the largest number of restaurants and the largest amount of revenue within the Darden stable. The company opened 40 new restaurants to bring the total number to almost 800. Sales at Olive Garden increased 4.3%, but same-store sales were weak, with an increase of just 0.3%. Darden continues to rework the menu and pricing at Red Lobster, its second-largest division. While sales decreased 2.1%, and same-store sales were down 2.6%, this was less of a decrease than last year. The two future growth drivers for Darden are Longhorn Steakhouse and their Specialty Restaurant Group.
Both of these concepts represent less than one fourth of Olive Garden's sales, so it will be years before they contribute the same amount to the bottom line. The Longhorn Steakhouse division shows why the company is putting money into developing this concept. Sales at this segment increased 12.7%, and same-store sales grew 3.6%. These strong results are part of the reason the company opened 34 new restaurants, bringing its total count to 391.
In The Specialty Restaurant Group, each concept is relatively small, and this seems to be a testing ground for where Darden will find its next phase of growth. The largest concept is The Capital Grille, which showed a 4% same-store sales increase.
Though the company's restaurant results were decent, there are two numbers in their financial statements that worry me greatly.
First, the good news: Darden repurchased 1 million shares in the current quarter, and in the last year diluted shares have dropped 4.52%. The bad news is operating cash flow only increased 6.6%, which is disconcerting with an earnings-per-share up 9%.
My second worry is connected to the company’s dividend. Darden generated $54.1 million in free cash flow, yet paid out $64 million in dividends. This performance led to a 118% free cash flow payout ratio. If this were isolated to one quarter, I wouldn't be concerned. However, last year the company paid out 110% of its free cash flow. In both 2011 and 2012, the company issued common stock of $22.7 million and $14.7 million, respectively, to cover its free cash flow shortfall.
Anytime a company must continually issue new shares to afford their dividend means it’s time to tread with care. With two consecutive years of over 100% free cash flow payout ratios, investors need to keep close watch on this number. The company's outlook seems to show future growth that matches analyst expectations, but my concern about the company's dividend, and slow operating cash flow growth, leads me to believe there are better values elsewhere.
Investors looking for faster earnings growth would do well to consider either Buffalo Wild Wings and its 20% expected growth rate, or Chipotle and its over 21% expected growth rate. Both of these companies are still rapidly expanding, and analysts see revenue growth in the high teens for each next year. While Chipotle offers more of a fast casual dining experience, and Buffalo Wild Wings is more of a traditional sit down restaurant, both offer much faster growth than Darden.
Investors who want a more established concept that has a good yield might consider looking into Brinker International. Brinker is expected to outgrow Darden on an earnings-per-share basis by about 2% a year. In addition, whereas Darden is paying out over 100% of its free cash flow, in the most recent quarter Brinker paid out just 31% of its adjusted free cash flow.
As you can see, competition in the restaurant industry is fierce in the restaurants and in the market. Slow cash flow growth and a high payout ratio are two issues that should worry Darden investors.
MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of Buffalo Wild Wings, Chipotle Mexican Grill, and Darden Restaurants. Motley Fool newsletter services recommend Buffalo Wild Wings and Chipotle Mexican Grill. 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.If you have questions about this post or the Fool’s blog network, click here for information.