Casual Dining Is About to Get Hot Again

Ted is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The casual dining segment of the restaurant industry has been in a downturn since the Great Recession. Restaurants normally do not earn large margins, so they rely on customer volume to earn profits. As foot traffic has decreased, so have the companies' profits.

However, if the economy picks back up, a few casual dining restaurants look pretty cheap. The best bargain appears to be Darden Restaurants (NYSE: DRI), which owns several casual dining brands.

Brutal competition

Darden is larger than its two main rivals, but earns similar margins. This is not an industry with sustainable competitive advantages, though some restaurant brands carry more weight than others.

For instance, DineEquity's (NYSE: DIN) IHOP brand is perhaps the most-recognized breakfast restaurant in the United States. The company's Applebee's restaurant is also a mainstay in the casual dining market, with more locations than Chili's and Ruby Tuesday. The size advantage gives Applebee's the scale to outmarket its competitors, but not necessarily outperform. Regardless, Applebees still has a long runway for growth both in the U.S. and abroad, and remains a valuable restaurant frachise.

Chili's, owned by Brinker International (NYSE: EAT), has high consumer awareness as well. All successful national restaurant chains have marketing power, which is why casual dining is basically a commodity product.

However, Brinker has been able to leverage its franchisees and expand its presence without enormous capital expenditures. This strategy allows it to earn a higher return on invested capital than DineEquity and Darden. However, the business model is easily replicable; there is nothing to stop competitors from doing the same. In addtion, Brinker's stock does not look cheap -- it trades for 16.4x last year's earnings and 9.1x EV/EBITDA.

Positioned to grow

Darden is well-capitalized and in position to take advantage of struggling independent dining restaurants that were hit hard by the economic downturn. In addition, it owns a host of restaurants that cater to a more affluent base than those owned by DineEquity and Brinker. The customers at, say, Eddie V's, are not as sensitive to price changes or swings in the economy as diners at Chili's and Applebee's. This affords Darden a degree of protection from the business cycle.

Management's long-term growth targets include at least 7% annual sales growth and 10% annual EPS growth. Most of this growth is likely to come from the company's specialty chains (Eddie V's, Yard House, etc). Over the last ten years, the company has grown sales at an annual rate of 6.2% and has repurchased a significant number of shares. Therefore, management's long-term growth objectives do not seem implausible, especially given a recovering economy.

Valuation

Darden has earned $3.73 per share over the last four quarters. The stock currently trades at $45.41 per share. So investors who buy today are getting an initial earnings yield of 8.2% ($3.73 / $45.41). This means that if the company were to continue earning $3.73 per share forever, investors would get an annualized return of about 8.2%.

However, management thinks the company will grow EPS by at least 10% annually for the foreseeable future. EPS growth is expected to come through a combination of sales growth, improving margins, and share repurchases.

Assuming the P/E multiple remains the same in the future, you can just add the EPS growth rate to your initial yield to get a ballpark estimate of you annualized return. So, if we think management will hit its target, we can add 8.2% + 10% to get an annual return of 18.2%.

I always want at least a 10% annual return on the stocks I buy, plus a wide margin of safety. This back-of-the envelope math makes Darden look like it might return over 10%. However, investors should always do their own research and not let management tell them what the value of the company is.


titans8904 has no position in any stocks mentioned. 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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