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Two Market Leaders, Two Very Different Investments

November 05, 2013 | About:
Pato Kehoe

Patricio Kehoe

7 followers
The casual dining industry is tainted by intense competition and fickle consumer preferences, so promotional offers and menu innovation are a must. Let’s take a look at two dominant players, Darden Restaurants Inc. (DRI) and Chipotle Mexican Grill (CMG), to see which strategy is most effective.

A Bargain Price for a Key Industry Player

Darden Restaurants is North America’s largest casual dining restaurant operator. With over 2,150 locations, more than 10% of the $75 billion domestic casual dining industry can be attributed to this company. This number puts them ahead of market names like Dine Equity or the Cheesecake Factory. This firm’s long-term success is due to its ownership of several highly recognized restaurant brands, all settled in high-traffic locations. Darden Restaurants’ core brands include Olive Garden, Red Lobster and Long Horn Steakhouse.

However, in the last few years the company expanded its horizon by opening five smaller, yet faster-growing, chains: Capital Grille, Yard House, Bahama Breeze, Seasons 52 and Eddie V’s. Gathered under the category Specialty Restaurant Group, they were created to expand the firm's target audience. And this will be a key factor in the company’s future, since cyclical and competitive headwinds have strongly affected the core brands Olive Garden and Red Lobster lately. Unsuccessful promotional strategies and stagnation in menu innovation have also put additional pressure on these brands’ traffic.

However, despite a slowdown in profits over the past few years, Darden Restaurants still maintains its narrow economic moat, due to its scale advantages, and bargaining power with suppliers. Furthermore, the company’s ownership of 50% of its locations gives them more flexibility to renovate or relocate units. This advantage will favor the firm in its initiative to remodel 430 Olive Garden restaurants, assimilating them to the farmhouses in Tuscany, Italy.

So, with core brands suffering from stagnant traffic, the company will have to focus on the SRG brands to keep its operating margins afloat. Nevertheless, the firm still maintains a history of high shareholder returns, and currently offers an exciting dividend yield of 4.10%. Also, with the stock trading at a price discount of 25% relative to the industry average, this might be a good moment to buy it cheap. Investment guru John Hussman also seems to feel bullish about Darden Restaurants, since he added nearly 60% to his already existing shares.

A Mexican Grill Worth Your While

[/b]Chipotle Mexican Grill is the market leader of the $7 billion, fast-casual Mexican restaurant sector. Its 1,500 restaurants, spread out through 43 states in the U.S, as well as Canada, the UK, France and Germany, have helped the firm earn $2.7 billion in sales last year. With a nearly 30% market share of the fast-casual restaurant industry, the company easily overrides competitors like Qdoba or El Pollo Loco.

Despite industry volatility and fast paced competition, Chipotle has demonstrated remarkable top-line growth and margin expansion. Its success is due to the simple, but customizable 65,000 menu combinations at an average price of $10 per customer. From burritos to tacos to salads, consumers can choose between fresh, high-quality ingredients, including four types of meats, and a wide range of extras. This culinary experience at an affordable price, along with the visually pleasing restaurant design, allows the firm to captivate an ample share of the fast-casual restaurant consumers.

Another point in favor of Chipotle is its ability to drive unit expansion forward effectively. As a fast-casual operator, the company faces lower real estate and labor costs than traditional casual diners, like Darden Restaurants. This will allow the firm to keep pushing new unit openings, attracting higher traffic, and increasing profitability. A good example is the recent inauguration of the third Asian-themed ShopHouse, Southeast Asian Kitchen, in Washington, D.C. The company has also made a point of brand differentiation, by tagging its products as genetically modified organism (GMO)-free. This strategy is likely to earn it a solid and loyal customer base, boosting traffic numbers yet again.

Although this company is on the rise, there are some issues that could slow down profits. Given a shortage of naturally raised meat suppliers, pricing may be unpredictable in the future. Also, the company is susceptible to commodity inflation, which could hurt operating margins. And, with the stock trading at a raging price premium of 117% relative to the industry average, investors should maybe wait for a more convenient entry point. Nevertheless, I feel bullish about Chipotle’s future, and investment guru Frank Sands must think similarly, as he recently purchased nearly 3 million company shares.

[b]Two Bright Prospects, but Only One Bargain
[/b]So, after comparing these two companies I feel most optimistic about Chipotle Mexican Grill. Despite its current price premium, this could be a great long-term investment, especially given its international market expansion. On the other hand, Darden Restaurants might be a good short-term investment, given its cheap price, but I’m less confident in this firm’s future outlook.

[b]Disclosure: Patricio Kehoe holds no position in any stocks mentioned.


About the author:

Patricio Kehoe
A fundamental analyst at Lone Tree Analytics

Rating: 4.5/5 (6 votes)

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