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Betting on Darden Restaurants
Posted by: Fede Zaldua (IP Logged)
Date: December 11, 2013 05:22PM

Hedge fund Barington Capital is pushing Darden Restaurants (DRI) — also held by John Hussman and owner of Red Lobster and Olive Garden restaurants — to break itself up. Barington seems to think that the smaller restaurant chains owned by the company would trade at higher multiples since they are not suffering the customer losses Red Lobster and Olive garden are going through. As a matter of fact, the smaller restaurant chains owned by Darden are increasing their same-store-sales.

Another exciting opportunity hinted by many analysts would be to spin off Darden's huge real estate portfolio or, more directly, keep cutting costs further. With so many possibilities in the menu, should you consider buying Darden's shares?

Summing Up Darden's Parts

Generally speaking, casual dining chains like Red Lobster and Olive Garden are not going through a great moment in the U.S. According to JPMorgan analysts, traffic at casual dining chains has fallen as much as 20% during the last six years. That said, this does not seem to mean that breaking up Darden would make its shareholders richer. Darden's EV/EBITDA valuation, at 8.1 times, is very close to its peer group. In addition, according to Oppenheimer analysts, if we break up the company into pieces and assign to each piece its corresponding peer group average valuation, we would be approximately in the same place. Let's take a look at specific numbers taking into account that Darden's peer group is trading at 8 times 2015 EV/EBITDA.

In order to arrive at Darden's current valuation (8.1 times EV/EBITDA), Oppenheimer applies a 7.7 times EV/EBITDA multiple to Olive Garden, a 7 times EV/EBITDA multiple to Red Lobster, a 8.7 times EV/EBITDA multiple to LongHorn Steakhouse and a 10.8 times EV/EBITDA multiple to the Specialty Restaurant Group. Since restaurant chains that are good comps to every each part of Darden trade at a similar level to that now implied in the valuation of the entire group, Oppenheimer's valuation seems fair to me.

Hence, I believe that the key to unlock value from Darden must be somewhere else. It wouldn’t be a bad idea to start from cutting costs further — Darden has already cut costs by $50 million thanks to Barington's pressure. After all, Darden's operating expenses in terms of sales still are twice as those at Brinker (EAT), one of its closest competitors, which trades at 7.7 times 2014 EV/EBITDA.

Overall, before breaking up itself, Darden should make some internal adjustments to increase its free cash flow (FCF) generation. The company could start by cutting costs further and reducing its capital expenditures — which are well above the industry's average in terms of revenues — targeting an 8% FCF yield.

Bottom Line

Since I believe it shouldn’t be tough for Darden to increase its FCF through cutting capital expenditures and costs, I would be long on the company's shares. Moreover, I also think there is money to be made through spinning off the company's real estate portfolio.

Darden's already high 4.4% cash dividend yield could be increased before any spin off is made and an aggressive share repurchase program could also be on the cards. The potential is there; shareholders only need an open management to start making the necessary changes.

Stocks Discussed: DRI, EAT,
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