Trouble Keeps Brewing at Darden


Source: Wikimedia Commons.

On Feb. 24, Starboard Value, an activist hedge fund, announced plans to press for a special meeting for investors of Darden Restaurants . The primary focus of the meeting, if conducted, would be to hold a non-binding vote encouraging Darden's management to reconsider the proposed spinoff of its Red Lobster restaurant chain.

As an owner of 5.5% of Darden's shares, Starboard believes that it bears the responsibility to prevent the business from engaging in a transaction that could, according to the hedge fund, destroy shareholder value.

Red Lobster is a mess!
Over the past three years, Darden itself has done pretty well. Between 2011 and 2013, the restaurant conglomerate successfully grew revenue by 14% from $7.5 billion to $8.6 billion. In terms of profitability, though, the company hasn't been quite as well off. With rising costs, particularly in its cost of goods sold, the restaurant chain has experienced a 13.5% decline in net income, which has fallen from $476.3 million to $411.9 million.

Much of the trouble stems from Darden's Red Lobster and Olive Garden restaurants. With the rise of fast-casual restaurants like Chipotle Mexican Grill and Panera Bread , more traditional concepts, such as those championed by Darden, have suffered. During its 2013 fiscal year, for instance, Red Lobster and Olive Garden reported a decline in comparable-store sales of 2.2% and 1.5%, respectively.

Heading into the new year, the company's situation worsened. In the second quarter of fiscal 2014, management reported that comparable-store sales for its Olive Garden operations contracted 0.6%. Red Lobster sales fared even worse, with a 4.5% year-over-year decline.

So what can be done?
In response to the poor performance of Red Lobster and Olive Garden, activist fund Barington Capital Group announced it had acquired 2.8% of Darden's shares. After news broke of the investment firm's stake, management was encouraged to spin off its two largest restaurant chains into a separate entity. By doing so, the company holding Red Lobster and Olive Garden could focus its efforts on reducing costs, while the company holding LongHorn Steakhouse, Bahama Breeze, and Darden's other chains could concentrate on growth.

Almost immediately, Darden announced that it would be willing to spin off Red Lobster while keeping its Olive Garden operations for the time being. In response to this announcement, Starboard Value began pressing management to reconsider its plan and explore alternative courses of action. These include creating a REIT (real estate investment trust) spinoff and/or dividing Darden into a business that includes Red Lobster, Olive Garden, and LongHorn Steakhouse while keeping its other five concepts in a separate entity.

Source: Darden Restaurants.

In the table above, where Entity A is the business that holds Red Lobster and Entity B holds those restaurants not spun off with Red Lobster, we can see the revenue and restaurant count of the three likely spinoff scenarios.

Something must get done!
Irrespective of what management elects to do about its assets, there is no question that something big must happen. Although the business has grown sales by 18.5% over the past five years, competitors like Chipotle and Panera are starting to eat Darden's lunch.

You see, over the past five years, revenue at Panera has grown an impressive 76%, from $1.4 billion to $2.4 billion. Chipotle has done even better. Between 2009 and 2013, the Mexican-style fast-casual chain grew revenue 112%, from $1.5 billion to $3.2 billion. Both companies benefited from a combination of more restaurants (after expanding throughout the United States) and rising comparable-store sales.

Because of these two growth factors, both Panera and Chipotle have succeeded in growing their bottom lines. Between 2009 and 2013, for instance, Panera's net income rose 128%, from $86.1 million to $196.2 million. Just as in the case of revenue growth, Chipotle did even better than Panera when it came to profitability. Over this time frame, the business saw its net income skyrocket 158%, from $126.8 million to $327.4 million.

Foolish takeaway
Right now, the situation facing Darden is not a pretty one. On top of being hit by competition that has it, as well as other rivals like DineEquity, Yum! Brands, and Ruby Tuesday, struggling to grow, it's trying to figure out the best way possible to please investors without losing face. Moving forward, it's difficult to tell what the company will do about its predicament, but the fact that it has so many different assets under its belt with potential for growth could provide the Foolish investor who trusts its management with significant upside.

Could Darden be the best company to hold for 2014?
Currently, Darden's situation is far from enviable. However, if management can decide on an efficient way to split up the company, it could create a lot of value for shareholders. Given this opportunity, is Darden the best stock to hold for 2014 or is there a better opportunity at hand?

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Daniel Jones has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Chipotle Mexican Grill and Panera Bread. 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.

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