Darden Restaurants: Popular Food, Unpopular Stock
Darden Restaurants (DRI) is the world's largest full service restaurant company, with over 2,100 operations in North America. If you haven't visited one of their chains, it seems especially likely that you have at least heard about one of the eight brands: Red Lobster, Olive Garden, Longhorn Steakhouse, Bahama Breeze, Season 52, The Capital Grill, Eddie V's and Yard House.
Presently, it seems as though the popularity of the food might become masked by an unpopular stock. Now there are a variety of concerns that arise from the current operating environment: greater competition, difficult marketing and lower guidance to name a few.
For instance, instead of spending say $25 for a two-person meal at Olive Garden, the consumer has the option of frequenting a Chipotle (CMG) or Panera (PNRA) instead. In addition, there are many close substitutes like the Cheesecake Factory (CAKE), Maggiano's (EAT) or Carrabbas (BLMN). You can make a case for your favorite selection, but really they all provide similar services and entrees. And of course Darden's other brands face similar competition.
It follows that marketing becomes fundamentally important to Darden's underlying business. Which - according to Morningstar analyst R.J. Hottovy - has been lackluster due to "ineffective promotional strategies and a lack of new menu innovations." Even Darden CEO Clarence Otis noted this industry necessity in Darden's most recent Annual report: "We began to match competitive promotional intensity around affordability, which involved being more aggressive with the pricing of our offers." There are simply many more affordable quality options out there than there were just a decade or two ago.
Finally, if the company comes out and tells you that it's going to make less money this year, that's probably a pretty good indication that everything isn't perfectly rosy. Yet it should also be noted that management appears focused on the task at hand.
So to be sure, there are a variety of risks associated with an investment in Darden Restaurants - even beyond what was just mentioned. However, I would like to point out a Warren Buffett quote that might be applicable: "Most people get interested in stocks when everyone else is. You can't buy what is popular and do well." If the future was clear and everyone thought Darden had terrific short-term prospects, then more people would be interested. In turn, an investment in Darden would likely be comparatively more expensive. Again, we're not suggesting that Darden isn't without risks. All that we're suggesting is that a negative short-term view has the potential to be beneficial if coupled with a positive long-term outlook.
For instance, when the company's operating results are presented below you will notice that Darden held up exceptionally well during the most recent recession. It follows that perhaps this current environment isn't quite as a bad as it might seem. Conceivably, if Darden could retain its same level of profitability in 2009, then it might be able to grow in the years to come.
Consider trying to get a table at Olive Garden on a Friday night. Maybe your experience has been different than ours, but it seems that people are consistently willing to wait.
Or perhaps you believe that the current dividend - now sitting at a yield around 4.7% - is sustainable over the medium-term. If so, an investor doesn't need too much growth or good news to achieve reasonable returns.
Speaking of sustainability, Darden has made strong strides in this area suggesting: "great companies understand and embrace their obligations to society." For instance, the company has already exceeded its 2015 goal to reduce water usage by 15% - translating to more than 1 billion gallons of water saved. Further, Darden is involved in projects like rebuilding troubled fisheries and is working to reduce their overall footprint. It's uncertain whether or not these initiatives will pay off financially, but it certainly appears to moving towards a sustainable path.
Finally, it's not altogether unreasonable to look for realistic growth moving forward. From the 2013 Annual Report, Clarence Otis suggests that the specialty restaurant group brands have: "the potential to deliver 17-19% total sales growth... driven by new restaurant growth." Additionally, the recent announcement of 13 new units opening in Asia might prove to be a valuable addition to their already growing international base.
Despite the risks and inherent competitive nature in the industry, Darden is still the largest casual dining operator. In tandem, this brings efficiencies of both scale and scope that enable the company to continuously evolve. Given the short-term negative outlook, it would seem that Darden is at the very least worthy of a closer look.
15 Years of Growth
Darden Restaurants has grown earnings (orange line) at a compound rate of 11.8% since 1999, resulting in a nearly 6 billion dollar market cap. In addition, Darden's earnings have risen from $0.90 per share in 1999, to today's forecasted earnings per share of approximately $3.23 for 2013. Further, Darden Restaurants has been paying a dividend (pink line) since 1995 and has been able to increase this payout for the last decade.
For a look at how the market has historically valued Darden Restaurants, see the relationship between the price (black line) and earnings of the company as seen on the Earnings and Price Correlated F.A.S.T. Graph™ below.
Here we see that Darden Restaurants' market price previously began to deviate from its justified earnings growth; starting to become undervalued during the recent recession and coming back to fair value as of late. Today, Darden Restaurants appears to be reasonably valued in relation to both its historical earnings and relative valuation.
In tandem with the solid earnings growth, Darden shareholders have enjoyed a compound annual return of 10.9% which correlates closely with the 11.8% growth rate in earnings per share. A hypothetical $10,000 investment in Darden Restaurants on December 31st, 1998 would have grown to a total value of $46,038.60, without reinvesting dividends. Said differently, Darden shareholders have enjoyed total returns that were roughly 2.8 times the value that would have been achieved by investing in the S&P 500 over the same time period. It's also interesting to note that an investor would have received approximately 3.4 times the amount of dividend income as the index as well.
But of course - as the saying goes - past performance does not guarantee future results. Thus, while a strong operating history provides a fundamental platform for evaluating a company, it does not by itself indicate a buy or sell decision. Instead an investor must have an understanding of the past while simultaneously thinking the investment through to its logical, if not understated, conclusion.
In the opening paragraphs a variety of potential risks and opportunities for growth were described. It follows that the probabilities of these outcomes should be the guide for one's investment focus. Yet it is still useful to determine whether or not your predictions seem reasonable.
Twenty-nine leading analysts reporting to Standard & Poor's Capital IQ come to a consensus 5-year annual estimated return grow rate for Darden Restaurants of 7.5%. In addition, Darden Restaurants is currently trading at a P/E of 14, which is inside the "value corridor" (defined by the orange lines) of a maximum P/E of 18. If the earnings materialize as forecast, Darden Restaurants' valuation would be $57.90 at the end of 2018, which would be a 9.2% annualized rate of return including dividends. A graphical representation of this calculation can be seen in the Estimated Earnings and Return Calculator below.
Now, it's paramount to remember that this is simply a calculator. Specifically, the estimated total return is a default based on the consensus of the analysts following the stock. The consensus includes the long-term growth rate along with specific earnings estimates for the next two upcoming years. Further, the dividend payout ratio is presumed to stay the same and grow with earnings. Taken collectively, this graph provides a very strong baseline for how analysts are presently viewing this company. However, a F.A.S.T. Graphs' subscriber is also able to change these estimates to fit their own thesis or scenario analysis.
Since all investments potentially compete with all other investments, it is useful to compare investing in any prospective company to that of a comparable investment in low risk treasury bonds. Comparing an investment in Darden to an equal investment in a 10 year treasury bond, illustrates that Darden Restaurants' expected earnings would be 3.3 times that of the 10 Year T-Bond Interest. This comparison can be seen in the 10-year Earnings Yield Estimate table below.
Finally, it's important to underscore the idea that all companies derive their underlying value from the cash flows (earnings) that they are capable of generating for their owners. Therefore, it should be the expectation of a prudent investor that - in the long-run - the likely future earnings of a company justify the price you pay. Fundamentally, this means appropriately addressing these two questions: "in what should I invest?" and "at what time?" In viewing the past history and future prospects of Darden Restaurants we have learned that it appears to be a strong company with reasonable upcoming opportunities, notwithstanding the short-term pressures. However, as always, we recommend that the reader conduct his or her own thorough due diligence.
Disclosure: Long DRI at the time of writing.