Darden Restaurants: Patience Will Be Rewarded

| About: Darden Restaurants, (DRI)

Darden Restaurants (NYSE:DRI) is down 20% from a 52-week high, pummeled by declining earnings, industry headwinds, and weak guidance. At recent prices in the $46 area the dividend yields 4.76%, with a strong history of annual increases. The stock is an attractive value for patient investors, who can receive a generous dividend while awaiting a catalyst.

Overview

The company's self-description:

Darden Restaurants, Inc., the world's largest full-service restaurant company, owns and operates more than 2,100 restaurants that generate over $8.5 billion in annual sales. Headquartered in Orlando, Fla., and employing more than 200,000 people, Darden is recognized for a culture that rewards caring for and responding to people. In 2013, Darden was named to the FORTUNE "100 Best Companies to Work For" list for the third year in a row and is the only full-service restaurant company to ever appear on the list. Our restaurant brands - Red Lobster, Olive Garden, LongHorn Steakhouse, Bahama Breeze, Seasons 52, The Capital Grille, Eddie V's and Yard House - reflect the rich diversity of those who dine with us. Our brands are built on deep insights into what our guests want. For more information, please visit darden.com.

Valuation

Darden's fiscal year ends the last week in May. Using 4 years actual, plus an estimate of $3 for fiscal 2014, projected five-year average EPS works out to $3.19. Applying a historical average PE5 of 14.3, shares are worth $46, as a fair market value.

The company owns most of its locations, and the resulting depreciation creates a very strong cash flow, relative to reported EPS. On the 4Q 2013 conference call, management estimates cash from operations at $1 billion for 2014, and expects capex to come in somewhere between $600 and $650 million. $1,000 operating cash flow less $625 capex is $375, divide by 130.3 shares and FCF is $2.87 per share.

The company operates approximately 2,100 units, and plans to add 80 in the coming year, for a 3.8% increase. Add 2% for inflation, and growth works out to 5.8%.

Assuming growth at that rate for 5 years, and terminal growth at 3%, I apply an industry average WACC of 7.8% and develop an intrinsic value of $70 per share. I don't expect that Mr. Market will pay up any time soon.

I'm investing on the basis that shares, currently fairly valued, will increase an average 5.8% per year, to which I add 4.8% for the dividend. Rounding down, the prospect of a long-term return of 10% annualized comes into view. That's superior to any realistic expectation for the S&P 500 (NYSEARCA:SPY), with a 60 month beta at 0.87 and 36 month beta at 0.64.

The Dividend

The five-year history of increases is impressive. However, the current payout at $2.20 annually is 73% of a $3 estimate for fiscal 2014 earnings. The company's stated payout target has been 40% to 50%.

CEO Clarence Otis has said that the board will look at dividend policy later this year, bearing in mind that the dividend is very well covered by expected cash flows. There's a tension here between management's desire to retain the company's status as a dividend growth investment, and the need to keep dividend policy in a sustainable relationship with capex and other calls on capital.

It's more realistic to think of Darden in terms of value or yield than it is to look for a continuation of the past dividend growth rate. A cut is unlikely, given the cash flow coverage.

Margins

For the 10 years ending fiscal 2013, net income as a percentage of revenue averaged 5.66%. Guidance for fiscal 2014 works out to 4.1%. The decreasing margins have management's attention.

Any projection applying estimates for extended periods of time is iffy. However, assuming revenue growth at the previously developed 5.8% and eventual reversion to the mean on margins, EPS could reach $5.50 in five years. Applying a PE of 15, a share price of $82 emerges. From current share prices, that works out to 12.3% annualized appreciation, to which one could add the dividend, currently 4.8%.

Under a mean reversion scenario, the increased earnings will serve as a catalyst.

Potential for Value Liberation

The business model calls for the company to own the buildings and sometimes the land where the restaurants operate. In 1999 the properties were placed into two REIT subsidiaries, as a way to improve real estate management, and potentially to access capital markets. In 2013 one of the REITs was closed, and the properties returned to the operating companies.

Ruby Tuesday (NYSE:RT) has done sale/leasebacks as a way to access real estate values, using the proceeds to pay down debt. It booked substantial losses in the process. DRI has been taking small losses when disposing of underperforming restaurants, and it's reasonable to believe that gains on sale would occur if the company monetized the real estate supporting its profitable operations.

DineEquity (NYSE:DIN), after acquiring Applebee's, converted it to a 99% franchised business model. In the process, the company booked gains on disposition of assets, very material to net income. From the 10-K:

We achieved a significant milestone in 2012. With the refranchising and sale of related assets of 154 Applebee's company-operated restaurants during 2012, we realized our vision of becoming a 99% franchised company put in motion when we completed the acquisition of Applebee's five years ago. We believe this highly franchised business model requires less capital investment and general and administrative overhead, generates higher gross profit margins and reduces the volatility of free cash flow performance, as compared to a model based on operating a significant number of company-owned restaurants.

During Darden's 2/26/2013 Analyst/Investor Conference, CEO Clarence Otis framed a discussion of the company's strategic history in a way that emphasized a willingness to take decisive actions to address underperformance or seize opportunity, and an unemotional approach to long time relationships. It's worth reading.

On the Fiscal 4Q 2013 conference call, Otis briefly touched on strategic considerations:

I think Brad talked about the fact that we are -- the way we think about it, I guess, is that we are less capital-intensive as our base of restaurants continues to grow and generate incremental cash that comes from the new restaurants and the percentage of new restaurant growth on that base declines, we are less capital-intensive. And so we've talked about the fact that we like the portfolio we have. We don't expect to add brands. And so we would see that percentage growth declining a little bit.

Reading between the lines, I think the company took a hard look at their situation, and concluded that growth of about 80 new restaurants per year, emphasizing the Specialty Restaurant Group, would be the most capital-efficient approach to growing the company.

If that doesn't work, the strategic history (and culture) as interpreted by Otis permits decisive action as a catalyst. I would give it two years.

Caveats and Reservations

The Casual Dining industry is under considerable pressure from the increasingly popular Fast Casual competition. Competition in the form of discounts and specials has placed further pressure on margins, to which concerns for inflation of food costs can be added. Red Lobster hasn't been able to pass through the cost of shrimp, which has been in short supply due to problems with disease at aquaculture farms in Asia.

Consumers are devoting substantial resources to upgrading automobiles, many of which have been retained far beyond the usual replacement cycle. Similarly, new houses or renovations and maintenance to existing residences compete for the limited disposable income available. Meanwhile, raises are not keeping pace with inflation.

Don't forget the Affordable Care Act. How this will impact a company that takes pride in being on Fortune list of the best 100 to work for, and the only restaurant so honored, is debatable. Darden includes the expected impact in its 2014 guidance. Staying off the political hot button here, it's an issue that confronts everyone in the industry.

My take: management at Darden is well aware of the challenges the company faces. It has ample resources in the form of capital, relative size, capable employees at all levels, and information technology. I plan to monitor conference calls quarterly to assess management's effectiveness in dealing with the issues. The presumption is that it will be successful.

Disclosure: I am long DRI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.