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Shares of Darden Restaurants (DRI) saw a correction on Friday after the restaurant company released its first quarter results.

While the current dividend yield looks attractive, the payout ratio and earnings multiple is a bit high, given the stagnant operating performance. I don't think the current yield provides enough margin of safety and remain on the sidelines, but will reconsider my opinion if shares were to fall further.

First Quarter Results

Darden Restaurants generated first quarter revenues of $2.16 billion, up 6.1% on the year before.

Net earnings fell by 36.4% to $70.2 million. Diluted earnings per share fell by 37.7% to $0.53 per share. Earnings badly missed consensus estimates of $0.70 per share.

Looking Into The Results

Revenue growth was driven by the acquisition of 46 Yard House restaurants and 103 net new restaurant openings. The company reported a 3.3% blended fall in same-restaurant sales for Olive Garden, Red Lobster and its LongHorn Steakhouse chain.

Sales at Oliver Garden fell by 0.4% to $918 million, driven by a 4.0% fall in comparable sales, mostly offset by 35 net new restaurant openings.

Red Lobster's sales fell by 5.5% to $624 million, driven by a 5.2% fall in comparable sales and a restaurant closure.

LongHorn Steakhouse sales rose by 14.2% to $325 million, driven by 47 new restaurant openings and a solid 3.2% increase in comparable sales.

Specialty Restaurant sales rose by 72.7% to $282 million, mainly driven by the acquisition of Yard House.

Total operating expenses rose by 266 basis points to 78.82% of total revenues. Food costs were relatively stable, up 12 basis points to 30.5% of total sales, yet the company expects some food cost inflation ahead. Labor costs were up by 112 basis points to 31.92% of total revenues as general expenses were on the rise as well.

As it typical for firms operating in the restaurant business, net profit margins are slim. Net earnings which totaled $70.2 million, equivalent of 3.3% of total revenues.

And Looking Ahead

To offset operational weakness, Darden is taking steps to reduce operating spending by some $50 million through job cuts and spending reductions. Operating costs savings for the fiscal year of 2014 are expected to reduce costs by $25 million, offset by $10 million in upfront costs, to re realized in the current quarter.

Diluted earnings per share are expected to fall between 3% and 5% for the full year of 2014 compared to last year. Underlying the profit targets are cost reductions, same-restaurant sales growth at the low end of a guided 0 to plus 2% growth rate, and the opening of new net 80 stores.

Note that last year's earnings, excluding special items, totaled $3.13 per share implying that earnings are seen around $3.00 per share for this year.

The company sees more volatility in the choppy market, given the changes the company is making to its two largest brands. The company is aiming to improve affordability and experience to drive traffic momentum again.

Valuation

Darden Restaurants ended the first quarter of fiscal 2014 with $108.9 million in cash and equivalents. The company operates with $2.72 billion in total debt, for a net debt position of around $2.6 billion.

Revenues for the fiscal year of 2013 came in at $8.55 billion, up 6.9% on the year before. Net earnings fell by 13.4% to $412 million.

Trading around $46 per share, the market values Darden at $6.0 billion. This values the business at 0.7 times annual revenues and 14-15 times annual earnings.

Despite the premium valuation, Darden is attracting investors by paying out a quarterly dividend of $0.55 per share, for an annual dividend yield of 4.8% at the moment. Hereby the company is paying out some 70% of last year's earnings.

Some Historical Perspective

Long-term holders in the stock have seen modest to good results. Over the past decade shares have roughly doubled from their low twenties toward $46 at the moment, after peaking as high as $58 at the end of last summer. After trading as high as around $54 in June of this year, shares are now at $46, trading flat for the year.

Between the fiscal year of 2010 and 2013, Darden has increased its annual revenues by a cumulative 20% to $8.55 billion. Net income stagnated just above the $400 million mark after peaking in 2011 and 2012.

Investment Thesis

Clearly the first quarter results were very poor. While the full year target calls for a limited fall in earnings, achieving this might actually prove to be quite a challenge.

While the summer has been really volatile there are some bright spots. The largest two chains, Olive Garden and Red Lobster, reported a 7.4% and 7.0% fall in comparable stores for July, respectively. This improved markedly to a fall of 3.2% and 1.7% in August. Also LongHorn reported solid growth in the final month.

The economy is recovering but the middle class is still seeing a drag from payroll tax increases, while Darden faces stiff competition from cheaper but good quality places from fast growing chains including Chipotle Mexican Grill (CMG) and Panera Bread (PNRA), among others. These places are mostly faster-dining chains, but with good quality food at cheaper prices.

The company is facing volatility in the overall restaurant industry, combined with volatility caused by the changes Darden is making at Olive Garden and Red Lobster. The focus is on increasing the affordability and improving the dining experience. The goal is to drive traffic momentum again.

Yet poor sales results and an expected 50 basis points increase in food costs will make it difficult to limit the fall in earnings this year. On the positive side, the company anticipates to achieve $25 million in cost savings, while the postponement of some of the Affordable Health Act will result in lower than expected costs as well.

Back in December of last year, I last took a look at Darden's prospects. I concluded that there was little upside with shares in their fifties, as I reiterate my conclusion today. The only real upside to shares is the fat dividend yield of 4.6%. Yet this represents a 73% payout ratio on this year's expected earnings as the company is valued around 17 times earnings.

I remain cautious despite the attractive dividend yield. I remain on the sidelines will to reconsider my stance when shares fall further toward their low forties.

Source: Darden Restaurants: Dividend Yield Not Enough Margin Of Safety