Darden Restaurants Could Bounce Higher On Lower Costs

| About: Darden Restaurants, (DRI)

Weak sales at its biggest chains and higher food costs have pushed shares of Darden Restaurants (NYSE:DRI) to the lower end of its range. Management is addressing its internal problem with costs and sales promotions while external factors may relieve other cost pressures. Shares could bounce higher over the next year as margins surprise and sentiment improves.

Not everyone wants Italian and Seafood

Shares of the largest publicly-traded casual dining company dropped almost 5% on first quarter earnings that missed estimates by a wide margin. Adjusted earnings per share of $0.53 were largely a result of heavy promotional discounting that failed to lure diners. Same store sales for the company's two largest chains were down between 4% and 5% on the quarter.

The company operates 2,138 restaurants in the United States and Canada, including 678 Red Lobster units, 822 Olive Gardens, 430 LongHorn Steakhouse units and 208 restaurants among the smaller chains of Capital Grille, Yard House, Bahama Breeze, Wildfish Seafood Grille and Seasons 52.

Management plans on increasing earnings per share by a compound annual rate of 10% to 15%, achieved by increasing same store sales by 2% to 4% per year and increasing the number of stores by 5% to 7% per year. The company has announced that it will cut spending by $25 million in the current year and eliminate as many as 85 jobs in operations.

Internal and external cost pressures should subside

The company has been one of the hardest hit by the dramatic supply disruption in shrimp. Disease in the largest three world exporters has cut supply and increased prices for shrimp by more than 50% over the last year. Seafood accounts for a quarter of Darden's cost of goods with shrimp accounting for a large percentage of the total.

The consensus for the full year is for $9.05 billion and $379 million in earnings. This would represent sales growth of 5.8% and a net margin just over 4%, both well within reason and maybe a little conservative. While revenue estimates are probably fairly close, I think a number of factors could contribute to lower costs and a higher net margin. My own estimate is for $452 million in earnings or $3.47 per share, almost 20% higher than the consensus.

First, management has announced its near-term focus on operating expenses and this should lead some improvement in margins. The $25 million in this year's savings is partially offset by about $10 million in costs to the restructuring program.

While the company is focused on improving same store sales, they will need to balance volume sales with the price of promotional programs. The two largest chains, Olive Garden and Red Lobster, have very strong brands and I think same store sales could rebound over the rest of the year.

A big contributor to the company's bottom-line could be moderation in shrimp prices. Shrimp grow to maturity within 3-6 months so it's possible that the current supply disruption could be reversed over the next year. This would significantly cut cost of goods and is something that has not been included in analyst expectations.

Adding to Short-term Alpha Portfolio

My view that earnings could surprise on the upside due to lower costs makes the stock a great inaugural addition to my Short-term Alpha Portfolio. This portfolio will take positions in stocks that have significant upside potential over the next year and catalysts that are not baked into current estimates.

Shares are trading at $46 per share with a 4.8% dividend yield. The price multiple of 14.7 times is higher than the five-year average of 13.1 times trailing earnings but is well under the industry average of 23.5 times. On my estimate for $3.47 in earnings this year, the shares should trade between $48.50 and $52.00 per share. My target price of $50 per share would yield a price return of 8.7% on top of the dividend yield.

Despite my short-term optimism for the shares, I don't think investors will want to be in it past the target price of $50 or for more than a year. The company does not manage costs very well and regularly disappoints investors, attributing weakness in the bottom-line to unexpected costs around promotional programs at its chain restaurants.

Management has committed to increasing the dividend each year, an admirable goal but it may run into the reality of struggling earnings. The problem is that the dividend payout is $287 million and would be 75% of consensus earnings next year. This means little will be left for future growth. Now dividends come out of cash flow and not earnings, but there is a fundamental relationship and the earnings of the company just do not support the current payout in the long-term.

For most positions in the Short-term Alpha Portfolio, I will seek to hedge weakness in the market or within the industry with a short position in a competitor. By selling shares of a company that is affected by the same industry or market trends, I focus my investment on just the upside potential in the target company and remove larger macro-event risk.

For the Darden Restaurants investment, I will short shares of the Wendy's Company (NYSE:WEN). The consensus estimate is for earnings to increase from $0.17 per share last year to $0.23 this year and for $0.27 per share in 2014. The nearly 60% increase in earnings runs counter to expectations of no sales growth this year and an 11% drop in revenue for 2014. I doubt that Wendy's will be able to boost profitability so significantly. The shares trade for a lofty 36 times trailing earnings, well above the industry average. Any progress on increasing the minimum wage, which already appears to be happening in California, will hit fast-food restaurants disproportionately and could lower earnings expectations further.

Darden Restaurants and Wendy
(Click to enlarge)

There are risks to the long-short strategy. Shares of Darden could fall while shares in Wendy's could increase, leaving me with a loss on both sides. I do not believe this will happen for the reasons stated above but will need to follow the two companies closely.

I will update return metrics and the portfolio history as more positions are added to my Short-term Alpha Portfolio. I plan on adding two to three positions per month for a minimum of ten holdings. This kind of portfolio is not for everyone and should only be a small percentage of your total holdings. There are risks to any market strategy and investors need to do their own research to make sure their own expectations merit a position in any individual company. As always, I look forward to any comments or suggestions on the portfolio and will be glad to answer any questions.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.