Not that long ago, I looked at Darden (NYSE:DRI), then trading in the $46 area, and opined that patience would be rewarded. Following the combination of a press release from activist investor Barington Capital and the company's next day response in connection with quarterly earnings, I closed my position, booking a small profit. With Starboard announcing its involvement, shares traded up (and over) the $53 area, and I sold short at that level. Why the sudden change of heart?
By way of background, Barington has proposed that Darden be split three ways: a mature company consisting of Red Lobster and Olive Garden, a growth company consisting of the other brands, and a REIT, holding the real estate. Darden now plans to spin off Red Lobster, and leave the rest of its operations under one roof.
Now Starboard Value, another activist, will be weighing in with an opinion similar to Barington's: they call for a three way split, with Red Lobster, Olive Garden and LongHorn as one company, the remaining brands as another, and a REIT.
Reassessing Ability to Drive Growth
After finding that Darden was fairly valued at $46, I saw intrinsic value at $71, based on a DCF analysis. Noting the company's history of growth by new restaurant openings, I postulated the ability to continue adding restaurants at a pace of 3.8% per year. Adding 2% inflation, growth was 5.8% for 5 years, and 3% thereafter.
However, the company's press release stated that they will not be opening new units at the previous pace:
Reduce unit growth, lower capital expenditures and forgo acquisitions: The reduction in new unit expansion will come primarily from suspending new unit growth at Olive Garden and more limited new unit growth at LongHorn Steakhouse, with new unit growth at the Specialty Restaurant Group continuing at a pace modestly below this year's level. The reduced unit growth will lower capital spending by at least $100 million annually. In addition, given the strength of the Company's brand portfolio post separation, the Company has determined to forgo acquisitions of additional brands for the foreseeable future.
Briefly, assumptions about future growth need to be revised downward, invalidating the previous DCF analysis.
Sour Notes on Monetizing Real Estate
Based on the premise that depreciated values normally understate the value of real estate, I suggested that ways could be found to liberate value. Barington's proposal called for a spin-off of the real estate into a separate REIT. Starboard's proposal is said to be similar.
The company's plan to enhance shareholder value blandly ignores the real estate. Curiously, prior to the fiscal 2013 10-K, the real estate was held in two REITs, so that either of them could have been spun off at an opportune time. Instead, one of them was closed. From the 10-K:
During fiscal 1999, we formed two subsidiary corporations, each of which elected to be taxed as a Real Estate Investment Trust ("REIT") under Sections 856 through 860 of the Internal Revenue Code. These elections limit the activities of both corporations to holding certain real estate assets. The formation of these two REITs is designed primarily to assist us in managing our real estate portfolio and possibly to provide a vehicle to access capital markets in the future. Both REITs were structured as non-public REITs.
During fiscal 2013, we merged one of the REIT entities into another subsidiary of Darden Restaurants, Inc. As a result of this merger, all restaurant property that was previously owned by the merged REIT was returned to Darden corporate entities that operate the corresponding restaurants at the sites. The second REIT remains in existence at the end of fiscal 2013 and continues to operate as a non-public REIT. Through our subsidiary companies, we indirectly own 100 percent of all voting stock and greater than 99.5 percent of the total value of the REIT. For financial reporting purposes, the REIT is included in our consolidated financial statements.
My guess is that the action was designed to place Red Lobster in full possession of its own real estate prior to a spin off. Barington suggests the need to include rent escalation clauses in order to make the proposed REIT spin-off marketable:
- Initial single tenant concentration issue will be mitigated in part by well structured, long-term leases with attractive rent step-ups and a solid credit rating.
- Will not include underperforming restaurants that "Darden-Mature Brands" may want to close or significantly remodel in the near term.
- REIT investors value predictable rent increases and are willing to lower their return hurdles to receive those low-risk increases, which translates into a premium valuation and increased liquidity that can be used to reinvest in the operating.
My interpretation: Underperforming restaurants have not been culled, and are unable to predictably pay attractive and increasing rents. There is only 100 cents in the dollar and the effort to market a REIT would saddle the restaurants with rent expense they cannot afford.
I've watched a few analogous situations deteriorate over the years. TravelCenters of America (NYSE:TA) was burdened by excessive rents owed to Hospitality Properties (NYSE:HPT), from which it was spun off, and with which it shared board members. Not pretty. Friendlys Restaurants (a restaurant/ice cream operation) was burdened by huge debt on its real estate, and limped along for years on razor thin margins before being taken private.
Red Lobster Brand Has Diminished Value
Darden has run an endless series of all you can eat promotions, focused on shrimp. Shrimp supply has been diminished by disease at the Asian aquaculture sites where most of it is produced. The publicity around this situation abnegates seafood's reputation as clean and nourishing food.
In an instablog, I remarked on the CEO's concept of investing in affordability:
But when CEO Clarence Otis talked about "investing" in affordability, he lost me. Investing the way he used it is about incurring expenses that create value, so from an entrepreneurial accounting point of view they are sort of capitalized and don't count on the profit and loss.
I'm not sure I see the value created when you train customers to look for the next promotional item before they go to your restaurant. Also, members of the obese nation are beginning to move away from the all you can eat outlook toward something a little healthier.
I should listen to myself sometimes.
What About Credit Ratings?
Darden has a fair amount of publicly traded debt, and is rated at Baa3 by Moody's and BBB- by S&P and Fitch, based on reviews conducted in October and December this year.
It doesn't matter whether you slice and dice Darden into two companies or three including a REIT, the debt needs to be repaid.
I sense a certain tone of toeing the line for rating agencies in Darden's press release. It's not unrealistic to imagine that the company's credit ratings would be reduced unless spending is curtailed and debt repaid. The coverage ratio on fixed charges has been deteriorating as earnings have declined.
As of August 25, 2013, the ratio of consolidated earnings to fixed charges stood at 2.7, down from 4.4 a year earlier. That's down from 5.4 in May 2011.
Possibly additional capital could be secured through arrangements other than publicly traded bonds. However, those who advance any such capital will protect themselves, and secure good size profits, a development that is unlikely to be favorable to retail equity investors.
What Happens to the Dividend?
A primary attraction of Darden has been the dividend, generous and backed by a history of increases. Over the past ten years, the payout ratio has gone from 5.9% to 72.8%. Now if this dividend is paid out to the owners of the proposed REIT, how can it also be paid out to owners of the residual mature Darden?
Barington's Proposal Requires a Greater Fool
Reviewing Barington Capital's performance as an activist, I see an uneven record and a penchant for confrontational tactics. It's possible that DRI's share price can be pushed higher as this plays out. Certainly with Starboard piling on, the day to day volatility will increase. There are negatives, as outlined above.
The REIT won't work unless the properties are cherry picked and loaded up with future rent increases. That would leave the mature company loaded up with an adverse selection of marginal properties and operations that are burdened by excessive rents.
Spinning off the successful brands is simply the reversal of the recent acquisition. It deprives mature Darden of its avenue for growth. It implies that Darden got a good deal, and amounts to flipping the acquired brands. I doubt that Darden underpaid for them.
Barington neglects to mention some concerned kibitzers hanging around the table - the rating agencies. They may not be inclined to hand out the "solid credit rating" which is supposed to go along with the leases. Darden's current Baa3 is awfully close to junk.
Monetizing real estate is not a panacea. Eddie Lampert was going to do great things with Sears (NASDAQ:SHLD) and its treasure trove of prime real estate. It's been a long time coming. The shares have spiked from time to time, but the trend is down, in an up market.
Barington's proposal amounts to creating a three way shell game and betting that somebody can be short-changed and bamboozled while things are moving around. Retail dividend investors are unlikely to fare well if they are drawn into the game.
I sold Darden short at $53.03 as a trade in my speculative account.