Darden Restaurants: 37% Below Fair Value

You may not recognize the Darden name, but chances are you've eaten at one of the firm's restaurants. Darden Restaurants (DRI) owns the Red Lobster and Olive Garden chains, both clear leaders in their respective casual dining categories.

With a relaxed atmosphere and a moderately priced menu, there is often a waiting list to sample Olive Garden's Italian cuisine. In fact, the chain has been a model of consistency over the past decade, posting same-store sales gains for a remarkable 53 consecutive quarters. As a result, the average Olive Garden unit now rakes in almost $5 million in annual sales.

Meanwhile, Red Lobster maintains a commanding lead in the seafood category. Almost 150 million guests visited a Red Lobster location last year, and those diners have voted the chain the nation's best seafood restaurant for 18 consecutive years, according to Restaurants & Institutions magazine.

With mature restaurant chains, growth can sometimes be hard to come by. However, management has done a good job of squeezing more revenues out of its existing store base, even in a tough operating climate that sees many diners eating out less. Over the past four years, Darden has seen its annual sales climb from $4.5 billion in fiscal 2003 to $5.5 billion in 2007. Meanwhile, earnings from continuing operations have jumped +93% over the same period to reach $2.53 per share.

And there is still room for further expansion. There are currently about 1,300 Olive Garden and Red Lobster units in operation throughout the U.S. and Canada, and management plans to add dozens more this year. The addition of newer concepts also has the potential to create a meaningful impact over the next few years. While the firm's Smokey Bones barbecue restaurants never picked up much traction (the chain was sold last December for $80 million), others like Bahama Breeze and Seasons 52 are still in the early growth stages.

Perhaps the biggest catalyst, though, is Darden's recent acquisition of RARE hospitality, owner of LongHorn Steakhouse and Capital Grille. With nearly 300 restaurants, LongHorn is well on its way to becoming a national brand, and the purchase gives Darden a firm foothold in the $13 billion steak segment -- almost as large as Italian and seafood combined.

Thanks in part to the acquisition, as well as continued organic growth from the firm's flagship brands, revenues are expected to rise +20% this year. And it's a safe bet that much of the company's cash flows will continue to be funneled into stock buybacks. Since 1995, Darden has repurchased 162 million shares, and currently only has 143 million shares outstanding.

Like others in the casual dining space, Darden has been hit with the double-whammy of rising food prices and lighter restaurant traffic. And over the past couple months, the shares have slipped from $40 to around $31. With that decline, the company is now valued at just $4.5 billion -- about 70% of this year's expected sales of $6.7 billion. And according to my calculations, the shares have the potential to appreciate +37% before reaching their fair value.

The current macroeconomic environment may remain tough for the near future, but Olive Garden and Red Lobster are proven brands that have made Darden the world's leading casual dining company. Once the dark clouds lift, the shares should see renewed buying interest.

Disclosure: None

Comments

[ballsschweaty]

Are you sure it's not 39% undervalued? How about 43% undervalued?

[Comment edited for abusive language. Commenter put on watch.]

[valueinvestor123]

Do you care to share your calculation to how you get to 37% or do you just want to throw the number out there. I am sure if I rushed to my portfolio manager and said, "I found a stock that is 37% undervalued. I won't show you the calculations, but take my word for it." They would be a bit hesistant to jump all over the idea. Also I like how you think its undervalued, but do not own any shares. Way to show real conviction!