Darden Restaurants: 3.8% Yield Makes Up For Expensive Valuation

| About: Darden Restaurants, (DRI)

Summary

Darden's transformation is well underway.

The stock is expensive at 23 times forward earnings after investor sentiment has greatly improved.

I like Darden as an income play but it's expensive on a fundamental basis.

Shares of ubiquitous restaurant operator Darden Restaurants (NYSE:DRI) have been on a tear since July after a multi-year period of trading in a relatively narrow channel. Shares are up from $43 to $58 in that short time period and spiking higher seemingly every day. DRI has been a battleground stock for years now as it has combated slowing traffic and earnings growth, trying to jumpstart both with new initiatives. After the spike, are shares still a buy? In this article I'll take a look at DRI to see if it could have a place in your dividend portfolio.

To do this I'll use a DCF-type model you can read more about here. The model uses basic inputs including earnings growth rates, which I've borrowed from Yahoo!, dividends, which I've set to grow at 4% annually and a discount rate, which I've set at the 10 year Treasury rate plus a risk premium of 6%.

 

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

             

Prior Year earnings per share

 

$2.34

$2.26

$2.52

$2.85

$3.22

$3.64

x(1+Forecasted earnings growth)

 

-3.40%

11.50%

13.05%

13.05%

13.05%

13.05%

=Forecasted earnings per share

 

$2.26

$2.52

$2.85

$3.22

$3.64

$4.12

               

Equity Book Value Forecasts

             

Equity book value at beginning of year

 

$16.04

$16.10

$16.33

$16.80

$17.55

$18.62

Earnings per share

 

$2.26

$2.52

$2.85

$3.22

$3.64

$4.12

-Dividends per share

 

$2.20

$2.29

$2.38

$2.47

$2.57

$2.68

=Equity book value at EOY

$16.04

$16.10

$16.33

$16.80

$17.55

$18.62

$20.06

               

Abnormal earnings

             

Equity book value at begin of year

 

$16.04

$16.10

$16.33

$16.80

$17.55

$18.62

x Equity cost of capital

8.25%

8.25%

8.25%

8.25%

8.25%

8.25%

8.25%

=Normal earnings

 

$1.32

$1.33

$1.35

$1.39

$1.45

$1.54

               

Forecasted EPS

 

$2.26

$2.52

$2.85

$3.22

$3.64

$4.12

-Normal earnings

 

$1.32

$1.33

$1.35

$1.39

$1.45

$1.54

=Abnormal earnings

 

$0.94

$1.19

$1.50

$1.83

$2.19

$2.58

               

Valuation

             

Future abnormal earnings

 

$0.94

$1.19

$1.50

$1.83

$2.19

$2.58

x discount factor(0.0825)

 

0.924

0.853

0.788

0.728

0.673

0.621

=Abnormal earnings disc to present

 

$0.87

$1.02

$1.18

$1.34

$1.48

$1.60

               

Abnormal earnings in year +6

           

$2.58

Assumed long-term growth rate

           

3.00%

Value of terminal year

           

$49.16

               

Estimated share price

             

Sum of discounted AE over horizon

 

$5.88

         

+PV of terminal year AE

 

$30.55

         

=PV of all AE

 

$36.43

         

+Current equity book value

 

$16.04

         

=Estimated current share price

 

$52.47

         

We can see the model produces a fair value of $52, several dollars lower than the $58 shares are trading for as I write this. That would lead us to believe that shares are moderately overvalued at this point but first, we need to understand what we're looking at. The model is intended to produce a price at which investors can receive a margin of safety when getting long. Given that shares are trading well above that price, it would appear that the margin of safety is zero. Let's take a look at the fundamentals to see if the fair value is valid or if there is more to this story.

Shareholders that have held Darden over the past few years certainly deserve a lot of credit for being patient. The company has struggled to maintain and grow traffic levels, there have been boardroom fights, and even high amounts of senior leadership turnover. However, after the storm passed the stock is up sharply on optimism for the future.

I think Darden is expensive at $58 per share. The stock is up huge in the last few months and the company's forward PE is now a mind-blowing 23. That is way too high for a company with DRI's recent history and expectations for future earnings. I just don't see it; I'd want to see earnings growth closer to 20% for the medium term before considering a forward multiple that high. I think the model got it right in forecasting a lower fair value than the current price because DRI has come too far, too fast.

That said, DRI is also moving in the right direction strategically. After struggling to grow its business for years, some substantial changes have taken place. The very public fight Starboard Value has taken to Darden has been resolved with the fund having its way with the senior leadership team. Keycorp is a fan of the move stating it will create shareholder value. Whether it will or not over the long term is yet to be seen but after being stagnant for years, I'm generally in favor of a management shakeup and it seems these guys know what they're doing.

Darden has also been hard at work with its transformation, trying different menu options, cutting costs and switching out its leadership team for new blood. Again, all of these things sound intuitive but they are difficult to execute on. It has been obvious from traffic numbers in recent years that Darden needed to revamp its menus and it is working on it. It also doesn't need the staff it once had so it's working on slimming down SG&A costs, including reducing unnecessary field management personnel. And the leadership team changes have been swift and all-encompassing, changing out virtually every top position within the company in recent months. The transformation is fully underway at Darden and I'm encouraged by the direction the company is taking.

However, that doesn't mean the stock is necessarily a good buy here. I think investors have bid the stock up to nosebleed levels when that kind of buying pressure is unwarranted by the fundamentals. Earnings are a real wild card for next year with so much change; there could be huge upside or downside to the company's forecasted earnings because we just don't know how all the changes will work out.

The reason many investors hold Darden - the dividend - is still very much intact. The stock is yielding a juicy 3.8% at present, even after the huge run up in shares, a massive yield in today's environment. Although Darden hasn't raised its payout in 18 months, next July has a decent shot at a moderate dividend raise. Even without it, the yield is huge and appears to be safe, drawing in income investors.

I really see that as the reason to own the stock right now; shares are too expensive on an earnings basis and should trade more towards $50 considering the fundamentals and uncertainty surrounding the transformation. I really like the dividend though and if you want income, DRI could be a great choice. I'd like to see it trade down a few dollars before pulling the trigger though. This business is on its way to a return to greatness but right now, I think that return to greatness has already been priced in.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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