Darden Restaurants Is Rolling Over, Prepare To Buy Lower
Summary
- Darden Restaurants is one of America's strongest restaurant stocks, yet its stock price has started to roll over.
- The entire industry has entered a difficult period with sky-high inflation, imploding consumer confidence, labor shortages, and supply chain issues.
- I expect the stock to fall to $100-$110 as investors will more than likely re-assess the valuation of consumer-focused stocks like Darden.
- However, that's good news for value investors, as better prices might be just around the corner.
Brett_Hondow/iStock Editorial via Getty Images
Introduction
It's time to talk about one of the most fascinating consumer stocks in America. Darden Restaurants (NYSE:DRI) is a rather straightforward company as it operates restaurants, yet it is delivering so much shareholder value in one of the most competitive industries - may be in the world. It's one of the few restaurant companies that can be considered a dividend growth stock with a good track record of high shareholder returns. And as much as I hate to say it, it's a black page in my history as I advised people to stay away during the peak of the COVID pandemic. I didn't know how bad COVID could get, but it thought me a lesson to look beyond drama. In this article, I'm discussing how I'm treating this company going forward. I believe that Darden will face significant headwinds as it deals with high inflation, imploding consumer sentiment, labor shortages, and supply chain issues. Additionally, COVID remains a longer-term risk.
In this article, I will give you the details and work you through my thought process.
So, without further ado.
Darden Outperformance
Darden has a $16.6 billion market cap. This makes it the 5th-largest stock listed company in the "restaurants" industry. It ranks below McDonald's (MCD), Starbucks (SBUX), Chipotle Mexican Grill (CMG), and Yum! Brands (YUM), meaning it's the largest restaurant focused on higher-quality dining.
In this case, we're in luck as Darden reported its 3Q22 earnings on March 24. That's the quarter ending February 24, 2022.
The numbers below show where the company makes most of its money. As of February 27, Darden owned 1,855 restaurants. That's 33 more compared to the prior-year quarter. 881 restaurants were Olive Garden followed by LongHorn Steakhouse (539). The other brands are combined in the "fine dining" and "other" segments. In this case, "only" The Capital Grille and Eddie V's are considered fine dining.
Looking at the bigger (sales) picture, it's fair to say that Darden is mainly casual dining as Olive Garden and LongHorn Steakhouse sales account for roughly 72% of total sales. These two brands account for 75% of total segment profit.
Darden Restaurants
The restaurant business is very, very competitive. Entry barriers are low, it's hard to retain clients once they have a bad experience, and headwinds include everything from labor, food inflation, pandemics, to the weather.
According to On The Line:
The restaurant failure rate is difficult to track nationwide, but the National Restaurant Association estimates a 30% failure rate in the restaurant industry.
Over the past 10 years, Darden has returned 294% including dividends. Beating the S&P 500 by roughly 4 points. That's impressive. Not only for a restaurant company, but because the performance dropped to almost zero during the pandemic (the time period would be different, but you get my point). Since then, the stock has outperformed the tech-heavy S&P 500 despite ongoing difficulties.
With regard to the dividend, we're not dealing with consistency and strength. The graph below shows per share dividends that were received in any given year. So, if a company hikes a dividend in December of year X, that hike is visible in the next year if that's the year when the dividend is paid.
What we see is a somewhat volatile history. The dividend has shown weakness prior to the pandemic. During the pandemic, the company suspended its dividend until September of 2020. Right now, investors receive a $1.10 quarterly dividend after a number of aggressive hikes. This implies a $4.40 annual dividend or a 3.3% yield. In the current environment, that's a high-yield investment.
TIKR.com
Unfortunately, I'm not that positive right now for a number of reasons.
Where It Gets Tricky
The point of me being negative towards Darden is not because I think that the company is doing something wrong, but because I'm cautious when it comes to economic developments.
As a starting point, let me use a short quote from Ambrose Evans-Pritchard's article in The Telegraph as he highlights the tricky environment quite well:
Mr Achuthan said the Fed is succumbing to the perennial pathology of central banks: having let inflation run loose it is now jamming on the brakes too hard after the cycle has already turned down.
In previous episodes the Fed blinked whenever the S&P 500 index fell by 10pc or so - the proverbial Fed "Put". This time inflation is so high that it might not blink until equities have fallen by 20pc or 25pc.
It will stick to its script until there is broken crockery everywhere, “meaning either a stock market crash, or a recession, or both,” he said.
Right now, we're facing a number of headwinds - some of them are related:
- High inflation - inflation is now at 7.9%
- Low consumer sentiment - close to the Great Financial Crisis lows
Both inflation and consumer sentiment are displayed in the graph below.
St. Louis Federal Reserve
This is what the direct comparison between the year-on-year change of the DRI stock price and Michigan consumer sentiment looks like:
Author (Raw Data: University of Michigan)
If consumer sentiment remains this low, we could see 20-30% more downside if it's accompanied by a recession.
Moreover, we're dealing with additional issues:
- Supply chain problems in various industries
- Labor shortages
- COVID (although it's fading quickly)
Darden Restaurants suffers from all of these problems. Its 3Q22 earnings came in below estimates. GAAP EPS missed by $0.17 as it came in at $1.93. Total revenue missed by $50 million.
The table below shows that things could have been worse. Restaurant EBITDA margins fell by 50 basis points to 19.4%. The main drivers were higher food and beverage prices and more expensive labor. During the quarter, wages were up 9%. The good news is that lower general and administrative expenses saved total operating income, which was mainly due to restructuring. I'm afraid that won't support margins on a longer-term basis if these inflationary pressures remain consistent.
Darden Restaurants
This is what the company commented on some of these issues:
However, Omicron impacted staffing for our supply chain partners in January as well. For labor intensive food production, this resulted in reduced supply and increased cost at a time when protein prices typically shift down from the heavy holiday buying season. Our distribution partners also experienced warehouse staffing challenges and driver shortages. Thus, we had expedited shipping costs and utilized more spot rate haulers in the quarter.
And with regard to the aforementioned EPS miss:
In fiscal January, however, we were significantly below our sales and profitability expectations as COVID cases surged, causing increased staffing shortages and reduced demand. We also experienced more severe winter weather than historical averages. As a result, sales were negatively impacted by over $100 million. This sales slowdown coupled with additional expenses related to sick pay, overtime and increased inflation, negatively impacted EPS by approximately $0.30 and was more than 100 basis points drag on EBITDA margins for this quarter.
Management also sees increasing cost pressure with inflation of 7% in its just-released quarter, which was higher than it previously assumed. Hence, the company ramped up pricing. In the third quarter, prices were 3.7% higher. In the fourth quarter, pricing is expected to be 6%. The way things are going, this won't offset input inflation. It's also worrying as these price hikes will be hard to swallow for casual dining customers.
Hence,
As a result, we now expect pricing to be just over 3% for the full fiscal year. This is well below our updated total inflation expectations of 6% for the year as we continue to execute our strategy of pricing below overall inflation to strengthen our value leadership position.
With regard to COVID, that's not an issue for now. Long-haul travel, for example, is still down, but things are recovering quickly now. However, bear in mind that Olive Garden's geographic footprint and guest demographics make it more sensitive to higher COVID cases, according to the company.
I cannot predict COVID, but I think it's a hidden risk here. It needs to be seen how the government (federal and state) react to a higher case count going into Fall when seasonal flu numbers rise. I think it could be a risk after the midterms.
Valuation
On a full-year basis (ending May 31, 2022), the company expects to generate EBITDA between $1.53 and $1.55 billion. Wall Street consensus is in the middle of that. After that, EBITDA is expected to gradually rise to $1.8 billion in the 2024 fiscal year with EBITDA margins of more than 16.0%.
TIKR.com
Using the $16.6 billion market cap and $370 million in expected net debt, we get an enterprise value of $17.0 billion. That's 11.3x FY2022 expected EBITDA.
Note that the valuation rate below is pre-pandemic as the impact of the pandemic on EBITDA ruined the y-axis. In this case, the valuation is fine. However, I believe that the stock will get cheaper as investors will increasingly price in inflationary pressures and lower economic growth.
For now, the company is "feeling good" about where it is in terms of inflation and pricing. However, I think that the market will re-price stocks in the consumer sector. Some of the best stocks on the market are now feeling the heat.
Right now, Darden is roughly 19% below its all-time high, making it one of the most severe corrections in recent history.
Personally, I'm looking for stock price weakness in the $100-$110 area. As consumer stocks are starting to roll over, investors can start to "de-risk" more quickly, causing restaurant stocks to underperform.
FINVIZ
And speaking of rolling over, this is what the ratio of equal weight consumer discretionary stocks (RCD) versus the S&P 500 looks like (black line) compared to consumer confidence. It's an ugly trend that I believe will cause a bit more damage to consumer stocks.
TradingView
So, with that said, let's summarize.
Takeaway
The restaurant business is one of the most competitive industries in the world. A third of restaurants close in their first year as competition is severe, it's hard to satisfy customers, and risks like inflation, labor shortages, weather, and others are always something to be aware of.
In this case, we're dealing with inflation at a multi-decade high, imploding consumer confidence, labor shortages, supply chain issues, and the risks of COVID coming back at the end of the year.
Darden is, historically speaking, a source of great shareholder wealth. The stock has outperformed the S&P 500 and not even the 2020 pandemic could end that.
However, right now, management is finding itself in a position where it needs to increase inflation expectations and menu prices, which is unlikely to be enough to offset input inflation. Expectations are that EBITDA margins will rise going forward, making the valuation look OK.
However, I believe that Darden will continue to roll over. I expect prices between $100 and $110 over the next few months as the industry (consumers in general) is weakening.
Don't go short, but use this as an opportunity to buy more at lower prices or to initiate a position if you are looking for restaurant/consumer dividends. I never recommend retail investors to go short anything. Buying future (expected) weakness is the way to go here.
(Dis)agree? Let me know in the comments!
This article was written by
Welcome to my Seeking Alpha profile!
I'm a buy-side financial markets analyst specializing in dividend opportunities, with a keen focus on major economic developments related to supply chains, infrastructure, and commodities. My articles provide insightful analysis and actionable investment ideas, with a particular emphasis on dividend growth opportunities. I aim to keep you informed of the latest macroeconomic trends and significant market developments through engaging content. Feel free to reach out to me via DMs or find me on Twitter (@Growth_Value_) for more insights.
Thank you for visiting my profile!
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.
This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
Recommended For You
Comments (9)
There are places selling $15 burgers, and $5 cookies, plus a lot of independents, and high end expense account dependent restaurants which will roll over first.
Not worried about DRI, at 16B when DASH is at 42B market cap.
I expect the stock to fall to $100-$110 as investors will more than likely re-assess the valuation of consumer-focused stocks like Darden.
However, that's good news for value investors, as better prices might be just around the corner."That is the kind of comment we see too often on these boards, although at least you say "more than likely" rather than something stronger. More than likely, food prices next year will reverse some of their gains - more normal weather in South America and Western Canada, increasing fertilizer output, less impact on food production from Covid, and perhaps more food/fertilizer from Russia/Ukraine.