#RuggeroRespigo on #Reddit #stockmarket Darden Restaurants Analysis Note: This analysis is by no means exhaustive, but rather an introductory view and valuation to provide a quick overview of some different methods and psychological approaches an investor may take.OverviewIn 1934, Benjamin Graham coined a now common saying among value investors, most notably Warren Buffett, who states it thus, “When a management with a reputation for brilliance tackles a business with a reputation for poor economics, it is usually the reputation of the business that stays intact.” Darden competes in a very difficult environment, but it is managed by some of the best restaurant operators in the industry. While the economics of the business are not necessarily poor, Darden would likely struggle to post acceptable returns on capital without the aid of such an adept management team. As it stands, the company has managed to return an average 22.9% on equity over the last ten years with a standard deviation of only 3%, an outstanding showing for a business model that includes owning and operating all but 5 of its 2,138 restaurants rather than a model based on the much less capital-intensive franchising approach. Sadly, their skills in capital allocation do not match their operating prowess.The company sports industry leading annual unit sales of almost $4 million among its 2,132 units, for total sales of $8.55 billion. Darden’s two biggest brands, Olive Garden and Red Lobster ranked 2nd and 4th in average unit sales among casual dining restaurants, respectively, as well as 3rd and 4th in total sales. Longhorn represents the third of Darden’s four wheels, with total sales of $1.2 billion and average unit sales of $3 million. Olive Garden and Red Lobster are the most mature of Darden’s brands, with established brands and unit counts. This allows the two to produce large quantities of free cash flow after investing for growth, providing the holding company with $650 million in excess cash. Longhorn will soon catch up with its older brothers, and currently earns enough to finance its own substantial growth, as well as the increased marketing investment needed to support its almost 40 annual net new store openings.To supplement its more mature restaurant brands, Darden has used their excess cash production in recent years to build a substantial collection of growth-oriented brands, collectively called the Specialty Restaurant Group. This segment contains five brands with aggregate revenues that should surpass the $1 billion milestone in fiscal 2014: Yard House, The Capital Grille, Bahama Breeze, Seasons 52, and Eddie V’s. Total revenue for the group increased 58% in fiscal 2013 as a result of strong growth in the existing brands, as well as the acquisition of Yard House.Darden’s primary issue coming out of the Great Recession is the divergence of its customer base to the extremes of the restaurant spectrum. Rising asset prices have pushed affluent customers into the arms of more elite restaurants, and high unemployment dragged its middle class customers to the more value-oriented fast food chains. This has essentially created a vacuum in the middle for the casual dining industry, resulting in significant pressure on same store sales. As a result, revenue growth has had to come from increasing store counts, requiring relatively larger capital expenditures and hampering margins.Red Lobster SaleOn May 16, 2014 Darden announced the sale of Red Lobster to Golden Gate Capital for $2.1 billion. At the time, we felt that the transaction significantly undervalued either the Red Lobster 705 restaurant real estate portfolio or the operating restaurant itself, the combined value of which we estimated to be $2.6 billion at a minimum. Indeed, our fears were confirmed when Golden Gate Capital then turned over 500 properties to American Capital Realty for $1.5 billion in a triple-net sale leaseback transaction, implying a $2.1 billion valuation for the full 705 restaurants. This means that Golden Gate essentially got the brand name and restaurant operation cash flow for free.As excellent restaurant operators, Darden could have negotiated a similar transaction with American Capital Realty while retaining the operating rights, or alternatively, retained the real estate while selling the restaurant operations to Golden Gate. Either of these would have provided greater value for Darden shareholders in the absence of a sale price north of $2.5 billion for the entire business. Instead, Golden Gate ended up with 205 Red Lobster restaurants and the rights to operate the full 705 locations for a net price of $600 million, and ACRP is receiving an 8% cash cap rate on $1.5 billion of property with an initial lease term of 24.5 years and 2% annual rent increases.Darden’s allocation of the $1.6 billion in after-tax proceeds is also lackluster. Of the total, $1 billion is being used to retire a portion of the total $2.5 billion in long-term debt. This is an entirely inefficient use of cash now that we can reasonably estimate the value of Darden’s remaining real estate portfolio at $4 billion+, implying a very reasonable loan to value ratio of about 60%. Additionally, there is already room for Darden to decrease interest expense by instead refinancing the $100 million of 7.125% debentures due in February 2016 at the prevailing market rate of 1.6% and the $500 million of 6.2% senior notes due October 2017 at 1.8%. The full $1.6 billion could then be used to continue the growth of the Specialty Restaurant Group either organically or through further acquisitions, with the excess being distributed directly to shareholders via additional dividends or share buybacks. All of the above points to Darden’s need for stronger financial skill on the Board of Directors to supplement their skills in restaurant operations.Balance SheetThe Darden Balance Sheet is of a very high quality. Its investment grade debt is primarily fixed rate, laddered well in stages with maturities ranging from 2016 to 2037, and structured with a long weighted average duration. The fixed rate for extended duration is a key feature given the generationally low interest rate environment. The $2.5 billion in long-term debt is quite reasonable against the backdrop of Darden’s extensive, high quality real estate portfolio, discussed in detail during the Red Lobster sale commentary.Assuming Darden’s stated post-sale capital allocation, the company will carry $233.6 million in cash and receivables, along with an estimated $248 million in inventory. The remaining current assets will be comprised of $163 million in prepaid or deferred expenses and taxes, for a total of $644.6 million. The long-term assets will require adjustments to reflect the estimated value above carrying value. The carrying value for the real estate will approximate $2.943 billion after adjusting for the absence of Red Lobster properties, but given the prevailing private market value implied by the American Capital Realty transaction, we can apply a $4.3 billion market value to the 1433 remaining restaurants owned by Darden. Intangible and other assets will total $1.238 billion, bringing total adjusted assets to $6.183 billion.On the liabilities side, $235 million of the sale proceeds will likely be used to payoff short-term liabilities relating to Red Lobster, with a further $177 million being transferred to Golden Gate. This leaves $1.004 billion in short-term liabilities. Long-term debt is carried at cost, but the remaining $765 million that Darden plans to use retiring debt will have to be deployed at prevailing market prices. Assuming Darden targets its debt with the highest coupon rates, it will require $109 million to retire the 2016 debentures carried at $100 million and $570 million to retire the 2017 senior notes carried at $500 million. This leaves the final carrying value for long-term debt at $1.896 billion. Adjusted deferred taxes and rent will total $478.2 million, capital leases $52.5 million, and $325.4 million other liabilities. Summing the adjusted liabilities side, we arrive at a total of $3.756 billion.Subtracting total adjusted liabilities from adjusted assets, the resulting figure is $2.427 billion. Assuming Darden completes its newly planned $700 million share repurchase resulting from the Red Lobster sale, the company would manage to buy 14 million shares at the daily average 2014 price per share of $49.96, bringing total shares down to 117.6 million. Dividing this into our adjusted book value of $2.427 billion, we arrive at a final per share net asset value of $20.63.Income StatementThe income statement adjustments are a bit more straightforward. Red Lobster accounted for about 30.5% of both sales and profits, so we can just back it out of the revenue and certain expense accounts. We will first analyze the income statement assuming a no-growth scenario. First, last year’s revenue of $8.552 billion minus the contribution from Red Lobster is $5.952 billion. The 10 year average for Cost of Goods Sold as a percentage of revenue is 77.3% with minimal deviation, while the 5 year average is 77.22%. Averaging these figures together and applying it to our revenue estimate, we arrive at total COGS of $4.599 billion, producing a net gross profit of $1.353 billion. Using the same method to estimate SG&A and Depreciation expenses projects $570 million and $275 million, respectively. The new figure for net interest expense of $89 million results from our balance sheet adjustments and the projected debt retirement resulting from the Red Lobster Sale. Taken together, the resulting pre-tax income estimate is $422 million. Applying a tax rate of 26.3% based on historical figures reduces this $422 million to a final net income figure of $311 million.To convert this earnings estimate into a valuation, we need first to apply a required rate of return. The historical on the S&P 500 including dividends is approximately 9.5%, so it seems reasonable to consider this the opportunity cost at which to discount future cash flows. $311 million divided by this 9.5% discount rate produces a total value of $3.274 billion. Dividing this by the diluted share count of 117.6 million calculated in the balance sheet section gives us estimated average EPS for continuing operations of $27.84. Note that this exceeds the previously estimated post-sale Net Asset Value of $20.63, reflecting Darden’s competitive advantage in restaurant operations. There is a problem however, the current market price for Darden stock is $49.72, far above either of our value figures. Using our trusty discounted cash flows formula, we find that the market price implies perpetual growth of 4.2%. From 1790 to 2013, real GDP growth in the United States was 3.74% annualized. In our view, it would be very difficult (read, mathematically impossible) for Darden to grow earnings faster than the U.S. economy forever. This is particularly problematic given Darden’s performance over the past decade. Even against the backdrop of fairly consistent revenue growth, earnings have had trouble producing an equivalent performance, with a tendency to fluctuate around an average in a linear, rather than exponential, fashion. The combination of this inconsistency and the mathematically unrealistic growth expectations implied by the market price lead us to doubt the wisdom of a long-term investment in Darden at such prices. Note that the Red Lobster sale, including Darden’s added allocation to share repurchases, reduced per share earnings from $3.13 to a projected $2.64. If future growth is not changed a result, that transaction is a 15.6% destruction of shareholder value. In order to justify the sale, Darden’s growth will have to increase by at least 1% annually from what it would have been prior to the sale, and this is in addition to the 4.2% already required to justify the current market price.
Posted on: Tue, 02 Sep 2014 20:29:51 +0000
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