Darden: A Lobster Spin-Off

12/30/2013 7:00 am EST


Our latest recommendation is a firm that has succumbed to pressure, from the activist hedge fund Barrington Capital, to simplify the company, explains Geoffrey Seiler, editor of BullMarket.com.

Darden Restaurants (DRI) will seek to spin-off its struggling Red Lobster brand, while also scaling back on opening new LongHorn steakhouse restaurants and suspending the opening of any new Olive Garden locations.

The company reported a 41% drop in net income for its fiscal second quarter ended November 24 and reduced its guidance for the full year. The combination of the partial breakup of the nation's largest operator of full-service restaurants, the profit plunge, and the weak guidance, sent the shares lower in early trading.

The company said it would also forgo the acquisition of additional brands for the foreseeable future, and would accelerate and enlarge a cost-reduction plan.

Darden said that while its intention was to execute a tax-free spin-off of Red Lobster, most likely in fiscal 2015, it would consider a sale, if offered the right price. Red Lobster has 705 restaurants in the US and generated approximately $2.6 billion in sales in fiscal 2013.

Darden's reported results, meanwhile, fell well short of expectations and the guidance cut weighed on the name. Darden reported that its second-quarter net income fell to $19.8 million, or 15 cents per share, from $33.6 million, or 26 cents per share, a year ago.

Darden's results were ugly, and its guidance poor, but in the long run, we think investors will embrace the plan to separate the tired Red Lobster brand, which, along with Olive Garden, has weighed on results for some time.

We also like that the company is taking its foot off the new restaurant gas pedal in the near term, to focus on getting the operations right at Olive Garden. A pause, until consumers are more receptive to casual dining chains, is appropriate.

The commitment to use the resulting savings from the lower capital outlays and restructuring efforts to return cash to shareholders and reduce Darden's debt should be music to investors' ears. The company is also refining its incentive plans to reward management for same-store sales and cash flow growth.

Barrington Capital wanted Darden to separate Olive Garden as well, but the Italian-themed chain has been at the heart of Darden's operations for some time and that was likely too big a leap for the company to make.

As it stands, Olive Garden will make up well over half of Darden's revenue and whether included in a spin-off or kept, it is imperative to get the business back on track.

The new COO Eugene Lee is more operations-focused and he's emphasized things like streamlining kitchen operations to improve service and save costs. Those kinds of small tweaks should pay-off in the long run.

As for a stand-alone Red Lobster, while the company will lose some buying power not being part of a larger company, it could give the new management more ability to take some chances to inject life into the brand. Better food and decor would be good places to start.

Kim Lopdrup, currently the President of the Specialty Restaurant Group, could look to reinvent Red Lobster into a healthier, more upscale chain, which is a little more appropriate for a seafood restaurant. We'd personally throw everything out the door except the biscuits.

Also important is Darden's commitment to return more cash to shareholders, including maintaining the existing dividend (and potentially grow it down the road). We think investors could consider opening, or adding to, positions on today's sell-off, as a company admitting its problems is the first step to solving.

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