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Shares in the restaurant operator tumbled Wednesday after weakness at newly acquired chains led to a profit shortfall
Darden Restaurants (DRI) is feeling the heat in other places besides its kitchens, missing a quarterly profit forecast and projecting lower growth this year as it deals with a dropoff in sales at two of its newest restaurant chains.
The world's largest casual dining company reported a profit of $43.5 million, or 30 cents a share for the second quarter of fiscal 2008, compared with $61.7 million, or 41 cents a share a year ago, as acquisition costs and other expenses offset a 17% gain in total sales from continuing operations. The results fell short of an average forecast of 50 cents a share among Wall Street analysts.
On Dec. 19, Darden's shares finished 21.3% lower at $28.60, nearly 20% the low end of its 52-week trading range.
Darden's latest results took a 12-cent hit from special items, including about nine cents in integration and purchase accounting adjustments related to its October acquisition of RARE Hospitality International, which owns the LongHorn Steakhouse and Capital Grille restaurants. Incremental financing costs trimmed another four cents off of earning, while litigation charges for the settlement of legal issues in California lopped off an additional two cents from profits.
Restaurant profit margins fell 1.5% during the quarter from the year-ago levels. Food costs climbed 0.3%, while the biggest impact came from labor and restaurant expenses, presumably reflecting negative operating leverage at Red Lobster and LongHorn, Citi Investment Research analyst Glen Petraglia said in a research note on Dec. 18.
The Orlando (Fla.) company also lowered its earnings outlook for fiscal 2008, saying it now expects profits to grow at 7% to 9% instead of the 10% to 12% range it previously had projected. That would translate to 2008 earnings of $2.70 to $2.75 rather than the $2.82 a share that Wall Street had been looking for, the Citi note said. Darden said the lower growth estimates are due to the adverse effect that depreciation in the U.S. dollar is having on commodities and the costs of products it imports from overseas.
Raymond James & Co. downgraded the stock to outperform from a strong buy rating, with analyst Brian Elliott saying that Darden's sales at stores open at least one year are no longer strong enough to offset its cost inflation, which seems to have risen significantly in the past three months. Investors who buy the shares at around $33 will be well rewarded over the next one to three years, Elliott predicted in a research note.
The RARE acquisition "is looking increasingly unfortunate," with Darden adding debt and risk in a tough industry environment at a time when it could rapidly be buying back stock at discounted prices with an underleveraged balance sheet, equity analyst David Palmer said in a UBS Investment Research note on Dec. 19. (UBS does and seeks to do investment banking with companies covered in its research reports.)
Lynne Collier, an equity analyst at KeyBanc Capital Markets in Dallas, agrees that the acquisition was poorly timed.
"[Darden] paid a premium price right before the valuations for the industry collapsed," she said. "When they announced the acquisition, valuations were still pretty strong for the restaurant industry." The $1.4 billion price tag was much higher than what the company would have paid for RARE even a few months later, she added. (KeyBanc expects to receive or intends to seek compensation for investment banking services from Darden within the next three months.)
Making matters worse is that RARE's brands, LongHorn and Capital Grille, have had unusually sharp drops in same-store sales, compared with Darden's signature Olive Garden and Red Lobster restaurants, she said.
In September, when Darden was finishing its due diligence on RARE's business, LongHorn's same-store sales were flat compared with the prior-year period but fell sharply – by 4.5% in October and by more than 3% in November – after the acquisition had closed. Darden manages its business for the long term, however, and probably saw a month or two of negative same-store sales for LongHorn as an aberration, not the start of an extended trend, Collier said.
LongHorn's same-store sales were hurt by a drop in promotions from last year and by the fact that a hefty 17% percentage of its 295 restaurants are locate in Florida, "the worst state for restaurant sales," which may be related to the state's outsized gain in foreclosure filings, Collier said.
In the second quarter, the LongHorn and Capital Grille restaurants contributed only 11% of Darden's total revenue. While those brands are important, "what's really important is that [Darden] keeps Olive Garden trending positively and that Red Lobster starts showing better numbers," Collier said.
Red Lobster's same-store sales have been very volatile, depending on the timing and frequency of promotions, she said. While the chain's overall trends have beat industry averages, consumers have said they think Olive Garden represents a better price-to-value proposition. And in the current economy, when consumers are increasingly feeling the crunch in their purses from higher gasoline and food costs, they're being more choosey about where they eat and want to go to places that offer the best value, she said.
Red Lobster is doing the right things to improve its business, including focusing on buying fresh fish and upgrading its facilities, but broader trends in the economy are hurting its sales, she said.
Darden's chairman and chief executive, Clarence Otis, said during a conference call to discuss the results that he thinks same-store sales will stabilize and grow over the next few months. One reason for that is the increase in gift card sales, which is up significantly this holiday season from last year, Collier said. She said she expects comparable-store sales to improve over the next six to 12 months.
During the conference call, Otis also said that despite the tough cost pressures, with the $40 million in cost savings expected to come from the RARE acquisition, "we're in a better position than in past to deal with the cost challenges."
In a CIBC World Markets note on Dec. 19, analyst John Glass said he suspected "there was disappointment on the pace of the $40 million in synergies, with the full $40 million not being reached until late fiscal year 2010." (CIBC does and seeks to do investment banking with the companies covered in its research reports.)
Although the double whammy of weakening sales and higher cost pressures is unprecedented, Darden is still the best operator in the casual dining industry, and with a cyclical recovery, these shares have significant upside potential, the CIBC note said.