Darden Has Value in Tough Sector

Darden Shares Hold Value in Overcooked Restaurant Sector

The latest financial results from Darden Restaurants (DRI - Analyst Report), reported yesterday, bolster our belief that restaurant sector’s recovery will be slower than investors expect.

The best-of-breed casual dining operator once again reported same-restaurant sales out-performed the industry, but they deteriorated markedly in May at two of the company’s three concepts, dropping 5% at both Olive Garden and Red Lobster, after rising 0% to 2% in March and April. Customer traffic plunged 8-10% at the two concepts. We suspect new promotions and discounting by competitors lured away Darden’s core value-conscious clientele.

For FY 4Q09 ended May 31, comps at both Olive Garden and Red Lobster dipped just 0.6%, but those of LongHorn Steakhouse fell 6.5%. Combined the restaurants same-store sales slid just 1.4%, far better than the 6.7% average drop in the casual dining industry Knapp-Track benchmark.

Darden’s out-performance was no surprise and reflects the durability of its strong brands and generous portions at reasonable prices, even in a recession.

But management of the bellwether chain sees no recovery on the horizon and expects the weakness seen over the last six months to continue for the next 12. To be sure, Darden expects blended same-restaurant sales at its three chains to be flat to down 2% in FY2010 ended May.

Casual dining competitors, including Red Robin Gourmet Burgers (RRGB - Analyst Report), California Pizza Kitchen (CPKI - Analyst Report), Cheesecake Factory (CAKE - Snapshot Report) and even Brinker International (EAT - Snapshot Report) are faring much worse -- a situation unlikely to improve dramatically.

In turn, we think the casual dining sector is over-valued and that achieving the 15% EPS growth implied by consensus estimates will be challenging. Kitchen and labor scheduling efficiencies, coupled with decelerating commodity prices, should more than offset the margin-squeezing effects of fixed occupancy costs on declining sales.

However, same-store sales are set to continue wilting, while unit growth has been nearly halted at most chains -- BJ’s Restaurant and Brewery (BJRI - Analyst Report) and Buffalo Wild Wings (BWLD - Analyst Report) remain two exceptions that are rapidly expanding.

Consequently, we recommend investors focus only on those operators with distinctive, skillfully operated concepts, reflected in superior ROE and growth prospects. Darden and Buffalo Wild Wings are two examples.

A testament to Darden management’s skill is its ability to generate ROE for the last twelve months of 25% in the middle of one of the severest recessions in decades. We expect earnings growth to accelerate to 7% in FY2010 (ended May) and to mid-teens in FY2011, after essentially no growth in FY2009. Trading at less than 11x depressed FY2010 earnings, we think the shares are a long-term value.

Likewise, Buffalo Wild Wings looks like a value. The sports bar and grill operator is trading at just 16% calendar 2010 earnings, despite an outlook for continued 20% to 25% earnings growth, while maintaining a mid-teens ROE.