Darden Restaurants

 

This is a story everyone pretty much knows so I won't waste time with a long description, however I will provide the numbers for those who don't have them fresh in their minds.  Darden owns the Olive Garden (582), Red Lobster (682), Bahama Breeze (32), and Smokey Bones (126) restaurant concepts.  Its Olive Garden chain is currently in the sweet spot of the industry.  I personally have never seen one without a 30+ minute wait for dinner Thursday-Sunday (although I am sure they have their share of under-performing stores), and the lunch value menu can compete with McDonalds (for crying out loud!).  Olive Garden has the perfect combination of taste, environment, and price (and whether you personally agree or not on taste, I think it is clear that the consumers in general have spoken).

 

It is a well-known story, but I want to focus on a very specific angle: cash flow (with growth prospects also coming into play).  DRI trades for 15.4x earnings, with an EV/EBIT of 11.1x ... nothing to get excited about.  But when you dig into the cash flow numbers, I think there is a lot of value here, and what I would consider growth-oriented value at that:

 

Market Cap: $5,250M

LT Debt: $500M

Excess Cash: $0M

EV: $5,750M

 

Revenue: $5,720M

EBITDA: $759M

Depreciation: $233M

EBIT: $526M

Net Income: $338M

 

Cash from Operations: $717M

Cash to Investing: $324M

Cash to shareholders: $430M

Payout ratio: 125%

 

**ROA:11.5%**

**ROE: 26.6%**

 

P/E = 15.4x

EV/EBIT = 11.1x

EV/EBITDA = 7.6x

 

Focusing on cash flow, DRI is generating enough cash to pay all of its earnings out to shareholders via dividends and buybacks, while still having plenty of cash flow from depreciation to re-invest in new stores.  And of this $340M in CapEx, $240M is used to open new stores, while only ~$100M is used to maintain & improve current stores (according to Darden investor relations).

 

Cash from Operations: $637M (adjusted down by $80M, assuming slight reversal going forward to a normalized working capital)

Maintenance CapEx: $100M

Owner Earnings: $537M

 

If DRI were to decide to stop opening new stores, it would be generating $537M per year in free cash, a FCF yield to equity of 10.2% (using market cap instead of EV because FCF is after interest expense).

 

A 10.2% free cash flow yield is great.  So the questions to answer are: is this sustainable, and does the $240M in CapEx create value?  If the CapEx creates value, then investors are even better off than if the company paid out all 10.2%.  Looking at DRI's past ROI & ROE record as well as the current environment, I feel very comfortable that Darden's investment in expansion will achieve strong returns.  Analysts are estimating 12% EPS growth for the foreseeable future, which outpaces growth in equity capital substantially, meaning ROE should continue to expand.  They are already getting a 26% return on the earnings they retain, so I am happy to see them re-invest a portion of cash flow instead of paying it out to me.  However, I am equally happy to see them pay out a substantial portion as well, because (1) this keeps them disciplined in their expansion, and (2) I think businesses which are currently paying out large amounts of cash deserve a significant premium to those who only promise large amounts of future cash.

 

So where does the capital they do re-invest go?  Well, Olive Garden still has some room for growth (although it will never come close to the number of Applebee's stores as Olive Garden required a larger population & economic base):

 

Olive Garden (582 locations)

Outback Steakhouse (938 locations)

Applebee's (1,860 locations)

Ruby Tuesdays (833 locations)

 

It's easy to picture Olive Garden locations growing to perhaps that of Outback, especially if they were to aggressively pursue the international segment.  Other CapEx mostly goes towards the Smokey Bones concept, which struggled this year but management has taken steps to turn it around.  This concept may continue to struggle, but DRI's cash cows should more than overshadow any further underperformance.

 

To the second question (sustainability), the thing that brings this all together for me is that DRI has the classic Buffett characteristics: a consistent operating history, high returns on retained capital, good management, a great product, low prices, and sustainable advantages (customer experience, and taste -- one of the best kinds of advantage).

 

The bear case is there are (and have been for some time now) dark recession clouds on the horizon, so retail in general has of course been taking it on the chin.  But DRI has historically weathered economic downturns very well.  And I am one who subscribes to the "be greedy when other are fearful" philosophy.

 

Another bearish point is worries about the Red Lobster concept.  I remember looking at DRI a couple years ago when it was at $21 and passing on it because I wasn't comfortable with Red Lobster.  Here we are two years later (and 75% higher), and Red Lobster has proved its staying power by posting strong performance despite the pessimism.

 

Valuation:  My target is $50 a share, which gives a potential 40% upside for a company which is far too established to be trading with that much upside.  My valuation is based on a DCF using $370M in free cash flow, a 9% cost of equity (due to the low beta, and you've got to give them credit for high visibility in terms of being a growth company, yet paying cash out to shareholders now rather than hopes for cash far down the road, like most other growth companies), and analysts' 12% earnings growth rate followed by 3% in perpetuity.  I think one of the two ways analysts add value is to be able to identify differences in implied perpetuity rates and what the rate will likely do (hence Buffett's success investing in Coke ... he knew that the company could blow away the low-to-mid single-digit perpetuity rates).  I think DRI growth 5 years out could be much higher than 3%, but I don't want this to get ridiculous.  We'll just have to wait for each year to pass, with the analysts pushing their 12% rate out one more year, and with another year's cash hoard being placed in investors' laps.

 

Conclusion: With no investment in expansion, DRI offers a 10.2% free cash flow yield on its market cap.  With CapEx, there is plenty of growth left in the Olive Garden concept, plenty of value in the Red Lobster concept, and more opportunities internationally and in their newer concepts.  Two years ago I looked at DRI and passed because of excessive pessimism.  I'm not going to make the same mistake twice.