Darden analysis: Analysts may be too optimistic

Market Realist

Strategic analysis: Should Darden spin off its brands? (Part 20 of 25)

(Continued from Part 19)

Darden not undervalued at this moment

The valuation of a company depends on growth and risk. At its current price of $51.70 a share and forward PE (price-to-earnings) ratio of 16.91x as of October 27, 2013, we think Darden isn’t undervalued—especially since shares have risen 7% from the announcement of Barington Capital Group LP’s stake. Although trailing PE ratios are often used, they’re best applied to mature companies with similar growth. When growth isn’t moving at the same place, it’s preferred to use valuations based on forward earnings because the market is future-looking. This is one reason you tend to see high-growth companies with higher valuations.

Why Darden isn’t undervalued

In our analysis, we used analysts’ average calendar year 2014 earnings per share to calculate forward PE. The chart above shows a strong negative relationship between the price that investors are willing to pay for 2014′s earnings and interest coverage—the ability for the company to pay interest. The higher the interest coverage, the higher the forward PE.

This is normal because companies with lower coverage ratios are often deemed more risky. This is because the ratios reflect a higher probability of being unable to pay interest or that the company has too much debt. So while the average PE ratio of BLMN, EAT, CAKE, TXRH, and DRI is 17.96 (higher than Darden’s current forward PE ratio of ~17x), Darden’s isn’t undervalued on the above chart.

Analysts may be too optimistic about Darden

Reliance on analysts’ estimates for future growth is a drawback of the forward PE multiple. You can also develop your own estimates. Current estimates call for around 5% to 7% growth in earnings for 2014. But unless Darden succeeds in bringing down costs and keeping its same-store sales growth from falling further, an increase of 5% to 7% in EPS (earnings per share) seems a bit out of reach. The company recently reported a quarterly EPS decline of 37.7%! A continual slide in earnings is a risk that could bring share prices down as valuation maintains itself.

Despite Barington Capital Group’s and Howard Penney’s calls that the company must do more to generate shareholder value, analysts’ responses have been mixed. According to a report on Reuters, Oppenheimer has said it doesn’t believe a breakup makes the most sense (especially off such weak numbers) and there are other ways to create value—by reducing capital expenditures to raise stock price. An analyst with Telsey Group agreed.

Reducing capital expenditure isn’t going to solve the problem

Reducing capital expenditure to raise stock price is a possibility, given that most investors who are holding on to Darden have probably been income or dividend investors and they’re more focused on cash flow than growth. Less money on expansion for Olive Garden and Red Lobster means more cash for the company if the return from investing in new restaurants is poor. One thing that almost all analysts agree: better to focus more on free cash flow generation rather than unit growth.

Although it’s highly unlikely that Olive Garden and Red Lobster would suddenly vanish, reducing capital expenditure isn’t enough if Darden is losing customers. Poor earnings and profits will eventually hit dividend growth and dividends. As long as competition from fast casuals remains intense and people switch towards cheaper and quicker meals, as we’ve discussed earlier, Darden’s shares aren’t going to see much growth. It’s times like this, when performance is dropping, that companies must do something. If performance worsens, that’s the time companies must do a spinoff.

Continue to Part 21

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