Why Darden’s dividend yield of 4.74% faces share price risk

Market Realist

Retirement picks: 4 restaurant stocks with dividends (Part 7 of 9)

(Continued from Part 6)

Darden’s target market: The middle class and mid price point

Darden’s facing a tough situation. Because its customers have largely been the middle class, Darden Restaurants Inc. (DRI) has performed very well pre-financial crisis when housing and stock prices were rising. Throughout the recession, the company was able to maintain its earnings growth, but it was driven by the addition of new acquisitions rather than organic growth. Since the recovery, the company’s Olive Garden and Red Lobster brands, which make up the bulk of its corporate revenue, have been struggling because consumers have been flocking towards cheaper alternatives amid a weak labor market recovery, rising competition from stores like Chipotle Mexican Grill (CMG), McDonald’s (MCD), and Yum! Brands Inc. (YUM), and an eroding middle class.

Promotions supporting same-store growth but hurting earnings

To keep customers coming back, the company has been giving out promotions and changing its menu so it’s more “value-based.” In fiscal year 2012, same-store sales grew 4.6% for its Olive Gardens brand, while Red Lobster saw declines of -1.2%. In fiscal year 2013, however, same-store growth fell to 2.4% for Olive Garden, while Red Lobster improved to -0.9%. Even though these promotions and changes have kept customers coming back, maintaining traffic, they’ve nonetheless negatively affected profitability. Gross margin, which stood at 24.01% in fiscal year 2011, dropped to 22.95% in 2012 and further fell to 22.11% in 2013.

Management has a lot on its plate

With competition rising from cheaper alternatives, the middle market in the food service industry is performing poorer than the rest. Will this just be a temporary condition, or will it be long-term? That’s the tough question Darden needs to figure out, and it’s not an easy one to answer. Plus, managing several brands that are targeted at differing customer segments and positioned at varying price ranges is no easy task. It’s the downside of trying to grow a company via acquisitions. The company’s plan to expand internationally isn’t likely to have a significant impact on earnings any time soon, considering it doesn’t really have an international division. Perhaps management will spin off some brands somewhere down the road.

A dividend yield of 4.0% may not be that attractive

Despite having a dividend yield of 4.74%, higher than the Consumer Discretionary Select Sector SPDR ETF (XLY), much uncertainty remains for the company in the short to medium term. With investors mainly focused on how the company will perform over the next few months in terms of earnings, dividend growth wouldn’t be a main driver. Besides, how much the company can increase its dividend is also anyone’s guess, with its historic 20% annual dividend growth being unreliable. Having said that, the company is initiating a cost cutting program to support profitability. But uncertainty remains because the new COO that was put in charge was previously a vice president of the company’s specialty restaurant group division, so we’re unlikely to see some game-changing results.

If there’s one company that has been successful in cutting costs, it’s Brinker International Inc. (EAT).

Continue to Part 8

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