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Darden Restaurants, Inc.'s Stock Price Is Seemingly Impervious to Gross Overvaluation

Ronald Thomas, CFA

I don't know what it is with restaurant industry valuations nowadays. So many are so high that they make no sense.

Visiting my daughter (a former casual dining marketing manager) in Dallas (a relative hotbed of restaurant concept creation), we ate at three or four concept restaurants that -- if taken public -- could be real competition for Chipotle Mexican Grill, Inc. (CMG) or Panera Bread Co (PNRA). And that was in only a one-week visit.!

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As of yesterday morning, we find that first-quarter GDP was revised downward to 1.8%, again showing the slow and tenuous nature of the economic "recovery." I can still point to a number of restaurant chains that discount compound average growth rates of EPS that are in excess of the sell-side average estimates. In my whole career as an analyst/sector portfolio manager, this has always been an almost infallible indication of stock overvaluation. Maybe there is less brokerage firm research floating around these days, creating openings for all of the Internet and other investment services to allow the blind to lead the blind, as MBA students, investment hobbyists, and even public relations people get to have their opinions in print and get a following while writing what is absolute drivel.

Getting a stock valued at an embedded growth rate higher than the sell-side average is easier for a growth stock, such as Chipotle or Panera, just because the growth number is higher and more uncertain. It is -- and should be -- much more unlikely to happen for a large and mature company.

But that has been the case for Darden Restaurants, Inc. (DRI). Darden at $50, using consensus EPS estimates for this year and next of $3.03 and $3.33, respectively, a 4.5% risk-free rate (3.5% long Treasury bond + 1% to counter the effect of quantitative easing), a 7% risk premium for a restaurant chain, and 2% terminal growth, discounts an 12% five-year EPS growth rate. Even if I assign a 6% risk premium for the largest chain in both seafood and Italian, the stock still needs to show a 9% growth rate to justify its price.

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Management now targets longer-term sales growth at 5-6%, which was recently cut from 7-9%. The formula is 1-2% comp store sales and 4% unit growth. But to maintain 1-2% comps requires 2% GDP growth, which is pretty much all the growth rate the US may get, at least until a new federal administration comes about. That 1-2% also assumes a modicum of price competitiveness, something that Olive Garden has not achieved as its prices are still hurting its comps.

The beef cycle could hurt steak chains for the next two to three years, and seafood prices make Red Lobster one of the highest-priced chains in the casual dining arena. There should be continued down trading into the fast casual pricing segment. Certainly Brinker International, Inc.'s (EAT) Chili's chain thinks so, as it is pushing for pizza business now as a cheaper product offering.

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Another factor working against Darden is that casual dining industry unit growth overall, which is now in the 2-3% range, is growing faster than US employment, putting continuing pressure on comp store sales overall. Also, using management's long-term unit growth goal for all of its concepts, there is only seven years of growth at 5% unit growth per year.

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The net of all of the above trends is that both comp store sales and unit growth goals are in jeopardy from the economy, industry trends, and Darden's positioning in the industry. It would be foolhardy in my in my opinion to believe that there will be any gross margin lift from actually achieving this 5-6% revenue growth. Indeed, it is more likely to be achieved with gross margin degradation.

A 3% growth rate implies a $34 stock, which would be a 31% decline. Even 6% growth points to a $39 price and a 22% decline.

I realize that the stock is being held up by a $2 dividend and a 4% yield when investors are looking hard for yield. But we have witnessed a big decline lately in consumer staples stocks that were bought for yield, so I would not hang my hat on yield to keep the stock up.

Of course, the high payout means that the company is cash constrained, and the dividend is unlikely to be hiked while the unit growth remains at 4%. Maybe the growth will be replaced with share buybacks, which would point to a stock price possibly in the low 40s.

But something has to give in the way that investors look at the outlook for the company. And that change will not support the present stock price of $50.

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