U.S. Markets close in 1 hr 39 mins

Why a standalone Red Lobster is key to the brand’s survival

Xun Yao Chen

Despite displeased investors, Darden may have made the best decision (Part 10 of 10)

(Continued from Part 9)

A standalone Red Lobster is key

Building on top of these management changes, post-separation Red Lobster is expected to have more tailored operating initiatives focused on “maintaining stable sales by retaining core guests.” Without the influence of other brands, management will have the flexibility to differentiate Red Lobster as the place for seafood occasions through a brand refresh. A leaner organizational structure will focus on expanding profits via lower G&A and TV advertising expenses. This last point was also noted in Barington Capital Groups’ recent presentation.

Leverage could drive share appreciation

The new Red Lobster will have a non–investment grade credit rating, with debt levels that would be supported by strong free cash flow, according to Darden. Our view is that this could drive a higher share price appreciation after the spinoff due to high financial leverage. A non–investment grade credit rating would also reflect Red Lobster’s uncertain future, a likely factor that would drive existing Darden investors to sell Red Lobster shares right after the spinoff. Poor historical performance of spinoff assets is one of many reasons experts say shares tend to fall (see Darden analysis: Why investors holding onto Darden could be sorry).

Margin improvement

As the company noted in its presentation, the new Red Lobster will have “significant margin improvement opportunity and better unit productivity.” If same-store sales do become more stable, the riskiness of investing in the stock should also fall. In other words, investors would be more willing to pay a dollar of earnings or cash flow from the company if management can turn Red Lobster into a more stable business.

Spinoff investing

Without more details and time, it’s unclear how successful the turnaround would be for Red Lobster after the spinoff. But recent developments are moving in the right direction and investors may want to follow this as a potential opportunity down the road. Spinoffs as a whole have outperformed the overall market. The Guggenheim Shipping ETF’s (CSD) outperformance against the S&P 500 is one example. Investors can find more information on this trend at Darden analysis: Why spinoffs outperform the market by 10%.

Browse this series on Market Realist: