What Does Darden's Proposed Spinoff Mean And Is It Even Needed?

On Wednesday, October 9, 2013, news broke that activist fund Barington Capital Group LP took a 2.8% stake in Darden Restaurants . Following news of the investment, the company stated that it was pressing Darden Restaurants to spin off into two separate companies.  By late November, the company had hired a team to focus on reviewing the company's proposal, a task that should be completed by the end of this month.  It should be noted though that Darden's management has yet to make a decision.


Reasons for Darden's proposed spinoff
As of the company's most recent fiscal quarter, it operated 2,155 restaurants under various names. The company has invested in multiple restaurant brands, and its two primary businesses are Red Lobster and Olive Garden. Though these are considered two very popular fine dining restaurants for consumers to frequent, a change in consumer tastes has resulted in declining sales figures for these restaurants.

For instance, as of the first quarter of the company's 2014 fiscal year, sales were up 6.1% compared to the same quarter a year ago. However, sales for Red Lobster were down 5.5% (5.2% on a same-restaurant sales basis). Olive Garden fared somewhat better with a sales decline of 0.4%, though on a same-restaurant sales basis it saw business decline by 4%.

It is with this disparity in restaurant sales in mind that Barington initiated its stake in Darden Restaurants. You see, while the company's larger restaurants have been underperforming, its smaller brands like LongHorn Steakhouse, The Capital Grille, Bahama Breeze, and Eddie V's have been growing, increasing their same-restaurant sales by 3.2%, 3.2%, 2.7% and 2.1%, respectively.

Because of the disparity between these smaller chains and Olive Garden and Red Lobster, Barington believes that it would be wise for the company to split up into two separate entities. Under this proposal, Red Lobster and Olive Garden would be combined into one separate company, while the remaining businesses under the Darden name would comprise another.

The idea of spinning off a portion of a business can prove beneficial at times, but detrimental at others.  Take the case of McDonald's and Chipotle Mexican Grill .  In 2006, McDonald's spun off its 90% stake in the fast-casual dining business shortly after it opened its 500th location.  The company's rationale was two-fold.  First, it could focus more on its core operations.  Second, it would allow the business to collect a nice sum of cash (around $1.5 billion) while permitting Chipotle to grow or die on its own. 

Implications for investors 
But, what does all this really mean for the investor who owns or desires to own shares of Darden Restaurants? In essence, the spin-off would result (assuming it takes place with no changes as of the most recent fiscal quarter) in one entity that would be composed of 1,568 restaurants under the Olive Garden and Red Lobster names, with 55% (or 863) being Olive Garden restaurants and the remaining 45% (or 705) being Red Lobster restaurants. The other entity would be made up of the remaining 587 restaurants that fall under the list of brands above, as well as Seasons 52 and Yard House. Whether this is a good move or not depends on your perspective and what you desire in an investment. 

Does Darden need a spinoff?
As we have seen, results for Olive Garden and Red Lobster have been dismal.  This suggests that the chains might be better off operating as a separate entity from the rest of Darden's chains.  However, there is some innovation under way at Olive Garden that management may be trying as a last attempt to fend off activist moves to break it up.

Last week, news broke that Olive Garden was debuting its newest addition to its menu; the Italiano Burger.  Packed with prosciutto, arugula, mozzarella cheese, and marinated tomatoes with a garlic aioli spread and accompanied by parmesan garlic fries, the burger appears to be a huge departure from the company's signature pasta.  Though it is possible that the burger will improve sales, there is some concern that management is making the same mistake that McDonald's has in the past.

This year especially, the largest restaurant chain in the world has suffered from lackluster results.  In November alone, comparable store sales in the U.S. fell 0.8% compared to the 0.3% increase that Mr. Market expected.  Though a portion of this decline is attributed to the advent of companies like Chipotle, another factor is an ever-growing menu.  By offering more items that require more time to prepare, service time slows and costs rise.  While Olive Garden's Italiano Burger might prove a surprise, the company may be better off focusing on margin improvement than on diversifying its menu and risking the same downside that McDonald's has been hit with.

A contributor to McDonald's woes has been Chipotle, which has increased significantly since its IPO.  It's possible that Darden might fear this kind of emergence from its brands, which could kill its Olive Garden and Red Lobster concepts.  

Foolish takeaway
Building a new Olive Garden restaurant or a Red Lobster costs an average of $4.11 million and $4.219 million, respectively (in juxtaposition to the lower cost per restaurant of, say, LongHorn Steakhouse, which is about $3.393 million). Because these entities are underperforming, it is highly likely that this larger enterprise would focus not on growth but on improving its operating margins. Meanwhile, the smaller company, composed of the individual restaurant brands, would likely focus on utilizing its resources to maximize its growth potential.

It is highly likely that investors who seek growth opportunities will prefer to invest in the smaller company following the spin-off, which could initially result in share price appreciation after the spin-off. On the other hand, other investors may prefer to bargain shop for companies that are well established but just need a little more attention to improve their profitability. These investors will likely prefer to invest in the company that owns Olive Garden and Red Lobster because the market may discount the value of this business.

The article What Does Darden's Proposed Spinoff Mean And Is It Even Needed? originally appeared on Fool.com.

Daniel Jones has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill and McDonald's. The Motley Fool owns shares of Chipotle Mexican Grill, Darden Restaurants, and McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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