More often than not, investors applaud management moves to unlock value through the announcement of a spinoff or sale of a business. This was not the case for Darden Restaurants ; the company's shares declined on news that the company intends to spin off (or potentially sell) its Red Lobster chain of restaurants. While the struggles of Red Lobster have been known to investors for some time, management's decision to spin off the chain is largely viewed as a concession that the Red Lobster brand is dragging down the results of Darden as a whole.
Investors are not excited about this decision for a couple of reasons. First, investors will become owners of the "New Red Lobster" entity and remain tethered to a business with declining revenues. Second, the "New Darden" excluding Red Lobster is still not exhibiting the strong growth seen across the spectrum of restaurants from fast-casual concepts like Chipotle Mexican Grill to high-end steakhouses such as Del Frisco's Restaurant Group . This quarter's revenue and earnings miss is evidence that Darden's focus on driving results might not be fixed by simply removing its most mature brand.
Darden and Brinker face growth difficulties
Darden managed to grow revenue by 4.6% in the most recent quarter, but this growth masks some significant concerns. Same-store sales for Red Lobster and Olive Garden, by far the two largest brands for the company, were down 4.5% and 0.6%, respectively. To make matters worse, the number of Red Lobster locations actually decreased (albeit by just one location) over the past year. These weak results were offset by strong performance in the "specialty" restaurant group headlined by LongHorn Steakhouse; LongHorn reported strong growth generated by a 5% increase in same-store sales and a 12% increase in restaurant locations.
Darden is not alone in this struggle to generate growth from mature casual restaurant concepts; Brinker International has had similar problems. Brinker's flagship Chili's concept reported a 1.6% decline in same-store sales at company-owned locations in the most recent quarter, and Maggiano's generated same-store sales growth of just 0.6%. While this illustrates the fact that casual dining has been weak in recent periods, that doesn't mean that there isn't money to be made in the restaurant sector.
Red Lobster spinoff doesn't create value for investors
In a presentation to investors, Darden management pitched the spinoff as a way to better align management focus given "divergent operating priorities and capital requirements" of Red Lobster and the "New Darden" brands. The fix is to create a new publicly traded Red Lobster entity that is leveraged such that its debt is non-investment-grade, has a core business that has generated negative same-store sales, and has even shrunk in total restaurant count over the past year. In this form, Red Lobster will be struggling to maintain revenue and will only be attractive to investors as a income investment.
The "New Darden" won't be much better off following the spinoff. Management has lowered growth guidance for the legacy entity by reducing projected capital expenditures on new restaurants by a third next year. As a result, new Olive Garden locations will be "minimal" and LongHorn growth is being scaled back from 30-35 locations to 15-20. So, the new "focus" on Darden's growth opportunities is to scale back growth. Interesting.
If separating growth opportunities from the management of mature brands was management's primary goal, this could have been accomplished far better by spinning off the high-growth "specialty" group that includes LongHorn, Capital Grille, Bahama Breeze, Yard House, Seasons 52, and Eddie V's. This group of smaller concepts has a total of just 190 locations, up 18% over the prior year.
A spinoff of the specialty brands would have created an exciting, high-potential growth stock with management that could focus exclusively on growth. Instead, these restaurant concepts will remain tethered to Olive Garden's 834 locations and a commitment to return capital to shareholders via dividend that comes along with a low-growth company.
Look elsewhere in the restaurant sector
As this chart clearly illustrates, Darden has lagged the market over the past year:
Following a spinoff of Red Lobster, it is hard to see the fate of either newly created company being much different since no value has really been unlocked beyond the simple fact that "New Darden" will look more attractive without Red Lobster dragging it down.
Historically, the best returns in the restaurant industry have come from concepts that can not only generate reliable same-store sales growth, but also grow the number of locations in operation significantly. This combination is what has made Chipotle such a fantastic investment; the company increased revenue 18% in the most recent quarter thanks to 6.2% same-store sales growth and the opening of 37 locations. Analysts expect that Chipotle can double its restaurant count domestically, plus further create value for shareholders via international growth and the expansion of the ShopHouse Asian Bistro and Pizzeria Locale concepts.
Again, this is what is so frustrating about management's decision to retain a strong spinoff candidate like Darden's "specialty" brands in a market where high-growth restaurant chains are commanding tremendous premiums and yielding significant returns for investors. Such a spinoff would have presented investors with a similar opportunity to Del Frisco's; with just 37 locations and 15 consecutive quarters of same-store sales growth, this chain is poised to grow significantly in the coming years and has delivered market-beating results.
The spinoff of Red Lobster does little more than split one underperforming investment into two. For investors who are looking to the restaurant sector for market-beating returns, I'd recommend sticking with Chipotle, Del Frisco's, and other high-growth concepts.
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The article Darden Tosses Red Lobster Back Into the Sea originally appeared on Fool.com.Fool contributor Brian Shaw owns shares of Chipotle Mexican Grill. The Motley Fool recommends Chipotle Mexican Grill. The Motley Fool owns shares of Chipotle Mexican Grill and Darden Restaurants. 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.