Keeping things simple is typically one of the best and most consistent ways to make money in business, and Darden Restaurants (DRI) has figured out how to do just that while still serving up large portions of high-quality earnings.
DRI reported fantastic third-quarter earnings recently that beat on both the top and bottom lines while the company also raised its guidance for 2018 (DRI’s fiscal year ends in May). The company also announced an acquisition of Cheddar’s Scratch Kitchen for $780 million in cash, which is expected to add to earnings per share in 2018 with those additional earnings doubling in 2019. The transaction will be financed with a combination of DRI’s existing cash of $391 million, its existing credit facility and possibly new debt.
Regardless of the sources of financing, thanks to DRI’s low existing debt, the new financing will leave DRI well within management’s desired leverage position. Since the 2014 divestiture of Red Lobster and the recently completed real estate transaction (DRI converted 424 properties to a REIT and received the proceeds) that allowed DRI to pay down a significant amount of debt, the company has become a lean and well-financed portfolio of brands that are leaders in the casual and fine-dining space. In fact, in the third-quarter earnings conference call, CEO Gene Lee emphasized how committed DRI is to simplifying its business through its decentralized platform that allows the brand presidents to stay focused on their respective businesses. The brands can then use Darden’s size and resources as leverage with suppliers and to better manage each brand’s human capital.
While DRI management is focused on delivering great service and value to its customers, I’d like to look at how DRI is delivering value to its shareholders through its excellent financial position and growing revenues.
When looking at a business, people often focus on typical return measures like return on equity (ROE), return on assets (ROA) and multiples based ratios like price to earnings, which can all tell you something informative about the business but also have drawbacks in their constructs. For example, P/E ratios tend to be lower for companies with higher debt-to-equity ratios since more debt means less earnings are available to equity holders, but the business could still be well run and creating value.
Then we have ROE and ROA metrics, which include significantly sized non-operating items like pension assets and equity interests in other companies, which don’t help with the day-to-day revenue generation of the core business. Also, net income, the numerator in ROE and ROA, is usually not adjusted for one-off items that aren’t indicative of the underlying business, which causes the ratios to give a misleading view of the core business.
For those reasons, a properly constructed return on invested capital (ROIC) becomes such an important metric. ROIC is designed to focus on the core aspects of the underlying business and the value it generates. Then, ROIC can be measured against a company’s cost of capital to show just how much value a business is really generating.
Without getting too heavily into the accounting involved in calculating ROIC, just understand that the goal is to have a numerator (return) and a denominator (invested capital) that are both derived from the core operations of the business. In the table below, I have calculated the ROIC for DRI and its main competitors. Along with ROIC, there is each company’s weighted average cost of capital (WACC), invested capital (investments needed to run the core business) and the economic profit (a cash flow metric that combines a company’s size with its ability to earn a return above the cost of generating that return).
The table also looks at ROIC without intangibles, which is a way to look at a company without its acquisition history and gives a more accurate picture of the core assets of the business. As you can see, DRI outperforms all but one of its peers in terms of ROIC (2016 w/o), but is clearly the dominant company in terms of actual economic profit generated. The table also presents an excellent exercise in showing how the market treats the differences in the composition of ROIC.
We can see DineEquity (DIN) has a very high ROIC without intangibles, but a declining ROIC with intangibles. This is a result of DIN’s declining operating profits combined with the accounting treatment of its Applebee’s franchise. In short, DIN has complex accounting issues that are being compounded by declining sales, which is why it trades around a trailing 10 P/E versus DRI, which trades around 21 (including the quarter just reported). DRI’s wise “keeping it simple” approach shows in its growing ROIC (especially relative to its peers) and supports its best-of-breed position in the restaurant industry.
This is not to say ROIC is the ultimate metric to be used for company valuations, but when it’s calculated properly and used along with other metrics, it provides excellent insight into how a company is running its business and how the market rewards its overall performance.
The argument against Darden and the restaurant industry in general has been the usual bear case that the consumer is struggling and that people in general are choosing to stay at home more. Given DRI’s excellent earnings and the strong consumer confidence data we have gotten, it’s safe to say consumer health is not an issue. However, there are trends in the marketplace that do show a consumer preference for the stay-at-home experience, which has also been a major theme highlighted by Jim Cramer on Mad Money.
In response to this stay-at-home trend, CEO Lee specifically stated on the third-quarter call that Darden is aware of consumers wanting to drive less and that the company is making an effort to bring the dining experience closer to its customers. Darden can establish this through better-located properties along with enhanced takeout and delivery options, so it does have choices.
The bottom line here is that Darden is adapting to customer trends, as can be seen in its above-industry sales growth. I suspect that as the economy continues to do well, Darden will be eating its competitors’ lunches while investors continue to dine on its excellent earnings.