Monday, 25 February 2013
Friday, 22 February 2013
Write Up: Wells Fargo Company
Background: Wells Fargo Company (WFC) is the fourth biggest bank in the
U.S. by asset size and the second largest by market capitalization. WFC can
generally be labeled a plain vanilla bank as it mostly derives its revenue from
fee income and the interest spread between deposits and loans.
Overview:
The 5 main points regarding WFC
1) Diversified and stable revenue stream
2) Comparatively low funding cost
3) High RoA
4) Comparatively low leverage
5) Conservatively managed
#1) Diversified and stable revenue stream:
WFC puts big emphasis on cross-selling its various products
and thereby increasing their overall stickiness. The thinking is that the more
products a client has with a bank, the more cumbersome/ inconvenient and hence
unlikely it is that he or she will switch to another bank. Wells Fargo’s
cross-selling has grown from 4.6 products/ household in 2004 to 6.04 products/
household in August 2012. Cross-selling products is very important as it not
only creates a sort of moat for a bank but also enables it to collect more fees
related to the various products which diversifies its revenue stream and makes
it less dependent on interest rates (and fluctuations thereof). The make-up of
noninterest income is also very important – WFC has only a small portion of
trading income, a very unstable revenue stream (to be kind). Currently, ~50% of
WFC’s revenue is non-interest revenue ($10.66B net interest income vs. $10.55B
noninterest income) and the noninterest income itself is much diversified and
of high quality.
#2) Comparatively low
funding cost:
WFC has very
low funding costs and high deposits relative to total liabilities. Deposits are
generally very sticky, however WFC’s are even more so due its strategic focus
on cross-selling, which enables it to keep its customers even though it is offering
the lowest interest rates (as compared to competitors) on its accounts. This
gives WFC a sort of pricing power in a commodity market (every bank
offers basically the same checking and savings accounts, loans, etc.). To
illustrate, in 2012, WFC’s funding cost was ~39% lower than that of JPM which
had the next lowest funding cost within the group, and WFC has a very large
amount of deposits relative to its overall liabilities. WFC has beaten every of
these 4 major competitors in terms of their funding cost in all but 1 of the
last 14 years.
#3&4) High RoA
and comparatively low leverage
WFC has consistently had a far higher RoA than its
competitors (in large part due to its lower funding costs) and can reasonably
earn around ~1.4-1.5% (RoA) in a normalized environment – looking at 2012,
that’s 67.7% higher than TD and JPM which have the next highest RoA within the
group. WFC is also by far less leveraged than any of its competitors, which, in
addition to the low-risk and diversified noninterest revenue, makes it a very strong
player in the financial services industry. (I am focusing on RoA rather than
RoE to avoid the skewing effect that the vastly different leverages would have
on RoE)
#5) Conservatively
managed
WFC has historically mostly steered clear of industry hypes/
asset bubbles (e.g. 2007 mortgage bubble, late 1980s/ early 1990s highly
leveraged transactions etc.). WFC had far lower net charge-offs (loan
write-offs) post 2007 than its competitors despite purchasing Wachovia which
had lots of bad loans mainly due to its Pick-a-Pay loan portfolio (the name
says it all). WFC emerged out of the 2007/08 bubble burst far stronger than it
was before, as the Wachovia transaction added a lot of value. Increasing the
deposit base is very difficult for a bank as people generally perceive it as
too inconvenient to switch their bank and only do so if there are tremendous
benefits associated with it. Based on WFC’s normalized return on deposits which
can (conservatively) be pegged at ~1.8-1.9% (for the year ended Dec.31 2012 it
was at 1.87%), the Wachovia transaction added between $7.67B to $8.1B in earning
power wherefore WFC snapped up Wachovia at a price of only ~3.5 – 3.7 times normalized
earnings (for a total price of $23.1B + $5B in integration costs) and thereby
grew its deposits by $426.2B to $781.4B (55% growth).
Free Cash Flow &
Valuation:
Looking at WFC’s P/FCF shows that WFC sells at around 10.47
times FCF ($186.3B diluted market cap), which equates to an equity yield of ~9.55%.
Factoring in dividends, WFC’s BV has compounded at ~11.5%/
year over the last 17 years while the share price (including div’s) has
compounded at ~6.98%. This gap in the two CAGRs stems from the 2007/08
financial crisis (which can also be seen at the sudden drop in WFC’s P/B
multiple). Between 1996 and 2006, Book Value + Dividends had a CAGR of 11.43%
while the share price had a CAGR of 11.49% (almost exactly the same). Since
2007, book value continued to compound at a very similar pace while the share
price declined (pulling down the share price CAGR) - in the long run however,
share prices grow at rates similar to the companies’ BV growth. Between 1996
and 2006, WFC sold at an average P/B multiple of 2.84 times which is 129%
larger than today’s multiple. Normalized earnings over the next 5+ years and a
less depressed Mr. Market should bring WFC back to above a 2.0 P/B multiple
(the premium afforded to such a strong bank).
Interest rate risk:
WFC has a natural hedge against interest rate fluctuations
as it is a large originator of MBS. The 2011 10-K provides a breakdown of
selected loans ($332B out of WFC’s ~$780B portfolio) of which 88% of 1-5 year
loans and 74% of 5+ year loans are variable rate. These loans will fluctuate
with interest rates while WFC’s existing MBS are largely hedged through
interest rate swaps, and the company can keep new MBS, originated at higher
interest rates, on its book to counter-act any pressure on its interest rate
spread.
Mortgages and
consumer loans:
WFC’s net charge-offs are starting to normalize again at a
level of 1.2% of average total loans. As of December 31, 2012, approximately 39%
of Wachovia’s Pick-A-Pay portfolio has been liquidated (since 2008) and the
entire liquidation portfolio has shrunk by ~50% since 2008. At Sept. 30, 2012,
out of the $318.6M real estate consumer loans, ~10% had a LTV (Loan-to-Value)
between 100-120% and ~9.6% a LTV greater than 120%. With the housing market having
hit a bottom and beginning to recover, even if a significant portion of the
>100% LTV customers were to default, the losses would not have a major
impact. Even under the extreme assumption of a 20% default of the 100-120% LTV
loans and 40% default of >120% loans (and assuming an average 140% LTV value
for the >120% loans), the losses would be between $8.77B and $14.2B which is
considerably below WFC’s remaining loan loss allowance which was at $17.8B at
Dec. 31, 2012.
Investment Banking:
WFC has started to focus on investment banking as a new
growth opportunity. As long as the focus is on underwriting new company offerings
and cross-selling products that involve minimal risk for the company itself,
this has the potential to be a good new noninterest revenue stream. However,
one should watch out for any significant revenue from principal transactions
and trading revenue (more specifically, the proportion of ‘market-making’
revenue and what types of assets (and in what size) the company has to keep on
its balance sheet to facilitate the market-making in a way that satisfies its
customers).
Conclusion:
Wells Fargo is a very strong bank which by far outperforms
its largest competitors in the most important areas. It has a diversified
noninterest revenue stream and low funding costs (which lead to high net
interest revenue) both of which explain its high return on assets. WFC has a very
low leverage multiple and is a bank that focuses on the core business of a
retail bank, that is, deposit taking and loan origination, and avoids most of
the bad stuff such as lax operating standards and a heavy reliance on trading.
At a P/FCF of 10.47 times and a P/B multiple of only 1.24 times, WFC is still a
cheap buy and has a lot of upside potential over the long-run when market
values of financial companies will again more closely resemble their underlying
economics.
Disclosure: I am long WFC
Friday, 12 October 2012
Write Up: Darden Restaurants Inc
Darden (DRI)
Background:
Darden operates a family of wholly owned, full service restaurant chains, mostly located in the U.S. with some presence in Canada, and a small number of franchised restaurants in Puerto Rico, Japan and Dubai. Darden operates in the following segments of the restaurant industry.
Casual Dining: Olive Garden (Darden’s largest brand), Red Lobster (2nd largest brand) and LongHorn Steakhouse (3rdlargest brand). These three chains comprise most of Darden’s business.
Polished Casual Dining: Bahama Breeze, Seasons 52.
Fine Dining: The Capital Grille, Eddie V’s and Wildfish.
Bahama Breeze, Seasons 52, The Capital Grille and Eddie V’s comprise Darden’s ‘Specialty Group’ which makes up only 5% of overall restaurants.
Industry:
The casual, polished casual and fine dining segments of the restaurant industry are marked by heavy competition. Darden is currently the largest full service restaurant company in the U.S. and the second largest in the world with 1,994 restaurants and around 180,000 employees (as of May 2012). Casual and fine dining represent 22% of the restaurant industry in the U.S. and growth has been negative since 2009 due to the economic crisis and slow recovery. In the meantime, the ‘fast casual’ segment has been growing between 4 and 11% since 2007 due to customers’ increasing emphasis on affordability and convenience, which represents a major shift in the restaurant industry. [i],[ii],[iii]
In light of this industry trend away from casual and fine dining - which puts Darden’s chains at a competitive disadvantage to begin with- it is worthwhile exploring what constitutes a competitive advantage in the restaurant industry.
Source of Competitive Advantage in the Restaurant Industry:
Casual Dining is facing strong competition from the quickly expanding Fast Casual segment as well as Delis in the local superstore.
Casual Dining restaurants attempt to justify their existence by providing superior service to fast food restaurants as well as higher quality food. However, the problem is that this advantage of quality and service has now substantially shrunk due to Delis and the Fast Casual industry
To establishing a competitive disadvantage, a casual dining restaurants needs to have sufficient product differentiation to maintain a customer base that will accept higher prices as compared to the fast casual restaurants, Delis and fast food restaurants.
However, the relationship between affordability and quality in the restaurant industry has structurally changed. Customers used to trade off one for the other in something similar to a one to one ratio. The ratio now seems to have increased in favour of affordability such that casual dining restaurants need to provide far superior service and quality to justify the slightly elevated prices. This puts Fast Casual restaurants which compete heavily on affordability and a bit on service ahead in the game. The question is whether the higher prices of casual dining restaurants result in a pay-off relative to the substantially higher expectations regarding quality and service which in turn require more investment in training, food quality, restaurant décor, advertising campaigns (to justify the elevated prices in the first place) etc.
It can therefore be concluded that to be successful, a casual dining restaurant needs a competitive advantage due to its atmosphere, food quality, service or other intangible characteristic that substantially differentiates it from other fast casual or casual restaurants and which outweighs the strong emphasis that people are increasingly placing on prices. However, creating such substantial intangible value is difficult as chain restaurants are largely standardized and all have a similar atmosphere, food quality and level of service.
To go to the opposite extreme and demonstrate the sheer lack of competitive advantage by Darden, I will refer to one of Red Lobster’s most popular promotions, the 'Festival of Shrimp' which you would expect to be Red Lobsters most successful product differentiation and competitive advantage (it may be worthwhile mentioning that this is one of Darden’s overall most successful and important regular promotions). Based on its past success and after extensive market research concerning customer’s expected response to a price increase, Darden decided to increase the price of the‘All-you-can-eat’, Festival of Shrimp, price from $11.99 (2011) to $12.99 (2012). This $1 price increase resulted in a decline in same restaurant sales (which was substantial enough for management to mention it in their 2012 Q4 conference call!) as it was deemed ‘too aggressive’ [v]. If the price of a restaurant’s most distinguished and popular event cannot be raised by $1 without resulting in a strong decrease in demand, this event has high substitutability and is only popular due to its affordability and not the brand’s image or loyalty to the brand. Hence, any competitor offering All-You-Can-Eat shrimp for somewhere between $11.00-$11.50 during the same time period should theoretically be able to steal a lot of Red Lobster’s customers (the same example applies to any other promotion that Darden uses in any of its chains) which represents an extensive risk regarding their competitiveness and indicates that Darden does not have a moat as it has to compete solely on price.
Company: (FCF calculation in Appendix)
Despite its lack of competitive advantage/ moat, Darden’s underlying business has been fairly profitable (low margins, but good FCF due to its many restaurants).
The company’s Free Cash Flow has increased at an annual average of 7.78%/year (geometric mean) between 2004 and 2012 (excluding numbers for 2007 & 2008 due to closure of their Smokey Bones chain in 2007 which caused FCF to drop and subsequently rebound abnormally).
At an average price to FCF of 12.36 times over the last 9 years (excluding 2007) Darden also gives the impression of a fairly good bargain.
Management has been reinvesting its FCF in expansion at an average of 53.7% per year, and the company has also been buying back stock since December 1995, to a total of 187.4 million shares repurchased as of May 2012 (133.2M shares outstanding (diluted) as of May 2012), with the average buyback lying at 72.7% of FCF per year.
Darden currently pays a $2 annual dividend[vi], has increased its dividend almost annually over the last 9 years and has an average Payout/FCF of 27%. Over the last 3 years, dividends have increased by 100%.
Adding together the reinvestments for expansion, stock repurchases and dividends illustrates that the company has been living well beyond its means which in turn explains the extensive leverage. Leverage can be good if used properly, however, Darden’s management has not always been wise when it comes to expansion and use of its money (more in the management section). Darden’s expansion target is a 5-5.5% increase in total stores per year which requires substantial resources, and the company is further remodelling many of its stores. As of May 2012, Darden had long-term obligations of $2.66B. Darden is expecting to increase capital expenditures from $640M (May 2012) to $750M throughout 2013 and is acquiring Yard House (upscale Bar and Grill restaurant chain) in a $585M cash transaction, which makes the dividend increase even more surprising. Darden has been spending in excess of its FCF over the last 9 years (the quantitative analysis extends only over the last 9 years, these trends may or may not have existed prior) and funded its increase in stock repurchases and dividends largely through debt. This strategy is not sustainable and suggests that the management is trying to increase the share price through a best-of-every-world approach by raising dividends to extraordinary levels, pursuing massive stock repurchase programs, all the while expanding at a rapid rate. This makes Darden a business that would be fairly unstable if confronted with a shortfall in cash generated from operations, e.g. due to a decrease in customer demand (recall at this point the adverse market trend which we have observed earlier). The company already has a credit rating of BBB (S&P) which is the lowest of the investment grade levels, so any adverse development would move the company into the non-investment grade level and make their high leverage even more difficult to finance.
Date
|
FCF
|
% Growth FCF
|
Share Price
|
Annual dividend
|
FCF/share
|
P/FCF per share
|
% of FCF used for Dividends
|
% of FCF used for Repurchases
|
% of FCF invested in Expansion
|
Jun-12
|
$2.00
| ||||||||
May-12
|
571.35M
|
-5.70%
|
$53.24
|
$1.72
|
$4.29
|
12.41
|
40.1%
|
65.65%
|
57.82%
|
May-11
|
605.86M
|
18.21%
|
$50.98
|
$1.28
|
$4.32
|
11.81
|
29.6%
|
63.63%
|
48.50%
|
May-10
|
512.51M
|
18.77%
|
$41.60
|
$1.00
|
$3.60
|
11.56
|
27.8%
|
16.60%
|
36.24%
|
May-09
|
431.50M
|
-15.52%
|
$34.79
|
$1.00
|
$3.07
|
11.32
|
32.5%
|
33.58%
|
62.57%
|
May-08
|
510.78M
|
133.26%*
|
$34.25
|
$0.80
|
$3.52
|
9.73
|
22.7%
|
31.21%
|
52.50%
|
May-07
|
218.97M
|
-45.58%*
|
$45.32
|
$0.72
|
$1.47
|
30.80**
|
48.9%
|
169.52%
|
59.72%
|
May-06
|
402.38M
|
9.15%
|
$36.51
|
$0.46
|
$2.56
|
14.24
|
17.9%
|
107.91%
|
41.85%
|
May-05
|
368.66M
|
28.37%
|
$32.80
|
$0.40
|
$2.26
|
14.54
|
17.7%
|
84.55%
|
52.64%
|
May-04
|
287.17M
|
$22.50
|
$0.08
|
$1.69
|
13.30
|
4.7%
|
81.99%
|
71.15%
| |
Geom. 7.78%
|
Avg. x12.36
|
Avg. 26.90%
|
Avg. 72.74%
|
Avg. 53.67%
| |||||
*Not included in Geo mean calculation since FCF unnaturally low in 2007 due to disposal of Smokey Bones brand and rebound correspondingly unnaturally high in 2008
| |||||||||
**Not included since share price did not reflect decline in FCF due to disposal of Smokey Bones. Assumption: Most people focused only on net income, not on comprehensive income
| |||||||||
Structure:
All of Darden’s restaurants in the U.S. and Canada are wholly owned by Darden. In general, the expansion strategy of restaurant chains is based on a major trade-off between speed and profit per restaurant. While franchising enables companies to expand rapidly and increase their presence and thus brand value in a short period of time, the profits the company derives from each restaurant are small since the franchisee retains most of the profits. Expanding without franchising (organic growth) is by far slower and the company bears greater risk due to sole ownership, however, all earnings go to the company. Many different arguments can be made for each expansion strategy within the U.S. and Canada, however, Darden’s strategy has worked out favourably for them as they now have a strong presence in the U.S. and receive all revenues from their operations. Darden, however, has limited exposure to international markets which would serve as diversification. Darden’s huge exposure to the U.S. market makes it vulnerable to changes in market trends and economic slowdowns.
Darden is attempting international expansion through franchising, which is a good strategy in and of itself since the company does not yet have a strong brand image internationally (e.g. in Japan) and as Darden is not familiar with foreign markets. A problem I see in this context is that Darden does not seem to have been very successful with their international expansion. This may be based on 1) management’s lack of interest in international expansion or 2) lack of interested franchisees overseas. I’m not sure which one is the lesser evil; the first stands for an imprudent management that does not see the problem with the risk of depending only on one market and the second stands for a lack of demand overseas, causing an inability to grow internationally and diversify to protect against market changes and other adverse developments within the U.S. (and Canada).
To be more specific, Darden had the following franchised restaurants as of May 2012: 22 Red Lobsters in Japan, 1 Red Lobster in Dubai, 5 LongHorn Steakhouse restaurants in Puerto Rico. Red Lobster has started its international franchising-endeavour in 1982 and had 42 franchised Red Lobsters in Japan in 2006 which has shrunk by more than half since then, which illustrates (in Japan) a definite lack of customer interest.
Competition:
As I have stated previously, the fast casual industry is expanding at a fast pace and the affordability aspect is becoming more and more important to the average customer. The threat to Darden’s business lies in this market shift, the ability of fast-casual restaurants to expand rapidly through franchising, and Darden's lack of a competitive advantage in its local operations (which I will explain further now). Despite Darden being the second largest restaurant company in the world, its restaurants compete with other restaurants (regardless of the size of their overall operations) within a local market. Darden does not have a competitive advantage based on its size (economies of scale), unlike other companies such as Wal-Mart, as Darden competes based on price and is unable to undercut fast casual restaurants or even casual restaurants and as it does not have much brand value due to its many restaurants (as we established in our analysis of the Festival of Shrimp). Therefore, the sum of Darden's restaurants is not greater than its parts since its restaurants compete within the local market without any advantage due to Darden's overall size. Due to their affordability and convenience, Delis have grown a lot in popularity, especially among people with higher incomes who like fresh, high quality meat products – these people are also a big part of the customer base of the casual dining industry[vii]. The omnipresence of supermarkets (which have their own Delis) thus spreads this competitor of casual dining restaurants into every town and represents a more affordable place to buy food.
Considering competition and market trends, Darden is clearly facing some headwinds. Fast casual restaurants and Delis seem to be appealing to many people who simply want to go somewhere ‘better’ than a fast food restaurant wherefore they previously chose casual dining. A big portion of these people will most likely not go back to casual dining restaurants even when the economy fully recovers since the financial hardship that many people have experienced over the last 6 years has reinvigorated a propensity to save (especially as many people have experienced a vast reduction in their personal wealth) and as fast casual restaurants and delis are now more readily available to them. Due to their dependence on the U.S. and apparent lack of ability to expand overseas, protection from these headwinds will be difficult for Darden.
Management:
As I mentioned earlier, management is trying to quadruple dip by appealing to their shareholders through extensive buybacks (over its history, Darden has bought back 140% of the shares that are currently outstanding), a high dividend (currently 3.6% dividend yield), expansion at a 5-5.5% rate (which is a lot considering that they are already the second largest restaurant company in the world and as this means continuously having to increase the number of net new restaurants per year) and occasional acquisition of other chains (such as the current $585M Yard House transaction). Most other companies will try to shine by pursuing one of these programs, but Darden is pursuing all four.
Management has been expanding Darden at a fast pace (plus, they are expanding organically, not through franchising, which makes rapid expansion very costly and exposes Darden to all of the risks). Expanding at such a pace often leads to mistakes and faulty decisions which can be very costly. I prefer a company that expands at a slower rate but is not forced to close, relocate or remodel its restaurants due to poor planning as these are unnecessary cash outflows that could be put to better use and can potentially damage a company’s image.
Over the past, Darden has consistently been forced to close or relocate restaurants of its various chains and is currently seeing the need to remodel a substantial amount of its Olive Gardens (their largest brand) which is very costly. Some examples of restaurant closures: Fiscal 2007 and 2008, 9 Bahama Breeze, 3 Red Lobster restaurants, 1 The Capital Grille and 1 Olive Garden. Fiscal 2009, 3 Red Lobster restaurants, 1 Olive Garden and 5 LongHorn Steakhouses. Fiscal 2010, 3 Red Lobsters and 3 LongHorn Steakhouses and write downs of 2 LongHorn Steakhouses, and 1 Olive Garden (suggests potential future closures). Considering that average opening costs lie between $3.5M and $4.3M per restaurant, plus other costs related to opening, these are very costly mistakes.
What dwarfs the cost of these mistakes is the closure of an entire chain. Darden developed its Smokey Bones brand in 2000 and operated 126 Smokey Bones restaurants in 2006. Despite signs signalling the weakness of Smokey Bones, Darden management continued an accelerated expansion until it sold most of the restaurants in 2007 at very unfavourable terms. Again, a lot of money was wasted and could have been put to way better use. This leads to another question regarding the fast expansion of Olive Garden. Even though the brand has long been performing at a very poor level due to the economic climate, and experienced continuous decreases in guest count in its established restaurants, management has continued its expansion strategy and puts the most emphasis on this brand. There has been no indication that would justify such continued reliance on this brand.
An example of management’s unconditional loyalty towards Olive Garden can be observed in their Q4 earnings call - the executives explained that they will be reducing prices at Olive Garden as their competitors have attracted a lot of their customers due to better affordability. Further, they mentioned promotions such as their Olive Garden two for $25 deal (which already compares unfavourably to most of their competitors which offer 2 for $20 deals), which should also increase customer traffic due to affordability. In the next breath, management mentioned that they expect the average check per customer to increase at Olive Garden. However, how does the average check per person increase if we are cutting our prices and if customers are putting increasing emphasis on affordability to decrease such check? Jason West from Deutsche Bank asked exactly this question which management tried to avoid by referring to a disadvantageous menu mix in the past which they are expecting to correct. But if customers want to keep the average check low, they will choose the cheapest items, and if at the end their check is not as low as it would be somewhere else, they will simply not come back. So, menu mix good or bad, by their nature, reduced prices (to compete on affordability) will reduce the average check, which is the reason why they are implemented in the first place. Darden already operates on fairly low margins, thus the battle on affordability is a fight that Darden cannot win since it will not be able to undercut the prices of other casual restaurants and definitely not of fast casual restaurants and at the same time remain profitable.
An example of management’s unconditional loyalty towards Olive Garden can be observed in their Q4 earnings call - the executives explained that they will be reducing prices at Olive Garden as their competitors have attracted a lot of their customers due to better affordability. Further, they mentioned promotions such as their Olive Garden two for $25 deal (which already compares unfavourably to most of their competitors which offer 2 for $20 deals), which should also increase customer traffic due to affordability. In the next breath, management mentioned that they expect the average check per customer to increase at Olive Garden. However, how does the average check per person increase if we are cutting our prices and if customers are putting increasing emphasis on affordability to decrease such check? Jason West from Deutsche Bank asked exactly this question which management tried to avoid by referring to a disadvantageous menu mix in the past which they are expecting to correct. But if customers want to keep the average check low, they will choose the cheapest items, and if at the end their check is not as low as it would be somewhere else, they will simply not come back. So, menu mix good or bad, by their nature, reduced prices (to compete on affordability) will reduce the average check, which is the reason why they are implemented in the first place. Darden already operates on fairly low margins, thus the battle on affordability is a fight that Darden cannot win since it will not be able to undercut the prices of other casual restaurants and definitely not of fast casual restaurants and at the same time remain profitable.
Another problem I see with Darden’s management lies with their strategy regarding employees. Darden has been voted as one of the 100 best companies to work for by Fortune for the second consecutive year in a row, which is very good. However, they are about to destroy this advantage before it even starts working for them. Happy employees means good service and thus a competitive advantage because customers will come back to a restaurant where they are treated well. Due to the Affordable Health Care plan, coming into effect in 2014, employers will be forced to provide expensive health insurance to employees working 30+ hours per week. Darden has started to push the hours employees may work to just below 30 hours per week to avoid this. Further, they are planning on relying more heavily on part time workers to ensure that employees work below 30 hours per week. This has already resulted in upset employees (there are many employee reviews that complain about basically getting kicked out of the restaurant once they get close to 30 hours per week), greater turnover (especially if you focus more on part time workers) and more unskilled servers who are not 100% dedicated to their job. Management also strongly reduced bartenders' and busboys' wages last year and is forcing servers to share tips to make up for these reductions; employees are one of a restaurant's most valuable assets and moves such as this one destroy relationships between employees and employers (at the same time, executive compensation has slightly increased over the years - symbols such as this one can create great contempt among employees which explains the hostile attitude of employees towards executives at the last shareholder meeting).
Talking about Darden’s management’s expansion strategies, I also want to mention Darden’s recent purchase of Eddie V’s, a luxury seafood brand, in November 2011. What surprised me about this purchase is that seafood costs have risen a lot lately and, despite being expected to fall a bit, will continue to be high in the future. So why buy a restaurant that heavily depends on seafood given that their current seafood restaurant, Red Lobster, is already experiencing dropping margins due to the increase in seafood prices (as a matter of fact, Darden has mentioned that they want to decrease the amount of seafood dishes on their Red Lobster menu because they feel that families with at least one family member that does not eat seafood will not go to Red Lobster)?
As I mentioned earlier, I do not think management uses its cash very wisely and squanders a lot of the potential provided to it through Darden’s positive FCF. In July 2012, management signed a deal to acquire Yard House for $585M in cash. The mind-boggling thing in this case is that Darden is only acquiring 39 restaurants in this deal. This puts the average value per restaurant at $15 million. Just to remind you, a new Red Lobster restaurant (highest start up costs) costs around $4.2 million to set up. Management could have opened around 3.5 Red Lobsters in lieu of each Yard House restaurant, which suggests that Yard House should rake in 3.5 times as much profit which is very unlikely. Darden has had a history of overpaying in their acquisitions, as can been seen at their purchase of the RARE brand (LongHorn and The Capital Grille) at an extensive premium.
Another long-term strategy that is currently being devised by management is Darden’s entrance in the field of lobster farming (Spiny lobsters – they do not have big claws and should not be confused with the Maine lobsters which are popular in North America). There are a few underlying issues with this concept:
Firstly, and somewhat unrelated to the endeavour itself, management is stretching the company into too many directions simultaneously. Extensive remodelling, expansion (including a $585 million cash purchase of Yard House), repurchases, dividends and a $300 million dollar project (granted, it is over a long time horizon, however it is still a costly project) which will most likely use up far more than $300M on the part of Darden. This is a lot considering that Darden is adversely affected by a contraction in the casual dining market and overall very low consumer spending.
Secondly, if Darden was able to successfully farm lobsters on a large scale, what prevents any other company in Asia from doing the exact same thing? There is no moat in this field (lobster farming is already being done in Malaysia on a non-commercial scale, as well as in other places around the world) so any major developments and great insights gained by Darden can cheaply be copied by anybody else (especially since patent infringements are quite frequent in Asia to begin with). Further, if Darden (and other companies copying Darden) floods the market with lobsters, the price of lobster will drop which could cause this venture to be unprofitable as lobsters require a lot of food and are thus very expensive to farm and the viability of this project solely depends on the high price lobsters fetch in the market. Darden also plans on only breeding the lobsters, after which it will sell them to other companies which then grow the lobsters, and subsequently sell them back to Darden. This means a decrease in their share of the lobster farming earnings (assuming there will be earnings) as they need to share the revenues with their partnering companies.
Thirdly, lobster farming has been unsuccessful at a commercial level for a reason – it is very expensive to grow lobsters, they eat a lot of food and there exists the risk of disease which can wipe out an entire lobster population in a short period of time. This could be very costly for Darden, plus any such disease would be very bad for Darden’s image and could decrease demand for their lobsters.
The lobsters will initially be sold mostly in Asia (again, other Asian companies can simply reproduce Darden’s business model and flood the market with lobsters) and due to North American demand for Maine lobster, most Red Lobsters will still heavily rely on Maine lobster from fishermen. Regarding the lobster farming, Darden’s management seems to be steering the company in a direction that may adversely affect its own Red Lobster brand (if Darden and/ or other companies flood the market with lobsters, the price of lobster will vastly drop which in turn may reduce their margins at Red Lobster) and is allotting a lot of capital to a project that has a very poor track record and questionable upside.
Conclusion:
Darden has had relatively good FCF growth and appears to be a relatively cheap purchase, however, the underlying business is facing major headwinds due to market shifts and management is unresponsive towards these changes. Further, management has a vision for the company that may be harmful for its own brands and requires substantial investment for an outcome that is very uncertain. Darden’s biggest brands have suffered a lot in the current economy and demand may not ever come back to its previous levels as fast casual dining and Delis are gaining popularity. Darden does not have a moat and has high substitutability within the restaurant industry, despite its size. The company’s inability to expand overseas represents another problem as it makes diversification difficult. The company is spending well beyond its means in an attempt to raise the share price and make shareholders happy, however, this is a very short-term oriented strategy and (especially in an uncertain economic environment) cannot be sustained at this level in the long-run. Overall, management uses company resources very inefficiently while trying to stretch the company in too many directions at the same time to be everything for everybody.
Date
|
FCF
|
% Growth FCF
|
Share Price
|
Annual dividend
|
FCF/ share
|
P/FCF per share
|
% of FCF used for Dividends
|
% of FCF used for Repurchases
|
% of FCF invested in Expansion
|
Jun-12
|
$2.00
| ||||||||
May-12
|
571.35M
|
-5.70%
|
$53.24
|
$1.72
|
$4.29
|
12.41
|
40.1%
|
65.65%
|
57.82%
|
May-11
|
605.86M
|
18.21%
|
$50.98
|
$1.28
|
$4.32
|
11.81
|
29.6%
|
63.63%
|
48.50%
|
May-10
|
512.51M
|
18.77%
|
$41.60
|
$1.00
|
$3.60
|
11.56
|
27.8%
|
16.60%
|
36.24%
|
May-09
|
431.50M
|
-15.52%
|
$34.79
|
$1.00
|
$3.07
|
11.32
|
32.5%
|
33.58%
|
62.57%
|
May-08
|
510.78M
|
133.26%*
|
$34.25
|
$0.80
|
$3.52
|
9.73
|
22.7%
|
31.21%
|
52.50%
|
May-07
|
218.97M
|
-45.58%*
|
$45.32
|
$0.72
|
$1.47
|
30.80**
|
48.9%
|
169.52%
|
59.72%
|
May-06
|
402.38M
|
9.15%
|
$36.51
|
$0.46
|
$2.56
|
14.24
|
17.9%
|
107.91%
|
41.85%
|
May-05
|
368.66M
|
28.37%
|
$32.80
|
$0.40
|
$2.26
|
14.54
|
17.7%
|
84.55%
|
52.64%
|
May-04
|
287.17M
|
$22.50
|
$0.08
|
$1.69
|
13.30
|
4.7%
|
81.99%
|
71.15%
| |
Geom. 7.78%
|
Avg. x12.36
|
Avg. 26.90%
|
Avg.72.74%
|
Avg. 53.67%
| |||||
*Not included in Geo mean calculation since FCF unnaturally low in 2007 due to disposal of Smokey Bones brand and rebound correspondingly unnaturally high in 2008
| |||||||||
**Not included since share price did not reflect decline in FCF due to disposal of Smokey Bones. Assumption: Most people focused only on net income, not on comprehensive income
| |||||||||
Disclosure: This is not investment advice. I do not currently hold a position in Darden nor am I planning on doing so in the foreseeable future
[i] The statistic differentiates between Midscale and Casual Dining but my analysis treats the two segments as one since the two are synonymous within the realm of Darden’s operations
[ii] http://chipotleeffect.com/blog/tag/restaurant-outlook
[iii] http://www.restaurantindustrytrends.com/snapshots.html
[iv] http://nrn.com/article/fast-casual-segment-influences-overall-restaurant-industry?ad=news
[v] http://www.morningstar.com/earnings/40177114-darden-restaurants-inc-dri-q4-2012.aspx?qindex=7&pindex=7
[vi]As of October, 2012
[vii] http://www.foodproductdesign.com/news/2008/02/hello-deli-industry-trends-to-watch.aspx
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