All Eyes on Darden as Economy Slows

Orlando, FLIt's always a roll of the dice when a restaurant chain, already feeling the sting of higher food costs and lower profits, takes the plunge and makes an acquisition that further increases its debt. And while a March 19th announcement by Darden showed revenues to be up, the good news could well be temporary as the sub-prime mortgage crisis, and the recession that appears to be coming in its aftermath, puts a crimp on consumer spending.

Meantime, Darden stands accused of violating the Securities Exchange Act of 1934 by allegedly inflating stock values through an alleged misstatement of the company's true performance. On the same day that Darden was announcing increases in profit and revenue, a lawsuit was initiated on behalf of stockholders. While the action has yet to be certified, the class action was filed with US District Court for the Middle District of Florida.

The suit alleges that given an environment of negative trends, rising food supply costs and under performing restaurants, the company had no basis for making allegedly positive statements related to the performance of its properties. On December 18th Darden lowered its profit forecasts for 2008.

Meantime, Darden's recent acquisition of the LongHorn Steakhouse and Capital Grille brands was not met with unbridled enthusiasm by analysts. In fact, the company—which already operates Red Lobster and the Olive Garden—posted a 30 per cent drop in profits for the second quarter, largely due to costs associated with the acquisition of the two, new brands. Couple that with rising food costs, dropping sales at Red Lobster and LongHorn, and fears of a recession, and one is not left with much optimism at the end of the day.

Acquiring Atlanta-based Rare Hospitality, which has LongHorn and Capital Grille under its umbrella, cost Darden $1.4 billion in borrowed funds, and while Darden executives were confident about the acquisition, the company's chairman and Chief Executive Officer Clarence Otis referenced a "challenging consumer environment" during a conference call to analysts and investors the week before Christmas.

That fact was hammered home by a restaurant stock analyst for St. Petersburg-based Raymond James who noted, "consumer spending continues to be soft in casual dining, and demand appears to be decelerating," according to Bryan Elliott in statements made prior to Christmas.

Darden's own chief executive acknowledged that consumers had been reigning in their restaurant visits in areas such as Florida, California and New England. Bad weather in December, and one of the harshest winters in recent memory, didn't help either.

This, in tandem with performance numbers that were viewed as nothing short of disappointing when they were announced in December and a downgrading of the company's expectations for the coming year, did little to fuel confidence.

To be fair, the March 19th announcement of a rise in third-quarter profit appears to vindicate Darden principals who saw value in the Rare Hospitality acquisition, in spite of the cost. Overall profit rose 18 per cent, and revenue was up 25 per cent. The news helped to restore confidence in the company, and shares rose 6.6 per cent in response. Darden also reaffirmed its expectation for profit growth for 2008 at somewhere between two and four per cent, and indicated it expects to see a rise in profit for 2008.

One analyst for Lehman Brothers suggested that the March 19th announcement eased recent investor fears, and suggested that Darden's results were impressive.

However, while investors have been placated for now, there is little doubt they'll be keeping a close eye on the company over the short term. It should be noted that while Darden's performance has improved since Christmas, much of that success was due to an increase in sales from Olive Garden. At the same time, sales from high-profile brands Red Lobster and LongHorn—one of the newest acquisitions—fell over the same period.

And David Palmer, an analyst at UBS who referred to Darden's mid-point earnings as "the most disappointing quarter form this company in years," suggested in a research note to investors prior to Christmas that "the purchase of Rare Hospitality is looking increasingly unfortunate, in our view.

"With the deal, the company has added...risk in a tough industry environment."

So far, that industry appears to be holding its' own. But with consumers facing real crisis on the mortgage front, and with fuel prices continuing to rise on the heels of a harsh winter, it is yet to be seen how consumers will adjust their spending.

History dictates that when costs of non-negotiable liabilities rise, such as the cost of housing and the price at the pump (people have to get to work), discretionary spending takes a hit.

To wit, people eat out less often.

Over the next several months, analysts will be scanning the financial horizons for signs of a deepening recession, and how that will be interpreted by the casual dining industry.

In the meantime, investors who purchased Darden stock between June 19th and December 18th 2007 may wish to consider joining the class action in Florida. Darden is also being investigated to determine if the company had breached its fiduciary duties under ERISA (1974) with respect to retirement plans and Darden 401(k) plans, given the drop in stock prices after the December 18th earnings and performance announcement.