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DARDEN: CLARENCE’S LEGACY, A HALF-BAKED PLAN

The CEO took his best shot at fixing the company and fell short. Will Starboard come to the rescue?

DARDEN: CLARENCE’S LEGACY, A HALF-BAKED PLAN

The CEO took his best shot at fixing the company and fell short. Will Starboard come to the rescue?


What the new Darden Should look like!

Otis’ legacy will be defined by his unwillingness to make the changes necessary to create significant value for shareholders.

The writing has been on the wall for quite some time that DRI needs to make significant changes to the operating structure of the company. We didn’t believe Clarence would pull the trigger this quarter. In fact, we didn’t think he would ever do it. We were wrong. However, the plan announced yesterday stops well short of what really needs to be done. What Clarence presented made little strategic sense and didn’t get at the heart of the problem. Darden is still a company with an inefficient operating structure.

INCONSISTENCIES IN OTIS’ STRATEGIC RATIONALE

“Transaction transforms the portfolio into two independent companies that can each focus on separate and distinct opportunities to drive long-term shareholder value.”

HEDGEYE — What about our plan instead! The “HWPenney” transaction transforms the portfolio brands into four independent companies that have leading market share in their respective categories. Each company will be driven by intensive focus on a single operating priority and shareholder value creation.

According to Otis, the “Old Darden” had 8 brands with “divergent operating priorities” and now the “New Darden” will have 7. Management admitted they can’t manage 8 brands, yet they think it’s a good idea to manage 7?

“Separation will allow ‘New Darden’ and ‘New Red Lobster’ to better serve their increasingly divergent guest targets.”

HEDGEYE — What about the divergent guest targets between Olive Garden and Yard House? We understand that a changing consumer dynamic creates the need for intensive focus on key guest targets, but the “New Darden” is anything but focused. Our plan creates three companies focused on: Steak, Italian, and Seafood. This would allow for intensive focus on key guest targets and specific brand priorities in each category.

“Separate organizations enables ‘New Darden’ and ‘New Red Lobster’ to better focus on their divergent value creation levers.”

HEDGEYE — This is nothing more than a bunch of filler. It’s embarrassing they think they can spin this idea as a strategic opportunity. Leading full-service restaurant companies are outperforming Darden because they have stronger business models and create more value for shareholders.

“Announced compensation changes for ‘New Darden’ and planned program for ‘New Red Lobster’ will result in appropriate incentives for management teams passionate about their respective businesses”

HEDGEYE — You don’t need to split the company to do that. If the “Old Darden” wanted compensation closely tied to each respective business, this would have already been in place. Does this suggest the “Old Darden” team members were not passionate about their respective business?

“Separation repositions the business to better serve differing shareholder investment requirements (growth and income vs. income/yield) and maximizes total shareholder value.”

HEDGEYE — This is a classic example of investment banker BS. The guidance for the “New Darden” looks the same as guidance for the “Old Darden.” How does this strategic plan better serve the different investment requirements of its brands?

The plan presented yesterday seemed reactionary and hastily put together. It doesn’t even address declining margins and potential solutions.

After a series of conversations with industry insiders and taking some time to digest the events, we’ve concluded that the strategic initiatives announced yesterday could actually end up creating more problems for the company. To be blunt, this strategy could be a complete disaster and result in value deterioration rather than creation.

POTENTIAL FOR VALUE DESTRUCTION:

Red Lobster may be less profitable and, as a result, less valuable.

By spinning-off the Red Lobster brand, management is essentially kicking a brand that is already down. The brand is in decline and has been for quite a while. For Darden to essentially say “we don’t want you” may send the wrong message to Red Lobster rank and file employees. In our opinion, this could create a lot of angst within the employee base and could lead to further underperformance. Everyone knows the brand is in trouble and by casting it off on its own is simply conveying to the Red Lobster team that they aren’t worthy. The probability that Red Lobster sees an accelerated decline in profitability just went up significantly.

The plan does not eliminate the issue of managing multiple brands.

This is why we’re here in the first place. Darden’s current portfolio, which is too big and too complex to perform is largely intact. This multi-concept structure has created significant inefficiencies in the operating structure of the company. This separation doesn’t do anything other than remove an underperforming brand from the portfolio. Our plan to fix Darden properly aligns the company’s brands and organizes the portfolio in a way that would be beneficial to each NewCo. The “New Darden” brands aren’t focused to create maximum shareholder value!

Clarence is building a moat around his castle.

After years of underperformance, someone must be held accountable, right? So Clarence has been deflecting blame on others and firing the people around him. It is time someone holds him accountable. He is the Chairman and CEO of a company that has vastly underperformed its peers for the past several years. When will he accept responsibility for his decisions?

They are not cutting unit growth or costs as aggressively as they should.

Darden plans to halt unit growth at Olive Garden for a few years, slightly slow unit growth at LongHorn and expect unit growth to be slightly lower next year at the Specialty Restaurant Group. This unit growth will save approximately $100mm in capital expenditures annually. In our opinion, management doesn’t want to halt growth, but they need to in order to maintain Darden’s dividend. We think they need to stop growing altogether and straighten out before they exacerbate the problems they are currently facing. Further, through support cost management the team expects annual savings of $60mm beginning in FY15. This is slightly up from the $50mm the company announced last quarter. For a company riddled with excessive spending, it’s very discouraging that they were only able to find an additional $10mm in annual cost savings. Management must cut costs more aggressively if they plan to unlock significant shareholder value.

There is no real plan to fix Olive Garden.

The company did not release any details around fixing Olive Garden. This should be their number one priority, considering that the brand will make up approximately 60% of the “New Darden.” We heard mumblings of the “Brand Renaissance” plan, but management failed to go into detail for competitive reasons. Just last quarter we listened to Brinker management detail their plans to improve operations within their four walls. The point is, this seems like a cop-out. If investors want to get behind this company now, they need to know what management plans to do to turn around the Olive Garden brand.

Management has lost all credibility to hit its targets.

This was evident from the very beginning of the call. But one analyst, in particular, directly confronted management about their lack of credibility:

It seems in the presentations that you gave us that the key to whether this could create value or not is on those operating income growth numbers, low to mid-teens at the New Darden and mid to high single-digits at the New Red Lobster. Why are those credible given the track record?”

We thought it was ridiculous management didn’t guide down FY14 projections after an abysmal 1QF14 and apparently, others are starting to feel the same way. Why they were so reluctant to do so is beyond us and now their credibility is in question. The concern here is, if Darden doesn’t hit the revised targets management announced yesterday, they will have failed to create any shareholder value despite the strategic rationale aimed at doing just that.