Should You Buy It: Darden Shares Not Appetizing

Its revenue rises, but so do its costs; earnings come in way short.
Author:
Publish date:

Darden Restaurants

(DRI) - Get Report

fell 20% Wednesday after posting lower-than-expected profits Tuesday night for its Red Lobster and Olive Garden restaurant chains.

The price decline was the stock's worst daily performance since Darden was carved out of General Mills in 1995.

Despite the glum report, a bright side remains: With Darden's stock closing at $28.60 Wednesday, down $7.74, or 21.30%, it is trading at just 10.5 times expected fiscal 2008 (ending May) earnings of $2.71 a share. The restaurant operator has not traded at such a low valuation in nearly 10 years.

If you're like most investors, you're probably wondering: Is this the ideal time to buy shares in Darden, or is the prudent decision here to avoid this loser and hope it sinks some more?

I'm here to steer you in the right direction.

After the market close Tuesday, Darden said that it earned 42 cents a share in the fiscal second quarter (ended November). This was well short of the consensus analyst profit estimate of 50 cents a share, even though Darden's revenue grew more than 17% year over year to $1.52 billion.

The culprit in the earnings calamity was a combination of slower same-store traffic to Red Lobster restaurants, as well as rising commodity input costs. Specifically, management said on the conference call that higher wheat and milk costs were cutting into margins, and the weak dollar made imported seafood more expensive. On the demand side, customers were coming in less to the company's locations in California, Florida and New England.

To Darden's credit, its more than 1,700 restaurants are well spread across the country, and those three regions account for only about 20% of total locations. Still, the company's target customers are middle-class consumers who historically have cut back on discretionary spending such as restaurant visits when the economy slows.

I'm also leery that despite this quarter's miss, Darden reiterated its full-year guidance for 19% to 20% revenue growth, based on 2% to 4% same-store sales improvement. That leaves room for further disappointment in the coming quarters, especially if commodity input costs remain high.

The restaurant chain does pay an 18% quarterly dividend (2.5% yield) that it still can comfortably cover with earnings, but that may not be enough to entice investors after this latest warning. And rather than buy back stock with company funds, management pledged $1.36 billion of cash to buy steakhouse operator Rare Hospitality in August.

Darden said that integration expenses related to the acquisition were higher than planned, and that the purchase was dilutive to earnings during the latest quarter. To finance the deal, the company also had to sell new bonds, tripling its total debt from the previous quarter to more than $2 billion.

When examining Darden and its financial woes, one can't help but compare it with where

Brinker International

(EAT) - Get Report

-- a Darden competitor -- was in July.

I told readers then to avoid Brinker International, which owns the Chili's restaurant chain. Brinker shares are down 32% since then, and I believe that Darden also has more downside risk, even after Wednesday's decline. Readers should steer clear of this potential value trap.

David Peltier is a research associate at TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Peltier appreciates your feedback;

click here

to send him an email.

Interested in more writings from David Peltier? Check out his newsletters,

TheStreet.com Dividend Stock Advisor

and

TheStreet.com Value Investor

.