Shares of Darden Restaurants (DRI - Get Report) are burning up the grill. The stock is up 36% in the last 12 months, 27% this year and 22% in the last three months. From the look of the chart, DRI shows no signs of cooling off either.
Back in December I was cautious on the stock. I thought Darden was more appropriately valued in the $60s and not in the low $90s (where it is today).
The company is scheduled to report its fourth-quarter fiscal 2017 results on June 27.
Darden operates full-service restaurants Olive Garden, Capital Grill, Yard House, Longhorn Steakhouse, Eddie V's, Seasons 52 and Bahama Breeze.
On April 24, the company acquired Cheddar's Scratch Kitchen for $780 million in an all-cash transaction. Cheddar's operates 165 locations, including 140 owned and 25 franchised, across 28 states, focused on down-home food made from scratch with lots of slow-cooked meats and the promise of fresh ingredients.
Management expects the deal to add $0.12 per share to Darden's earnings in fiscal 2018 (ending May) and $0.20-0.25 in fiscal 2019 as the companies combine operations and reduce costs. Darden said Cheddar's has an average unit volume of $4.4 million and an average check of $13.50.
After the deal closed, management gave fiscal 2017 EPS guidance of $3.95-4.00 on same restaurant sales of 1.5%. Looking to fiscal 2018, analysts see EPS of $4.43 on $7.9 billion in revenue, which includes the Cheddar's acquisition.
Darden is currently trading at 21x forward EPS estimates, which seems like a very full valuation for a company with single-digit revenue growth. In fact, according to Standard & Poor's, in the five-year period ending May 2016, which excludes the company's restructuring and acquisitions, Darden generated a compound annualized revenue growth rate of -1.6%.
I know investors are excited by Darden's prospects, but it's even harder than back in December to justify its valuation at this level. I still think the stock should trade at mid-teens (14-16x) forward EPS estimates, or around $66. Once the deal-making is done, Darden will have still have to operate in a tough industry with slow growth.
In 2015, the company spun off its real estate into a real estate investment trust (REIT) and used the proceeds to buy back shares, complete acquisitions and pay down debt. The company faces higher rents and prospects of having to pay higher wages in an economy that is near full employment.
In my town, the local supermarket is paying $21 per hour for summer help. How will serving unlimited breadsticks and salad compete with that? Labor makes up about 31.5% of Darden's estimated fiscal 2017 sales.
In my opinion, investors are about to face a round of indigestion as they come to the realization that Darden is unlikely to generate very much top-line growth and the shares are richly valued.