After joining QV earlier this year, a significant part of the onboarding process involved familiarizing myself with our portfolio holdings by reviewing and providing ‘Seven Test’ updates on many of our global strategy holdings. The Seven Tests are the common analytical framework we have used to evaluate businesses since the firm’s inception. One of the holdings that initially stood out to me was Darden Restaurants.
AN ATTRACTIVE FRANCHISE AT A GREAT PRICE
Darden Restaurants is the largest casual dining company in the U.S. Its brand portfolio includes Olive Garden, Longhorn Steakhouse, Cheddar’s.
Darden was initially purchased in our global large cap and U.S. strategies during the midst of the pandemic in August 2020. This was a period of great uncertainty for the restaurant industry, but over the course of the team’s analysis of the business, it became clear Darden demonstrated many of the enduring traits that we look for in a quality investment.
At the time we purchased Darden we wrote: “The fall of restaurant activity is unprecedented but temporary. It has created a very rare opportunity to buy high quality, growing restaurant businesses at meaningful discounts to the broader market. We think the severity of the downturn will improve the competitive positions of the largest, best-established businesses like Darden and that its casual value-based dining menu will be very attractive to consumers looking to get out of their homes for a meal.”
What made Darden appealing to the team in 2020? It had a strong balance sheet with just ~0.5x net leverage. Despite the uncertainty of the pandemic, we didn’t see a scenario where debt levels would become unmanageable. Darden had demonstrated an enviable track record of persistent revenue growth, growing earnings per store and stable profit margins through a variety of economic environments over the prior two decades. The company’s track record helped the team gain comfort in the sustainability of profitability over time.
Source: Capital IQ
Darden’s management team had a track record of menu innovation, cost improvement and using data analytics to drive efficiencies and the customer experience. Management also viewed COVID as an opportunity to reduce variable employment and to simplify kitchen operations and menus. Our expectations at the time were that these improvements would increase operating margins by 150bps, and that most of these increases would be sustained.
Although management had prudently suspended their dividend during the pandemic, they had consistently returned excess capital to shareholders in the past two decades through a mix of dividends and share buybacks. They had also generally deployed capital back into the business at reasonable rates of incremental return. Historically, capital return was an important component of the 10-15% annual return goal management telegraphed to shareholders, accounting for 3-5% with earnings growth comprising the remainder.
As the largest casual restaurant chain in a fragmented market, Darden had a scale advantage that allowed them to benefit from purchasing, data investments, and fixed cost leverage. The savings generated from Darden’s scale allowed them to invest in growth opportunities, the customer experience and in their value-for-money proposition in ways competitors could not. At a time when it was estimated that over 10% of US restaurants were expected to permanently close due to covid restrictions, Darden had the size and scale to survive the downturn intact and emerge stronger.
Despite these positives, Darden was trading at a substantial discount to what the team believed the business would be worth in the next few years and just 13.5x our estimate of underlying normal earnings compared to a five-year median of 21.9x. Given the strong execution, ongoing efficiency initiatives, and the low starting valuation multiple, the downside appeared limited and the return potential looked attractive.
Source: Capital IQ
DARDEN’S STABLE EXECUTION CONTINUES TODAY
Darden has delivered reasonable results in the three years since we first invested. After the post-pandemic recovery, earnings continued to grow at 7% last year and are expected to rise 10% this year. Management has continued to build shareholder value with the recent acquisition of Ruth’s Chris Steak House. This purchase is accretive to Darden’s earnings and should offer an opportunity to extract supply chain and purchasing synergies which will benefit Ruth’s profit margins.
While Darden remains an attractive franchise with reasonable long-term prospects, at ~19x current earnings today, it no longer represents the opportunity it did in 2020. While not every investment works out as Darden has, from a seven-test perspective it provides a good template for what we strive to own in our strategies.