Consumer

Tara Lachapelle is a Bloomberg Gadfly columnist covering deals. She previously wrote an M&A column for Bloomberg News.

With Chipotle -- the one-time restaurant stock of choice -- embroiled in a bad-burrito debacle (the latest evidence coming Tuesday evening when it released horrendous sales figures), investors are starting to redevelop a taste for Darden Restaurants. It may not possess Chipotle's cool factor, but the $8 billion owner of Olive Garden, suburban America's carbilicious take on Italian dining, seems to be headed in a better direction at the moment. 

Breadstick Breakaway
Shares of most North American casual restaurants fell in the past year, while Darden's stock advanced 15 percent.
Source: Bloomberg

Darden is in the middle of a turnaround that began in late 2014, when activist investor Starboard Value overthrew its entire board amid sagging sales. The CEO was also essentially eighty-sixed -- along with made-up Italian dishes like pastachetti -- and replaced by Gene Lee, the company's former chief operating officer. For the past 12 months, only three of the 37 restaurant stocks in the Russell 2000 have been beating Darden. 

Olive Garden still isn't a popular spot for the New York City crowd, so I can't vouch for whether their food is better, but the new team does seem to be on the right track. It's also clear now that Red Lobster was a burden on the business that won't be missed by shareholders. (The seafood chain was sold to private equity just prior to the activist-led overhaul.) Darden also owns Longhorn Steakhouse, Capital Grille and Eddie V's, but Olive Garden -- which has the lowest average customer bill of all Darden's chains -- generates more than half the company's revenue. That revenue is climbing once again, albeit modestly.

Making Strides
Olive Garden's same-store sales have been positive since the fourth quarter of 2014, after Darden's battle with its activist shareholder came to a head.
Source: Bloomberg

New leadership has increased Darden's profitability, putting margins more in line with peers. Expense reductions are on track to beat previous forecasts, and in December, Darden said cost savings for its fiscal year ending in May will total $80 million to $90 million. As much as $40 million more are projected for the following year.

The biggest question is whether Darden can up keep up the momentum. Last week, Brian Vaccaro, an analyst for Raymond James, cut his rating on the stock to "underperform," the equivalent of a sell recommendation, citing a "cautious macro outlook" and a stock that's "priced for perfection" after its period of outperformance. He's the first on Bloomberg's analyst database to do that; other analysts' ratings are pretty much split between buys and holds. On average, they forecast a 9 percent gain in Darden's share price over the next 12 months. And on Tuesday, trading in Darden call options reached the highest volume this year, a bullish sign. 

Bringing Back Profits
Cost-cutting initiatives should continue to improve margins, says Bloomberg Intelligence analyst Jennifer Bartashus.
Source: Bloomberg

As Gadfly's Shelly Banjo noted in December, Darden operates in the middle market for restaurants, which is exactly the spot that could get squeezed by widening income inequality. Less wealthy consumers will flock to cheaper stores and eateries (e.g. fast food), while wealthier diners opt for upscale places. And while lower gas prices are good for the people Olive Garden caters to, broader concern is building about the stability of the U.S. economy. A slowdown wouldn't be good for Olive Garden or Darden's other restaurants.

Darden also needs to be careful that it doesn't go too far in its cost slashing. A book excerpt published by the news site Salon on Monday connected the dots between food-borne illness and restaurants trying to save money through lower wages. Using Olive Garden, it makes the point that because tipped employees make only around $2 an hour and aren't given paid sick days, they're more inclined to come into work ill. So they could be coughing all over your five cheese ziti al forno. (Olive Garden says that employees make about $15 an hour on average including tips and that food safety is a priority.)

Cheap Eats
Darden trades at a discount to most U.S. restaurant companies with at least $1 billion of market value. Pricier stocks tend to be in the fast-food realm, while sit-down chains have some of the lowest valuations.
Source: Bloomberg

No restaurant company, particularly one trying to revive its popularity, wants to grapple with the problems Chipotle has recently faced. Chipotle's stock dropped off nearly 50 percent while mired in the months-long, nationwide food-safety scare. Before that, the chain was on top of its game and had just announced a plan to hire 4,000 employees in a single day, which was sort of bragging rights showing how well it was doing. I'm not saying the pressure on Darden to widen margins is going to give patrons norovirus. The point is that its turnaround plan needs to be sustainable without sacrificing quality. 

So far, the changes Darden has made are gaining traction with both diners and investors. But just like a bad meal, it takes a little while to know how it will go down.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Tara Lachapelle in New York at tlachapelle@bloomberg.net

To contact the editor responsible for this story:
Beth Williams at bewilliams@bloomberg.net