Can Darden Restaurants Overcome Its Third-Quarter Gloom?

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Investors no longer want a seat at the table with Darden Restaurants (NYSE: DRI), the owner of the Olive Garden and Longhorn Steakhouse chains. After reporting fiscal third-quarter earnings that showed sales beat analyst expectations, but it came up light on profits, shares of the restaurant operator have lost 12% of their value.

It was a seemingly strange reaction to a report where management raised full-year guidance, but maybe it created an opportunity too.

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Undercutting its efforts

Despite the increase in sales, profit margins are falling because Darden was relying too heavily on promotions to bring in customers. Operating margins in the quarter fell from over 12% to under 11%, and though net margins rose year over year, that was due solely to a big tax benefit the company received. Earnings were cut in half before income taxes. However, Darden realizes its discounting program is running into the law of diminishing returns and it's planning on cutting back its promotions, but it was able to almost entirely offset the expense through hedging.

The Italian restaurant chain, Olive Garden, is a microcosm of what's afflicting the restaurant operator. Sales were up 3.7% in the quarter and segment profit increased more than 4%, but it was the lowest performing of any of its units. Longhorn Steakhouse saw a 4.3% sales increase and a 5.8% segment profit increase, while the fine dining segment was up 7% and 10.7%, respectively.

While Olive Garden's comps were better than Longhorn's, it was mostly the result of higher prices. Guest traffic was up only 0.1%. While that's better than the steakhouse's 0.1% decline, it wasn't the same kind of pull it had in the past as the promotional efforts didn't generate the same response from customers.

As a result, Darden's management says it's going to pull back on promotions, reducing the calendar from nine events to six and putting on the shelf its formerly popular Buy One, Take One deal that had customers taking home a prepared meal when they ordered a pasta dish. Darden CEO Gene Lee says although that particular promotion is actually a profitable one for the chain because it's "additive" as soup, salad, and breadsticks are often added in, by running it for too long it becomes less effective. "Our intuition told us that long-term, you have to protect these promotions over time," Lee said.

Buy One, Take One will be run just once a year, like the Never-Ending Pasta Bowl promotion -- another of its most successful deals that tends to boost sales, traffic, and profits.

Looking beyond the restaurant

Where the market seems to be missing the opportunity in Darden Restaurants is in the growth of takeout food as an increasingly important component of its business. Off-premise sales grew 13% in the period and accounted for approximately 15% of total sales. It points to Valentine's Day where although it's difficult to get a seat at a table in a restaurant, it has also made it become Olive Garden's busiest takeout day of the year.

Right now, Darden is still focused more on large-party catering for its off-premise business, where the average order size is $300. Its other chains also have takeout service, but it's in Olive Garden where the real opportunity lies because its food travels well and Darden's unique packaging keeps the experience consistent with what's seen inside the restaurant.

The restaurant industry remains in a state of flux. The market analysts at TDn2K say the growth restaurants saw in the fourth quarter has now stalled again, and rolling three-month sales are down 0.1% with comps off 2.4%. In February, though, comps were down 3% indicating the slowdown may be back.

Darden Restaurants has been performing above the industry for the most part, and though the market reacted to its earnings report with fear that the fiscal fourth quarter will be weak, it appears management's goal of focusing on what works and jettisoning what's least effective has been a proven winner and should serve it well.

Even after the sell-off, however, Darden's stock isn't cheap and investors may want to wait a bit longer to see how the current quarter plays out before pulling their chairs back up to the buffet.

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Rich Duprey has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.