The Bullish Case For Darden Restaurants, Inc.

Ben Strubel On Potentially Purchasing Darden Restaurants, Inc. by Ben Strubel, Strubel Investment Management

Dear Investors,

A recent conversation with my new intern as well as a few recent client calls sparked an idea for a new addition to my client quarterly newsletter.

My intern and I were discussing a family member’s mutual fund investment portfolio. During the conversation my intern wondered out loud “I wonder what [the broker who sold the funds] invested his money in? I doubt it’s the same stuff he sells.”

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You may or may not be aware but I invest my own money in the same investments my clients are in. So, I plan on including an overview of my own investments each quarter. I also think this will be helpful for clients who get worried when the market heads south. They will be able to see that I’m still invested in the same stock heavy portfolio as I always was and I haven’t made any changes.

Most client accounts I manage are custodied at either FOLIO Investments or TradePMR. I’ve had my personal account at FOLIO.

Most client accounts I manage have their investments split between our dividend stock fund, capital appreciation stock fund, emerging market stocks (via Vanguard index fund), real estate (via Vanguard index fund), investment grade bonds (via Vanguard index fund), and inflation protected bonds (via iShares index fund). I have all of these same investments in my account. Some larger accounts have individual municipal or corporate bonds. It is virtually impossible for me to invest in the exact same individual bonds as clients so instead I added an investment in a municipal bond index to try to be invested alongside those clients to the best of my ability.

You also may notice I have an investment in what I call a small cap fund. This is a new quantitative based small cap fund I’m evaluating making available to clients, but first I’m testing it out myself with my own money prior to clients.

The reason is this. Have you ever heard any of those mutual fund commercials where they advertise “90% of our fund’s beat their Lipper average” or “95% of our funds are rated 4 stars or above”? Sounds like a great fund company right? Well here is the mutual fund industries dirty little secret on how they can appear to have a great fund lineup.

The first trick they use is to seed a large group of funds in secret. They register these funds with the SEC but only put their own money in to them (at least they use their own money to experiment…), no outside investors, and they do publicize any of the funds. The funds that outperform are then made public, and they get to bring their previous but private track record with them. The underperforming funds are killed off. So you start 10 funds. 9 underperform and 1 outperforms. You kill off the 9 funds and make the 1 outperformer public. Ta da! You now have a perfect track record of 100% of your mutual funds outperforming… except that it’s basically a big lie.

The second trick is even more insidious. When public funds begin to underperform the mutual fund companies will merge them with outperforming funds. For instance let’s say my mutual fund company has 4 funds. Fund A and Fund B are outperformers. Fund C and Fund D underperform. We just merge Fund C in to Fund A and Fund D into Fund B. Ta da! Once again we now can brag that 100% of our funds outperform.

While I too am raising a new fund in private like the mutual fund companies I can at least be a little bit more transparent about the process with my clients and potential investors. I can also tell you that I’m not experimenting with the validity of the strategy for the fund but rather whether it is viable and cost effective to invest in smaller cap stocks with lower trading volumes through FOLIOs twice-per-day window trading platform.

In any case without further ado here is my portfolio.

My investment breakdown is as follows:

  • 42.5% in our Dividend Fund
  • 42.5% in our Capital Appreciation Fund
  • 5% in the test Small Cap Fund
  • 2% in Real Estate (Vanguard Real Estate Index, VNQ)
  • 2% in Emerging Market Stocks (Vanguard Emerging Market Index, VWO)
  • 2% in Investment Grade Bonds (Vanguard Total Bond Market Index, BND)
  • 2% in Inflation Protected Bonds (Barclays iShares TIPS Index, TIP)
  • 2% in Municipal Bonds (iShares S&P National AMT-Free Municipal Bond Index, MUB)

As you can see I have a stock heavy portfolio as I believe our strategies for investing offer the best opportunity for long term wealth creation.

Note: I also have an older IRA account opened during grad school at Scottrade. That account is invested solely in one stock, Philip Morris International (PM) which is a stock we hold in both of our stock portfolios.

Darden Restaurants, Inc. (DRI)

We have been talking for several quarters in client newsletters about potentially purchasing Darden Restaurants, Inc. (NYSE:DRI). After hedge fund Starboard Value was able to replace the entire board of directors at Darden, we went ahead and invested in Darden at what we believe is approximately the same price Starboard paid for its shares.

For those unfamiliar with Darden, it is the parent company of Olive Garden, LongHorn Steakhouse, Bahama Breeze, Seasons 52, The Capital Grille, Eddie V’s, and Yard House–with Olive Garden being by far the largest chain. The previous management team pretty much ruined Olive Garden with a combination of ill-fated ideas, poor management, and poor execution.

In September, Starboard Value released a 300+ page presentation that outlined the problems with Darden Restaurants, Inc. (NYSE:DRI) and how they were going to fix them. There is not much I can add to their thorough analysis of the issues and their proposed solutions. Instead, I’ll focus on my personal experience, why we think Starboard’s plan for Darden makes sense, and why we chose to invest alongside them.

In Lancaster, PA, we have two Olive Gardens, a newer one built several years ago and one that’s been around for at least a decade. I had the unfortunate experience of visiting both in the past few years. Every year my friends and I usually have a “Friendsgiving” sometime in November or December. Through some unfortunate circumstances, we ended up at Olive Garden twice. (It was cheap, centrally located, and could seat a large group on short notice… probably because everyone else knew it was terrible.)

For reference, my personal experiences happened long (years) before Starboard Value made an investment in Darden Restaurants, Inc. (NYSE:DRI).

Olive Garden offers unlimited breadsticks and salad. One of the things that struck me as odd during my visit was that they made no effort to regulate the amount of food they gave you. They just threw a bunch of breadsticks on the table. If you asked for more, you didn’t get just one or two more breadsticks; they just brought another whole batch. Same with the salad. It was served in gigantic communal bowls. When one person in our group wanted a little more salad, we got another bowl, which promptly went to waste minus a serving for the one person who wanted more salad. I was astounded at just how much food was wasted. It was brought out in vast quantities as though it were a medieval feast.

The second thing that struck me as odd was the sheer size of the menu. It listed page after page of offerings, a lot of which was not or did not seem Italian, including a burger and a few weird fish entrees. (I’m not a foodie so I’m not sure what is and isn’t “proper” Italian food.) Also, many pages on the menu offered items that seemed redundant.

The third thing I noticed was the lack of emphasis on alcohol. Alcohol is a high margin product, and Italian food, probably more so than other cuisines, is usually paired with wine.

When I read Starboard’s presentation on Darden Restaurants, Inc. (NYSE:DRI), I saw they highlighted the same problems I saw in my personal experience. More importantly, Starboard had common sense solutions.

The breadstick solution that Starboard proposed was to serve one breadstick per guest plus one additional breadstick for the table. If you want more, then you may ask and they will bring you more. Starboard estimated this will save $4-$5M per year. This approach makes more sense than just dumping baskets of breadsticks on the tables. They also proposed to get rid of the giant punchbowls of salad, although they have not yet been specific on the new process. (It’s hard not to get any less classy than serving a glorified feeding trough of salad, so I believe Starboard’s new method will be an improvement.)

The gigantic, redundant menu did not go unnoticed by Starboard. Olive Garden has 96 menu items, and LongHorn Steakhouse has 98! (The average Italian chain’s menu numbers in the mid-70s, and the average steakhouse menu in the mid-60s.) Starboard pointed out that a menu this large leads to poor execution; it’s difficult for the cooks to make almost 100 dishes consistently excellent. In addition, the huge menu means more food prep that employees must do each day. Finally, my own opinion is that food quality suffers as well. How many people on any given night will order the Tuscan Burger at Olive Garden? How long are the beef patties in the freezer, waiting for that one rare customer who wants a burger at an Italian place? How much prepped food is thrown out daily or weekly because it is a rarely ordered menu item? Starboard estimates that $30M to $48M in food prep and associated costs can be cut out by slimming down the menus to more reasonable sizes.

As for alcohol, the average Italian chain gets 16.5% of its sales from alcohol. Olive Garden gets just 8%. Starboard estimates that bringing Darden Restaurants, Inc. (NYSE:DRI)’s alcohol sales up to the industry average could add up to $56M in EBITDA (Earnings before Interest Taxes, Depreciation, and Amortization). Starboard does have some ideas that are a bit over the top: They propose adding sommeliers to a few, specific, high traffic stores. I’m not sure that idea will get much traction but certainly training servers a bit more about what wine to pair with which dish and how to increase quantity and quality of alcohol sales should work.

If you are interested, I highly recommend reading Starboard’s presentation. In my opinion, it is by far the best investment presentation I have ever seen. It does a great job laying out all the problems and proposing specific solutions as well as the potential financial impact of the solutions.

We believe that Starboard will be successful at Darden Restaurants, Inc. (NYSE:DRI). Similar to H&R Block, new management has come in and put forward a sensible, comprehensive plan to revive a once great franchise. Just like H & R Block Inc (NYSE:HRB) it will also be a multi-year effort.

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The Capital Appreciation Fund and the Dividend Fund are innovative, investor friendly alternative to traditional actively managed mutual funds called a Spoke Fund ®. We can also customize portfolios for clients seeking less risk and volatility by including allocations to other asset classes such as bonds and real estate.

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The performance data presented prior to 2011:

  •  Represents a composite of all discretionary equity investments in accounts that have been open for at least one year. Any accounts open for less than one year are excluded from the composite performance shown. From time to time clients have made special requests that SIM hold securities in their account that are not included in SIMs recommended equity portfolio, those investments are excluded from the composite results shown.
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  • Reflect the deduction of a management fee of 1% of assets per year.
  • Reflect the reinvestment of capital gains and dividends.

Performance data presented for 2011 and after:

  • Represents the performance of the model portfolio that client accounts are linked too.
  • Reflect the deduction of management fees of 1% of assets per year.
  • Reflect the reinvestment of capital gains and dividends.

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