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Takeaway: Make no mistake about it; Otis’ top priority is saving his job.

STARBOARD STRIKES

Starboard Value announced in a 13D filing this morning that it has retained former Brinker International CFO and EVP Charles Sonsteby to serve as an advisor in its battle against Darden Restaurants.  Starboard will pay $50,000 in cash to Mr. Sonsteby who will, in turn, use the proceeds to purchase Darden stock.

We view this as another favorable development for Starboard.  Adding the former Brinker CFO will help the activist bring sanity to Darden Restaurants.  In his role as the CFO of Brinker, Charles helped lead one of the great success stories in the new era of casual dining.  In this new era of casual dining, companies that focus on operating efficiently and doing one thing right create the greatest value for shareholders.  His experience and expertise makes him another extremely valuable asset.

MANAGEMENT FIGHTS BACK

Darden held a business call update yesterday morning to run through its strategic plan and rebuttal to activist pressure.

During the presentation, it became abundantly clear to us that the plan to spinoff Red Lobster was merely a hasty reaction to shareholder pressure.  Unfortunately, the activists don’t agree with this plan and are intent on stopping it.  Following the call, Barington Capital stated that it has lost confidence in the ability of Otis to manage the company.

DRI PREANNOUNCES

Management preannounced 3Q14 results yesterday and, as we expected, they fell far short of consensus estimates.  Darden expects same-restaurant sales in the quarter to decline 5.4% at Olive Garden, decline 8.8% at Red Lobster, increase 0.3% at LongHorn and decline 0.7% at SRG.  While Olive Garden and Red Lobster continue to be the mismanaged brands we’ve become accustomed to, weak results at SRG, Darden’s growth vehicle, confirm our view that the Specialty Restaurant Group isn’t so special.  In order to fulfill its true potential, this group should be separated from the larger, more mature brands with divergent strategic and operational priorities.

OLIVE GARDEN’S BRAND RENAISSANCE

The only thing new that came out of yesterday’s presentation was an in-depth look into Olive Garden’s Brand Renaissance plan.  Fixing Olive Garden has suddenly become management’s top priority.  While we agree with this positioning, and have been calling for it for the past year, we don’t have much faith in the current operating team.  This repositioning effort includes new lunch and dinner menus, nationwide remodels, a new approach to advertising and promotion, and even a new logo!  While we are impartial to the new logo, critics came out in full force on Twitter yesterday.

DRI: THINGS ARE HEATING UP - 1

DRI: THINGS ARE HEATING UP - 2

DRI: THINGS ARE HEATING UP - 3

Look, we’ll give credit where it is due.  Management is, in a sense, taking an aggressive approach here no matter how reactionary it may seem.  With that being said, it concerns us that outside pressure was the driving force behind these changes.  A strong and capable management team would have made these changes a long time ago.  After a prolonged period of underperformance, we’ve lost confidence that the current team can spearhead a successful turnaround at the ailing brand.

PUSHING FORWARD WITH THE CURRENT STRATEGIC PLAN

Management intends to push forward with its plan to spin off Red Lobster.  According to them, this will remove an underperforming and volatile brand from the portfolio and separates the portfolio into two companies to allow each to focus on “separate and distinct opportunities to drive long-term shareholder value.”  We’ve been pretty forthright in our disagreement with this plan.  Based on management’s own numbers, and own chart, Red Lobster and Olive Garden have similar guest profiles as they both appeal to lower income consumers.  LongHorn Steakhouse, on the other hand, is the clear outlier as it appeals more to upper income individuals.  Management is talking out of both sides of their mouth.

DRI: THINGS ARE HEATING UP - chart4

Part of management’s rationale behind the Red Lobster spinoff was to allow both new companies to better serve their increasingly divergent guest targets.  This is nothing more than an excuse for management to rid itself of an underperforming brand that has become irrelevant under their watch.  The New Darden will still have divergent guest targets.

Management briefly discussed why other potential portfolio separation alternatives – including a spinoff of LongHorn/SRG – don’t make strategic sense.  Among several reasons offered was the potential for weak cash flows at SpinCo, a large amount of existing debt at NewCo, the jeopardizing of an investment grade rating and a likely cut to the dividend.  While all of these statements are legitimate, they don’t necessarily strike us as major concerns.  If Darden were to spinoff SRG or LongHorn/SRG, the SpinCo would most certainly be considered a growth company.  Weak cash flows and a cut to the dividend would not only be expected, but accepted as well.  Further, management avoided touching upon the advantages this would create for both NewCo and SpinCo, including a more intensive focus on similar guest targets, brand priorities and shareholder needs.

Management also offered up a rebuttal to the proposed separation of Darden’s real estate into a publicly traded REIT.  We don’t profess ourselves to be REIT analysts, so we’ll stay clear of this debate.  All we know is that both sides have supposedly done their due diligence on the proposal and both have come to vastly different conclusions.

The key takeaway from yesterday is that management is going on the offensive and we applaud them for that.  We did not, however, learn much new and are still unconvinced that the current team, under the proposed operating structure, can right the ship at Darden.  We plan to offer a more detailed analysis of management’s proposed spinoff at a later date.

Howard Penney

Managing Director