Starboard Is Right
Starboard is doing the right thing. They’ve officially taken on the task of saving the largest publicly traded casual dining company in the world. From our vantage point, there is a high probability that Jeffrey Smith and his team will gain a majority position on Darden’s Board of Directors.
It will be a long, hot summer for the folks in Orlando and we want to be clear about what we think Starboard Value’s move last week means for the shareholders and employees of Darden Restaurants. In our view, Starboard has assembled a highly qualified group of professionals that will be able to rebuild a broken company into one of the most admired, while making a lot of money for all constituents along the way.
We didn’t personally know the people at Starboard prior to their investment in DRI, but we’ve been impressed with how thoughtful they’ve been in their business endeavors. Nobody is perfect, but we don’t view them as a stereotypical activist investor out to make a quick buck. From what we’ve seen in their public presentations, it is clear that they see a significant long-term opportunity.
While Starboard has not formally put a price target on the stock, we believe there is an opportunity for them to make 2-3x their investment over the next three to five years. As we’ve said before, Darden represents a “generational opportunity” that does not come around too often in the restaurant space. In my twenty years as a restaurant analyst, I’ve only seen a similar type of opportunity three other times.
Knowing that Starboard is fully committed to getting control of the Board is critical to realizing any potential upside. If Starboard is successful, which we believe they will be, it will send a loud and clear message to Darden employees and the Greater Orlando community: the future is bright.
Unfortunately, getting to that point is not going to be easy and we suspect some serious mudslinging is about to begin. There is no doubt that Clarence Otis and his advisors will be working overtime to discredit Starboard and their slate of Board nominations. We feel fairly confident that Darden will be specifically gunning for Brad Blum, because he represents the biggest threat to Otis’ job.
After advocating for change at Darden for the past two years, we are more confident than ever that senior management and the Board must be replaced. Darden continues to mislead shareholders and the investment community by telling a demonstrably fabricated tale of shareholder support.
In fact, based on our conversations, this support nearly ceases to exist in any capacity. We estimate that Darden only has support from 5-10% of the outstanding shares. The Red Lobster fire sale has further enraged shareholders who explicitly demanded a Special Meeting to discuss the merits and motives of such an ill-advised transaction. We believe the vast majority of outstanding shares are in the hands of what we consider to be Starboard advocates.
Starboard’s Slate, Darden’s Brass
Last week, in a letter to Darden shareholders, Starboard nominated 12 directors to stand for election at Darden’s 2014 Annual Meeting. According to the release, the slate of nominees is a culmination of “experienced restaurant operators with expertise in Darden’s major business lines, and experts in real estate, finance, turnarounds, supply chain, and, critically, effective public company governance and compensation programs.” Importantly, we believe these candidates, in aggregate, are more qualified to help orchestrate the biggest revival in the history of casual dining than the current Board.
Getting to the heart of the matter, by nominating 12 Board members, Starboard hopes to effectively gain control of the company. Given management’s blatant disregard for shareholder rights and history of destroying value, we can comfortably say they’ve brought this upon themselves.
Shortly after the news hit, Darden released a press release in which it said: “by attempting to replace all 12 members of the Board with its own preferred nominees, Starboard is seeking effective control of the Company – representation which is disproportionate to Starboard’s recently acquired approximate 6.2% stake in Darden and which does not offer Darden shareholders a control premium for such change in control.” Our initial thought was that the change of control premium would come when Starboard gets control of the company.
Two things come to mind as it relates to this. First, Starboard and its potential Board members own 2x the amount of stock that Darden’s management and current Board own, so their interests are more closely aligned with other shareholders. Second, the current management team’s track record is so poor that most shareholders are begging for a major shakeup.
The other part of the Darden rebuttal was that “Starboard’s assertions continue to be based on incorrect and unrealistic analysis, which results in misleading conclusions regarding the value associated with the sale of the Red Lobster business.” Having read Starboard’s letter several times, we’re having a difficult time seeing where Starboard is being misleading. It makes us wonder if management can objectively read what the financial community is saying about the Red Lobster sale. Did management see what happened to its stock the day they announced the Red Lobster sale?
Darden goes on to say “the recently signed agreement to sell the Red Lobster business and the actions underway to reinvigorate restaurant performance, reduce costs and ensure a sound financial foundation to support Darden’s dividend reflect the input we have received from shareholders.” That statement is misleading in its purest form. If management’s plan reflects the input from shareholders, why did they not allow shareholders to vote on the Red Lobster transaction?
Darden’s cavalier attitude toward shareholders has led to an unsustainable pattern of behavior that will result in wholesale changes at the company when the Annual Meeting comes around.
Starboard’s slate of nominees possess highly relevant and broad based expertise, including significantly greater restaurant operating experience. Several of the nominees, in particular, have considerable experience turning around restaurant companies – something the current management team has proven incapable of doing.
Aside from Darden’s potential efforts to attack Starboard’s slate of nominees, the next big event for Starboard will come when they detail specific plans to fix Olive Garden and other operational issues at Darden. We still contend that Darden should spinout LongHorn and Capital Grille into a separate steak company and explore an IPO of Yard House. Olive Garden needs to stand alone and Starboard needs to communicate to the investment community how they plan to turn around the flagship brand.
The 180 Rule is in Effect
All told, Starboard’s recent actions ensure that our longer-term bullish thesis remains intact. Despite the Red Lobster sale, we continue to see tremendous value that can be unlocked through various, highly feasible initiatives. However, with the Annual Meeting four or five months away, we see downside in the stock over the immediate and intermediate-term due to the significant and abrupt loss in earnings power.
Starboard must replace the current Board in order to unlock Darden’s inherent value. Barring a change of this nature, Darden would immediately become one of the best shorts in the entire restaurant space. As always, our bear case remains Chairman and CEO Clarence Otis.
Starboard’s attempt to replace the entire Board may seem overly aggressive, but those intimately involved with the situation know that this is a legitimate, even likely, possibility. The Board’s questionable practices have become increasingly egregious and its mockery of corporate governance has reached seemingly insurmountable levels. Shareholders, collectively, must put this to an end.
Call with any questions.
Howard Penney
Managing Director
Fred Masotta
Analyst
