This post is part of the Reporter’s Notebook blog.
Almost from the moment that Starboard Value-backed nominees won every seat to the Darden Restaurants board of directors last year, the company has been looking at options for its real estate.
A decision on that analysis could come soon, and KeyBanc Capital markets Analyst Chris O’Cull believes that a real estate spinoff could improve shareholder value at the Orlando-based company by $5 to $7 a share — without putting pressure on restaurant operations.
Darden owns a lot of real estate. The owner of Olive Garden, LongHorn Steakhouse, Yard House, Bahama Breeze, Capital Grille, Seasons 52 and Eddie V’s owns more than 1,200 pieces of property. Starboard has estimated them to be worth $2.5 billion to $3 billion, and that spinning off that real estate would create $1 billion in shareholder value.
The likeliest scenario is that Darden will spin the real estate off into a real estate investment trust, or a REIT. Darden would take all of its real estate, put it into a separate company, and then spin it off to shareholders. That separate company would lease that property back to Darden.
The spinoff strategy would enable Darden to avoid paying taxes on the deal, which is key in any real estate strategy. “If you do something, it has to be tax free, or have minimal tax consequences,” O’Cull said.
Investors are pushing a number of companies from all sorts of industries to spin off real estate. REITs get higher multiples on Wall Street than do restaurant companies, O’Cull said, because low interest rates have investors looking for investments that produce cash and generate returns. Also, REITs typically distribute about 90 percent of the cash they receive to shareholders in the form of dividends.
Restaurant companies that own a lot of real estate typically don’t get the credit for that real estate on the public markets. Investors believe that companies such as McDonald’s Corp. and Darden are thus undervalued, and would be better off if that real estate were spun off to shareholders.
REITs, O’Cull said, typically have valuations of 16 times earnings before interest, taxes, depreciation and amortization. Casual dining restaurants, by comparison, trade for about 10 times EBITDA.
The big challenge in real estate spinoffs is that they put more pressure on the company to improve profits. Companies that own a lot of real estate do so in part to avoid rent payments. Spinning off real estate suddenly forces restaurants to pay that rent. If they struggle, those payments can get difficult to make. Many a concept went bankrupt years after sale-leaseback deals.
In Darden’s case, however, the restaurants have high unit volumes. As such, the deal can be structured in a way where rent is relatively low, at 6.5 percent of sales, which is still enough to attract investors. If the company had low volumes, it wouldn’t be able to do that. “You could do the deal, add value to shareholders, and not put a lot of pressure on restaurants to perform at a certain level,” O’Cull said.
The other benefit to shareholders is that the REIT could grow beyond Darden’s properties. “The key is putting in an experienced management team that would quickly diversify the tenant base,” O’Cull said. That team would be able to borrow money to acquire more properties. That would be important because the REIT would not be fully dependent upon Darden to succeed — one of the primary drawbacks of a REIT situation.
From Darden’s standpoint, a REIT is something the company can do to improve value without affecting customers. And the company's chairman certainly seems positive on the idea, at least judging by recent comments.
“That’s something we can do that has no effect on restaurant operations,” Darden Chairman, and Starboard CEO, Jeff Smith said on Bloomberg Television this week. “It can unlock a lot of value. The restaurants continue to run, and nothing affects the restaurant in terms of who owns the restaurant.”