Market Mad House

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Long Ideas

Is Income Inequality Killing Darden Restaurants?

Like a lot of companies that cater to middle-class customers, chain eatery operator Darden Restaurants (NYSE: DRI) has been facing a real struggle to survive lately. Darden, which rode the wave of middle-class prosperity in late 20th century America, has had to drastically change its business model to deal with disappearing customers.

Darden, like department store operators such as Macy’s (NYSE: M), has had to cope with a shrinking middle-class customer base. Pew Social Trends reported that the percentage of Americans that can be viewed as middle class shrank from 62% in 1970 to 43% in 2014. This hurts Darden, which operates eateries designed for middle-class family dining, such as Olive Garden.

Two years ago Darden sold its best-known brand, seafood house Red Lobster, a fixture in suburban America, to Golden Gate Capital. That left Darden with a stable of slightly more upscale restaurant brands that seems more in keeping with America’s declining middle class and growing income inequality, such as the Yard House brew pubs and the Capital Grille steakhouses.

Such a move made sense because the percentage of Americans that can be considered in the upper income tier has more than doubled between 1971 and 2014, rising from 4% to 9%, according to Pew. To add icing to the cake, the amount of money in the upper class’s wallets grew dramatically; around 49% of aggregate income in the United States was going to upper income families in 2014.


So from a demographics standpoint, Darden’s decision to sell off Red Lobster, a favorite location for middle-class Sunday dinners, and concentrate on microbrews and high-priced steaks made sense. Yet investors will want to ask the obvious question: Is Darden making money with the new business model? Do the financial numbers justify Darden’s share price?

Is Darden Restaurants Making Money?

The latest crop of Darden financial numbers, those from November 30, 2015, definitely do not justify the $61.93 a share the company was trading at on January 22, 2016. Some of the numbers are so bad they even cast doubt on Darden’s whole business model.

Particularly bothersome was a free cash flow of -$4.7 million. This is troublesome because Darden reported a free cash flow of $35.2 million in November 2014. There was also a revenue of $6.905 billion, a modest increase over third quarter 2014, when Darden reported a revenue of $6.423 billion.

Also disturbing was Darden’s net income, which was $368.7 million for third quarter 2015. That’s really bothersome because the company reported a net income of $666.6 million in November 2014. This means Darden lost $297.9 million, or nearly $300 million, in income in just a year; that’s hardly a healthy company.


That’s a major hit to the bottom line because Darden reported making $463.7 million in cash from operations in Third Quarter 2015. That number too was a major drop from Third Quarter 2014, when Darden generated $750.1 million in cash from operations. By my calculations, the company’s cash from operations shrank by $286.40 million in just a year.

These numbers indicate that Darden’s business model is not working; it is losing money and not making up for lost income or cash. Instead, we get a picture of a company that is struggling to survive.

What Is Next for Darden Restaurants?

My prediction is that Darden is going to have to cut back on its operations or sell assets in the near future. There is simply no way it can go on with negative cash flow and these massive drops in cash from operations.

The company will need to seriously consider culling the number of restaurants it owns (around 1,500) or getting rid of some brands. It currently operates Olive Garden, Longhorn Steakhouse, Bahama Breeze Island Grille, Seasons Fresh Grill, the Capital Grille, Eddie V’s Prime Seafood and Yard House brands. One or more of these may have to go if this company is to survive.

A major problem here could be high operating costs—either rising food prices or increased real estate expenses. Labor costs could be a problem too because Darden currently has around 150,000 employees.

Payroll costs could go up because the restaurant industry is currently experiencing a labor shortage, according to The Washington Post. The biggest shortage is for cooks, who are obviously Darden’s key employees. Higher wages could be necessary for the company just to keep its kitchens running.


Why Investors Need to Be Afraid for the Middle Class

Darden’s troubles also raise serious questions about the health of America’s middle class and consumer economy. It seems as if many Americans simply lack the cash to eat out anymore, which is cutting into Darden’s business. Another problem is that Darden may not be keeping up with changing tastes, particularly the desire for a greater variety of ethnic cuisines on the part of average people.

Investors should avoid Darden, which is heading for a major implosion if it cannot fix its business model. Yet Darden’s troubles should also be a serious lesson for investors: Stay away from consumer brands that cater to a middle-class market. The great American middle class may no longer be large enough or affluent enough to sustain such fixtures of suburban life as sit-down restaurants.