In Restaurants, Pure Growth Is Best

 | Feb 03, 2014 | 10:42 AM EST  | Comments
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Stock quotes in this article:

dri

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cmg

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fbhs

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tyc

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pm

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krft

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cag

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mpc

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Which is better? Is it shrinking in order to grow, or just pure growth? Right now that's being put to the test in the restaurant group -- and as much as I think shrink-to-grow is often the way to go, in this particular milieu it's pretty clear you want growth, not break-up and shrinkage.

The cases in point? Darden (DRI) and Chipotle (CMG). The former is throwing in the towel on its core concept, Red Lobster, and spinning it off and reducing new-unit growth while suspending acquisitions. Chipotle, on the other hand, is accelerating new-store growth and putting money down on new concepts and joint ventures that could turn out to be acquisitions.

We saw what happened last week when Chipotle announced its latest quarter with smoking plus-9%-growth in comps: The stock shot from $483 to $557. That's a similar pattern to what we saw when the previous quarter was released, after which the stock went from $439 to $510.

During that period Darden went from $51 to $49. That, coincidentally, is the same distance the stock has traveled since the company announced its shrink to grow plan -- something that seems to have been prompted by two different activists seeking to bring out value.

Of course, if you want a longer-term history, in the last four years Chipotle has gone from $99 to $551 while Darden has advanced $38 to $49, although the latter has given you more than $6 in dividends during that period. Still, if you look at that run Buffalo Wild Wings (BWLD) has taken from $43 to $141, DineEquity (DIN) from $27 to $77, Starbucks (SBUX) from $22 to $71, Panera (PNRA) from $60 to $169, and Brinker (EAT) from $14 to $48. All of those other players have been committed to growth, and the growth has worked.

But I care more about Chipotle vs. Darden, because Chipotle is a company that invents new concepts. First it was Shophouse Southeast Asian Kitchen and now, with an investment in a local pizza chain, Pizzeria Local. The latter is a promising idea brought to the company by two graduates of the French Laundry, the legendary French restaurant in California run by Thomas Keller. Meanwhile, of course, Chipotle's putting up more and more stores, announcing an impressive plan for 180 to 195 new restaurants in 2014, to provide it with more locations than ever before.

The comps at Chipotle have accelerated while they have stagnated at Darden. If you break Darden into the three meaningful divisions, you see Longhorn at plus 5% in the most recent quarter while Olive Garden was at minus 0.6% and Red Lobster finished at minus 4.5%. Given those declines, it is hard to believe that anyone will want the Red Lobster spin-off -- and, given the spotty cash flow of the whole operation, it is a wonder that the company has the chutzpah to even attempt to spin off the property. Hence why I think that, in contrast to so many other situations, the shrink-to-grow concept here has been a total bust.

Why is this? I think it is simple: execution. Chipotle has had terrific growth because it has a product that people love -- one that is as natural and organic as a fast casual food restaurant can have. On the other hand I think Darden, for better or for worse, is regarded as a boring, "same old, same old" chain with nothing that's compelling. All it has are recycled advertising campaigns heavily promoted on television that do little to bring people into the stores.

Chipotle spends a lot of time thinking about how to make its stores better and better, and how to distinguish itself from other companies in the restaurant business. Darden seems to do nothing of the sort. It seems to fail repeatedly at creating new concepts. I bet that Chipotle will blow out Shophouse when it is ready, and it is also about to go overseas with Chipotle in a meaningful way. International's been a total bust for Darden.

I think the wonder of Darden is that someone hasn't challenged the company before, and it took so long for anyone -- in this case Starboard and Barrington, two hedge funds -- to challenge the company.

Now, when we see companies breaking up in order to bring out value, they tend to be those that are unwieldy and difficult to determine their worth. Think about some of the best ones: Fortune Brands (FBHS), Tyco (TYC), Philip Morris (PM), Kraft (KRFT), Ralcorp (now owned by ConAgra (CAG)), Marathon Petroleum (MPC), ConocoPhillips (COP) and American Standard. All of those companies had two different value streams under the same roof -- perhaps one with fast growth with low-cash-flow spinoff, and the other with slow growth with a dividend. Or, quite simply, they had different disparate entities that didn't belong to each other but were worth far more separate.

In each case, you got big moves all across the board when there were hints that the companies would split up, to the actual announcement, to the day of the split. Then, course, there was the aftermath, when analysts embraced the pieces or we had some rather rapid takeovers.

Contrast those with Darden, for which I think the Red Lobster independence will simply produce a terrible restaurant chain and a slow-growing restaurant chain, both with uncertain cash flows. It's the worst kind of deal.

Darden and Chipotle demonstrate that, in the end, what shareholders really want out of a restaurant chain isn't a split-off of a good restaurant and a bad restaurant, like some sort of "good bank, bad bank" solution -- which is what this really us. Shareholders want a company that grows within reason, with consistent comps gains and a differentiated model that produces long-term returns. That's something that Darden has proven to be incapable of doing under CEO Clarence Otis, but which is the be-all and end-all of the co-CEOs Steve Ells and Monty Moran.

My conclusion? Either dismiss Otis and bring in some new blood, or simply sell Darden or even short it, perhaps with puts so you do not have to pay that dividend. But buy Chipotle, even up at these levels, because it's doing everything right at the same time that Darden, surely, is doing everything wrong.

Random musings: Chipotle chief financial officer Jack Hartung is scheduled to appear on Mad Money tonight.

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