June 18, 2014
A nasty fight is brewing between Darden Restaurants, Inc.’s management team and hedge fund shareholders Starboard Value LP and Barington Capital Group LP over Darden’s sale of its Red Lobster chain to private equity firm Golden Gate Capital. Same store sales at Red Lobster have been declining, raising pressing questions about what to do to reinvigorate the chain which, with 706 locations in the US and Canada, accounts for 30 percent of Darden’s sales revenue. Unfortunately, the dispute between Darden’s management and its activist shareholders is not about the best way to turn the restaurant chain around, but centers instead on disagreement over the best use of financial engineering to maximize shareholder value.
Darden’s, which also owns such well-known chains as the Olive Garden, LongHorn Steakhouse, Bahama Breeze, and Capitol Grille, is the largest full-service restaurant company in the world with over 180,000 workers at over 2,000 locations and a market value of nearly $7 billion. In recent years its mature brands – Red Lobster and Olive Garden – have experienced stagnant or declining same store sales.
The Restaurant Opportunities Center(ROC) United and other worker advocates blame the faltering performance at the two chains on the lack of investment in workers and on illegal behavior by management, including wage theft, that have damaged the restaurant brands. In one particularly egregious case, the failure to allow hourly paid workers to earn paid sick days endangered the health of hundreds of restaurant patrons. The failure to provide employees with any paid sick days led an employee at a North Carolina Olive Garden to come to work sick, potentially infecting as many as 3,000 customers with Hepatitis A and generating negative press for Darden. A class action law suit was filed on behalf of affected customers. Accusations of wage theft also plagued the two restaurant chains. Two wage theft cases involving workers at Red Lobster and Olive Garden restaurants in California were settled for $4 million. This followed an earlier settlement in which 20,000 workers, who had been denied rest and meal breaks at Red Lobster and Olive Garden restaurants, shared in a $9.5 million award.
The ROC United argues that it is not too late for Darden to change direction and improve business performance at these restaurants:
Darden can correct its course now and become a beacon in the restaurant industry for practices that are sustainable for workers and the public health. From a business perspective, this path results in decreased turnover costs …. Moreover, this path does not entail any risks to the company’s brands …. In fact, Darden’s brands would instead garner praise from the growing base of consumers who are concerned about eating ethically ….
The hedge fund shareholders eschewed any interest in improving the operating returns of the chains and proposed a different path to enhancing shareholder value – dividing Darden into three companies. One would consist of the Red Lobster and Olive Garden chains which, despite falling profits, together generate the lion’s share of Darden’s revenue. According to Barington Capital Group, this company would be able to pay out dividends to the company’s shareholders. The second would consist of Darden’s fast growing chains, including LongHorn, Capital Grille, and Bahama Breeze. Strong profits in these chains would no longer be available to mask declining profits at Red Lobster and Olive Garden, but would lead to a rising share price for the streamlined company. The third company would hold all of Darden’s extensive real estate holdings, leasing them back to the Darden restaurants that currently occupy them and using the rent it collects to make dividend payments to shareholders. (See here and here).
Darden management chose a different route to increasing shareholder value. On May16, Darden CEO Clarence Otis Jr. announced the sale of Red Lobster to private equity firm Golden Gate Capital for $2.1 billion. That same morning, Golden Gate announced that it had sold the real estate assets of 500 Red Lobster properties in a sale-leaseback deal with American Realty Capital for $1.5 billion. Darden, which sold the chain for 9x earnings before interest, taxes, depreciation and amortization expects to clear $1.6 billion which it will use to retire debt, buy back shares, and continue paying dividends (see here and here). Despite the protests of Starboard, this is quite a good deal for shareholders.
For workers, however, the prospects are likely to be grim. Red Lobster is a chain already struggling to remain profitable. In the first quarter of 2014, same store sales in the U.S. fell 8.8 percent. The sale-lease back deal engineered by its new PE owners makes a turnaround that much more difficult to achieve: the sudden obligation to make rent payments will squeeze already tight margins. Local Red Lobster managers will come under added pressure to hold down wages and cut workers’ meager benefits – this at a chain that already has a poor record of respecting employees’ rights and adhering to employment law. Restaurant closings are likely. Golden Gate Capital, which received financing for the deal from Deutsche Bank, Jefferies, and GE Capital, has relatively little of its own money at stake. Its investment could easily be recouped should it choose to have Red Lobster use its still high revenue to fund dividend recapitalizations or require the restaurant chain to pay fees for monitoring and other services.
We have seen this movie before and, as we document in Private Equity at Work: When Wall Street Manages Main Street, it often ends badly for the restaurant chain and its workers. Buffets, Friendly’s, Charlie Brown’s, Marie Callender’s, Real Mex, Sbarro and Uno’s all faced bankruptcy while in private equity hands after entering into sale-leaseback agreements for their real estate assets. But it doesn’t have to end this way. If Golden Gate really wants to take steps to build on the restaurant chain’s strong brand, it can team up with its employees, pay its wait staff fairly, reduce turnover and improve morale, and build the Red Lobster brand into one that is attractive to the growing ranks of restaurant patrons who are concerned about sustainable and ethical dining.