Deal Gives Red Lobster Little Room For Error


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The real estate question has always been complex in the restaurant business. Financial guys hate when restaurant companies own real estate, because it doesn't generate strong returns. But many restaurant operators love having at least some real estate, as a hedge against falling sales. So we tend to have no opinion when it comes to the real estate questions dominating the activist actions at Darden and Bob Evans.

But the more we look at this Red Lobster deal, the more we question the move to sell real estate at this point. Golden Gate Capital bought Red Lobster for $2.1 billion, then sold the real estate in one fell swoop to American Realty Capital for $1.5 billion in a sale-leaseback deal. (John Hamburger will look at this deal with more scrutiny in the upcoming print issue of The Monitor.)

But this sale-leaseback puts immense pressure on Golden Gate to reverse Red Lobster's awful earnings trends.

Red Lobster's same-store sales had fallen in five of the past six years, and in its most recently reported quarter had double-digit declines in traffic. The loss of customers, coupled with rising costs for food and labor and other issues, have hammered the chain's earnings.

Net earnings in the past two fiscal years had fallen more than 21 percent, to $126.1 million in the 12 months ended May 2013. In the six months through November, according to SEC documents, those earnings fell 82 percent.

So let's get this straight: We're taking a brand with badly falling sales and earnings, and will then load it up with rent costs? The cash rent Red Lobster will be paying is not insignificant, about $118.5 million. That's about half of the chain's annual EBITDA.

This is probably why Darden was so resistant to the idea of a real estate spinoff, and perhaps it's why the company was so itchy to unload its seafood brand.

By selling off the real estate immediately, Golden Gate is betting on its ability to improve earnings and stop the bleeding on Red Lobster's top line. Indeed, the chain has a lot going for it, thanks to its high unit volumes, its well-known brand name and those Cheddar Bay Biscuits.

But it won't be an easy fix by a long shot. The chain's traffic has been undone over the years by a diminished value perception. Its prices have risen at a rate that outpaces its reputation, to the point that more customers don't think it's worth the price. Customers at this point would prefer spending less to get good quality food at fast casual brands or they're opting to get their meals at hot, local independents. There will be a lot of pressure on the brand to cut prices (and costs) to improve traffic, and there are some casual dining operators we know who are worried about just that. A better fix will be to improve quality and use savvy marketing to improve the chain's reputation.

Whatever the fix, Red Lobster's real estate sale gives its new owners little room for error in the coming years.

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