Good morning, Sujeet Indap here and excited to fill in for Rob today.
Yesterday, Nvidia produced its usual blowout quarter: Revenues up 262 per cent year on year, $26bn in total for the first three months of the fiscal year, ending April.
Most interestingly, the company will split its shares 10 to 1 in order to “make stock ownership more accessible to employees and investors” (it’s share price is about to touch $1,000, roughly doubling so far in 2024). Such pie-splitting exercises should not create shareholder value, but these days just about anything can send Nvidia’s stock price off to the races.
Hard to Starboard
The collapse this week of Red Lobster has understandably been focused on its sharpest hook: a $20 all-you-can-eat shrimp promotion (known as “Ultimate Endless Shrimp”) that allegedly benefited its primary shellfish vendor, Thai Union, which happened to be its largest equity shareholder.
But the Red Lobster saga really traces back a decade to one of the most sensational boardroom showdowns of recent memory. Red Lobster was then part of Darden Restaurants, whose biggest banner is the hokey Italian chain Olive Garden. The activist hedge fund Starboard Value had by early 2014 taken a 6 per cent stake in Darden, arguing that the incumbent management were the wrong chefs in the kitchen.
In the midst of the months-long proxy fight, Darden sold off Red Lobster for $2.1bn in cash to the private equity firm Golden Gate Capital, a decision and deal price that inflamed both the already furious Starboard and essentially every other big shareholder.
In October 2014, Starboard managed to defeat the entire 12-person Darden board, an almost unprecedented corporate governance rout at a Fortune 500 company.
Darden, which today operates such brands as Cheddar’s, Capital Grille and Ruth’s Chris Steakhouse, has subsequently thrived, at least for shareholders. Since the beginning of 2014, around when Starboard started making noise, Darden shares have almost tripled, in line with the S&P 500 but well ahead of arch-rivals Brinker (Chilli’s) and Bloomin’ Brands (Outback Steakhouse).
At the peak of its campaign, Starboard shared a 294-page PowerPoint presentation listing its grievances and turnaround plan that itself would become legendary. Its suggestions included specific operating improvements for Olive Garden processes in such areas as boiling fettuccine and allocating breadstick capital.
But perhaps its most substantive idea pertained to real estate. Olive Garden and Red Lobster owned most of its land and buildings. And in the low-interest rate environment, Starboard saw an arbitrage opportunity in exploiting what it described as Darden’s embedded “rent subsidy”.
In 2015, after seizing control of the board, Starboard-led Darden spun off most of its properties — more than 400 — into a real estate investment trust, a listed company that would act as the operating company’s landlord. REITs do not pay federal income tax as long as they distribute nearly all of their cash flow to shareholders.
And while Darden shares themselves are up 190 per cent in a decade, Darden plus the pro rata portion of Four Corners Property Trust is up 205 per cent. (Also: Darden and FCPT pay significant dividends so the combined total return is even higher.) The combined market cap of the pair today is $21bn.
Starboard was furious that Darden’s previous management tossed Red Lobster overboard before the hedge fund could get its hand on its land, buildings and operations. But Red Lobster’s current predicament may have stemmed from how its real estate was harvested over the years.
According to bankruptcy court filings, Red Lobster has only $300mn of traditional funded debt against annual revenues of $2bn. Reduced traffic along with higher operating costs have led to ebitda falling by 60 per cent and the resulting liquidity crunch. A year ago, it had $100mn of cash, which has today dwindled to less than $15mn.
And then there is the matter of its lease payments owed to landlords. Court filings said that it owes a whopping $190.5mn annually in lease payments.
A few months after acquiring Red Lobster for $2.1bn in 2014, Golden Gate immediately sold the bulk of its underlying property to a Reit called American Realty Capital Partners for $1.5bn. In 2016, Golden Gate sold a 49 per cent equity stake in Red Lobster to Thai Union for $575mn, terms that valued the entire Red Lobster equity at nearly $1.2bn.
Golden Gate completely sold out of Red Lobster in 2020 at an undisclosed price. But just based on these public figures, Golden Gate’s equity returns seem substantial.
Golden Gate’s equity returns are then Red Lobster’s thin margin for error. Creditors led by Fortress Investment Group are expected to take control of the company and use the Chapter 11 process to shed bad leases and reorganise into a slimmer company.
One thing that struck Unhedged is how Darden, as a public company, managed its balance sheet seemingly far more conservatively than the privately owned Red Lobster.
Here are the leverage ratios that Darden disclosed in its annual filings:
Darden’s overall ratios of lease-adjusted debt to book capital have not moved much in the past decade even as lease expense owed to the Four Corners Reit have obviously jumped. Essentially, the company reduced loan and bond debt with cash flow and swapped in the lease debt that underlies the Reit.
These “opco-propco” financial engineering gambits are understandably controversial for the added permanent risk that they create by separating the real estate. Either activist hedge funds or private equity firms have finite horizons and will aggressively take profits, leaving everyone else to be potential bagholders.
As for Red Lobster, the bankruptcy is a chance to reset and there is at least one person out there feeling optimism. Sumit Roy, the CEO of Realty Income, which is the Reit landlord for more than 200 Red Lobster locations, offered this assessment recently on an earnings call:
I think of Red Lobster as a — it’s a pretty strange story. They have 700 unique locations. They garner 14% of the casual seafood concept. That is a very hard thing to do. And the fact that they generate north of $2 billion in revenue, if you look at it on a per unit basis, that’s just right around $3.5 million per unit. So it’s not a top-line issue as much as it is an operations issue. They’ve gone through several changes in terms of ownership. Obviously, there have been several changes in terms of management. And this is a business that, in our opinion, hasn’t been very well run.
If you look at the balance sheet, is it a balance sheet issue at Red Lobster? In our opinion, it’s not. They have [$300]mn of debt. And this is really a question of, is there an operator out there that could come in and basically manage this business even to a reasonable level of margins? Today, I don’t believe they’re generating a whole lot of ebitda.
And so if this can be operationally right sized, we believe that this is a concept that should come out and should survive and do quite well given the footprint that they’ve been able to establish.
Get in touch at sujeet.indap@ft.com and tell me what your favourite chain restaurant is.
