Activist investors likely to continue to push for change in US restaurant industry, Fitch says; slow US economic recovery, weak top-line growth has led to long period of restaurant stock market underperformance

CHICAGO , May 19, 2014 (press release) – Activist investors are likely to continue to push for change in the U.S. restaurant industry, according to Fitch Ratings. The slow U.S. economic recovery and weak top-line growth, particularly in casual dining, have led to a long period of stock market underperformance, motivating activists to search for ways to extract value that could be detrimental to bondholders.

However, firms such as Darden Restaurants, Inc., which last Friday announced plans to sell Red Lobster for $2.1 billion or about 9x trailing 12-month EBITDA, are moving forward with strategic initiatives, despite objections from activist investors.

The Russell 3000 Restaurant Index, a broad index of the largest U.S. restaurants that includes Darden, Bob Evans Farms, Inc., Cracker Barrel Old Country Store, Inc. and BJ's Restaurants, Inc., has underperformed the S&P 500 Index by approximately 20% over the past two years. Although all of these firms are currently returning more cash to shareholders, each is being targeted by activist hedge funds who are seeking a greater return on investment. Most of the activists targeting restaurants individually own less than 10% of the firm but are demanding more transformative actions, such as breaking up the business, monetizing its real estate, gaining greater board representation, or selling the firm.

We take demands by activists very seriously because they are a major distraction to management and could lead to heightened event risk for creditors. Fitch does not explicitly factor threats from activists into ratings, as many overtures have been unsuccessful. But Fitch continually monitors developments to ascertain whether changes in financial or operational strategy become more or less likely. Increased leverage, in order to enhance shareholder returns, and reduced financial flexibility limits the ability of restaurant chains to navigate in an operating environment that Fitch expects to remain strained in the near term.

A strong board of directors, the composition of a firm's shareholder base, and an experienced management team all continue to play important roles in the ability of targeted firms to defend themselves against activists. Darden's board of directors has evaluated various strategic options to enhance shareholder value, the firm's largest shareholders include value-oriented investors, and Fitch believes management has responded to activist investors' proposals appropriately. Darden believes the structure of the agreement to sell Red Lobster enables it to capture the value of the brand and its real estate. Monetizing Darden's real estate is a key element of the activists' proposals.

Fitch affirmed Darden's Issuer Default Rating at 'BBB-/F3' and removed the ratings from Negative Watch on Friday due to reduced uncertainty regarding the separation of Red Lobster and management's plan to use the majority of net proceeds for debt reduction. Fitch views the probability of completion as high because the divestiture of Red Lobster has been approved by Darden's board of directors, is not subject to approval from shareholders, and the buyer has committed financing. Fitch also expects Darden to maintain credit metrics suitable for its investment grade rating; such that the total adjusted debt/EBITDAR ratio is at the low end of the 3.0x-3.5x range and FCF will approximate $100 million within one year of the transaction, which is expected to close by the end of August 2014.

The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.

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