Here’s Why You Should Ignore the Trend and Bet on Darden Restaurants

Darden Restaurants, Inc. (NYSE:DRI)‘s stock opened around 2% in red on Tuesday, but it has high chances to gain more ground on the back of solid financial results that topped the estimates. The restaurant operator posted consolidated sales of $1.69 billion, up by 5.7% on the year, while its earnings per share surged by over 112% to $0.68 in the first quarter of fiscal 2016, ended August 28. Aside from the fact that the company’s profit beat the consensus estimate by $0.10, Darden’s same-restaurant sales growth amounted to 3.4% during the quarter.

The company’s net income from continuing operations on a GAAP basis stood at $0.63 per share, compared to a loss of $0.14 a year earlier. It was negatively affected by some $0.05 per share charge related to Darden’s plans to spin-off its real estate business. In its outlook for the full fiscal year, Darden Restaurants said it expects earnings per share from continuing operations in the range between $3.15 and $3.30, up from the previous $3.05 to $3.20, while same-restaurant sales growth for the full year is forecasted in the range of 2.0% to 2.5%.

Darden Restaurants, Inc. (NYSE:DRI) currently has ambitious plans to separate its real estate into a tax free transaction advocated by one of its top shareholders, Jeff Smith‘s Starboard Value. Mr. Smith managed to replace the entire board of directors last year after a widely-followed activist campaign that accused the previous board of mismanagement, particularly during the transaction that involved the sale of the “Red Lobster” chain, which Smith argued was sold below its actual value.

However, a recent move by the IRS suggests that the intentions of Darden Restaurants, Inc. (NYSE:DRI) and other companies that want to unlock shareholder value through the separation of real estate into a publicly-traded REIT might be in jeopardy. Under the current legislation, companies are required to include a part of its actively-operating business and, so far, Darden’s plans complied with this rule as the company intended to include six LongHorn steakhouses in San Antonio. But last week, the IRS issued a guidance in which it expressed its concerns with such transactions, saying that the active businesses included in REITs are too small compared to the value of the real estate. Nevertheless, Darden currently believes that it will manage to get through with the spin-off.

Following Smith’s successful activist campaign, Darden Restaurants, Inc. (NYSE:DRI) seems to be set on the rebound, which can be noticed by the 36% growth registered by its stock in the last 52-weeks (it gained 7% in 2014, mainly advancing after the appointment of the new board in October). Another metric that suggests why investors should be bullish on Darden is the significant improvement in the hedge fund sentiment towards Darden Restaurants. We determine the sentiment based on the data from the equity portfolios of over 730 hedge funds from our database. We compile the figures for the number of funds that are bullish on a company and the overall value of their holdings as part of our strategy, which involves imitating 15 most popular small-cap picks among hedge funds. In the last three years, our approach generated returns of over 118% and managed to beat the S&P 500 ETF (SPY) by approximately 60 percentage points (see more details here).

With this in mind, let’s take a closer look at the popularity of Darden Restaurants among the investors from our database. At the end of June, 38 funds held $1.22 billion worth of the company’s stock in aggregate, equal to 13.70% of the company and significantly above 29 investors that held stakes valued at $1.06 billion in aggregate at the end of March. Starboard Value holds the largest position, which contains 11.64 million shares and amasses over 18% of its equity portfolio, followed by Cliff Asness‘ AQR Capital Management and Joel Greenblatt’s Gotham Asset Management, both of which initiated stakes between April and June and reported 1.10 million shares and 583,700 shares in their 13Fs respectively.

With this in mind, it looks like Darden Restaurants, Inc. (NYSE:DRI)’s decline is an overreaction, since the company posted solid earnings and hedge funds are betting on the company’s long-term prospects. The stock looks even more attractive to those who might want to bet on its spin-off plans, since the transaction will unlock significant shareholder value that currently lies in the company’s real estate assets.

Disclosure: none