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Red Lobster – In a Pinch, Clawing Its Way to the Bottom

Posted by on November 3, 2014

Red Lobster AcquisitionDarden, the restaurant operator (Olive Garden, Longhorn Steakhouse, Yard House, Capital Grille ) sold Red Lobster a few months ago. The acquirer was / is Golden Gate Capital, a private equity firm based in San Francisco, that also holds California Pizza Kitchen. Eddie Bauer, Zales and other consumer facing businesses. Golden Gate was formed by ex-employees of Bain.

The published price was $2.1 billion, of which approximately $1 billion was outstanding debt, which must be retired.

Various publicly stated reasons for the sale included 1) activist investors belief the company could perform better, and 2) the company’s desire to focus on its more profitable brands. But one can’t help but thinking they just wanted to cut a loser loose, as their other brands perform so much better than the Lobster.

The last financial figures I was able to find put the Lobster’s revenue at $2.62 billion for 2013, about $3.5 million per store, although per store sales on a year to year basis have fallen for several years. Darden claims a profit margin of 5.7 % across its entire line of brands.

Optimistically, if the chain in fact did turn in a 5.7% margin, or $148 million, the sale price reflected a valuation of 15x profit. In reality, the multiple was probably higher than that, as Darden has publicly stated that other portfolio brands perform better than Lobster.

Coinciding with the closing, Golden Gate spun the real property of the company, at least over 500 locations, for $1.5 billion, to American Capital Realty Partners, seemingly resulting in a net purchase price of $600 million for the restaurant chain.

On the surface, the sale / leaseback seems like a brilliant move, bring the acquisition value to only about 4x profit, with the previous margin assumption.

But behind the scenes, it is a recipe for disaster. Chain restaurants, especially in the fast casual segment, aim for profit in the 2% – 5% range; in other words, the segment is a very low margin business.

Prior to the sale, Red Lobster’s operating expenses did not include rent, as they owned their buildings. Now they will add a rent expense line to their P/L, reducing the margin even more.

The restaurant chain says it has suffered from a couple of different circumstances – during the downturn, most every restaurant’s performance was diminished, and the Lobster in particular suffered from dramatically increasing prices in fresh seafood. (Particularly a shrimp blight in Asia – personally I’d be happier and a potential customer if Lobster made a commitment to buying only wild caught American shrimp).

So there are two paths to private equity investors receiving a substantial return over the life of this deal: dramatically increase revenue or profit. In the fast casual segment, it’s unlikely a rapid rise in revenue will come, unless the parent spins off a majority of restaurants as franchises, and books those sales as revenue. With over 700 restaurants in the portfolio, and supposedly near a “50% share’ of the seafood restaurant segment (according to some sources), it’s unlikely they will be adding a significant number of new company-owned outlets.

That leaves increasing profits as an option, and that means cutting costs either with suppliers or layoffs. By some accounts, the former appears to be happening.

In one of my other business interests, I regularly hear from restaurant diners who report on their experiences. Over the past two months, Red Lobster diner reports have increasingly received poorer marks, particularly for the quality of food.

One diner was indignant that the ‘melted butter’ served with seafood wasn’t butter (nor was the spread served with the biscuits) (nor upon asking was any real butter available), another complained of the “fresh fish” tasting “old,” while still another talked about fish filets being prepared and served “untrimmed” giving diners an appearance of receiving a larger portion, even though the edible portion was less than the restaurant previously served. The biggest complaint I have heard is that the size of shrimp in dishes has grown increasingly smaller, with one diner saying “they looked like 30-40s.”) A quick glance at some Yelp reviews this morning confirms there quite a few disenchanted customers.

As I wrote about the Burger King takeover a few months ago, Red Lobster is in peril if they don’t focus on the three things that bring customers into a restaurant: food quality, experience, and value.

Apparently those points are concepts that have eluded private equity.

When prices get so out of whack that diners can chose fast casual at the same price point as McDonalds, and likewise, some fast casual diners can hit full service restaurants for the same price point, clearly something has to change.

(And please dear god, don’t let the changes include selling crappy product with your name on it in the frozen food aisles at grocery stores).

I’m not omniscient (darn it), but I don’t see the Red Lobster transaction ending well for investors. Just my opinion of course.

Footnote:  A couple days after I wrote this, Red Lobster announced they were making substantial changes to their menu, including adding more lobster. Duh.  The most brilliant strategy?  This quote from management:  “Menu items are also presented in the way diners order, “beginning with drinks and ending with desserts.”   Probably took a $500,000, 750 page  study from Booz or McKinsey to figure that out.

(Red Lobster began as one seafood restaurant in Lakeland, Florida in 1968 and is now the world’s largest casual dining seafood restaurant company, with 47 percent market share in the seafood specialist segment, over 700 restaurants in the United States and Canada and more than 58,000 employees)

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