Darden’s dilemma shows us bitter truths about boardroom behavior

By Steven Pearlstein, Published: January 3 | Updated: Sunday, January 5, 12:12 AM

Editor’s note: After a year-long hiatus, Steven Pearlstein’s business and economics column resumes today. It will appear every other week in Sunday Business. Pearlstein is also a professor of public and international affairs at George Mason University.

I made my first trip to a Red Lobster last week — I had the Bar Harbor Lobster Bake — to better understand the financial melodrama that is playing out on Wall Street and in the company’s boardroom. It’s a case study of everything that’s wrong with the current version of “shareholder capitalism.”

Red Lobster, along with Olive Garden, LongHorn Steakhouse and the Capital Grille, is part of Darden Restaurants, the country’s leading operator of casual-dining restaurants. Last spring, Barington Capital, a small “activist” hedge fund, bought a 2 percent stake in Darden and, as such funds always do, presented Darden management with a restructuring plan designed to boost its stock price by 65 percent. The plan called for breaking Darden into three more-focused and efficient public companies — one with its mature, slow-growing brands, such as Red Lobster and Olive Garden, another with its younger, faster-growing brands, and a real estate investment trust to own and manage Darden’s extensive portfolio.

Darden’s management hired Goldman Sachs to help it consider how to deal with the challenge and finally announced the week before Christmas that it would spin off Red Lobster as a separate company, load it up with debt, slow expansion of its other brands and use the extra cash to buy back shares — all of it in the cause of delivering “enhanced shareholder value,” the polite euphemism for goosing up the stock price.

That restructuring plan failed to satisfy Barington, or any of the other activist hedge funds, which tend to prey on the same quarry. A second, Starboard Value, which now has 5 percent of Darden’s shares, put forward an even more aggressive plan that included “monetizing” existing restaurants by selling them off to franchisees. Starboard made explicit a threat that Barington had only implied: that if it doesn’t get its way, it will mount a campaign to oust the company’s directors and management.

To savor the delicious irony of this situation, a little Darden history is in order.

It begins in 1970 when General Mills, maker of Cheerios, Pillsbury flour and Betty Crocker brownie mix, decided that it could deliver more growth and greater stock price stability to investors if it diversified into other industries that had different cycles, cost pressures and risks. Over the next decade, it bought toy companies (the makers of Play-Doh and Monopoly) and clothing companies (Eddie Bauer and Talbot’s) with the idea that its access to cheap capital and sophisticated management would allow it to build them into big new divisions. William Darden’s small Red Lobster chain was bought by General Mills in 1970, and Darden stayed on as a top executive as the company expanded its restaurant division.

Wall Street loved such conglomerates — until it came to realize that they had a knack for taking well-run companies, expanding them too fast, hobbling them with too much bureaucracy and running them into the ground. So by the mid-’80s, Wall Street began demanding that companies focus on core products in which they held dominant positions and sell off everything else. Many divisions were sold at discounted prices to private-equity firms that quickly turned them around and took them public again at hefty profits. Others were spun off to shareholders as separate public companies. Once again, the rationale was “enhancing shareholder value.”

By the time what became Darden Restaurants was spun off in 1995, it had successfully launched Olive Garden, its family Italian restaurant, and was well on its way to every major suburban shopping mall in America. Using well-tested operational formulas, it provided good value to budget-conscious suburbanites, relying on national television advertising and price promotions to drive traffic. Wall Street loved the Darden growth story — until it realized that Red Lobster and Olive Garden had pretty much saturated the market.

Desperate to win the kind of stock price valuations (and incentive compensation) that only growth companies command, Darden embarked on a strategy of buying up smaller restaurant chains with potential to be taken national. In 2007, it bought LongHorn Steakhouse and Capital Grille for $1.4 billion. In 2011, it was Eddie V’s, a higher-end fish restaurant, for $59 million. And in 2012, it was Yard House, an American pub-style chain, for $585 million. In each case, Darden executives touted the acquisition as a way to generate sales and earnings growth, diversify the company’s customer base and leverage operational synergies, all of it in the service of enhancing shareholder value.

Unfortunately for Darden, the synergies and efficiencies never materialized (they rarely do), while growth from the new brands was not enough to offset the decline in sales and profitability of its much larger mature brands. So Darden found itself in that Wall Street no-man’s land where it could not be neatly categorized as either a pure growth company or a mature, dividend-paying stock. It was only a matter of time before analysts would downgrade the stock, activist hedge funds would pounce, and the company would be forced into yet another bout of financial engineering to “unlock” the unrecognized value of its assets and “enhance shareholder value.”

The news release announcing Darden’s new strategy, and the transcript of the management’s conference call with Wall Street analysts, read like a parody of the financial mumbo-jumbo, management buzzwords and PR spin that passes for corporate communication these days.

During the conference call, executives who were privately seething at what they view as the unfair public criticism hurled at them by the activists hedge funds lined up to declare how “thrilled” and “excited” they were about the new strategy and structure. And while “value for shareholders” was mentioned in virtually every paragraph, there was little or no mention of improving the food or service for customers or sharing any of the benefits of restructuring with front-line employees, 20 percent of whom earn the legal minimum of $2.30 an hour before tips.

The first thing to understand about these never-ending bouts of buying up and spinning off is that they create little, if any, long-term economic value. If running slow-growing Red Lobster is really so different from fast-growing LongHorn Steakhouse, there is no reason Darden could not organize itself in a way that lets every brand, or group of similar brands, be managed independently, with centralized technology, purchasing, marketing and real estate services made available to brand managers who want to take advantage of any benefits or efficiencies they might offer.

And while it is true that there are some investors who want to buy growth stocks and others who like stocks offering stability and dividends, there are also plenty of investors who seek a combination of growth and income, and ought to be clever enough to assign different valuations to different segments of the company.

These endless restructurings are nothing more than a con game concocted to generate short-term trading profits and investment banking fees for the Wall Street wise guys and inflated compensation for executives. It has little, if anything, to do with providing good value to customers. It has nothing to do with providing good jobs for workers. And, ironically, it doesn’t even generate a better return to long-term shareholders. It is the last refuge of weak and unimaginative corporate leaders who are unwilling to or can’t succeed the old-fashioned way — by recruiting and motivating loyal employees to provide great products and services at competitive prices.

As for the lobster bake, it was a generous portion, fresher tasting than I expected but a bit bland. The freshly-baked cheese rolls were a big hit.