Strategic analysis: Should Darden spin off its brands?

Part 23

Darden analysis: Why Darden’s real estate has a 27% upside

Using REITs to reduce tax payment

Remember that a company’s income is charged a corporate tax rate. So by the time shareholders get their share of real estate income from Darden Restaurant Inc.’s (DRI) business, it’s been taxed once at a company level—which isn’t attractive. But say Darden moves all of its real estate assets into another company and makes that a REIT. Because REITs aren’t subject to corporate taxes if they distribute more than 90% of their income to shareholders, it’s less money for the government, but more for the shareholders. Consequently, Darden’s after-tax real estate income will rise, and so will the value of the stock.

Baringot's Pro FormaEnlarge Graph

Darden isn’t maximizing the value of its real estate

Darden has an “internal REIT,” according to Barington Capital Group. The hedge fund notes, however, that the restaurant isn’t maximizing the value of the its real estate holdings or its potential tax benefits, since Darden’s taxable income and tax rates are similar to its peers. This includes those with substantially fewer real estate holdings.

Creating a REIT would transfer income to non-taxed investment

Spinning off Darden’s real estate business into a separate REIT company would move some income off of Darden’s current income statement. Of course, expenses like property taxes will transfer to the new REIT company too. But any income generated from the business won’t be taxed at a corporate level, and would only be taxed when shareholders receive them—which should add value.

Earnings appreciation due to tax saves only 5%

Barington Capital Group estimates that as much as $177 million of nontaxable operating income could shift out of Darden. After subtracting applicable interest expense for the new REIT company, pre-tax income amounts to $111 million—equivalent to 24% of the company’s current pre-tax income. Now, Darden essentially doesn’t have to pay 20% tax on 24% of the last twelve months of pre-tax income. This equates to 4.8%. It isn’t a lot, right? A savings of 4.8% in tax from pre-tax income means an earnings increase of 5.0%. Well, if Darden is somewhat correctly valued at this moment, a 5.0% increase in earnings will only translate to a 5.0% increase in share price.

But REITs aren’t valued based on PE multiples

Note, however, that REITs aren’t valued based on PE multiples. Instead, they’re often based on FFO (funds from operations) and dividend yield because depreciation isn’t really an expense for properties. On an EV/EBITDA or PE basis, REITs tend to have higher valuation multiples at 15 to 50 times plus, respectively.

Creating a REIT could unlock value worth 27% more

Using Barington Capital Group’s estimated real estate value and its valuation method that can be found in its letter, but with lower EV/EBITDA and EV/EBIT multiples, a share of Darden should be worth about $65—a 27% upside from the current value because of the real estate spinoff. This is close to what Howard Penney had valued Darden’s real estate assets at—$15 to $20 a share from the current price of $51.

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