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Tuesday, June 10, 2014 - 14:45
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Tuesday, June 10, 2014 - 14:45
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Tuesday, June 10, 2014 - 14:45

This Household Name Could Earn 27% As It Slumps

Tuesday, June 10, 2014 - 2:45pm

I don't know about you, but I've been seeing more Red Lobster commercials than usual over the past few months. While it's been many years since I've stopped in for LobsterFest, the marketing push did pique my curiosity.

What was going on at Darden Restaurants (NYSE: DRI), Red Lobster's parent company? Were they trying to revive the struggling brand?

Not exactly. Darden is selling the 46-year-old brand that gave the company its start for a mere $2.1 billion (roughly $1.6 billion net after taxes). Approximately $1 billion from the sale will be used to pay down a portion of its big debt load (total liabilities come in at close to $5 billion), while the remaining $600 million will be allocated to buy back shares in an effort to keep its dividend alive and improve earnings per share (EPS).

This deal may be a lifesaver in the short term, but it also opens up many questions about Darden's growth and stability.

Red Lobster was Darden's second-largest unit (in sales) next to Olive Garden, with Longhorn Steakhouse coming in third. All three units saw traffic decreases in 2013 and collectively saw a year-over-year decrease of 1.3% in 2013 sales.

Its specialty niche dining group -- which includes the Capital Grille, Bahama Breeze, Seasons 52, Eddie V's Steakhouse and Yard House -- did see strong sales growth in 2013, but these restaurants only represent a relatively small portion of the company's total sales.

The bottom line is that earnings from continuing operations have been on the decline since 2011. And it's unlikely selling Red Lobster will be the beginning of a turnaround; analysts have been reducing EPS estimates, as you can see on the chart:

When I look at Darden, I see a company that has missed three of its past four earnings estimates while trying to reinvent itself. DRI's 4.3% annual dividend yield will likely continue to attract some investors, but I don't buy the arguments that Darden should be valued like its peers, as their situations are quite different.

The longer-term picture might look better for Darden if it can continue to squeeze growth from its niche brands and keep costs low, but I see struggles ahead in the next few quarters.

A Short- and Long-Term Problem
As we all know, shorting anything in this market can be risky. For DRI, I see technical issues as well as the fundamental stress. This is ideal if you're betting against the bullish market trend.

DRI recently moved above its 50- and 200-day moving averages, pushing shares from $49.50 to $51. There is a bit of a wedge that has formed going back to January, which likely gave us the temporary near-term bounce to the upside before the stock resumes its series of lower highs and moderately bearish trend.

I want to be clear: I don't think this stock will drop like a rock. I see a 6% to 8% pullback in this low-volatility name that should allow us to generate a potential 27% gain in a month or two.

Here's how...

DRI Put Option Trade
Today, I am interested in buying DRI Oct 55 Puts for a limit price of $5.90 or less. Be sure to use limit orders in this trade, as the bid-ask spreads are wide.

Risk graph courtesy of TradeMonster

This put option has a delta of 70, which means it will move roughly $0.70 for every dollar that DRI moves, but it costs 1/10th the price of the stock.

The trade breaks even (on expiration) at $49.10 ($55 strike price minus $5.90 options premium), which is 3.6% below current prices.

We are looking for a quick move lower to $48.20 in the stock over the next month, which would equate to roughly $7.50 in the option, which is where we will place our target.

For our stop-loss, we are going to allow a $2.90 drawdown on the price of the option, setting our stop-exit if the option dwindles down below $3. Be careful using physical stop-loss orders with this name; it's better to use a trigger order that alerts you or triggers a sale if the bid of the option goes to $2.95.

Action to Take -->
-- Use a limit order to buy DRI Oct 55 Puts at $5.90 or less
-- Set stop-loss at $2.95
-- Set price target at $7.50 for a potential 27% gain in one to two months

This article was originally published at ProfitableTrading.com:
Name-Brand Company Could Deliver 27% Gains as It Slides

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Jared Levy does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.