Who killed Red Lobster?

0:05Pushkin. The unimaginable has happened. Red Lobster has gone bankrupt. Today on the show, who threw the casual dining seafood chain into the boiling water and why? This is Unhedged, the markets and finance podcast from the FT in Pushkin. I am Rob Armstrong. Joining me today is the master of the unlimited shrimp offering, Sujit Indap, the FT's Wall Street editor. Sujit, what is your record for shrimps eaten in one sitting? A dozen would be more than enough, I think. Oh, gee, that's nothing. A dozen, it's like embarrassing to even admit that. That's like not even a proper shrimp cocktail. In any case, I'm glad you're on the show.

0:58What happened here? Yeah, so this has been boiling or brewing for a few months now. There's been stories about distress at Red Lobster and news articles that focused really on this all-you-can-eat shrimp promotion that they had implemented a couple of years ago called Endless Shrimp. And was it literally people eating too much shrimp that drove this business into Chapter 11? I mean, that's kind of hilarious, if true. Yeah, it didn't help. I mean, if you read the court documents that have come out, there's some math on that. They said the endless shrimp promotion cost them like$11 million. There's a whole dispute around the longtime owner of Red Lobster, which is a Thai fishing company called Thai Union, which happened to be its largest supplier of shrimp.

1:52So not only did they own the company, they were providing the shrimp. And was there some kind of mischief around stuffing the channel with shrimp? So the owner whose equity was impaired was actually making money off of just being a vendor. There's some dispute about that. But let's go back to the beginning, which I guess Red Lobster used to be part of Darden, which is a big chain. That's right. So Red Lobster now is an independent company, but its problems can be traced back a decade ago when it was part of this restaurant conglomerate called Darden, which is best known for Olive Garden. but it happened to own Red Lobster and a few other banners as well.

2:31Yes. Of course, we can't mention Olive Garden without mentioning free breadsticks. I mean, you're talking about unlimited shrimp. Darden and Olive Garden, they gave you all the salad and all the breadsticks you can eat. A promotion I took advantage of when I was a hungry young man on college road trips, I would stop and abuse the breadsticks at Olive Garden. Yeah, absolutely. They have that meal where it's like unlimited breadsticks, salad, and soup. And so, yeah, they were all part of the same company 10 years ago. And to your point, there was what is now a legendary or iconic proxy fight between the Darden incumbent management and board and then this well-known activist hedge fund called Starboard Value, which famously goes to companies, buys up some stock and tries to make big changes in the company's operations.

3:22And so this became a famous moment in Wall Street history because Starboard, which is a bunch of Wall Street guys, had very specific operating as well as financial suggestions for the company. And they had released this now famous PowerPoint deck, almost 300 pages long, where in addition to their ideas about spinning off subsidiaries and real estate, they had real suggestions on how Olive Garden should be like working the kitchen and how much salt they should be putting into the pasta that they're boiling, how they should be presenting breadsticks. I remember this. And it seems to me they weren't salting the water at all.

4:03And as an Italian on my mother's side, you know, this makes my blood boil to say nothing of the water they're boiling. Yeah, the blood and the water is boiling. Yes. And so, yeah, there was – apparently they were not putting any salt, which is some kind of huge faux pas. I'll take your words on that. Apparently there's some issues around how the salt damages the actual steel containers. But yes. They were trying to save money on the hardware and making flavorless pasta as a result. Yeah, exactly. And so there was this whole debate about this. This is what got the attention of the salt in the pasta pot, the breadsticks, how they should present those and various other seemingly arcane details of running a fast, casual restaurant in strip malls and shopping malls.

4:49So there's a huge proxy fight. Who wins that one? So this ends up also being a legendary moment in Wall Street, not just that presentation. Starboard happens to replace the entire 12-person board of directors. Usually there's what happens, there'll be a settlement where they get a couple of seats or they're only running a slate of like four. It's supposed to be conciliatory. But they were so outraged at how the Darden management was running the business, including Red Lobster, which we'll get to in a second. They sacked the entire board. I don't think I've ever heard of another proxy fight where they cleared out the entire board.

5:24Yeah, for a large company, it is basically unprecedented. It was an amazing moment. There was all these fancy law firms and investment banks and communications firms working for Darden, and they were just totally humiliated. And that will be a seminal moment in investor activism. They sack the board. And what do they do next? Once they have the controls, what do they do? So in the midst of that proxy fight, Darden had done something that further alienated both Starboard and the broader shareholder base, which was they sold Red Lobster to a private equity firm. And Starboard and the other shareholders had other ideas.

6:07They thought there was a lot of value in Red Lobster and they wanted the chance to implement their own plan. And instead, the company just did it themselves. And the price they got, which was just over$2 billion in a sale to the private equity firm Golden Gate Capital, was thought to be really cheap and inadequate. And then we got a sense of that a few months later after that sale when Golden Gate sold the real estate of Red Lobster to a real estate firm for$1.5 billion. So essentially - They only paid$600 million for the business is what that means. The brand of the business, yeah, basically was just peanuts.

6:45But the interesting thing about Darden, and this was the broader Starboard plan, was that Olive Garden and Red Lobster both owned nearly all of their real estate, as well as the land and buildings. Starboard called this a rent subsidy, that in fact, there's all this value. If you have land, if you own a building, whatever kind of building it is, and you're not charging some third party rent for it, then that is thought to be in value creation terms, like a missing opportunity or something that just is untapped. I don't quite see that though, right? Because the lack of rent they are paying, if it's all one company, the rent they're not paying appears as profit on the bottom line.

7:32Do you see what I mean? Yeah, and that theoretically is correct. What you're really doing is rearranging existing cash flows. And if you decide to, for lack of a better word, monetize that real estate, you're making a bet that if you just rearrange the cash flows, there's going to be a different multiple if you split those companies into two. Right, a multiple meaning the valuation of the business will be higher if you split the companies into two. Yeah, that's right. So one plus one would be two and a half or three or four. And it happens there's a quirk in the U.S. tax code that, at least on the surface, makes that happen.

8:10Walk us through that quirk. Seems important. Yeah. So there's something called real estate investment trust. It's a type of corporate structure where you have essentially like a landlord that collects all those rents and pays more than 90 % of it to shareholders. in the form of dividends, then it can avoid federal income tax. So it's like so many corporate structure moves, it turns out at the end to be a tax diddle. Yeah, there's actually two things going on. There's the tax, though, which actually creates value because you're not paying that tax. There's just more money left over in that kind of system.

8:50And then separately, REITs, as I said, are dividend machines. And dividend machines get paid. Yeah, we're quite valuable as standalone companies in the 2010s because in a low interest environment, something that pays you three or four or five or six percent was valuable just as a stock. And so Starboard's idea is, hey, why don't we separate the real estate, create a new company, which we'll call REIT. The operating company, which is profitable, will just pay this rent to this REIT. and you have two companies and the value of that operating company, the one that's actually running the restaurants and boiling pasta and putting breadsticks into jars, that company is worth something.

9:35And then this landlord is worth something. And you add those two together, it's going to be worth more than it was before. Okay. So now we have the setup in place. We have like a controlled experiment almost because the old Darden management managed to sell Red Lobster. We now have two companies, Old Darden and Red Lobster. Both have broken into Opco, Propco businesses, but one goes bankrupt and the other, I mean, I think Olive Garden and the rest of Darden is doing okay. Is that right? So what's the difference here? Yeah. So let's just talk about what happened post 2014 and 15. So again, Red Lobster is sold to Golden Gate Capital immediately sells the real estate to a different REIT, gets a billion and a half dollars immediately, which obviously helps fund the purchase price and get them a pretty good return.

10:32So that's one thing that happens. And then Darden is left over and the leftover Darden, which is mostly all of Darden, it creates its own REIT, which it spins off to shareholders. And so if you're a shareholder of Darden, you have now two pieces of paper. You have old Darden, which is the business that manages the restaurants. And then you have this piece of paper, which is the REIT, which was called Four Corners Trust. And that is a REIT, which it pays a separate company, which it pays rent to. And that is worth something. So you have two pieces of value. And those two pieces of value, if you look at how they've performed, is quite well.

11:06It's something like, according to the math I had in the unhedged I wrote last week, it had appreciated more than 200%. So tripled. If you add them together, it's actually more if you include the dividends. And that's just ahead of the S &P 500. But more importantly, the rest of the casual dining sector, companies like Brinker, which is Chili's, and others, those companies have struggled. And it's become a very competitive environment in this space, which is going to bring us back to Red Lobster in a second in their struggle. So Darden, old Darden, done quite well. It's executed quite well. This is actually one of the more successful, not just activist campaigns, but kind of value creation plans.

11:46After that, the rest of the restaurant sector has struggled, which brings us to what drives Red Lobster into bankruptcy. So you said earlier, it's not just the unlimited shrimp promo and Homer Simpson coming into the restaurant and eating until the business cracks. If you read the bankruptcy documents, what happens is that in general, this category of casual dining has just been hammered pretty hard. It's very competitive. It's very promotional. If you ever drive by a shopping mall or a strip mall, you see Olive Garden, you see Red Lobster, you see Chili's, you see Applebee's, and so many more.

12:25They're all kind of the same, right? And so it ends up being a very promotional space. And so promotional means meaning just they're giving tons of discounts. There's kind of discounts and there's little kind of differentiation. And so the pandemic ultimately becomes its own death knell, right? Because obviously restaurants shut down, Red Lobster wasn't particularly adept in takeaway and online ordering and delivery. Like the traffic count now is something like 30 % down from pre-pandemic. And then you layer in what I just described before about this optical tropical model. There's a landlord and then there's the lesser, right?

13:05The lessor. Yeah. And that would be Red Lobster. And so it turns out it's paying$190 million in rent to its landlord, which is an enormous amount of money. And that is a fixed obligation. This is a heavy burden on this company. Yeah, it's a huge burden. And any kind of operating slip up is going to put them behind the eight ball. Yes. but I'm wondering where Golden Gate is in all this. They bought it for 2.1. They sold the property for 1.5. So now they've paid 600 million for this business. Where are they at now? So in 2016, there's another masterstroke from them. They sell 49 % of the business for almost$600 million.

13:48So now they've made all their money back and they still own half of the business. Yeah, that's right. So they sell it to Thai Union And then they, Golden Gate, ultimately exit in 2020 right around the time of the pandemic. And they're out. Good timing. Yeah, the timing is good. They undoubtedly made a lot of money to consider, you know, they put in only a small amount of equity and borrow a lot. Returns on equity for them must be quite substantial. So then this company, Thai Union, which is a publicly traded Thai company that is a vendor of fish, ends up owning or controlling Red Lobster, even as it's like it's a large vendor to it, which may or may not be its own conflict of interest.

14:29Yes. Sujit, let me ask you this. Is this a kind of classic story for the private equity haters out there, where private equity gets hold of a nice, juicy lobster, and by the time they're out, there's nothing left but some shells and rancid lemon butter, as it were? That's a good question. I think it's a little bit more complicated than that because Golden Gate, when they sold it, obviously, we went through the numbers and those seemed very attractive. But Thai Union, whom they sold it to, is an operating company. It's obviously in the seafood business, part of the value chain at least. And so they had every ability to manage it better.

15:15Obviously, the pandemic was its own challenge. But there is a real sense that the current problems for Red Lobster, while the leases are onerous, there were definitely opportunities to run this company better. And there's been a bunch of management changes. I think the most interesting thing I came across in my research when I wrote this on Hedge last week was, and I put this at the end of the newsletter, was the comments from the REIT, which is publicly traded, called Realty Income. There's a CEO of that was asked about Red Lobster Heat. His company is the landlord for more than 200 of them. Not everyone, but like the vast plurality of them.

15:54And he said a bunch of interesting things, which I just quoted at length at the end of the column. And he said, you know, this company does$2 billion in sales, which is a lot. It has 14 or 15 % market share. And his view was like the top line isn't that bad. The actual kind of outlines of the business are decent. And he just made the point. It's been mismanaged or under-managed. There's been a lot of management changes. And so there's a new chance or a new opportunity for the new owners, which will be the lenders of Red Lobster led by Fortress Investment Group, to actually, through the bankruptcy process, clean up the balance sheet, clean up the leases, which you can do.

16:32And we've talked about it. We're talking about this today, right? Because Red Lobster is an iconic brand. We see the commercials. We have all memories going there. And in some form, maybe shrunken. Yeah. Yeah, Red Lobster can still exist. This podcast is still going to exist after a short break when we come back for Long and Short.

17:01Welcome back. This is Long Short. That part of the show where we go long things we like and short things that we don't like. Suji, do you have a long or short? I will go long Chili's. And for no other reason, in the dull suburb I grew up in, it was my favorite fast casual chain. And whenever I drive by one, I feel like stopping. Is the food actually better than Applebee's? I mean, this is the question we all have to ask. Which one is actually the best food? I don't think Applebee's is that great, either as TGI Fridays. Chili's by far offers the most quality. I'm putting quality in quotes. Whatever the quality is, the portions are large, which is what is important for large people like me and you, Suji.

17:45Indeed, all you can eat, chips and salsa. So going from the pedestrian to the sublime, I'm going to be long Caravaggio. I asked my readers the other day, because I'd been to Venice for a business trip, and I'd looked at these paintings, and I said, oh, you know, there's so many great paintings there. Readers, send me your top five painters. and there was like more response to this question than any finance question I've ever asked in my entire career as a journalist. People just flood in with responses and as it turns out, everybody loves Caravaggio. He clearly beats your Van Goghs, your Michelangelo's, your Titian's, your El Goya's, your Velasquez.

18:27There's a lot of love out there for Caravaggio. You do not want to be short this painter. With that, listeners, thank you, Sajid, for joining the show. And we will be back in your feed on Thursday.

18:43Unhedged is produced by Jake Harper and edited by Bryant Erstat. Our executive producer is Jacob Goldstein. We had additional help from Topher Forges. Cheryl Brumley is the FT's global head of audio. Special thanks to Laura Clark, Alistair Mackey, Greta Cohn, and Natalie Sadler. FT Premium subscribers can get the Unhedged newsletter for free. A 30-day free trial is available to everyone else. Just go to ft.com slash unhedged offer. I'm Rob Armstrong. Thanks for listening.