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Why Darden is overheated—and how to play it for a drop

Source: Olive Garden

Higher gasoline prices can hurt casual dining companies in two ways: They take money from their consumers' pockets, and they compress the companies' margins by increasing costs. As a result of this and other factors, the impressive rally in stocks like Darden Restaurants may finally be coming to an end.

Steady inflation, recovering home prices, decreasing unemployment and rising consumer confidence have helped propel consumer discretionary stocks. The 24.5 percent median return among consumer discretionary stocks is the highest of any sector in the S&P so far this year.

Shares of casual dining restaurants—such as Cheesecake Factory (up 35 percent this year), Texas Roadhouse (up 50 percent) and Darden Restaurants, whose biggest brands include Red Lobster and Olive Garden (up 13.5 percent)—have contributed significantly to that exceptional performance.

The news for consumers is not entirely rosy, however, so it may be time to start questioning whether that rally is likely to continue.

(Read more: Restaurants fear tough DWI law will be buzzkill for light drinkers)

While rising asset prices certainly help the balance sheet of many Americans, as the value of their homes and investments rise, their free cash flow has not seen similar growth. The end of the payroll tax holiday is estimated to reduce after-tax pay by about $1,000 per year for the average household. Since June 28, gasoline prices have also risen sharply—gas prices are up about 15 percent in just over two weeks. This coincided with the sharpest rise in interest rates in decades. Sharp increases in rates could slow home and new car sales, and increase interest expense on floating-rate consumer credit.

The precise impact of any one of these factors is hard to estimate, but in the aggregate, reducing the amount of spending money consumers have eventually impacts their discretionary spending. Quite simply, this means that they will dine out less. And some recent sales data confirm that diners may be losing their appetites.

The Knapp-Track Index follows year-over-year same-store monthly sales changes for the casual dining industry, and the most recent update on June 30 showed a 2 percent year-over-year decline.

But the reduction in consumer spending is only one of the challenges facing casual dining. Increases in energy and food costs are also compressing margins.

It might have been possible to look past these concerns if valuations were cheap—but they aren't. Darden Restaurants, for example, is trading at a 20-percent-plus premium to its historical valuation of earnings and EBITDA (earnings before interest, taxes, depreciation and amortization) over the next 12 months.

(Read more: Discretion advised: Consumer discretionary valuation soars)

So should is it time to short Darden?

Well, perhaps, but shorting stocks carries unlimited risk. However, by selling a call spread, one can make a bearish bet while limiting potential losses if the stock rallies.

For example, with Darden shares trading at $51.15, one could sell the August 50/52.5 call spread as follows:

• Sell the August 50-strike call for $1.80

• Buy the August 52.5-strike call for $0.55

This would result in a net credit of $1.25, or exactly half of the difference between the strikes. The max profit is simply the credit received, or $125 per spread sold. On the downside, max loss is limited to $125, which will be suffered if Darden shares rally above $52.50 by August expiration.

—Mike Khouw is managing director and primary strategist at DASH Financial. Follow him on Twitter: @Michael_Khouw.

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