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Should Red Lobster be set free? Let shareholders decide

It may be time for Darden Restaurants to let shareholders take Red Lobster into their own hands.

Red Lobster in Times Square, New York.
Adam Jeffery | CNBC
Red Lobster in Times Square, New York.

For months, Darden shareholders have been bombarded with ideas about how to fix the struggling restaurant company. It started in September, when hedge fund Barington Capital sent the company a letter urging it to split into two companies and place its property into a real estate investment trust to unlock hidden value. In December, Darden fired back with its own proposal, which would spin off its Red Lobster restaurant chain while keeping the property and remaining restaurant businesses, including Olive Garden, housed in the original company.

The merits of both plans are debatable. It's unclear how Red Lobster would fare as an independent company with shrinking sales and restaurants in suboptimal locations. And there have been many proposals to create REITs out of retailers' property fromMcDonald's to Target that never panned out.

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But one thing that's almost certainly clear is that the Red Lobster deal would destroy any hopes of the activists getting their way. Without the property attached to the Red Lobster chain, the REIT deal envisioned by Barington would be tough to pull off. And the Red Lobster spin is timed to take place before the company's annual meeting in the fall, when the activists would have had a chance to elect new board directors. A spokeswoman for Darden said "the actions announced in December were unrelated to Barington."

One proposal that makes more sense came Monday from Starboard Value, another activist fund that has bought 5.5 percent of Darden and sided with Barington. Starboard has asked shareholders to call a special meeting to have Darden shareholders vote on the merits of a Red Lobster spin. It would take 50 percent support simply to call a special meeting, and even if shareholders vote against the Red Lobster deal, management can technically forge ahead with it.

But shareholders should call for a meeting—whether they like the Red Lobster proposal or not. The reason is that if the Red Lobster deal scares off activist investors entirely, management will avoid a serious discussion with shareholders about how to best create value.

Left to its own devices, management has a poor track record. Since the start of 2011, Darden shares are up just 9 percent while the S&P 500 has risen nearly 47 percent and Chili's owner Brinker International has gained 152 percent. A big problem has been a slowdown in sales, which put Darden's profit margins under pressure thanks to its inflated cost base. Things don't appear to be getting much better, with analysts expecting same-restaurant sales to decline 1.7 percent at Darden in the year through May.

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Shareholders may not love every aspect of the activists' proposals. But the activists are important because they are likely to suggest ideas that management hasn't. And if the activists propose their own board directors at the annual meeting, management will feel pressure to entertain any ideas that appeal to shareholders.

First, Darden could probably remove significant costs. In the year through May 2013, Darden spent $205,145 per store in general and administrative expenses. That compares with just $153,407 per store for Brinker in its most recent fiscal year.

There's reason to believe Darden's costs could be at least as low as Brinker's given it has a much larger store base, which creates economies of scale. If Darden could reach Brinker's level of so-called G&A per store, it would save $111 million per year, substantial for a company expected to earn $338 million in net income in the year through May.

Darden's Red Lobster plan, by comparison, includes just $60 million of annual cost savings by 2015.

Also, Darden has made no mention of plans to franchise its store base, which is entirely company-owned. Such deals have been successful for fast-food chains like Jack in the Box that have made such a switch. Analysts expect Jack in the Box to have an operating profit of $180 million in the year through September, up 50 percent from two years earlier.

There also are ways for Darden to extract value from its real estate without placing all of it into a REIT. One alternative is to sell select properties and then lease them back.

Darden probably has a range of options for creating more shareholder value. But if investors allow the company to keep too much control, they may never get to see the real menu.

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—By CNBC's John Jannarone. Follow him on Twitter @jannarone.

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