Description

Overview

DineEquity is a dominant market share leader in the family dining and casual dining restaurant spaces.  It has a high quality franchised business model, and is trading at a very attractive valuation.  We believe now represents a compelling buying opportunity as the stock has traded off based on several widely held misperceptions about the Company, including: 1) a belief that it is overleveraged; 2) a focus on GAAP earnings, which are materially lower than cash earnings; and 3) concerns about short-term business performance.  As the Company completes the final stages of its refranchising initiative and converts its remaining company-operated restaurants into franchised stores over the next 12-18 months, we believe the stock should be worth $80 or more, representing over 100% upside from current levels.

Investment Thesis

High Quality Franchised Business Model

DineEquity is the largest full-service restaurant company in the world.  Its two brands are IHOP, America's largest family dining restaurant chain with roughly 1,500 locations, and Applebee's, America's largest casual dining restaurant chain with roughly 2,000 locations. 

One often underappreciated fact about the restaurant industry is that operating restaurants and franchising restaurants are two completely different business models.  Operating restaurants is generally a tough business - capital intensive, low margin, high fixed costs, exposed to food input costs, and exposed to macroeconomic and consumer weakness.  Franchising restaurants, on the other hand, if executed successfully, is arguably one of the best businesses in existence - it requires almost no capital to set up or grow, and provides a high margin, recurring cash flow stream with minimal operating leverage, or food cost exposure as the franchisor takes a cut of revenue of all the franchisee-operated stores in return for marketing, menu testing, and other minimal franchisee-supporting activities.  Moreover, a restaurant franchisor actually benefits from inflation as its fee is calculated as a percentage of revenue and so it grows as franchisees raise prices to accommodate higher labor and food costs. 

IHOP, the predecessor company to DineEquity, realized this fact in the early 2000s.  It decided to convert the IHOP brand to a franchise-only business model, and from 2002 to 2006, took the IHOP system from 93% franchised to 99% franchised, by refranchising (ie, selling to franchisees) the remaining company-operated stores.  Even this small shift in business mix created significant shareholder value, as EBITDA margins went from 22% to 29%, capex went from 39% of sales to 3% of sales, and ROIC went from 11% to 18% over those 4 years.  The Company's stock went from $28 to $49 as its P/E multiple went from 14x to 20x over the same time, expanding materially more than the multiples of other casual and family dining restaurants during the same period (eg, EAT, DRI, BOBE, CBRL).

In 2007, after it had fully completed the IHOP refranchising, the Company was generating substantial free cash flow and decided to purchase Applebee's (roughly 74% franchised at the time), with the stated goal of replicating its successful strategy and transitioning Applebee's to a franchise-only business model.  This was essentially a public LBO, where the proceeds from refranchising the remaining company-operated Applebee's stores would be used to pay down the acquisition financing, leaving the Company with two fully franchised brands generating significant recurring free cash flow. 

Refranchisings slowed during 2009 and 1H 2010 due to financing conditions, but over the past year the Company has made significant progress, refranchising 214 Applebee's stores, and based on announced refranchisings, the Applebee's system will be 91% franchised by the end of this year (and the entire company will be 95% franchised since IHOP is 99% franchised). 

The refranchising process creates significant noise in the reported P&L.  Until the transition to fully franchised is complete, the few remaining company operated stores continue to contribute a disproportionate amount of revenue, costs, and capex to the financial statements, obscuring the attractiveness of the company's high margin, low capex franchise business that is already generating the vast majority of profits.  Moreover, as the company refranchises stores by selling them to franchisees, it makes it appear that revenue is decreasing rapidly, even though that is part of an intentional plan to get to a fully franchised business that has lower revenue but much higher margin and ROIC.  As the business model transition is completed over the next 12-18 months, this noise will clear and investors will be able to fully appreciate the stability of the Company's cash flow.

Attractive Valuation

At the current stock price of $36.32, DIN has a market cap of $675m and TEV of $2.3bn.  In 2011 it should generate EBITDA of $315m (7.4x) and EBITDA - CapEx of $290m (8.1x).  The Company's 2011 free cash flow guidance is for $112 - 122m, representing a 17.3% free cash flow yield to the equity at the midpoint, for a recurring franchise fee stream with minimal operating leverage.

Similar highly franchised businesses (Tim Hortons, Domino's, Choice Hotels, Dunkin' Brands, the Burger King acquisition by 3G) trade at 11x - 13x EBITDA - CapEx.  We believe that DIN is currently trading more like a traditional restaurant operator, but deserves to trade more in line with its highly franchised peers.  Due to the leverage at the Company, as the enterprise value multiple expands from 8x EBITDA - CapEx to 11x, the equity will more than double, from $36/share to $80+.

Importantly, the company recently announced a share repurchase program, for $45m or 7% of the market cap.  We think this is a smart way to allocate capital given current prices.

Misperception #1: Too Much Leverage

Optically, the Company's leverage appears to be significant at 5.3x EBITDA.  However, remember that this is not a restaurant operating business; it is a franchisor that collects a stream of annual royalty fees from its franchisees - exactly the type of business that should be levered.  In reality, the Company's coverage ratios are ample.  The Company's interest expense this year will be ~$130m, vs. $315m of EBITDA and $290m of EBITDA - CapEx.  The Company will generate $112 - 122m of excess cash flow after debt service, with minimal operating leverage if top line were to worsen.

We actually believe that DIN's leverage is an asset for equity holders, as it is extremely low-cost and long-dated with loose covenants.  The debt consists of ~$750m outstanding on a senior facility due 10/17, recently repriced lower to L+300 with a 125bps LIBOR floor, and $785m of 9.5% senior unsecured bonds due 10/18. 

Moreover, the Company is deleveraging, paying down debt with the proceeds from refranchising Applebee's stores and the cash generated from the franchised business.  Net leverage of 5.3x is down from almost 7x immediately after the acquisition in late 2007, and we estimate it should be 4.4x by the end of next year given continued refranchisings and free cash flow generation.

One final point on leverage is that some analysts actually overstate the Company's leverage by including $139m of capital lease liabilities carried on the balance sheet in their total debt calculations.  The Company explains in Note 10 of its 12/31/2010 10-K that these are leases on restaurants where the Company has actually subleased the stores to franchisees, and is actually earning a positive spread from charging the franchisees a higher rental rate than it is paying itself to the actual landlord.  We thus exclude this liability from our debt calculations.

Misperception #2: GAAP vs. Cash Earnings

Due to amortization from the Applebee's acquisition, DIN's D&A materially exceeds the minimal capex required for its highly franchised operations.  In the LTM, D&A was $56m, vs. $25m of cash capex.  Additionally, due to all its refinancings and amortization of related discounts and fees, DIN has significant non-cash interest expense running through its income statement (roughly $17m in the LTM). 

Combine these two factors and you have a stock that looks like it is trading at ~9x P/E on GAAP EPS of ~$4 / share, but in reality is trading at a ~6x multiple of cash EPS of ~$6 / share.

Misperception #3: Business Performance

We believe investors view DIN as a no-growth company.  This is incorrect.    The Company expects franchisees to open 60 - 75 IHOP stores per year, representing 4 - 5% top line growth at IHOP (43% of total units) and without any additional capital from the Company.  Net unit growth at Applebee's has been more muted, but is still expected to increase at ~0.5% per year, again without any capital required.

In terms of SSS, Applebee's has been comping positively for the past 4 quarters as the Company has revitalized the menu and marketing, driven by the 2 for $20 promotion, and the neighborhood bar theme.  Applebee's has also been helped by a stoppage of the expansionary boom of casual dining restaurant building in the early 2000s - neither they nor any of their major competitors (Chili's, TGI Friday's, Ruby Tuesdays) have been building stores since 2007, such that casual dining doors per capita in the US has come back in line with historical levels after being arguably oversaturated for a few years.

IHOP SSS have been weaker for the past 2 quarters (down 2.8% in 1H).  Prior to that, IHOP had had positive SSS for 16 of the past 17 years, the one exception being 2009 when SSS were down less than 1% (0.8%).  IHOP has been a strong, resilient concept over time, and we have confidence that IHOP will endure.  

Most importantly, since it is fully franchised, short term SSS trends due to seasonality, timing of new menu items, or macro/consumer sentiment has a limited impact on the Company's ability to generate substantial free cash flow.

Conclusion

DIN is a dominant market share leader with the #1 brands in family dining and casual dining.  It is rapidly approaching its goal of being 99% franchised with higher margins, lower capital requirements, and higher ROICs.  It has an optimal capital structure and its restaurants remain highly profitable to its owner/operators.  It has traded off recently due to the perception that it is a highly levered restaurant company with exposure to macro/consumer weakness, but this limited view neglects the reality of recurring franchise fees with minimal operating leverage.  The equity is currently at a 17% free cash flow yield, and as the refranchising is completed in the next 12-18 months, and investors realize the quality of the business model, the multiple will expand, and we believe the stock will double or more. 

Catalyst

Debt paydown from free cash flow generation and continued refranchisings

Completion of refranchising program which will be reflected in the financial statements as margin expansion, capex evaporation, and ROIC expansion

Share buybacks