Description

Overview

I wrote up DIN in September, 2011, and the stock has appreciated 71% in the 15 months since my writeup.  I am submitting the idea again as I believe there is significant upside left in the name – specifically, I believe there is 80%+ upside over the next 6 – 9 months as the Company gives more clarity around its capital allocation plan going forward. 

DineEquity is a very attractive business – its high quality franchised business model results in a stable, predictable royalty stream that grows with no capital required.  It is undervalued by the market, trading at a significant discount to other purely franchised peers.  It has a conservative capital structure for the quality of its business, now under its 5x net leverage target, and the ability to significantly increase earnings and free cash flow in 2014 when it can refinance its bonds, likely at a much lower interest rate.  Most importantly, the Company is on the verge of announcing a new capital allocation plan.  If the Company were to pay out 100% of free cash flow annually to shareholders as regular dividends, which we believe is possible given that the leverage level is now conservative and the business model requires minimal capital to grow, the stock would be trading at close to a 10% dividend yield at today’s price.  If it were to then trade at a 5% dividend yield, in line with what we believe to be a number of relevant comps, the resulting stock price would be ~$122 / share, providing ~82% upside to the current price in the near term.

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 ~1,600 locations, and Applebee’s, America’s largest casual dining restaurant chain with ~2,000 locations. 

As of 4Q 2012, DIN’s entire restaurant system will be 99% franchised.  The franchised business model is extremely attractive – DIN (the franchisor) takes 4.5% of sales of every IHOP and 4% of sales of every Applebee’s location in the world.   Its main responsibilities are marketing and menu-testing, as the franchisees put up the capital to build and maintain the restaurants, and absorb the fixed costs and managerial responsibility of running the restaurants’ operations on a daily basis.  The franchise fee stream that DIN receives as the brand manager/licensing company is thus a high-margin, sticky, recurring royalty stream that requires no ongoing capital to maintain or grow.  The earnings of the Company are a stable annuity that are quite insulated from macroeconomic pressures, as the business has minimal operating leverage (ie, if Applebee’s same-store-sales are down 2%, DIN’s earnings will be down 2%, whereas if Cheesecake Factory’s same-store-sales are down 2%, CAKE’s earnings are likely to be down 10%).  Moreover, while cost inflation of food inputs generally hurts restaurant operating companies, it generally helps franchisors like DIN, as franchisees have to raise prices to keep up with cost inflation, and DIN receives a % of the franchisees’ revenue.

See my September, 2011 writeup for more history on the Company, but DIN reached an inflection point in the current quarter (4Q 2012), when it finally finished a multi-year refranchising effort.  The Company was formed in its current structure in 2007 when IHOP (99% franchised at the time) levered up to buy Applebee’s (~75% franchised at the time).  The Company has spent the past 5 years selling Applebee’s units to franchisees and using the proceeds to pay down the acquisition financing and de-lever.  This transformation was finally completed in 4Q 2012, and now the entire Company will be 99% franchised again.  This is important because even having a few company-operated restaurants contributes a disproportionate amount of revenue, costs, and capex to the reported financial statements, distorting the picture for investors and obscuring the underlying attractiveness (high margin, capital-lite nature) of the franchisor business model.  2013 will be the first clean year when investors can truly see what the pure-play franchised business looks like, and we believe this will help the stock trade more in line with other pure-play franchisors (see below).

It’s important to note that the franchised business model only works if the franchisees themselves are solidly profitable, and the good news in DIN’s case is that its franchisees are very healthy.  When the Company was still operating Applebee’s units, it was running them at 15% - 16% 4-wall operating margins on average unit volumes of ~$2.2m annually, and it made it clear that franchisee stores were running at higher unit volumes and higher operating margins, indicating that the franchisees are doing very well.  Our own industry diligence suggests that the same is the case for IHOP franchisees as well, indicating that DIN’s business model is highly sustainable.

It’s also worth noting that DIN has several growth opportunities available to it, none of which require capex on the part of the Company.  These include: 1) Improved brand management and execution at IHOP, which has been comping down low single-digits for the past several quarters but is undergoing a menu revitalization; 2) SSS recovery as the economy improves and unemployment continues to decline (Applebee’s and IHOP’s average unit volumes are still 10% and 7% below peak, respectively); 3) Unit increases in newly refranchised territories, where franchisees have rights to build new stores; 4) International expansion – IHOP has just begun opening units in the Middle East; and 5) Royalties from food product sales in national retail outlets like Wal-Mart – IHOP has also just begun to explore this avenue for incremental profits.

Undervalued Relative to Pure-Play Franchised Peers

There are only a handful of other companies that operate with a pure-play franchisor business model, including Burger King (95% franchised), Domino’s (96%), Tim Horton’s (99%), Dunkin’ Donuts (100%), and we would also include Choice Hotels (100% franchised hotel company).  These companies on average trade at 12x 2013E EBITDA, 13.6x 2013E EBITDA – CapEx, and a 5.4% 2013E Free Cash Flow Yield (ie, 18.5x cash earnings).  This compares to DIN (99% franchised) at 8.9x 2013E EBITDA, 9.4x 2013E EBITDA – CapEx, and a 9.7% 2013E Free Cash Flow Yield (ie, 10.4x cash earnings).

Some of the other comps I mentioned are projected to grow faster than DIN, but not all of them.  For example, Choice Hotels, which trades at 12.1 EBITDA, 13x EBITDA – CapEx, and a 5.6% Free Cash Flow Yield, has consensus projections of only ~4% revenue growth and ~6% EBITDA growth for the next 2 years.  Tim Horton’s (13.3x EBITDA – CapEx and 4.9% FCF Yield) and Domino’s (13.1x EBITDA – CapEx and 6% FCF Yield) are each only expected to grow EBITDA ~1 - 2% better than that for the next two years.  DIN could achieve growth similar to Choice if it sees 1 – 2% unit growth and ~2% SSS growth, which are reasonable expectations.  DIN will also likely see a one-time step-up of ~12% Free Cash Flow growth in 2014 when it is able to refinance its bonds at a lower interest rate (see below).

Aside from growth, the biggest difference between DIN and the other comps I mentioned is that they all return significant amounts of capital to shareholders, which makes sense because, as purely franchised businesses, they need no capital to run or grow their operations.  DIN has used all of its cash flow to de-lever for the past 5 years due to the leverage it took on to complete the acquisition of Applebee’s, but now that it has finally gotten below its 5x net leverage target, it is planning to announce a new capital allocation strategy in the near term.  We believe any plan that includes an ongoing return of capital to shareholders would be a catalyst for re-rating of the stock (see below).

Conservative Capital Structure and Ability to Refinance Bonds at Lower Interest Rate

After de-levering for the past 5 years, DIN is now conservatively capitalized for its business model at 4.7x net debt / 2013E EBITDA.  We project the Company will generate $287m of EBITDA in 2013, with $111 of interest expense, $46m of cash taxes, and $15m of CapEx, resulting in an excess free cash flow cushion of $116m.  Given the stability and lack of operating leverage in the business, this is a large cushion, and its coverage ratios of 2.6x EBITDA / Interest and 2.5x EBITDA – CapEx / Interest are excellent.  Given that the debt is not due until 2017 and 2018, DIN has no liquidity concerns.  Similar pure-play franchised businesses regularly sustain more leverage than this – for example, Domino’s completed a refinancing in March 2012 that levered the company 5.7x at that time.

DIN’s capital structure consists of $504m outstanding under an L+300 term loan (with a 125bps LIBOR floor), and $761m outstanding on 9.5% Senior Unsecured notes.  These debt instruments were issued in fall of 2010, when the Company was more levered, had not yet completed its refranchising efforts, and the credit markets were not as tight as they are today.  Today the bonds trade above 113, for a 4.3% yield-to-worst.  These bonds are callable in October, 2014, and the Company will likely refinance them at a much lower interest rate.  Assuming they can be refinanced at a 6 – 7% interest rate, that would amount to $19 – 26m of annual interest cost savings for the Company.  This would further increase its interest coverage from 2.6x EBITDA / Interest to 3.1x – 3.4x, and take annual Free Cash Flow from $116m to $129m - $134m.  This is of course before any unit growth or improved SSS.  We note that Pro Forma for this refinancing, the equity is currently trading at an 11% FCF Yield (9x cash earnings).

New Capital Allocation Plan

Now that DIN has completed its multi-year refranchising and de-levering effort, it has indicated it will announce a new capital allocation plan in the near term.  Given that the existing business requires essentially no capital to maintain itself and grow, the capital structure is conservative and net leverage is under the Company’s previously indicated 5x level, and there are several large shareholders who have indicated they would not favor another acquisition, the Company should have the ability to return cash to shareholders on an ongoing basis. 

Given that FCF should be roughly $116m in 2013, growing to $130m+ after it can refinance its bonds the following year, if the Company announced a policy of paying out 100% of FCF as a regular dividend, it could pay a $6 / share annual dividend in 2013, growing to $7 / share after it refinanced its bonds the following year.  If the Company traded at a 5% dividend yield on its 2013 dividend, the stock price would be $120, representing 80% upside from the recent price of $67.

We believe this is a reasonable scenario for a number of reasons: 

-          First, looking at all restaurant companies that pay dividends (YUM, THI, DRI, BKW, DNKN, EAT, CAKE, WEN, CBRL, TXRH, BOBE, CEC, BAGL), they have an average payout ratio of 47% and on average trade at a 2.5% dividend yield.  These companies on average have capex obligations representing 33% of EBITDA, vs DIN at 5%, and they generally do have more growth opportunities.  Given DIN’s lower capital requirements and more mature business model, there is no reason it couldn’t pay out twice as much (which would be a 94% payout ratio) and trade at twice the yield (which would be 5%)

-          Second, looking across the equity market, there are numerous examples of companies with very high payout ratios that trade at low dividend yields.  These companies generally fit the same financial profile as DIN – they participate in mature industries and generate stable cash flows.  Many utilities fit this description – DUK, SO, WMB, SE, POM, TEG – on average payout 86% of earnings and trade at 4.8% dividend yields.  These companies have average net leverage of 4.6x and projected 2013E earnings growth of 6%, very similar to DIN.  We would argue DIN’s annuity-like business model is similar to that of a utility in its stability.  Many other examples exist of companies with high payout ratios and low yields – PAYX (83% payout, 4% yield, 7% EPS growth), IRM (86%, 3.4%, 6%), RGC (96%, 5.8%, 8%), LEG (78%, 4.3%, 10%).  Again, like DIN, these are stable cash flow generators in mature industries (document storage, movie theaters, furniture)

-          Third, we note that Domino’s, another pure-play franchisor, has paid out >140% of the free cash flow it has generated since its 2004 IPO, in the form of periodic special dividends to shareholders.  When including the amount that Domino’s has spent on share repurchases, it has returned ~217% of the free cash flow it has generated since its 2004 IPO to shareholders.  In other words, Domino’s realized that, given its stable and capital-lite business model, it can sustain incremental leverage as earnings grow and simultaneously return all of its ongoing cash flow to shareholders.  DPZ’s stock has appreciated >495% since its IPO, and is a powerful example of the idea that a pure-play franchisor can pay out 100% (or more) of its free cash flow to shareholders

-          Finally, another interesting analogy for the purely-franchised DIN is the tobacco companies.  With stable, recurring revenue, high margins, and minimal capital requirements, the big 3 US tobacco companies return all their cash to shareholders because, like DIN, there is simply no way for them to reinvest it in their business.  They pay out 80% of earnings on average, use the rest to buy back shares, and trade at an average 5.3% dividend yield today.  They are projected to generate only 4% EBITDA growth, and, unlike DIN, face the risk of secular decline and continued regulatory and litigation exposure

All of these examples give us confidence that it is reasonable for DIN to pay out much of its free cash flow and trade at least at a 5% dividend yield.  If it paid a $6 / share annual dividend (100% of 2013E FCF) and traded at a 5% yield, the stock price would be $120, an 80% premium to the current price.  This would represent 13.5x EBITDA – CapEx, in line with other purely franchised peers (CHH, THI, DPZ, BKW, DNKN).  Even if the Company decided to pay out 80% of its FCF ($4.85 / share annual dividend) and traded at a 6% dividend yield, this would result in a stock price in excess of $81, representing 21% upside from the current price, still significant appreciation in a short time period.

Conclusion

DIN has a high quality franchised business model and a conservative capital structure.  The equity is currently trading at a ~10% FCF yield, and 11% PF for its likely 2014 bond refinancing, a significant discount to other pure-play franchised companies at 5 – 5.5% FCF yields.  In the current quarter (4Q 2012), DIN has completed a multi-year refranchising initiative, marking a transitional point in the Company’s history.  It has indicated it will shortly announce a new capital allocation plan, and the DIN equity story seems likely to change from a de-levering/refranchising story to a return of capital to shareholders story.  If DIN were to institute a policy of paying out close to 100% of its annual Free Cash Flow as a regular dividend to shareholders, it would result in a 2013 dividend of over $6 / share, creating the equity today at close to a 10% dividend yield.  Such a stable, predictable dividend would be highly prized in today’s persistent low interest rate environment, and would likely attract an entirely new group of yield-oriented investors into owning the stock, creating permanent long-term value for shareholders.  If the Company were to do that and the equity were to trade in line with a number of relevant comps, we think a stock price of $120+ is reasonable in the near term, representing 80%+ upside from the recent price of $67.

Catalyst

Announcement of new capital allocation policy

Refinancing of 9.5% bonds in 2014 at a lower interest rate

Free Cash Flow generation

Multiple expansion in line with pure-play franchised peers