Description

We recommend purchase of Dine Brands, the owner/franchisor of Applebee’s and IHOP. 

The thesis here is pretty simple, this is a high margin franchise business, trading sub 10x EBITDA and sub 10x FCF.  After years of weak performance, Applebee’s seems to have stabilized and IHOP is a good asset, in our opinion better than Denny’s which trades for 11.5x 2022e EBITDA.  The company generated plenty of FCF in 2020 without having to issue any shares and at this point is back to its pre-pandemic EBITDA/FCF.  With close to $300m of cash on the balance sheet, strong FCF and the business having recovered we believe a combination of buyback/dividend is coming shortly.

The labor shortage/food inflation will work themselves out at some point and frankly as the franchisee DIN is somewhat protected here (inflation is actually a benefit to DIN).  If you believe that Applebee’s is now stable and IHOP continues to grow as it has done historically, then 10x FCF (with 4.2x leverage end of 2021) is too cheap – especially considering that all of the FCF is likely to be returned to shareholders via buyback/dividends.

Applebee’s franchise system has about 1,627 restaurants (also 69 company owned, likely to be refranchised) with what should be an average unit volume of about $2.6 million this year versus $2.5 million in 2019 as the company benefits post-pandemic from more food delivery penetration, mom and pop restaurant closings and undoubtedly some stimulus/excess savings benefits as well.  The system count peaked at over 2,000 locations in 2017 and comps in 2016, 2017, 2018 and 2019 were -5.0%, -5.3%, +4.9% and -0.7% - the business had been in decline due to poor management and menu missteps. 

That said, comps versus 2019 have been strong at +10.5% in Q2 2021 versus Q2 2019.  Of course there’s some of the post covid stimulus benefit but we believe that with new management, a slimmed down group of restaurants with better operators and a general environment which should be favorable to scale casual dining players (better technology, better place to work, less mom/pop competition) and very importantly a much higher penetration of pick-up/delivery business, that at the very least Applebee’s should be able to operate flattish from here with net closings likely going to zero in the next year or two and a bit of positive comp.  For what it’s worth, management actually believes that the chain will actually begin to net grow its franchise restaurant count beginning in 2023, so there is possibly come upside to our flattish go forward assumption.

Applebee’s has a fairly concentrated system with 30 franchise groups that own the 1,531 domestic Applebee’s stores (Greg Flynn owns 444 of them as of 12/31), and the company says the 5 largest groups own 52% of the restaurants.

IHOP, unlike Applebee’s has been a moderate growth story which we expect will continue.  There are 1,744 restaurants in the franchise system chain with an average unit volume of close to $2 million.  Comp store sales in 2017, 2018 and 2019 were -1.9%, +1.5% and +1.0% while average unit growth during those years was +2.4%, +2.3% and +1.1%.  DIN also sells pancake/waffle mix at very high margins and leases/subleases 621 of IHOP’s locations as well. 

Comps were down -3.4% in Q2 2021 versus Q2 2019 as the breakfast category is more impacted by Covid with fewer people leaving the house for work and stopping for breakfast as well as the labor shortage impacting IHOP restaurants ability to stay open 24 hours (27% of IHOP’s open 24 hours now versus more than 50% in 2019). 

We think that going forward post the labor/Covid residual issues currently impacting this segment, that IHOP ought to be able to post 1% - 2% comps and 1% - 2% unit growth and therefore 3% - 4% total revenue growth.  The closest comp here is Denny’s with about 1,580 franchise locations (65 owned locations), with similar comps but no real unit growth and average unit volumes of only $1.7 million – Denny’s trades at 11.5x 2022e EBITDA for less growth than IHOP. 

There are 279 IHOP franchisees who own the 1,667 domestic IHOP stores, the 5 largest own 30%.

Financials.  Second quarter revenue and EBITDA was $233m and $72m up from $228m and $68m in 2019.  Bear in mind that advertising revenue is a zero-margin pass through and totaled $72m in the second quarter – ex advertising, revenue and EBITDA was $161m and $72m, a margin of 45% (if you subtract out company owned restaurant revenue that likely get franchised at some point the EBITDA margin is 55%).

With the company expecting to invest some catch up SG&A spend in the second half, we expect Q3 and Q4 to come in at the low to mid $60’s millions of EBITDA which combined with a weaker COVID impacted EBITDA of $58 million in the first quarter gets us to $255m in 2021 EBITDA.  With $20m cap-ex, $65m in cash interest, $25m in cash taxes and $5 million in net use of working capital/finance leases/note receivable collections we get to $140m of free cash flow in 2021, about $8.00 per share.

2022 should show decent EBITDA growth as IHOP continues to recover and has an easy Q1 comp.  We expect $270m to $275m in 2022 EBITDA (vs. $273m in 2019) and close to $150m in FCF - $8.50 per share assuming some buyback.

Going forward, in general we assume EBITDA grows 3% - 4% annually driven by growth at IHOP (which we believe makes up about 60% of the company’s EBITDA), and as stated above a flattish go forward at Applebee’s. 

The balance sheet should show about $300m in cash by year-end with $1.3B of notes coming due in 2024 and 2026, so about $1 billion of net debt on $255m of EBITDA is a 4x leverage level which we believe the company is comfortable with going forward.  That said, the $150m in FCF that DIN should generate in 2022 will likely go 100% back to shareholders, we assume $100m in buyback and $50m in cash dividends (about $3 per share). 

The combination on an annual basis of 3% - 4% EBITDA growth and 4% - 6% share count decline would drive high-single digit growth in FCF per share to around the $8.50 level in 2022, potentially bringing a $97 share price plus our assumed $3.00 in annual cash dividends, that’s about a 17% IRR (we have used a 10x EBITDA multiple).

The reality is that 10x EBITDA for an all franchised 50%+ EBITDA margin business is too low.  There is upside here, particularly if Applebee’s can grow somewhat.

Summary.  The valuation seems too low and we are coming in after Applebee’s has been cleaned up and potentially in front of better than expected growth at both brands driven by growth in food delivery/pickup and in general the advantages of a scale business in the post Covid era as well as lots of mom and pop restaurant closings.  We are also likely in front of a significant dividend/buyback announcement.  

Catalyst

Applebee's stabilization, IHOP covid recovery and capital return (dividend/buyback).