Web Exclusive: Should IHOP Pursue an Acquisition of Applebee’s?

Analysts are divided over the latest rumor about IHOPs possible offer to buy Applebees.

By Maya Norris, Managing Editor -- Chain Leader, 6/25/2007

While both IHOP Corp. and Applebee’s remain mum about whether the pancake chain is interested in buying the casual-dining giant, industry analysts are divided as to whether the deal is a good fit for both companies.

On June 13, Bloomberg reported that IHOP put in a bid of more than $2 billion, citing “a person with direct knowledge of the offer.” The report surfaced after Applebee’s announced in February that it was exploring strategic alternatives to enhance shareholder value including possible recapitalization or sale of the company. That came on the heels of Richard Breeden of Greenwich, Conn.-based Breeden Partners, which owns 5 percent of Applebee’s stock, complaining about the company’s declining comps and guest traffic over the last two years.

Inside Track

Some observers say the deal makes sense for IHOP, which announced in April that it was looking for a franchised restaurant chain to buy. IHOP CEO Julia Stewart has a track record of success with both chains. Stewart was president of Applebee’s from 1998 to 2001. During her tenure, she rolled out a new menu and introduced the “Eatin’ Good in the Neighborhood” campaign, which helped increase same-store sales. Since joining IHOP in 2001, Stewart has retooled the franchisee business model, remodeled restaurants, and introduced menu items to boost lunch and dinner business. The company has seen same-store sales increase 2.5 percent in 2006 and 2.9 percent in 2005.

“You’ve got a CEO at IHOP that’s very familiar with the Applebee’s system and probably has her own ideas at how they might be able to fix the brand,” says Michael Gallo, senior vice president of New York-based CL King & Associates who follows IHOP.

“When she was a decision maker, it was very strong. She left and what’s happened to Applebee’s? There was still some benefit after she left, but then there’s been deterioration. Operating margins have dropped significantly since she’s gone,” says Craig Weichmann of Dallas-based Weichmann & Associates. “She went to IHOP and she’s energized IHOP. The track record has been very good. She’s breathed into an old-line company new hope and new direction. And so she’s done a very admirable job energizing IHOP. And those are the kind of financial characteristics the financial marketplace likes to get their arms around.”

Returns of the Day

Applebee’s might also provide a good return on investment for IHOP. With 521 company stores and 1,409 franchised units, Applebee’s has a stable royalty stream from franchise fees. In addition, it owns much of the real estate for its company stores. IHOP could refranchise those stores and tap into the real-estate assets through a sale or sale leaseback.

“It looks to us like the corporate stores at Applebee’s on a fully loaded basis including G&A and cap ex don’t generate any cash flow,” Gallo says. “So the opportunity to refranchise those, bring in some proceeds and reduce overall purchase structure while converting it into high-feeding royalty income seems to make a lot of sense.”

Risky Proposition

However, not everyone believes that IHOP should buy Applebee’s. Michael D. Smith, a restaurant analyst who covers Applebee’s for Kansas City, Mo.-based Oppenheimer & Co., says the concepts are too different to realize any significant synergies. IHOP’s breakfast focus doesn’t match up with Applebee’s lunch and dinner business, he says.

In addition, with 1,302 units, IHOP has a stock market value of $960 million, half that of Applebee’s market cap of $1.88 billion. “It’s an awfully big bite for IHOP, don’t you think?” Smith says. “They’re pretty levered, and they’d have to borrow a couple billion dollars to do it. In the current environment, that could happen. But then they’d be even more levered. And I’m not sure you would want to have either one of those concepts if the environment doesn’t change in the near future.”