IHOP's Thomas Conforti: The Right Mix

The Web version of this article has been expanded to include additional material that did not appear in the September print edition of CFO magazine.

It was the end of a brutal week for IHOP International's Thomas Conforti, and the CFO wanted to steal away to indulge in some comfort food before heading back to the company's Glendale, California, headquarters. Earlier that week, on July 16, IHOP announced it would buy the substantially larger Applebee's International in an all-cash deal worth $2.1 billion. The announcement sent Conforti, CEO Julia Stewart, and other executives through a gauntlet of press, investor, and merger-related meetings. "We were so hungry [when we got back] that we didn't want to go the office until we went to IHOP. I had a simple omelet and a corn-cake pancake — it tastes like cornbread, and with maple syrup, it's outstanding," recalls the finance chief.

Conforti, 48, will likely need a few more of his favorite pancakes to tide him over before the deal is finalized. If the merger is approved by Applebee's shareholders, and Conforti is able to complete the financing as expected, the deal could close as soon as mid-October. Then he and his colleagues will begin the heavy lifting that will ultimately transform Applebee's from a staid casual-dining chain into an intellectual property (IP) growth engine.

Conforti sat down with CFO to discuss why IHOP intends to abandon Applebee's business model, how it will use the chain's balance sheet to seal the deal, and what it's like digesting a much larger company.

Before joining IHOP in 2002, you were a divisional CFO at Disney, responsible for its $20 billion retail business. What convinced you to move to a franchise-restaurant business that generates about $2 billion a year?
It was clear that [IHOP management] was going to completely change the direction of the business. And during my first week, I was part of a team that presented the board with a plan that said the old way of doing business had to be revisited. At the same time, our largest shareholder, Southeast Asset Management, had filed a Form 13D [shareholder resolution] expressing a desire to have the company consider different business models. We spent the next three weeks preparing a case that said our old franchising business model — which was balance sheet–intensive — needed to be abandoned.

Applebee's is bigger than IHOP in terms of revenue (36 percent), cash flow (70 percent), market capitalization (40 percent), and retail units (33 percent) — how will you digest it?
Julia Stewart and I have worked for far bigger businesses than the combined IHOP/Applebee's business, so in terms of size it's no big deal. But it is always challenging when you buy a company: integration is always easy on paper, right? Our banker came up with a great label [for the deal]. He called it a leveraged repeat, instead of a leveraged recapitalization. We're taking Applebee's and restructuring it in the same way we restructured IHOP — into a model that generates high levels of cash flow through royalty payments. Plus, we were able to raise a bunch of leverage using Applebee's balance sheet. Of the $2 billion or so of acquisition proceeds, about $1.8 billion is coming from Applebee's. In essence, we are leveraging off its balance sheet to buy it. Anyone in our place would have done the same.

But not every CFO would have used a whole company securitization to raise capital to finance the deal. Why did IHOP choose the structure?
I can't talk too much about the [IHOP or Applebee's] securitizations, because they were private-placement deals. But we concluded that securitization was how we would get the best benefit out of our new business model. In 2003, we became a franchising-driven IP company and changed the capital- and time-intensive way we drove new restaurant development. As a result of the shift, IHOP generates most of its revenues from collecting royalties. (IHOP collects a 4.5 percent brand royalty payment on revenues from franchisees. That revenue stream is used to back loans made to the company via a securitization structure. The Applebee's securitization will be structured the same way.)

You mentioned that IHOP's new business model, which will ultimately become Applebee's new model, bucks tradition. How?
We are unusual birds. Out of the 1,300 retail units in the IHOP system, we own only about 10 restaurants (1 percent of the total system), all in the Cincinnati market, which we use for research and development. Conventional wisdom in the restaurant-franchise business says that you need to own and operate about 20 percent to 30 percent of your system to be successful, so you have "skin in the game," but we don't subscribe to that.

Why not? What was wrong with the old franchise model?
There was a cost to doing business the old way. We had to use our capital to get it done. IHOP used to act as a financial and real estate intermediary for our franchisees, charging them a one-time entrance fee of $250,000, of which up to 80 percent was financed by IHOP at 11 percent interest. We also built the building, sat on the lease, and allowed the franchisee to sublet the building. And we financed the franchisee's restaurant-equipment package 100 percent. When I joined, our capital expenditure [capex] was $145 million. Now it's $9 million.

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