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The pancake house reworked its franchise structure so its negative cash flow turned into $60 million in free-cash-flow. Can IHOP executives make it happen again at Applebee's?
Marie Leone, CFO.com | US
July 16, 2007
IHOP Corp., the parent company of the famed pancake house franchise, announced a deal on Monday to buy eatery chain Applebee's International in an all-cash deal worth $2.1 billion, or about $25.50 per share. The transaction will be financed using a whole-business securitization backed by Applebee's assets and added borrowing under IHOP's current securitization structure, company officials say.
The key to a whole-business securitization – sometimes called a whole company securitization – is the intellectual property, IHOP's main business these days. The whole business securitization is a more complex version of traditional securitizations.
Under such arrangements, a parent company isolates revenue-producing assets such as trademarks or patents by selling them to a limited-purpose, bankruptcy-remote shell company. The IP assets are usually the "crown jewels" of the company's intellectual property portfolio. The shell issues bonds that are backed by the assets, and uses the proceeds to provide a secured loan to the parent. The assets are actively managed, usually by the parent under agreement with the shell, to generate continued cash flow and to preserve the value of the IP.
IHOP's crown jewels are its brand name and its secret pancake mix. It's likely that Applebee's jewels will be similar. Going forward, IHOP hopes to leverage the Applebee's brand by reworking its business model, essentially transforming the 508 company-owned Applebee's stores into franchise restaurants that lease the brand and other intellectual property to create a steady revenue stream.
About three years ago, IHOP did the same thing with nearly all of its 1,319 pancake houses, converting 99 percent of them into franchises. That shift resulted in a $130 million "flip" in free cash-flow for the company, CFO Tom Conforti said in a previous interview. What's more, the change reduced capital expenditure (capex) spending by $136 million.
"We took a business that had negative free cash-flow of around $70 million a year, and in a two-year period we were generating free cash- flow in the $50-million-to-$60-million range," Conforti told CFO.com earlier this year. Since then, says Conforti, IHOP has been growing same-store sales at 3 percent to 4 percent annually. Further, he pointed out, when he joined the company in 2002, capex spending was $145 million. It was down to $9 million at the time of the interview.
IHOP was able to boost its metrics by revamping its business model and dumping physical assets from its balance sheet. Under its old business model, IHOP acted as a financial and real estate intermediary for franchisees. The company would charge a one-time entrance fee of $250,000—of which 80 percent was financed by IHOP (at an 11 percent interest rate). IHOP would then build the restaurant and sit on the lease, allowing franchisees to sublet the building. The rent would be marked up to compensate for the real estate risk.
Further, IHOP would provide 100 percent financing for the franchisee's restaurant-equipment package. On average, that loan came out to be about $350,000 per unit, which was financed with a 25-year note, also at 11 percent.
When IHOP moved to the revenue model, the company did two things: It got out of the real estate and equipment-financing business for new franchisees, and it offered existing franchisees the chance to buy their own buildings and equipment. (In aggregate, IHOP still generates about $30 million on the physical assets it still owns.)
Under its new business model, IHOP collects royalties on its intellectual property: about 4.5 percent of revenues per store for its IHOP brand. The franchisees must also buy IHOP's proprietary pancake mix. At 4 percent of revenues, Applebee's royalties are slightly lower, and it's unclear at this point what other revenue flows will be tapped.
When Conforti and his team structured the securitization of IHOP's debt earlier this year, the company announced that the transaction was a "very flexible form of debt financing that would allow IHOP to fund future growth, through increased leveraged." Indeed, that seems to have happened with the Applebee's acquisition. IHOP plans to raise about $175 million from its existing securitization to contribute to the Applebee's deal. It will then arrange for a new Applebee's securitization to fund the rest of the purchase. Meanwhile, IHOP will use a bridge loan to complete the transaction, until the two securitizations are sealed.
Conforti noted in a conference call on Monday that he expects to get final deal approval from Applebee shareholders within three months, the same time the new securitization pacts should be finalized. No unsecured debt will be used to complete the buyout, and the securitization will use fixed-note instruments. Thus, the debt doesn't have any declining-rate feature based on debt covenant criteria. Conforti also mentioned during the call that the cost for transferring about 40 liquor licenses from Applebee's to IHOP has been factored into the securitization total already. The transfer, however, requires regulatory approval
The change to an IP company bucks conventional wisdom in the franchise-business industry, says Conforti. Typically, restaurant franchise companies own and operate 20 percent to 30 percent of their system to remain successful. "But we don't subscribe to that. We think many of our investors have been quite pleased [with our decision]," noted Conforti, who contended that investors are interested in a company that generates cash flow while suppressing capex.
On Monday, the company projected that by unloading certain Applebee's assets through sale-leaseback transactions, and making it an IP business, it would generate $950 million in cash over a three-year period. The finance chief asserted that he used the securitization structure for the Applebee's purchase because the company is familiar with it, and the deal allows "maximum borrowing at the lowest cost possible."