Should you short DineEquity (DIN)?
At first glance at this rather ridiculous graph, one is immediately inclined to say YES, bring it on! However, the chart looks a little less silly if you expand the time period to, say two years:
Before we get into the drama behind these charts, let's introduce the company
Based in Glendale, Calif., DineEquity and its franchisees own or operate almost 3,400 restaurants under the Applebee's Neighborhood Grill & Bar and IHOP brands. The company owns the Applebee's (with 1,992 system-wide restaurants as of March 31, 2009) and IHOP restaurant chains (2400 restaurants), classified as 'casual dining', that is, dining at a rather modest price deemed to be less sensitive to discretionary consumer spending.
Applebee was purchased in November 2007 financed by issuing $2.3B in debt (of which $0.5B has been retired). And that debt is playing a rather central role. As you can gauge from the second graph, the combination of the huge amount of debt financing in relation to the take-over, and the credit and economic crisis conspiring to cast serious doubt on the viability of that move. The price move that was exacerbated by shorts jumping on the stock.
First, some metrics:
Negative sales growth
- 2008 revenue $1.61 B
- 2009 expected revenue $1.35B
- 2010 expected revenue $1.13B [Yahoo]
- 2008 $1.42
- 2009e $1.39
- 2010e $1.8 [Yahoo]
- This year's p/e would be almost 25
- Next year's p/e still be almost 19
- 3.22M out of 17.41M outstanding and a float of 14.43M [Yahoo]
- Cash $114.72M
- Debt $2.36B [Yahoo]
- We estimate the interest expense for fiscal 2009 will be approximately $190 million to $200 million, which includes approximately $40 million of non-cash interest charges. [10-Qp20]
Very good quarter recently Q109, figures from April 28 [10-Q]
The consensus expectation of 29 cents [Yahoo] (or 16 cents [Reuters]) were well and truly beaten as the results came in at 72 cents, including one time gains (on debt retirements and asset sales) it would have been $1.80.
Like other casual diners (and indeed most of the market in general), these upward surprises have largely come from cost cutting [Reuters]. However, same store sales were not as bad as some other chains. Domestic same-store sales at IHOP restaurants rose 2 percent, while Applebee's systemwide domestic same-store sales fell 3 percent [Reuters].
And the company has a couple of tricks up its sleeve to manage the huge debt burden.
Applebee is currently 80% franchised (20% own operated restaurants) - there are 401 company operated restaurants, a majority of which the company plans to franchise by the end of 2010. IHOP is already almost completely (that is, 99%) franchised, and there are only 12 company operated restaurants.
An idea of the proceeds from this strategy can be gauged from the following quote:
That's roughly $1.6M per franchise, and if they would franchise 300 out of the remaining 401 company operated restaurants, that would provide roughly $500M (or $650M if they franchise all of these), although much less will be booked as a gain of course, especially since property prices are quite depressed. But that's not terribly relevant, as the aim is to generate cash, as we will shortly discuss.
They also claim that cash-flow will be more stable, but we couldn't make out if there is a systematic and/or sizeable difference in income generated from franchised restaurants (royalties e.d.) versus company operated ones.
There are no guarantees that the franchise program will be completed by the end of next year; it depends on conditions, by which they mean prices. They won't franchise if they think they won't get fair value.
The company can buy back its own debt on the open markets as its fair value is less than carrying value. The difference is booked as a one-time profit. This quarter (Q109) for instance,
The Company retired certain Series 2007-1 Class A-2-II-X Fixed Rate Term Senior Notes due December 2037 with a face amount of $78.4 million for a cash payment of $49.0 million. The Company recognized a gain on extinguishment of this debt of $26.4 million after the write-off of the discount and deferred financing costs related to the debt retired [10-Q p25].
That really is quite substantial for a single quarter. It's especially the combination of these two advantages that makes the situation a lot less worse than one, at first sight, might be inclined to think. The franchising policy reduces capital outlays (indeed, it can book considerable proceeds which enables even more debt retirement), so as long as operating income is more than interest payments, debt can continued to be retired if these conditions in the debt market remain, which is indeed what they foresee.
So, interest payments are roughly $50M per quarter (including non-cash dividends on preferred stock of roughly $40M). Is operating income large enough to leave cash for debt retirement? The company thinks so:
We believe that we will have the necessary liquidity through our current cash balances, operating cash flow, the IHOP revolving credit facility and proceeds from additional franchising of Applebee's company-operated restaurants to fund our debt service requirements, capital expenditures and other operational cash requirements for at least the next year. However, if we are not able to achieve forecasted revenue targets and operating improvements or effect franchisings of Applebee's restaurants at prices currently anticipated, this assessment would have to be reconsidered. Additionally, certain Applebee's Notes have accelerated payment dates of December 2012, and we will likely seek to refinance this debt if it has not been repaid prior to then. We may not be able to effect any future refinancing of our debt on commercially reasonable terms or at all.
In the event that we are unable to refinance the Applebee's securitization debt by December 2012, then Applebee's will have the ability to extend the scheduled payment date for six months. The interest rate on the Applebee's securitization debt will increase by 0.50%, and any unpaid amount will accrue interest at such increased rate [10-Q p27].
So operations need to generate enough cash to pay interest and taxes and capital outlays, and debt retirement. And the longer it does, the lower the debt, hence interest payments become, the easier this becomes.
We think that part of the phenomenal fall and subsequent phoenix-like rise, is attributed to changing beliefs about this ability, and these beliefs have been given a substantial boost by the fact that they managed, in what can only be described as a difficult quarter, to retire so much debt. However, looking at the charts of competing 'casual diners' (RUTH, BWLD, CAKE, CMG, RT,EAT, DRI, MRT, CPKI), they all show very similar dramatic upturns, so there are considerable sectoral forces at work.
The operational side holds the key, it must continue to provide excess cash with which debt can be retired
Here is what the company had to say about operations:
Cash provided by operating activities increased to $57.7 million during the quarter ended March 31, 2009 from $10.0 million in the same period in 2008, primarily due to changes in working capital in addition to higher operations profit and lower interest in the quarter ended March 31, 2009. Changes in working capital provided cash of $25.4 million in the first quarter of 2009, due primarily to the timing of payments for taxes and advertising. The timing of tax payments can be difficult to predict and can contribute to the volatility of cash provided or used by working capital. Changes in working capital used cash of $33.5 million during the quarter ended March 31, 2008, due primarily to payments of accrued payables.
We think it's going to be very difficult for them to maintain this kind of performance
Note in the quote above the substantial changes in working capital "primarily due to the timing of payments for taxes and advertising". In fact, the income tax benefit, at 73 cents a share, was larger than the net profit per share excluding one-time gains. That is, without the income tax benefit, they would not have been profitable in Q1 at all...
Looked from another angle, in their guidance for the whole of 2009 they expected $100-110M of free cash flow, plus an additional $15M (approximately) in additional cash from the structural run-off of the IHOP business unit's long-term notes receivable. But half of that ($59M) has already been achieved this quarter. So, Next quarters are not likely to be so good. Indeed:
We do not expect to maintain the company restaurant margin of 16.4% achieved in the first quarter of 2009 throughout fiscal 2009 [10-Qp24].
And indeed, the current (Q2) quarter, analyst (despite recent upward adjustments) expect just $5.4M or 31 cents per share in profit, although one cannot help but notice that the last three quarters, the analysts covering this company were way too pessimistic, with really huge upward 'surprises' in all three quarters [Yahoo].
Also, as the company succeeds, debt prices will surely start to reflect that, and the rather steep discount the company has been able to retire debt this quarter could very well shrink considerably. But by then, debt should be down to a more manageable levels.
Not everybody is convinced either:
J.P. Morgan restaurant analyst Steven Rees said in a client note that DineEquity could be hurt if it cuts costs too much. He added that he remained cautious on the company's long-term outlook still-elusive restaurant sales [Reuters].
Much of the success is priced in
However, if they do pull it off, they will merely avoid serious trouble, and even that is by no means guaranteed, seems to be priced into the stock price to us. And for the time they're using whatever they generate to reduce the debt, there is hardly any cash or debt possibilities to expand. The stock has also gained an absurd amount in a very short time.
Agreed, it had also been driven down to absurd low levels, but we feel that a short position, or perhaps better still, the selling of some calls could provide a nice return (perhaps the May or June 35 calls). The latter will provide gains even if the stock merely pauses, as time value and volatility reductions will eat into option premiums (although the more illiquid option series especially suffer from rather large bid/ask spreads). A general market pause, which we think is due, would also help.