DineEquity Inc (NYSE: DIN) owns, operates and franchises two causal and family dining restaurant concepts: Applebee's Neighborhood Grill and Bar and the International House of Pancakes, or IHOP. The company started as IHOP and transformed into DineEquity with the all cash, highly levered acquisition of Applebee's in 2007 for $2.1 billion. The company now has more than 3,500 restaurants in eighteen countries, with more than 400 franchisees.
The Past: Applebee's Acquisition
Prior to the 2007 acquisition, Applebee's owned and operated 511 locations of its 1,976 locations (the remaining being franchised). By owning and operating its own restaurants (as well as real estate at 200 of these locations), growth was capital intensive and management of such a large entity required a significant level oversight in terms of G&A expense.
IHOP's rationale for purchasing Applebee's was driven by a desire to franchise Applebee's existing locations, thus freeing up capital as a result of both the sale of the franchise (and the franchise fee of $35,000 per location) as well as the underlying real estate (in sale-leaseback transactions). Working capital would also be freed up, and the new growth would be achieved in a much less capital intensive manner. All of this would contribute to immediate cash generation (which was committed to repaying lenders), along with a new business model that would generate more significant free cash flow. Additionally, by franchising these locations, the combined company would be able to eliminate much of Applebee's existing G&A expense structure as the same level of oversight would be unnecessary and much of IHOP's franchisee oversight could be applied to new Applebee's franchisees (thus, significant expense synergies).
This is how it was supposed to work. Now, 4.5 years hence, we can look back and assess how things have gone.
The Present: How Things Look Today
At the time of the acquisition, the company believed the intended sale of 510 of Applebee's 511 owned locations would be complete by 2010. Unfortunately, this process has been delayed, with an additional 176 Applebee's remaining to be franchised (more than a year after the process was supposed to complete).
Let's consider the leverage situation. In the quarter immediately prior to the acquisition, DIN had debt and capital leases amounting to $341 million relative to $208 million in equity (nearly all of which was tangible) for a D/E of a respectable 1.6x. The acquisition ratcheted debt and capital leases up to $2.43 billion, creating a D/E of nearly 12x. Unfortunately, intangible assets amounted to $1.72 billion, so tangible equity became significantly negative.
I am not a fan of acquisitions which generate significant goodwill, as this is the most opaque and difficult to analyze asset. All too frequently, this is written down as reality sets in and the premium paid suddenly appears foolish.
Today, the company has $1.73 billion of debt and capital leases, having managed to repay $700 million or nearly 30% of its obligations. This is good, however despite repaying such a large amount, the company's D/E ratio has remained largely the same, in the excessive 11-12x range. This is largely the result of - surprise! - the write-down of intangibles which now stand at $1.52 billion. In 2008, the company wrote down $113.5 million of Applebee's goodwill and $44.1 million associated with the tradename. Unfortunately, it did not end with intangibles, as the company wrote down $26.8 million associated with Applebee's restaurants and $40.6 million on the real estate it sold.
One of the other justifications for the transaction was the expected improvement in free cash flow. It is important to focus on free cash flow in this situation because the company's earnings are extremely noisy due to the non-cash impairment and restructuring charges, one-time cash gains on the sale of franchises, among other one-time events. Over the last three years, free cash flow has averaged $133 million, which is an improvement of 160% from the three year average prior to the acquisition of $51.3 million. This is good.
The company also mentioned more efficient operations (via reduced G&A as a proportion of revenues) as a justification. In the three years prior to the transaction, the company's G&A averaged 17.2%. In the three most recent years, G&A averaged just 12.4% (14.5% in the most recent year), representing a significant reduction and largely achieving what the company expected. This too is good.
The Future: Is There A Value Opportunity?
When valuing a company, we have to be clear where we see value. In his beginners value investing text, Value Investing: From Graham to Buffett and Beyond, Columbia University professor Bruce Greenwald provides a clear framework for different levels of valuation, beginning with a straight assets-based valuation (which was the core of Benjamin Graham's philosophy) and moving up through an earnings power valuation to a valuation based on a franchise value for those companies with persistent super-normal returns (the core of the Buffett/Munger philosophy).
As discussed above, DIN is not an asset play, or at least is not an easily valued asset play. The bulk of its assets are intangibles which are extremely difficult to assess even for those with extensive experience in the industry. There are a range of proxies that could be used for valuing the brand names and other intangibles, but only the most extremely liberal assumptions would be capable of turning negative tangible equity into an asset valuation capable of producing a margin of safety.
Going to the other end of the spectrum, we can consider whether DIN possesses a competitive moat such that there is a franchise value (franchise in this context is very different from the fact that DIN operates as a franchised restaurateur!). We have to ask ourselves whether the company generates super-normal returns and is capable of doing so in the future. As discussed above, DIN's accruals-based earnings since the Applebee's acquisition have been quite noisy, and the extreme leverage has rendered normalized returns on equity somewhat difficult to assess. One way around this is to use cash based returns metrics, such as CROIC (Cash Return on Invested Capital), which "looks through" the leverage and assesses the amount of free cash flow the company can produce based on an enterprise valuation. In this regard, since the acquisition, DIN has earned CROIC averaging just 5.6%. In other words, not impressive at all (and down from a still paltry 8.76% on average for the three years prior to the acquisition). There does not appear to be a franchise value that allows DIN to earn excessive returns (which is to be expected given the competition in the casual dining industry).
So this leaves us with an earnings power valuation. We first consider whether the company's future earnings are expected to be more impressive than present earnings. This is often the case for companies still digesting a large acquisition, like DIN. Unfortunately, while DIN still has some remaining Applebee's locations to sell, the bulk of progress appears to be complete, as discussed above. For example, the company has largely achieved its expected G&A synergies (this investor presentation suggests next year G&A will be roughly in line with the past year or two). Second, the company has sold most of its Applebee's locations and all of the real estate it acquired in the acquisition. So while we can assume perhaps marginal improvements over the next few years on the expense side, it appears that the best a DIN investor can hope for is growth on the revenue side which will come both from improving same store sales (as the economy continues to recover) and new store development. We can factor these into our model and make some conservative assumptions to find a normalized level of free cash flow generation which we discount to the present.
Unfortunately, when we do this, it becomes abundantly clear that DIN is not undervalued unless using extremely aggressive assumptions (that far exceed the company's own projections, at least for the next year). Part of this is due to the company's 40% run-up since October. Aggressive scenarios may be warranted as we do see signs of an economic recovery in the company's core American market. Furthermore, investors can take solace in the fact that the company is committed to reducing its leverage which could produce a situation like SuperValu (NYSE: SVU) whereby holding EV steady the reduction in leverage will lead to gains accruing to equity. Holding EV steady is an assumption we should only make where EV is already quite low relative to free cash flows (on a side note, this creates a second possible source of returns in terms of multiple expansion). Unfortunately, unlike SVU, DIN trades at an aggressively high EV/EBITDA (more than twice that of SVU) so there is a real risk that the company could experience multiple contraction. At the very least, it is important to recognize the riskiness of assuming the company's multiple will hold steady in this case.
Despite the fact that there isn't a value opportunity here, there are a few good takeaways. First, never rely on just one performance measure. Here, if you relied on the returns on equity, you would get a vastly misleading picture of the company because of its high debt load. Always be sure to consider at least one whole enterprise (equity + debt) returns metric. Second, be wary of large acquisitions and especially those that result in a significant level of intangible assets. Large acquisitions are rarely a "steal" for the acquirer (especially when conceived of during a period of market euphoria) and intangibles are extremely difficult to assess. Finally, when considering a company that has undertaken big transactions in the past, it is always worth considering what "best case" assumptions were used to sell investors on the deal and compare these with actual performance to date. In this case, we see that, even as DIN has achieved the bulk of its expected synergies and asset sales, the result has been far from impressive for shareholders.
What do you think of DIN?