IHOP to Flip Applebee’s Business Model

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?

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.

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