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?

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.”

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