The Web version of this article has been expanded to include additional material that did not appear in the September print edition of CFO magazine.
It was the end of a brutal week for IHOP International’s Thomas Conforti, and the CFO wanted to steal away to indulge in some comfort food before heading back to the company’s Glendale, California, headquarters. Earlier that week, on July 16, IHOP announced it would buy the substantially larger Applebee’s International in an all-cash deal worth $2.1 billion. The announcement sent Conforti, CEO Julia Stewart, and other executives through a gauntlet of press, investor, and merger-related meetings. “We were so hungry [when we got back] that we didn’t want to go the office until we went to IHOP. I had a simple omelet and a corn-cake pancake — it tastes like cornbread, and with maple syrup, it’s outstanding,” recalls the finance chief.
Conforti, 48, will likely need a few more of his favorite pancakes to tide him over before the deal is finalized. If the merger is approved by Applebee’s shareholders, and Conforti is able to complete the financing as expected, the deal could close as soon as mid-October. Then he and his colleagues will begin the heavy lifting that will ultimately transform Applebee’s from a staid casual-dining chain into an intellectual property (IP) growth engine.
Conforti sat down with CFO to discuss why IHOP intends to abandon Applebee’s business model, how it will use the chain’s balance sheet to seal the deal, and what it’s like digesting a much larger company.
Before joining IHOP in 2002, you were a divisional CFO at Disney, responsible for its $20 billion retail business. What convinced you to move to a franchise-restaurant business that generates about $2 billion a year?
It was clear that [IHOP management] was going to completely change the direction of the business. And during my first week, I was part of a team that presented the board with a plan that said the old way of doing business had to be revisited. At the same time, our largest shareholder, Southeast Asset Management, had filed a Form 13D [shareholder resolution] expressing a desire to have the company consider different business models. We spent the next three weeks preparing a case that said our old franchising business model — which was balance sheet–intensive — needed to be abandoned.
Applebee’s is bigger than IHOP in terms of revenue (36 percent), cash flow (70 percent), market capitalization (40 percent), and retail units (33 percent) — how will you digest it?
Julia Stewart and I have worked for far bigger businesses than the combined IHOP/Applebee’s business, so in terms of size it’s no big deal. But it is always challenging when you buy a company: integration is always easy on paper, right? Our banker came up with a great label [for the deal]. He called it a leveraged repeat, instead of a leveraged recapitalization. We’re taking Applebee’s and restructuring it in the same way we restructured IHOP — into a model that generates high levels of cash flow through royalty payments. Plus, we were able to raise a bunch of leverage using Applebee’s balance sheet. Of the $2 billion or so of acquisition proceeds, about $1.8 billion is coming from Applebee’s. In essence, we are leveraging off its balance sheet to buy it. Anyone in our place would have done the same.
But not every CFO would have used a whole company securitization to raise capital to finance the deal. Why did IHOP choose the structure?
I can’t talk too much about the [IHOP or Applebee's] securitizations, because they were private-placement deals. But we concluded that securitization was how we would get the best benefit out of our new business model. In 2003, we became a franchising-driven IP company and changed the capital- and time-intensive way we drove new restaurant development. As a result of the shift, IHOP generates most of its revenues from collecting royalties. (IHOP collects a 4.5 percent brand royalty payment on revenues from franchisees. That revenue stream is used to back loans made to the company via a securitization structure. The Applebee’s securitization will be structured the same way.)
You mentioned that IHOP’s new business model, which will ultimately become Applebee’s new model, bucks tradition. How?
We are unusual birds. Out of the 1,300 retail units in the IHOP system, we own only about 10 restaurants (1 percent of the total system), all in the Cincinnati market, which we use for research and development. Conventional wisdom in the restaurant-franchise business says that you need to own and operate about 20 percent to 30 percent of your system to be successful, so you have “skin in the game,” but we don’t subscribe to that.
Why not? What was wrong with the old franchise model?
There was a cost to doing business the old way. We had to use our capital to get it done. IHOP used to act as a financial and real estate intermediary for our franchisees, charging them a one-time entrance fee of $250,000, of which up to 80 percent was financed by IHOP at 11 percent interest. We also built the building, sat on the lease, and allowed the franchisee to sublet the building. And we financed the franchisee’s restaurant-equipment package 100 percent. When I joined, our capital expenditure [capex] was $145 million. Now it’s $9 million.
Will the Applebee’s company-owned stores also be shrunk to 1 percent of the system?
We think 5 percent is a low-enough number [for Applebee's]. I think Julia wants two [test] markets, one on the East Coast and one on the West Coast. We don’t need [to own] 25 or 30 percent of the system, but we don’t feel that anyone will press us to go from 5 percent ownership to zero. It will take two to two-and-a-half years, maybe sooner. We’re already getting calls. It’s amazing how many people are out there who want to buy Applebee’s franchises, and how many people there are who want to buy the real estate that we are going to sell.
What part of the new business model will pique shareholder interest?
If you don’t have capex and are generating a bunch of cash flow, the issue that is of great interest to shareholders is what level of leverage do you feel best about? [Regarding IHOP], we increased leverage from $130 million in debt to $175 million in term loans, and a $25 million revolving component of the securitization. By increasing debt by 50 percent, we are saying that we certainly believe we can sustain that level; it indicates that we are very comfortable with higher rates of leverage.
Internally, what piques your interest; that is, what are your key metrics now that the new business model is in place?
Cash and number of shares outstanding. To show that we’ve drunk the Kool-Aid on cash, our key internal measure of performance is cash from operations. That focus on cash gives us added incentive to [better] manage receivables and payables. And over the last three years, we’ve returned about $270 million in cash to shareholders in the form of dividends and share repurchases. So in three years we’ve gone from [being] a net user of capital to a generator of cash flow, and then returned that cash to shareholders.
You are slowly getting rid of real estate and equipment leases to reduce capex — what else have you done to slash capital spending?
We cut deals on underperforming company-operated restaurants to get them into the hands of franchise operators. In addition, new franchisees are required to purchase or develop their building and equipment without financing from IHOP. [Interestingly], 75 percent of new development is being done by existing franchisees.
Were customers affected by the new model?
Yes, in a positive way. By getting out of our old way of franchising, we are able to focus on operations and marketing. For example, we put in place a stringent rating system for our franchise operators that raised operating performance. We also introduced a new advertising campaign, a new building prototype, a remodeling program for existing restaurants, and [we] enhance our core menu regularly.
What made Applebee’s so attractive to IHOP?
It met our acquisition criteria. For example, Applebee’s is not competitive with our brand. The deal leverages our proven competencies of franchising, G&A management, and brand turnarounds. The chain is of material size, so that we’re not wasting our time on something that won’t move the needle. [And] we expect the deal to be modestly accretive [with respect] to earnings in 2008, and substantially more accretive in the outer years. Also — and this is important — Julia knows this business. She was at Applebee’s for a number of years, running most of the units, [including] the U.S. business. She thinks it’s a great brand and business that has very talented franchisees.
You said Applebee’s doesn’t compete with the IHOP brand. How so?
All restaurants compete, but we believe that Applebee’s is largely a dinner concept and IHOP is a breakfast concept. IHOP’s lowest level of business — about 15 percent — is around dinner. Also, a large number of IHOP restaurants operate 24 hours a day. And Applebee’s serves alcohol; IHOP doesn’t. So there is certainly a different competitive positioning between the two concepts.
Do the alcohol licenses expand your borrowing base?
We have the ability to put those units [that sell alcohol] into the deal and borrow against them, as if the liquor licenses were secured. We are able to do that for a period of, I think, nine months after the close of the securitization. If we’re not able to resolve liquor-license transfer issues within that period, then we have to remove those units from our collateral basis. But we’re confident, we’ve done our due diligence, and attorneys who specialize in liquor licenses have assured us that the transfer can be done in a reasonable period of time.
Will the IHOP franchise model become an industry trend among chain restaurants?
You know, I don’t know. We’re credited with a lot of shareholder-friendly initiatives, such as getting out of company operations, reducing capital expenditures, returning cash to shareholders. We believe in it. But I don’t know if the rest of the industry is moving in that direction. It seems like some are, and some aren’t. [However], it’s amazing how many people are out there who want to buy Applebee’s franchises, and how many people want to buy the [Applebee's] real estate that we’re going to sell.
The new model sounds promising. But when you abandoned the old model, didn’t the company also reduce revenues?
We made a tradeoff. We reduced capital expenditure by $130 million a year, and had to reduce cash from operations from about $80 million to $60 million. I don’t know about you, but I’d trade $130 million for $20 million any day.