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DineEquity, Inc. 10-Q 2008
UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
FORM 10-Q
Commission File Number 001-15283
DineEquity, Inc. (Exact name of registrant as specified in its charter)
(818) 240-6055 (Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
DINEEQUITY, INC. AND SUBSIDIARIES
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DINEEQUITY, INC. AND SUBSIDIARIES (In thousands, except share amounts)
See the accompanying Notes to Consolidated Financial Statements.
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DINEEQUITY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share amounts) (Unaudited)
See the accompanying Notes to Consolidated Financial Statements.
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DINEEQUITY, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) (Unaudited)
See the accompanying Notes to Consolidated Financial Statements.
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DINEEQUITY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. General
Effective June 2, 2008, IHOP Corp. changed its corporate name to DineEquity, Inc. (the “Company”). The accompanying unaudited consolidated financial statements of the Company have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three-month and nine-month periods ended September 30, 2008 are not necessarily indicative of the results that may be expected for the year ending December 31, 2008.
The consolidated balance sheet at December 31, 2007 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by U.S. GAAP for complete financial statements.
These consolidated financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.
2. Basis of Presentation
The Company’s fiscal quarter ends on the Sunday closest to the last day of each quarter. For convenience, all fiscal quarters are reported as ending on March 31, June 30, September 30 and December 31. The third fiscal quarters presented herein ended September 28, 2008 and September 30, 2007, respectively.
On November 29, 2007, the Company completed the acquisition of Applebee’s International, Inc. (“Applebee’s”) pursuant to an agreement and plan of merger entered into by and among the Company, CHLH Corp. and Applebee’s. Upon consummation of the acquisition, Applebee’s became a wholly owned subsidiary of the Company. The accompanying consolidated financial statements include the accounts of the Company and its subsidiaries that are consolidated in accordance with U.S. GAAP. All intercompany balances and transactions have been eliminated in consolidation. However, the subsidiaries have not guaranteed the obligations of the Company, and the assets of the subsidiaries generally are not available to pay creditors of the Company. Also, the Company has not guaranteed the obligations of the subsidiaries, and the assets of the Company generally are not available to pay creditors of the subsidiaries.
The preparation of financial statements in conformity with U.S. GAAP requires the Company’s management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, the Company evaluates its estimates, including those related to provisions for doubtful accounts, legal contingencies, income taxes, long-lived assets and goodwill. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results could differ from those estimates.
Certain reclassifications have been made to prior year information to conform to the current year presentation. These reclassifications had no effect on the net income or financial position previously reported.
3. New Accounting Pronouncements
In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Accounting Standards (“SFAS”) No. 157, Fair Value Measurements (“SFAS 157”). In February 2008, the FASB issued FASB Staff Position (“FSP”) No. 157-2, Effective Date of FASB Statement No. 157, which delayed for one year the applicability of SFAS 157’s fair-value measurements to certain nonfinancial assets and liabilities. The Company adopted SFAS 157 as of January 1, 2008, except as it applies to those nonfinancial assets and liabilities affected by the one-year delay. The adoption did not have a material impact on the Company’s consolidated financial position or results of operations. The Company is currently evaluating the potential impact of adopting the remaining provisions of SFAS 157 on its consolidated financial position and results of operations.
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3. New Accounting Pronouncements, continued
In June 2007, the EITF reached consensus on Issue No. 06-11, Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards (“EITF 06-11”). EITF 06-11 requires that the tax benefit related to dividend equivalents paid on restricted stock units which are expected to vest be recorded as an increase to additional paid-in capital. The impact of adopting EITF 06-11 in 2008 did not have a material impact on the consolidated financial statements.
In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations (“SFAS 141(R)”). SFAS 141(R) establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any noncontrolling interest in the acquiree and the goodwill acquired. SFAS 141(R) also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. SFAS 141(R) is effective for fiscal years beginning after December 15, 2008. The Company will adopt SFAS 141(R) in the first quarter of fiscal 2009 and apply the provisions of this statement for any acquisition after the adoption date. As the statement may only be applied prospectively, the adoption of SFAS 141(R) would impact our consolidated financial statements only if the Company enters into a business combination after the effective date.
In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities (“SFAS 161”). This statement requires companies to provide enhanced disclosures about (a) how and why they use derivative instruments, (b) how derivative instruments and related hedged items are accounted for under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, and its related interpretations, and (c) how derivative instruments and related hedged items affect a company’s financial position, financial performance, and cash flows. SFAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. The Company will adopt the new disclosure requirements on or before the required effective date. As SFAS 161 does not change current accounting practice, there will be no impact on the Company’s consolidated financial statements.
In April 2008, the FASB issued FSP FAS 142-3, Determination of the Useful Life of Intangible Assets (“FSP FAS 142-3”). FSP FAS 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No. 142, Goodwill and Other Intangible Assets (“SFAS 142”). The intent of FSP FAS 142-3 is to improve the consistency between the useful life of a recognized intangible asset under SFAS 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS 141(R) and other applicable accounting literature. FSP FAS 142-3 is effective for financial statements issued for fiscal years beginning after December 15, 2008 and must be applied prospectively to intangible assets acquired after the effective date. The Company is currently evaluating the potential impact, if any, of FSP FAS 142-3 on its consolidated financial statements.
In May 2008, the FASB issued SFAS No. 162, Hierarchy of Generally Accepted Accounting Principles (“SFAS 162”). This statement is intended to improve financial reporting by identifying a consistent framework, or hierarchy, for selecting accounting principles to be used in preparing financial statements of nongovernmental entities that are presented in conformity with U.S. GAAP. While this statement formalizes the sources and hierarchy of U.S. GAAP within the authoritative accounting literature, it does not change the accounting principles that are already in place. This statement will be effective November 17, 2008. The Company is currently evaluating the potential impact, if any, of the adoption of SFAS 162 on its consolidated financial statements.
4. Business Acquisition
The total transaction value (including direct transaction costs and expenses) of the Applebee’s acquisition was approximately $2.0 billion. The Company has accounted for the Applebee’s acquisition using the purchase method and, accordingly, the results of operations related to this acquisition have been included in the consolidated results of the Company since the acquisition date. The purchase price for this acquisition was allocated to tangible and intangible assets acquired and liabilities assumed based on their estimated fair values at the acquisition date of November 29, 2007. The Company believes the fair values assigned to the assets acquired and liabilities assumed were based on reasonable assumptions. The purchase price allocation for the Applebee’s acquisition is preliminary. The Company’s fair value estimates for the purchase price allocation may change during the allowable allocation period, which is up to one year from the acquisition date, if additional information becomes available.
A significant portion of the fair value assigned to property and equipment in the preliminary purchase price allocation was related to 511 Applebee’s company-operated restaurants. In the preliminary purchase price allocation, the Company used global assumptions as to rental data and capitalization rates that were applied to the entire portfolio of properties.
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4. Business Acquisition, continued
Subsequently, the Company analyzed this information on a store-by-store basis and determined certain fair values from the preliminary purchase price valuation should be revised downwards. Additionally, the data used to estimate the capitalization rate in the preliminary allocation was based in part on industry data, the reporting of which lagged the actual timing by several months. Once data on capitalization rates being utilized in late November 2007 became available, the Company updated the capitalization rate assumptions accordingly. As a result of the review described above, the estimated fair value allocated to property and equipment was revised downward by approximately $146 million in the second fiscal quarter of 2008.
The table below summarizes the three balance sheet items most impacted by the revision to the preliminary purchase price allocation as of November 29, 2007. The impact on all other balance sheet items was not significant.
* Including assets reclassified to held for sale subsequent to November 29, 2007
The unaudited pro forma data of the Company for the three-month and nine-month periods ended September 30, 2007 set forth below gives effect to the Applebee’s acquisition as if it had occurred at the beginning of 2007 and includes (1) the amortization of other comprehensive loss resulted from a swap the Company entered into in July 2007 to hedge the interest payments on the securitization transactions which were entered into on November 29, 2007 to finance the acquisition; (2) interest expense (including amortization) related to the securitization transactions that took place during 2007; (3) additional depreciation and amortization expense related to the pro forma stepped-up basis of assets acquired in the acquisition and (4) the tax effect resulting from the pro forma adjustments based on an assumed effective annual tax rate of 39.5%. This pro forma data is presented for informational purposes only and does not purport to be indicative of the results of future operations of the Company or of the results that would have actually been attained had the acquisition taken place at the beginning of 2007.
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5. Impairment of Long-Lived Assets
The Company assesses long-lived assets for impairment when events or changes in circumstances indicate that the carrying value of the assets may not be recoverable. As discussed in Note 9, Financing Obligations, in June 2008 the Company entered into sale-leaseback transactions related to 182 parcels of real estate (land, buildings and improvements). The net book value of the real estate assets exceeded the proceeds received by the Company from the transactions by approximately $40.8 million. Accordingly, an impairment loss of that amount was recorded in the second fiscal quarter of 2008.
As part of the ongoing assessment of the recoverability of its long-lived assets, the Company recorded impairment charges of $28.3 million for the three-month period ended September 30, 2008. Of that amount, $26.8 million related to Applebee’s properties and primarily resulted from a continuing deterioration in credit markets in general and a decline in operating results of Applebee’s company-operated restaurants expected to be franchised in particular geographic areas. The remainder of the impairment related to an individual underperforming IHOP property.
6. Segments
The Company’s revenues and expenses are recorded in four segments: franchise operations, company restaurant operations, rental operations, and financing operations. Within each segment, the Company operates two distinct restaurant concepts: Applebee’s and IHOP.
Applebee’s
The franchise operations segment consists of restaurants operated by Applebee’s franchisees in the United States, 17 countries outside the United States and one U.S. territory. Franchise operations revenue consists primarily of franchise royalty revenues. Franchise operations expenses include costs related to intellectual property provided to certain franchisees.
The company restaurant operations segment consists of company-operated restaurants in the United States and China. Company restaurant sales are retail sales at company-operated restaurants. Company restaurant expenses are operating expenses at company-operated restaurants and include food, labor, benefits, utilities, rent and other restaurant operating costs.
Rental operations and financing operations activities are not currently part of Applebee’s business.
IHOP
The franchise operations segment consists of restaurants operated by IHOP franchisees and area licensees in the United States, one U.S. territory and two countries outside the United States—Canada and Mexico. Franchise operations revenue consists primarily of franchise royalty revenues, sales of proprietary products, franchise advertising fees and the portion of the franchise fees allocated to IHOP intellectual property. Franchise operations expenses include advertising expense, the cost of proprietary products and pre-opening training expenses and other franchise-related costs.
The company restaurant operations segment consists of company-operated restaurants in the United States. In addition, from time to time, restaurants that are reacquired from franchisees are operated by IHOP on a temporary basis. Company restaurant sales are retail sales at company-operated restaurants. Company restaurant expenses are operating expenses at company-operated restaurants and include food, labor, benefits, utilities, rent and other restaurant operating costs.
Rental operations revenue includes revenue from operating leases and interest income from direct financing leases. Rental operations expenses are costs of operating leases and interest expense on capital leases on franchisee-operated restaurants.
Financing operations revenue consists of the portion of franchise fees not allocated to IHOP intellectual property, sales of equipment, as well as interest income from the financing of franchise fees and equipment leases. Financing expenses are primarily the cost of restaurant equipment.
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6. Segments, continued
Information on segments is as follows:
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7. Income Taxes
The Company files U.S. federal income tax returns, as well as tax returns in various state and foreign jurisdictions. With few exceptions, the Company is no longer subject to U.S. federal income tax examinations by tax authorities for years before 2004, or to state or non-U.S. income tax examinations for years before 2000.
The Company adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes—An Interpretation of FASB No. 109 (“FIN 48”) on January 1, 2007. As a result of the implementation of FIN 48, the Company recognized a $0.7 million increase in the liability for unrecognized tax benefits, excluding related income tax benefits, which was accounted for as a reduction of retained earnings at January 1, 2007. At December 31, 2007, the Company had a liability for unrecognized tax benefit including potential interest and penalties, net of related tax benefit, totaling $16.9 million, of which approximately $0.1 million is expected to be paid within one year. For the remaining liability, due to the uncertainties related to these tax matters, the Company is unable to make a reasonably reliable estimate when cash settlement with a taxing authority will occur.
The total unrecognized tax benefits as of September 30, 2008 and December 31, 2007 were $15.2 million and $13.8 million, respectively, excluding interest, penalties and related income tax benefits. Of the $15.2 million, $3.4 million excluding related tax benefits would be included in the effective tax rate if recognized prior to adoption of SFAS No. 141(R). The Company estimates the unrecognized tax benefits may decrease over the upcoming 12 months by an amount up to $0.4 million related to the settlement with taxing authorities and the lapse of the statute of limitations.
As of September 30, 2008, the accrued interest and penalties were $7.2 million and $2.6 million, respectively, excluding any related income tax benefits. As of December 31, 2007, the accrued interest and penalties were $8.0 million and $2.6 million, respectively, excluding any related income tax benefits. The decrease of $0.8 million of accrued interest is primarily related to the release of reserves, which was partially offset by the accrual of interest during the nine months ended September 30, 2008. The Company recognizes interest accrued related to unrecognized tax benefits and penalties as a component of income tax expense which is recognized in the Consolidated Statements of Operations.
The Company has various state net operating loss carryovers representing $1.5 million of state taxes as of December 31, 2007. The net operating loss carryovers will expire, if unused, during the period from 2008 through 2027.
The Company has recorded a deferred tax asset related to a change in the enacted tax law for the state of Michigan. The Company cannot assert on a more than likely basis that the asset will be realized. Therefore, a valuation allowance of $3.6 million has been recorded to offset the entire asset. Of the $3.6 million, $0.7 million was recorded in the year ended December 31, 2007 and $2.9 million was recorded as part of the preliminary purchase price allocation of Applebee’s.
The effective tax rate for the benefit recognized was 20.9% and 42.0% for the three-month and nine-month periods ended September 30, 2008, respectively. The effective tax rate for the benefit recognized is lower than the federal statutory rate of 35% for the three-month period ended September 30, 2008 primarily due to the non-deductibility for tax purposes of certain impairment charges recognized in the period. The effective tax rate for the benefit recognized is higher than the federal statutory rate of 35% for the nine-month period ended September 30, 2008 primarily due to tax credits, partially offset by state income taxes and the non-deductibility for tax purposes of certain impairment charges recognized in the period. The tax credits are mainly FICA tip and other compensation-related tax credits associated with Applebee’s company-owned restaurant operations.
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8. Long-term Debt
Long-term debt consists of the following components:
For a complete description of the respective instruments, refer to Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.
In August 2008, the Company retired certain Series 2007-1 Class A-2-II-A Fixed Rate Term Senior Notes due December 2037 with a face amount of $23.5 million for a cash payment of $20.0 million. The transaction resulted in a gain of $2.4 million after the write-off of the discount and deferred financing costs related to the debt retired.
In October 2008, 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 $35.2 million for a cash payment of $20.0 million. The Company expects to recognize a gain on extinguishment of debt of approximately $13.6 million after the write-off of the discount and deferred financing costs related to the debt retired (See Note 15, Subsequent Events).
9. Financing Obligations
On May 19, 2008, the Company entered into a Purchase and Sale Agreement relating to the sale and leaseback of 181 parcels of real property (the “Sale-Leaseback Transaction”), each of which is improved with a restaurant operating as an Applebee’s Neighborhood Grill and Bar (the “Property(ies)”). On June 13, 2008, the closing date of the Sale-Leaseback Transaction, the Company entered into a Master Land and Building Lease (“Master Lease”) for the Properties. The proceeds received from the transaction were $337.2 million. The Master Lease calls for an initial term of twenty years and four five-year options to extend the term.
The Company has an ongoing obligation related to any Property until such time as the lease related to that Property is assigned to a qualified franchisee in a transaction meeting certain parameters set forth in the Master Lease. Due to this continuing involvement, the transaction was recorded under the financing method in accordance with SFAS No. 98, Accounting for Leases: Sale-Leaseback Transactions Involving Real Estate, Sales-Type Leases of Real Estate, Definition of the Lease Term, and Initial Direct Costs of Direct Financing Leases—an amendment of FASB Statements No. 13, 66, and 91 and a rescission of FASB Statement No. 26 and Technical Bulletin No. 79-11, (“SFAS 98”) and SFAS No. 66, Accounting for Sales of Real Estate (“SFAS 66”).
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9. Financing Obligations, continued
Accordingly, the value of the land, buildings and improvements will remain on the Company’s books and the buildings and improvements will continue to be depreciated over their remaining useful lives. The net proceeds received have been recorded as a financing obligation. A portion of the lease payments is recorded as a decrease to the financing obligation and a portion is recognized as interest expense. In the event the lease obligation of any individual Property or group of Properties is assumed by a qualified franchisee, the Company’s continuing involvement will cease. At that time, that portion of the transaction related to that Property or group of Properties is expected to be recorded as a sale in accordance with SFAS 98 and SFAS 66 and the net book value of those Properties will be removed from the Company’s books, along with a ratable portion of the remaining financing obligation.
In July 2008, the Company entered into a sale-leaseback transaction with respect to its support center in Lenexa, Kansas. In connection with this transaction, the Company received approximately $39 million in proceeds. The initial term of the leaseback agreement is 15 years. As the Company expects to have continuing involvement in the form of future subleasing of a substantial portion of the support center, the transaction was recorded under the financing method in accordance with SFAS No. 98 as described above.
During the third fiscal quarter of 2008, the lease obligation related to one Property was assigned to a qualified franchisee. In accordance with the accounting described above, the transaction related to this property was recorded as a sale with property and equipment and financing obligations each reduced by $1.9 million.
As of September 30, 2008, $8.4 million was included in other accrued expenses as the current portion of financing obligations and $363.6 million was reported as long-term financing obligations in the Consolidated Balance Sheet.
As of September 30, 2008, future minimum lease payments during the initial terms of the leases related to the sale-leaseback transactions are as follows:
10. Stock-Based Compensation
From time to time, the Company grants stock options and restricted stock to officers, directors and employees of the Company under the 2001 Stock Incentive Plan (the “2001 Plan”) and the 2005 Stock Incentive Plan for Non-Employee Directors (the “2005 Plan”). The stock options generally vest over a three-year period and have a maturity of ten years from the issuance date. Option exercise prices equal the closing price of the common stock on the New York Stock Exchange on the date of grant. Restricted stock provides for the issuance of shares of the Company’s common stock at no cost to the holder and generally vests over terms determined by the Compensation Committee of the Company’s Board of Directors. The restricted stock generally vests only if the employee is actively employed by the Company on the vesting date, and unvested restricted shares are forfeited upon termination, retirement before age 65, death or disability, unless the Compensation Committee of the Company’s Board of Directors determines otherwise. When vested options and restricted stock are issued, the Company generally issues new shares from its authorized but unissued share pool or utilizes treasury stock.
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10. Stock-Based Compensation, continued
The following table summarizes the components of the Company’s stock-based compensation expense included in general and administrative expenses in the consolidated financial statements:
As of September 30, 2008, $21.7 million and $7.3 million (including estimated forfeitures) of total unrecognized compensation cost related to restricted stock and stock options, respectively, is expected to be recognized over a weighted average period of approximately 1.97 years for restricted stock and 2.5 years for stock options.
The estimated fair values of the options granted year-to-date in 2008 were calculated using a Black-Scholes option pricing model. The following summarizes the assumptions used in the 2008 Black-Scholes model:
Option activity under the Company’s stock option plan as of September 30, 2008, and changes during the nine months ended September 30, 2008, were as follows:
The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between the Company’s closing stock price on the last trading day of the third quarter of 2008 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on September 30, 2008. The amount of aggregate intrinsic value will change based on the fair market value of the Company’s stock and the number of in-the-money options.
A summary of restricted stock activity for the nine months ended September 30, 2008 is presented below:
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11. Other Comprehensive (Loss) Income
The components of comprehensive (loss) income, net of taxes, are as follows:
The amount of income tax benefit allocated to the interest rate swap was $2.4 million and $6.1 million for the nine months ended September 30, 2008 and 2007, respectively. The amount of income tax benefit allocated to the temporary decline in securities was $0.1 million for the nine months ended September 30, 2008.
12. Assets Held for Sale
The Company classifies assets as held for sale and ceases the depreciation and amortization of the assets when there is a plan for disposal of the assets and those assets meet the held for sale criteria as defined in SFAS No. 144, Accounting for the Impairment or Disposal of Long-lived Assets. At December 31, 2007, assets held for sale comprised primarily the old corporate headquarters of Applebee’s, Applebee’s corporate aircraft, and Applebee’s company-operated restaurants in California and Nevada expected to be refranchised.
In January 2008, the Company sold the old corporate headquarters for $9.0 million, net of commissions, and the corporate aircraft for approximately $2.8 million.
Certain purchase price fair values allocated to property and equipment as of November 29, 2007, were revised downward. As a result, assets held for sale were reduced by $11.2 million. Additionally, as the result of continuing deterioration in the credit markets in general and a decline in operating results of Applebee’s company-operated restaurants expected to be franchised in particular geographic areas, an impairment was recognized on assets held for sale of $4.0 million.
During 2008, four parcels of land held for future restaurant development and three company-owned restaurants in the Delaware market were reclassified as assets held for sale. Additionally, one company-owned restaurant was reclassified out of assets held for sale after a determination was made the Company had continuing involvement with the property.
The sales of the restaurants in California and Delaware were completed the third fiscal quarter of 2008. The Company received proceeds of approximately $29.2 million from these transactions.
At September 30, 2008, assets held for sale comprised primarily company-operated restaurants in Nevada expected to be refranchised and four parcels of land held for future restaurant development.
The following table summarizes the changes in the balance of assets held for sale during 2008:
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13. Net (Loss) Income Per Share
The computation of the Company’s basic and diluted net (loss) income per share is as follows:
* The effects of adding shares from the assumed conversion of Series B Convertible Preferred stock to the denominator, the related add-back of the dividends on Series B Convertible Preferred stock to the numerator and the effect of adding stock option equivalents and restricted stock to the denominator are anti-dilutive for the three months and nine months ended September 30, 2008 and the three months ended September 30, 2007.
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14. Commitments and Contingencies
In addition to those matters that are described in previous reports, the Company is subject to various lawsuits, claims and governmental inspections or audits arising in the ordinary course of business. Some of these lawsuits purport to be class actions and/or seek substantial damages. In the opinion of management, these matters are adequately covered by insurance or, if not so covered, are without merit or are of such a nature or involve amounts that would not have a material adverse impact on the Company’s business or consolidated financial statements.
15. Subsequent Events
On October 9, 2008, the Company closed the sale of 15 company-operated Applebee’s restaurants in Nevada and received after-tax proceeds of approximately $7.8 million.
On October 27, 2008, the Company announced it had entered into asset purchase agreements for the sale of 66 company-operated Applebee’s restaurants located in Houston and Dallas, Texas and Albuquerque, New Mexico. The agreements for the sale of these restaurants do not contain financing contingencies, but are subject to regulatory processes related to liquor license transfer and other customary closing conditions. Both Texas transactions are expected to close in the fourth quarter 2008, with the New Mexico transaction expected to close early in the first quarter 2009.
In October 2008, 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 $35.2 million for a cash payment of $20.0 million. The Company expects to recognize a gain on extinguishment of debt of approximately $13.6 million after the write-off of the discount and deferred financing costs related to the debt retired.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Forward-Looking Statements
The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements in certain circumstances. This report contains statements that involve expectations, plans or intentions (such as those relating to future business or financial results, new features or services, or management strategies). These statements are forward-looking and are subject to risks and uncertainties, so actual results may vary materially from those expressed or implied by any forward-looking statements. You can identify these forward-looking statements by words such as “may,” “will,” “should,” “expect,” “anticipate,” “believe,” “estimate,” “intend,” “plan,” and other similar expressions. You should consider our forward-looking statements in light of the risks discussed under the heading “Risk Factors” in our most recent Annual Report on Form 10-K, as well as our consolidated financial statements, related notes, and the other financial information appearing elsewhere in this report and our other filings with the U. S. Securities and Exchange Commission. We assume no obligation to update any forward-looking statements.
Overview
The following discussion and analysis provides information we believe is relevant to an assessment and understanding of our consolidated results of operations and financial condition. The discussion should be read in conjunction with the consolidated financial statements and the notes thereto included in Item 1 of Part I of this Quarterly Report and the audited consolidated financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2007. Except where the context indicates otherwise, the words “we,” “us,” “our” and the “Company” refer to DineEquity, Inc., together with its subsidiaries that are consolidated in accordance with U.S. GAAP.
Effective June 2, 2008, IHOP Corp. changed its corporate name to DineEquity, Inc. The Company was incorporated under the laws of the State of Delaware in 1976. We own and operate two restaurant concepts in the casual dining and family dining niches: Applebee’s Neighborhood Grill and Bar®, or Applebee’s, and International House of Pancakes, or IHOP. The first International House of Pancakes restaurant opened in 1958 in Toluca Lake, California. Shortly thereafter the Company’s predecessor began developing and franchising additional restaurants. In November 2007, the Company completed the acquisition of Applebee’s International, Inc. (“Applebee’s”), which became a wholly owned subsidiary of the Company. References herein to Applebee’s and IHOP restaurants are to these two restaurant concepts, whether operated by franchisees or the Company. Retail sales at restaurants that are owned by franchises and area licensees are not attributable to the Company. With more than 3,300 franchised or owned-and-operated restaurants combined, we are one of the largest full-service restaurant companies in the world.
Restaurant Concepts
Applebee’s
We franchise and operate restaurants in the bar and grill segment of the casual dining industry under the name “Applebee’s Neighborhood Grill & Bar®.” With 1,997 system-wide restaurants as of September 30, 2008, Applebee’s Neighborhood Grill & Bar is one of the largest casual dining concepts in the world, in terms of number of restaurants and market share.
Generally, Applebee’s franchise arrangements consist of a development agreement plus a separate franchise agreement for each franchised restaurant. Development agreements grant the exclusive right to develop restaurants in a designated geographic area over a specified period of time. The term of a domestic development agreement is generally 20 years. The development agreements provide for an initial development schedule of one to five years, as agreed upon by the Company and the franchisee. After the initial development schedule, the Company and the franchisee generally execute supplemental development schedules as provided in the development agreement.
The franchisee enters into a separate franchise agreement for the operation of each Applebee’s restaurant. Our standard franchise agreement has a term of 20 years and permits renewal for up to an additional 20 years upon payment of an additional franchise fee. Our standard franchise arrangement calls for an initial franchisee fee of $35,000 and a royalty fee equal to 4% of the restaurant’s monthly net sales. We have agreements with a majority of our franchisees for Applebee’s restaurants opened before January 1, 2000, which provide for a royalty rate of 4% and extend the initial term of the franchise agreements until 2020. The terms, royalties and advertising fees under a limited number of franchise agreements and other franchise fees under older development agreements vary from the currently offered arrangements.
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We currently require domestic franchisees of Applebee’s restaurants to contribute 2.75% of their gross sales to a national advertising fund and to spend at least 1% of their gross sales on local marketing and promotional activities. Under most Applebee’s franchise agreements, we have the ability to increase the amount of the required combined contribution to the national advertising fund and the amount required to be spent on local marketing and promotional activities to a maximum of 5% of gross sales.
We are pursuing a strategy which contemplates transitioning from our current 76% franchised system to an approximately 98% franchised system. Since November 29, 2007 we have franchised 44 company-owned restaurants in the California, Nevada and Delaware markets and we have agreements to franchise an additional 66 company-owned restaurants. This heavily franchised business model is expected to demand less capital, generate higher margins, and reduce the volatility of cash flow performance over time. Additionally, we sold 182 of our fee-owned Applebee’s properties (approximately 91% of our total fee-owned locations) through sale-leaseback transactions in June 2008 and we completed the sale-leaseback of our Lenexa restaurant support center in July 2008.
The following table summarizes Applebee’s franchisee restaurant development commitments for 2008 and 2009 since the Applebee’s development agreements generally provide for a series of two-year development commitments after the initial development period.
We have amended development agreements with a small number of franchisees due to changes in market conditions and concerns about possible new unit performance in specific markets. In addition, for a portion of the year we allowed certain franchisees to delay building restaurants while the Company evaluated the approval of a new prototype restaurant design.
IHOP
Under our current business model which was adopted in January 2003, a potential franchisee first enters into a single store development agreement or a multi-store development agreement and, upon completion of a prescribed approval procedure, is primarily responsible for the initial development and financing of the new IHOP franchised restaurant. In general, we do not provide any financing with respect to the franchise fee or otherwise. The franchisee uses its own capital and financial resources along with third party financial sources to purchase or lease a site, build and equip the business and fund working capital needs.
The cash received from a typical franchise development arrangement includes (a) (i) a location fee equal to $15,000 upon execution of a single store development agreement or (ii) a development fee equal to $20,000 for each IHOP restaurant that the franchisee contracts to develop upon execution of a multi-store development agreement; (b) a franchise fee equal to (i) $50,000 (against which the $15,000 location fee will be credited) for a restaurant developed under a single store development agreement or (ii) $40,000 (against which the $20,000 development fee will be credited) for each restaurant developed under a multi-store development agreement, in each case paid upon execution of the franchise agreement; (c) franchise royalties equal to 4.5% of weekly gross sales; (d) revenue from the sale of pancake and waffle dry-mixes; and (e) franchise advertising fees. The franchise advertising fees are comprised of (i) a local advertising fee generally equal to 2.0% of weekly gross sales, which is usually collected by us and then used to cover the cost of local media purchases and other local advertising expenses incurred by a local advertising cooperative, and (ii) a national advertising fee equal to 1.0% of weekly gross sales. Area licensees are required to pay lesser amounts toward advertising. As approved by our franchisees, in 2007 and 2008 a portion of the local advertising contribution has been reallocated to the national advertising fund allowing us to advertise on a national basis in order to reach our target audience more frequently and more cost effectively.
IHOP franchised restaurants established prior to 2004 under our old business model (the “Old Business Model”) were usually developed by the Company, and required our substantial involvement in all aspects of the development and financing of the restaurants. In particular, under the Old Business Model, we identified the site for a new IHOP restaurant, purchased or leased the site from a third party, built and equipped the restaurant and then franchised it to the franchisee. In addition, IHOP typically financed approximately 80% of the franchise fee over five to eight years and leased the restaurant and equipment to the franchisee over a 25-year period.
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The cash received from a typical franchise arrangement under the Old Business Model included: (a) the franchise fee, a portion of which (typically 20%) was paid upon execution of the franchise agreement; (b) interest income from the financing arrangements for the unpaid portion of the franchise fee under the franchise notes; (c) franchise royalties typically equal to 4.5% of weekly gross sales; (d) income from the subleasing of the leased real property under a franchisee sublease and income from the leasing of the owned real property under the related leases to franchisees; (e) income from the leasing of equipment under an equipment lease; (f) revenue from the sale of pancake and waffle dry-mixes; and (g) franchise advertising fees. The franchise advertising fees are comprised of (i) a local advertising fee generally equal to 2.0% of weekly gross sales under the franchise agreement, which was usually collected by us and then used to cover the cost of local media purchases and other local advertising expenses incurred by a local advertising cooperative, and (ii) a national advertising fee equal to 1.0% of weekly gross sales under the franchise agreement. As approved by our franchisees, in 2007 and 2008 a portion of the local advertising contribution has been reallocated to the national advertising fund allowing us to advertise on a national basis in order to reach our target audience more frequently and more cost effectively. In a few cases, with respect to the reacquired restaurants or otherwise, we have agreed to accept reduced royalties and/or lease payments from franchisees or have provided other accommodations to franchisees for a period of time in order to assist them in either establishing or reinvigorating their business.
The following table summarizes IHOP signed restaurant development commitments including options as of September 30, 2008:
The actual number of scheduled openings in any period may differ from the number of signed commitments following the conclusion of negotiations with franchisees regarding possible modifications to their development obligations. The Company expects franchisees to open from 20 to 25 IHOP restaurants in the fourth quarter of 2008.
Segments
We identify our segments based on the organizational units used by management to monitor performance and make operating decisions. Our revenues and expenses are recorded in four segments: franchise operations, company restaurant operations, rental operations, and financing operations. Within the applicable segment, we operate two distinct restaurant concepts: Applebee’s and IHOP.
Applebee’s
The franchise operations segment consists of restaurants operated by Applebee’s franchisees in the United States, 17 countries outside the United States and one U.S. territory. Franchise operations revenue consists primarily of franchise royalty revenues. Franchise operations expenses include costs related to intellectual property provided to franchisees.
The company restaurant operations segment consists of company-operated restaurants in the United States and China. Company restaurant sales are retail sales at company-operated restaurants. Company restaurant expenses are operating expenses at company-operated restaurants and include food, labor, benefits, utilities, rent and other restaurant operating costs.
Rental operations and financing operations activities are not currently part of Applebee’s business.
IHOP
The franchise operations segment consists of restaurants operated by IHOP franchisees and area licensees in the United States, one U.S. territory and two countries outside the United States—Canada and Mexico. Franchise operations revenue consists primarily of franchise royalty revenues, sales of proprietary products, franchise advertising fees and the portion of the franchise fees allocated to IHOP intellectual property. Franchise operations expenses include advertising expenses, the cost of proprietary products and pre-opening training expenses and other franchise-related costs.
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The company restaurant operations segment consists of company-operated restaurants in the United States. In addition, from time to time, restaurants that are reacquired from franchisees are operated by IHOP on a temporary basis. Company restaurant sales are retail sales at company-operated restaurants. Company restaurant expenses are operating expenses at company-operated restaurants and include food, labor, benefits, utilities, rent and other restaurant operating costs.
Rental operations revenue includes revenue from operating leases and interest income from direct financing leases. Rental operations expenses are costs of operating leases and interest expense on capital leases on franchisee-operated restaurants. The rental operations segment is exclusively generated by IHOP.
Financing operations revenue consists of the portion of franchise fees not allocated to IHOP intellectual property, sales of equipment, as well as interest income from the financing of franchise fees and equipment leases. Financing expenses are primarily the cost of restaurant equipment.
Key Overall Strategies—Update
See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.—Key Overall Strategies” contained in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2007 for a detailed discussion of Applebee’s and IHOP’s key strategies.
Recent developments with respect to several key strategies for Applebee’s include:
Franchise Company-Operated Restaurants and Sell Owned Real Estate
· We have franchised 44 restaurants in the California, Nevada and Delaware markets and have agreements to franchise 66 additional restaurants, exceeding our goal to franchise 100 company-operated Applebee’s restaurants in fiscal 2008.
· In June 2008, we completed sale-leaseback transactions for 182, or 91%, of our fee-owned, company-operated restaurants as discussed in Note 9 of Notes to Consolidated Financial Statements.
· In July 2008, we completed the sale-leaseback of our restaurant support headquarters in Lenexa, Kansas.
Re-energize the Applebee’s Brand
· In March 2008, we introduced a new Applebee’s advertising campaign—“It’s a Whole New Neighborhood.” Our message in the ads clearly focuses on classic Grill & Bar food in a way that is unique to Applebee’s.
· During the first quarter of 2008, we also solidified new brand positioning for Applebee’s, refined our customer targets, introduced our new menu strategy, and finalized our marketing approach through 2009.
· We plan on promoting value offerings for the balance of 2008 to compete more effectively and to drive improved traffic performance.
Improve Restaurant Operations
· Our strategy to improve operations execution at Applebee’s restaurants system-wide has begun. An operations rating system has been developed and will be implemented in the fourth quarter of 2008.
Strengthen Company Restaurant Profitability
· We have implemented several initiatives to increase restaurant profitability including improved labor rate controls, a change in vacation policy, menu simplification, price increases, and detailed review of complimentary meals and discounts in our restaurants. While operating margins have been favorably impacted by these initiatives, the improvement has been partially offset by reduced guest traffic, and higher commodity and utilities costs. We expect to see further improvement with our restaurant sales and operating margins in the last quarter of 2008 as we deploy new value-oriented strategies, we continue to improve hourly labor productivity, we reduce hourly benefits, we continue our focus on managing controllable spending and as utility costs are operated to moderate.
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Restaurant Data
The following table sets forth, for the three-month and nine-month periods ended September 30 of the current year and prior year, the number of effective restaurants in the IHOP system and information regarding the percentage change in sales at those restaurants compared to the same periods in the prior year. “Effective restaurants” are the number of restaurants in a given period, adjusted to account for restaurants open for only a portion of the period. Information is presented for all effective restaurants in the IHOP system, which includes IHOP restaurants owned by the Company, as well as those owned by franchisees and area licensees. Sales at restaurants that are owned by franchisees and area licensees are not attributable to the Company. However, we believe that presentation of this information is useful in analyzing our revenues because franchisees and area licensees pay us royalties and advertising fees that are generally based on a percentage of their sales, as well as rental payments under leases that are usually based on a percentage of their sales. Management also uses this information to make decisions about future plans for the development of additional restaurants as well as evaluation of current operations. Pro forma information on Applebee’s restaurant data and restaurant development and franchising activity is presented in the section entitled “Pro Forma Comparison of Three Months and Nine Months ended September 30, 2008 with Three Months and Nine Months ended September 30, 2007 —Applebee’s” herein.
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