July 20, 2009 - 8:08pm EST by
2009 2010
Price: 29.50 EPS $0.00 $0.00
Shares Out. (in M): 17 P/E 0.0x 0.0x
Market Cap (in $M): 505 P/FCF 0.0x 0.0x
Net Debt (in $M): 2,050 EBIT 0 0
TEV ($): 2,550 TEV/EBIT 0.0x 0.0x
Borrow Cost: NA

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Price: $29.95 (7/20/09) LTM-adjusted ROIC: 6.7%     LTM-adjusted ROTC: 16.2%
Market Cap: $505M      Enterprise Value: $2.5B        EV/LTM adj EBIT- maint capex: 9.0x

Investment Thesis - DineEquity is a short because:
-DIN is a business in secular decline, yet valuation reflects a strong consumer recovery and perpetual cash flows
-Deteriorating fundamentals could result in earnings below expectations and actions unfavorable to shareholders

Key Investment Factor #1 - Assumptions required to justify current valuation are unrealistic

Little Upside to Valuation - Clearly, the U.S. is in the middle of a deep recession and consumer spending is severely depressed. While the timing and magnitude of a recovery are unknown, eventually discretionary spending will return to "normal" levels. However, even using very optimistic recovery assumptions, DIN shares are expensive. Using generous assumptions including significant overhead reductions, substantial unit growth and a significant increase in traffic , DIN's normalized EBIT after restructuring efforts are completed is slightly less than $300M per year. Figure 1 below shows approximately what DIN's cash flows would look like if we assume the company is able to execute its strategic plan by the end of 2011 and the U.S. begins a strong recovery in the second half of 2009. As shown, even under these optimistic assumptions, DIN shares appear expensive.

Figure 1: DIN Valuation Assuming Strong Recovery in 2H09 and Perpetuity of Terminal Cash Flows ($mm)
                                         2009   2010   2011   Terminal
Free cash flow to the firm      $190   $210   $210     $185
Cash from asset sales (1)     $100   $200   $150     $0

Present value @ 10% cost of capital                           $2,137                  
+ Excess cash (incld restricted)                                   $200                     
+ PV of notes recievable(2)                                         $100                     
- Preferred stock                                                         $225                     
- Debt and corporate financing obligations(3)             $1,850
Residual Equity Value(4)                                   about $350mm                       
(1) Assumes asset sales resume in 2H09. All sales are done at approximate replacement cost      
(2) Discounted principal payments on franchise notes receivable ex. direct financing leases                     
(3) Includes only financing obligations related to corporate headquarters. All other financing obligations and capitalized leases are reassigned to new owners
(4) Assume 35% tax rate. Assumes net zero cash flow impact from deferred tax liabilities and depreciation / interest expense tax shield                

Structural Challenges, Poor Unit Economics and Poor Franchisee Health Should Lead to a Shrinking System - The above valuation assumes a perpetuity value of expected normalized cash flows. In reality, DineEquity's business is in a state of permanent secular decline. The reasons for this secular decline are as follows:

1) Consumer preferences have shifted away from family dining and varied menu casual dining concepts such as IHOP and Applebee's -I doubt it is possible to find an experienced and thoughtful industry participant who would dispute that consumer preferences are moving away from DineEquity's brands, yet investors do not seem to realize this. The data also supports this conclusion. From 1997 to 2007, Applebee's AUV growth has been about 300bps /yr slower than both the average U.S. restaurant AUV growth (per data provided by the US Economic Census) and the growth in industry costs (data provided by Bureau of Labor Statistics). This indicates sharply declineing customer visits even during 'bubble years'  as consumers choose competing options over Applebee's. This trend appears to be accelerating as the concept becomes increasingly irrelevant to today's consumer and thus Applebee's is likely to die a slow death similar other once iconic restaurant chains such as Bennigan's, Shoney's and Sizzler.

2) New unit economics do not justify replacement costs - DIN was able to grow the company's unit base due to the rapid growth in consumer spending and the cheap leverage available to franchisees over the past cycle. As shown in Figure 3 below, in the absence of these conditions, on average DIN's concepts do not earn their replacement cost and thus are unlikely to be built in significant numbers. Based on my discussions with those in the industry, the reason we still see a small number of franchisees opening units is that the entire building process takes about a year. While a year ago conditions may have justified expansion, we are likely to see the system begin to contract in the second half of 2009 (vs. management guidance of net unit increases). To note, DIN sold 103 Applebee's units (which included some owned buildings) to franchisees in 2008 at an average purchase price of under $500K, including 74 units (albeit underperforming units) in 4Q at an average price of less than $300K, which is clearly less than replacement value.

Figure 2: Approximate Applebee's Franchisee Unit Economics/Purchase Price ($mm)
APPB Co-Owned LTM AUV                                    $2,200
Cash flow margin after maintenance capex(1)       19.0%
Rent(2)                                                                 $175.0
Franchisee and advertising fees (7.75%)             $170.5
Pre-tax cash flows                                                $72.5
Taxes (35%)                                                         $25.4
After tax cash flows                                              $47.1
Theoretical purchase price at 9x cash flow(3)       $450K
(1) Based on discussions with industry participants. Approx 150bps higher than company equivalent margin due to certain structural / operating advantages of franchisees
(2) Based on discussions with industry participants and company disclosed transactions  
(3) Based on discussions with industry participants. Reasonable multiple given high levels of risk and effort required

3) Poor franchisee health will restrict capital for expansion - Several industry contacts have noted that given the very high leverage used by franchisees over the last cycle, many have breached loan covenants. My contacts in the franchise leading business have indicated that while lenders such as GE Capital are unlikely to push for bankruptcy, they are increasing interest rates by about +400bps-500bps and placing significant restrictions on the use of cash flow. Accordingly, franchisees may not be able to expand even if they wanted to do so.

Thus, perhaps it is reasonable to assume that in the long run, excluding any impact of an eventual economic recovery, DIN's unit count and average unit volumes will decrease by about 2% per year. This would cause cash flows to decline by about 5% per year. As shown in figure 3, under this scenario the equity is worthless and the debt is impaired.

Figure 3: Approximate Valuation Under Most Likely Assumptions ($mm)
                                             2009     2010    2011    Terminal(4)             
Free cash flow to the firm       $170     $190      $190      $1,100
Cash from asset sales (1)      $50      $200      $100       $0

Present value @ 10% cost of capital                      $1,492                        
+ Excess cash (incld restricted)                              $200                  
+ PV of notes recievable(2)                                    $100                  
- Preferred stock                                                    $225                  
- Debt and corporate financing obligations(3)        $1,850                        
Residual Equity Value(5)                                     ($283)                  
(1) Assumes assets resume in 2010. All sales are done at approximate market value. Current market values based on recent transactions and discussions with industry participants        
(2) Discounted principal payments on franchise notes receivable ex. direct financing leases                     
(3) Includes only financing obligations related to corporate headquarters. All other financing obligations and capitalized leases are reassigned to new owners
(4) Value of $160mm in cash flows declining by 5% / year                                
(5) 35% tax rate. Assumes net zero cash flow impact from deferred tax liabilities and depreciation / interest expense tax shield                

Management Has Demonstrated Very Poor Capital Allocation - Equity of declining companies can make particularly good shorts when management attempts to invest in growth rather than return cash to owners. DIN is run by entrenched Chairman/CEO Julia Stewart and overseen by a long-tenured and friendly board. Stewart is responsible for destroying tremendous shareholder value via the acquisition of APPB (which some industry sources believe was motivated by personal reasons rather than shareholder interests), yet she received total compensation in 2008 of nearly $4.5mm. One could argue that higher debt levels and more active shareholders will lead to better capital allocation in the future than was the case in the past. While this may be possible, given management's track record such a behavior change is unlikely. Furthermore, it is not encouraging that the company's vice president of legal sold more than 40% of his shares on May 5th at about $33/share.

Key Investment Factor #2 - Poor fundamentals lead to earnings misses or actions unfavorable to shareholders

Pricing Unsustainable, Traffic Falling - Several data points suggest that negative trends in casual dining seen in 1Q are getting worse: 1) "Real time" industry data points such as Knapp Track and NPD as well as conversations with those in the industry suggest that quarter-to-date traffic declines are several percentage points worse than in 1Q. 2) Very aggressive 2Q pricing promotions, such as $5 entrees at TGI Friday's and $7 entrees at Chili's, will make the 4% price increases at Applebee's unsustainable without risking an even more sever near and long term traffic declines. My industry contacts indicated that casual / family dining customers are generally of modest means and are highly sensitive to perceived value. Even one visit which causes a customer to feel as if they have overpaid can turn that customer off a brand for life. 3) Previous economic cycles suggest that sales trends will continue to deteriorate - During the past two U.S. recessions, restaurant traffic declines track lagging indicators such as unemployment. This suggests that traffic could fall further over the next couple of quarters.

Expectations Too High, Actions Unfavorable to Shareholders Possible - Given the combined traffic and pricing pressure for DIN, for the remainder of the year it is perhaps not unreasonable to assume -8.0% traffic/mix declines at Applebee's (vs. -6.7% in the first quarter), offset by +2% price increases (vs. +3.5% in the first quarter) and flat comps at IHOP.  This would not only result in earnings misses relative to expectations (Applebee's comp declines of -6% vs. expectations of 2%-3% declines), but could also force the company take actions that impair shareholders, such as selling units on unfavorable terms, suspending dividends on the preferred or accepting expensive capital.  

For example, suppose that DIN does not sell any assets or pay back any debt for a year. At the end of 1Q10, the company will lap the gain on debt in 4Q08 and 1Q09 and the required coverage ratio will fall to 7.0x. As shown in Figure 4, EBIT would need to fall only a few percentage points to violate covenants. This is not to suggest that DIN is likely to violate a debt covenant, since even with high comp declines DIN should be able to pay back some debt and could generate cash through the actions mentioned. Rather, the margin for error is perhaps slimmer than management is suggesting.  

Figure 4: DIN Leverage Ratio ($mm) - In the absence of gains on debt retirement, EBIT only needs to fall by ~5% to violate future covenants
                                                Q1 20009 (Actual)    Q1 2010 (Possible)
LTM Operating income                       $258                        $245
+ rental segment interest expense   $22                          $22
+ stock based comp                           $12                          $12
+ D&A                                                $62                          $62
+ other one-time                                 $3              
+ gain on debt                                   $41              
EBITDA                                              $398                        $341
Annual lease                                    $90.6                       $90.6
EBITDAR                                            $488                        $432
Total Debt                                         $3030                      $3030
Debt/EBITDAR                                    6.2x                         7.0x


Declining unit counts, Short and Long-run earnings disappointments, Possible required corporate actions that impair shareholders, such as selling units on unfavorable terms, suspending dividends on the preferred or accepting expensive capital.

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