There is a massive change about in the fast-casual restaurant (traditionally called the QSR, for "quick-service restaurant") industry. After years of dated designs, calorie-laden menus, and wait staff covered in cheeky buttons, the companies are taking a fresh look at what consumers want out of a low-cost, casual eatery. With that in mind, it may not be as surprising that Fast Company magazine named DineEquity's (DIN +2.50%) Applebee's the second most innovative company in food. To most, Applebee's is not known as a center of progressive cuisine and dining comfort, but things seem to be changing. On the corporate level, DineEquity may be offering investors attractive growth at low prices. Here is what value seekers should know going into DineEquity's fourth-quarter and full-year earnings.
Progressive business
According to the market, it's no secret that DineEquity is an attractive company -- the stock is riding near its 52-week high and has gained nearly 48% in the last 12 months. Though buoyed by the disposal of an asset and cost savings, the company was able to double its bottom line in the first nine months of the year compared to the prior year. For the fourth quarter of 2012, analysts are estimating $0.81 per share, down $0.09 from 2011's quarter. The company has come in ahead of estimates by at least 5% for the past four quarters.
It hasn't been pure sales growth that drove the business up in a year when competitors such as Darden Restaurants (DRI +0.42%) underperformed and ended the year near flat, but that doesn't mean the company can't sustain this pattern. DineEquity has been changing its restaurants from corporate-owned to franchise. I find this to be one of the most encouraging signs regarding the company.
Franchise away
The franchise model has proven to be most appealing for quick-service restaurants and even some retail stores. By becoming a pure royalty-collector and focusing on overall brand management and product-curating, a business shifts operational costs away from the parent company and generates more cash flow. For example, Sears Hometown and Outlet Stores (NASDAQ: SHOS), the Sears Holdings spinoff whose share price has spiked since its IPO, has been wisely transitioning its hardware stores to franchise owners -- cutting operating costs and fattening margins on an otherwise low-margin business.
This has been DineEquity's plan for the last year, and it's working. It is also likely the reason that former Pershing Square senior partner Mick McGuire has taken such a strong interest in the company and acquired nearly 10% of the outstanding shares. If you take a look at many of Pershing's investments past and present, it is easy to identify favoritism toward franchise models and leveraging real estate.
Even more interesting regarding McGuire's involvement (and akin to Bill Ackman at Pershing) is the hedge fund manager's recent activism, which looks to be well received by company management.
Activist dining
Marcato manager McGuire is happy with the franchise model, as stated, but he thinks the company can now leverage that consistently growing cash flow. Specifically, McGuire met with the board of directors in December to give advice on how to maximize equity value. This includes the following:
- Keeping the leverage ratio at five times net debt/EBITDA, meaning the company should not currently focus on paying down its borrowings. According to him, this is not a good use of the free cash flow.
- Distributing an annual $6-per-share dividend. Another benefit of the franchise model is that the company can grow its cash without laying out tons of capital. The franchise owners are the ones who focus on boosting same-store sales and increasing their personal restaurant count. That means that DineEquity needs to do something with its cash pile, and it probably won't be R&D.
Another one of the investor's suggestions, and something that has already seen progress, is the refinancing of existing borrowings. McGuire believes the company's bank facility was creating a "mandatory cash flow sweep" and should be either renegotiated or switched to a new lender. The company recently announced that its effective term loan rate is now 3.75%, down from 4.25% last year and 6% before that.
Appealing to all
Income investors may want to pay close attention to DineEquity going forward. A $6 dividend, if implemented, would create an attractive return, especially when coupled with capital appreciation. In my opinion, DineEquity remains an attractive value play as further steps to enhance equity value and free up cash flow should generate substantial shareholder returns. This is further buoyed by the dividend income.
On a P/E basis, DineEquity may appear more expensive (forward P/E of 17.3) than Darden, which trades at 12.5 times forward earnings. However, the company is better positioned with its still-recent franchise model to generate more cash flow per share and a chunky dividend.
