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Business Combinations within the Restaurant Sector
There are a few reasons that consolidation occurs within the restaurant industry. In many cases, a company is looking to increase its store base and market share, and the easiest method is to purchase another restaurant operator. In other cases, a company aims to acquire a more famous brand to aid a struggling or lesser known brand. Others look to utilize a strong capital base to develop a new or unknown concept.
Applebee’s and IHOP
This merger occurred at the end of 2007 when IHOP used a lot of debt to purchase the struggling Applebee’s Neighborhood Grill concept, forming a new entity subsequently named DineEquity (DIN). The biggest proponent and motivator behind the deal was the CEO of IHOP, Julia Stewart, who earlier in her career, worked as president of Applebee’s. The structure of the transaction was similar to many other leveraged buyouts. IHOP took on over $2 billion in borrowing to buy a much bigger company in Applebee’s. Management has since started to restructure Applebee’s from its company owned operating model to a 98% franchise-based model. The change in model, according to the company, would reduce capital costs and earnings volatility and increase cash flow for Applebee’s. Management had success with the IHOP concept a few years ago in a similar franchising initiative.
Despite a strong outlook early on, the merger has encountered a few hurdles over the past few years. A poor real estate market made it difficult for management to sell the company owned pieces of land in 2008, resulting in substantial non-operating losses. At the same time, macroeconomic troubles led to same-store sales declines at IHOP and even more so at the Applebee’s concept.
Still, investors responded positively to the merger in 2009 and 2010, when the stock rose from less than $10 a share, to its current value of more than $50 a share. Upon first glance, this appears to be a lofty valuation, given the company’s weak top- and bottom-line performance since the merger, including substantial share-net deficits on a GAAP basis. However, better comparable store sales and higher cash flows from the company’s franchising efforts have driven a more optimistic outlook from investors. Using a fairly simple discounted free cash flow analysis (using 2010 as the base year, an average cost of capital of 10%, and a low single-digit growth rate) DineEquity shares could be valued at their current trading price and possibly higher. The question is whether the company can sustain its positive cash flow advances. High debt and lackluster demand at the two maturing chains may prove too much of a burden to support future growth.
Wendy’s and Arby’s
This merger was initiated by Triarc in 2008, and more specifically by its major owner, Nelson Peltz, primarily to bolster his large stake in the struggling quick service hamburger chain, Arby’s. There were reservations before this deal, particularly by investors of Wendy’s. The transaction was an all-stock deal, and Wendy’s share holders received only about a 6% premium. Many long-time owners, including the founding family, felt that Arby’s poor performance would bring down that of Wendy’s. So far, that appears to be the case. The combined company, called Wendy’s/Arby’s Group (WEN), has reported slumping sales through 2010, and even poorer earnings. As a result, the stock has been anchored at about $4-$5 a share, with little prospect of moving higher. Wendy’s has since been looking to dispose of Arby’s, its less-than-stellar counterpart. It hired UBS to help in its search, though it remains to be seen whether the company can find an acquirer.
McDonald’s Corp. (MCD - Free McDonald's Stock Report) has remained the leader within the quick service restaurant industry, thanks to its strong brand awareness and efficient operations. However, acquisitions and subsequent divestitures have played somewhat of a role in the company’s success over the last decade. It purchased Chipotle Mexican Grill (CMG) in 1998 and increased the size of the operation from 16 units to more than 500 by the time of its initial public offering in January, 2006. Chipotle was one of the industry’s most successful IPOs, more than doubling its $22 offering price in its first day. McDonald’s benefited from this tactic, selling off its entire stake subsequent to the IPO, and netting over $1 billion.
The company had less success with another major food concept, Boston Market. McDonald’s bought the chain in mid-2000, and continued to operate and expand the chain until 2007. It eventually divested the unit to a private equity group for not much more than it paid for it.
McDonald’s has since focused on developing its flagship brand rather than looking to new concepts to bolster growth. So far, this strategy has worked. Despite lackluster macroeconomic conditions, revenues and profits have increased at a steady pace for the Golden Arches, which is a lot more than others within the restaurant industry can say. Now that the economy appears to be on a better footing, McDonald’s may pursue opportunities in other concepts, as returns become more attractive.
Although mergers and acquisitions within the restaurant sector have been less prominent recently, there have been a few operators taken private, namely CKE (Hardee’s, Carl’s Jr.), Burger King, and Landry’s. Moving forward, healthier business conditions ought to result in some of these companies returning to the public market, as valuations improve and private investors look to profit from these ventures.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.