Applebee's International APPB
by John Owens, CFA, CPA
Analyst Note 02-13-2006
After reviewing Applebee's APPB fourth-quarter results, announced Wednesday, we are increasing our fair value estimate to $33 per share from $30 to account for cash generated by the business and other minor changes to our discounted cash-flow analysis. Revenues in the quarter increased 10.7% to $300.2 million, almost entirely driven by expansion from 1,671 to 1,804 units. Systemwide comparable sales increased just 1.0%, as customer traffic declined amid high gas prices and economic uncertainty. With these weak comps and rising labor and occupancy costs, operating earnings fell from $34.0 million to $31.6 million, representing a 10.5% operating margin. Clearly, this was not a good quarter for the company, which management acknowledged. To address the weakness, Applebee's will introduce a wave of "cravable" and "higher flavor" menu items over the next 18 months, while still emphasizing its value and convenience proposition. The company will also roll out new initiatives later in the year to boost sales during the underleveraged lunch and late night day parts. In our opinion, these new menu items and initiatives will help to reinvigorate the Applebee's brand. We would also note that comparable sales in January finished 6.3% higher (see our previous Analyst Note).
Thesis 02-13-2006
Applebee's should remain a leader in the fast-growing casual dining segment of the restaurant industry. The company is benefiting from economies of scale, an alliance with Weight Watchers WTW, and stronger carryout sales. In our opinion, the chain has plenty of room for expansion.
We think the $63 billion casual dining segment has good growth prospects. From 1996 to 2004, casual dining sales increased at a 6.2% compound annual rate, with chain restaurants growing at an even faster 9.4%. Gains in real disposable income and desire for convenience in a time-pressed society have driven the increased spending, and we expect the trend to continue.
As one of just two casual dining firms with an economic moat, Applebee's is well positioned to capitalize on this growth. The chain dominates the grill and bar segment with more than 1,700 domestic units, about 70% larger than leading rival Chili's EAT and more than twice as big as Ruby Tuesday RI. This scale provides Applebee's with tremendous marketing muscle, which has contributed to an impressive run of 30 consecutive quarters of comparable sales growth.
An exclusive five-year agreement with Weight Watchers, the world's leader in weight-loss services, gives the chain another edge over rivals. The Applebee's menu features 10 Weight Watchers items, with each selection listing calories, fat and fiber grams, and Weight Watchers points. Applebee's has also broadened its customer reach with an increased focus on Carside To Go service, which accounts for about 10% of sales at company-operated units, up from 5% in 2002.
With a potential universe of 3,000 domestic restaurants, Applebee's still has substantial opportunity for growth, in our opinion. The management team has proved very adept at development, opening at least 100 new restaurants for 13 consecutive years. The company has been particularly successful in seizing a first-mover advantage in small-town locations with a unit design that generates healthy returns. Over the past five reported years, the firm delivered a 23% average return on invested capital, well above our estimate of its cost of capital.
Despite its strong position, Applebee's still faces challenges in this highly competitive industry. About 65% of its company-owned restaurants are situated in the Midwest and New England, areas experiencing economic softness. This has taken a toll on the company, contributing to lackluster sales growth and lower profitability. Rising construction costs have also slowed development. We'd still recommend a margin of safety before investing in the shares.
Valuation
Our fair value estimate, based on a discounted cash-flow analysis, is $33 per share. Over the five years ending in December 2010, we project revenue will increase an average of 11% annually, fueled by expansion and modest growth in same-restaurant sales. In our forecast, the company opens around 40 restaurants per year, while franchisees annually roll out roughly 80 new units. From 2006 to 2010, we estimate the operating margin will average 12%-13%, compared with 14.7% in the prior five-year period. This estimated drop in margin is primarily due to incremental stock compensation expense, but also reflects a growing proportion of sales from company-owned restaurants (which have a lower margin than the franchise business) and higher restaurant operating costs, partly offset by positive leverage in general and administrative expenses. Our valuation is contingent upon the company continuing to secure attractive sites for new units at reasonable prices.
Risk
Applebee's operates in the highly competitive bar and grill segment. The chain must battle rivals for customers, locations, and franchisees. Rising food, labor, or energy costs could drag on profitability. Given steep gas prices and home heating bills and higher interest payments on credit cards and mortgages, some customers could forgo appetizers and desserts and stick to lower-price entrees and drinks. Others may stay home or trade down to fast casual and quick-service restaurants.
See Previous Analyst Reports
Close Competitors TTM Sales $Mil Market Cap $Mil
Applebee's International 1,188 1,774
* Brinker International 4,018 3,567
Ruby Tuesday 1,188 1,795
T.G.I. Friday's NA NA
* Darden Restaurants 5,504 6,258
* Outback Steakhouse 3,506 3,045
* Morningstar Analyst Report Available | Compare These Stocks
Data as of 06-30-2005
Strategy
Applebee's seeks to increase revenue by introducing new menu items, expanding carryout sales, cobranding with Weight Watchers, and increasing national television advertising. Management aims to expand the chain to at least 3,000 units domestically and 1,000 units abroad. The company occasionally acquires franchise units, though it does not expect to own more than 30% of the total chain.
Management & Stewardship
Applebee's recently announced it would split the roles of chairman and CEO, which we applaud. Accordingly, the company is seeking a new CEO to replace Lloyd Hill, who has held the job since 1998. Hill, who will remain chairman, has been a director since 1989 and a member of the executive team since 1994. During his eight years as CEO, Applebee's nearly doubled in size to more than 1,800 restaurants, and total returns to shareholders have averaged about 20% per year. In 2004, Hill was paid $1.3 million in salary plus bonus, which we view as reasonable. He also received a very generous package of restricted stock, options, and long-term incentive payouts. We think Applebee's has a strong and deep management bench and would not be surprised if the board tapped president and chief operating officer David Goebel to succeed Hill. Overall, the executives and directors have demonstrated good stewardship, in our opinion. We especially like the fact that executives are required to own a multiple of their salary in company stock, including 4 times base salary for the CEO. We do, however, take a dim view of the company's poison pill, staggered board elections, and other takeover defenses, which could favor the interests of management over shareholders.
Profile
The company develops, franchises, and operates restaurants under the Applebee's Neighborhood Grill & Bar brand, the largest casual dining concept in the world. Applebee's offers a full-service lunch and dinner menu with an average check per guest of $10-$10.50. As of December 2005, there were 1,804 Applebee's restaurants: 1,318 franchise and 486 company units. The chain has a presence in 49 states and 14 foreign countries.
Growth
Over the five years ending in 2005, Applebee's delivered 12.0% compound annual sales growth, primarily driven by expansion of company-owned and franchised restaurants. During the period, comparable-restaurant sales growth averaged 3.4% per year.
Profitability
From 2001 to 2005, Applebee's operating margin averaged 14.7%, but fell to 13.0% last year largely due to rising labor and occupancy costs. Lackluster same-store sales also weighed on profitability.
Financial Health
As of December 2005, the company held $188 million in net debt, which excludes hefty lease commitments and franchisee guarantees. The business generates strong free cash flow, leading us to believe the company is in good financial health.
by John Owens, CFA, CPA
Analyst Note 02-13-2006
After reviewing Applebee's APPB fourth-quarter results, announced Wednesday, we are increasing our fair value estimate to $33 per share from $30 to account for cash generated by the business and other minor changes to our discounted cash-flow analysis. Revenues in the quarter increased 10.7% to $300.2 million, almost entirely driven by expansion from 1,671 to 1,804 units. Systemwide comparable sales increased just 1.0%, as customer traffic declined amid high gas prices and economic uncertainty. With these weak comps and rising labor and occupancy costs, operating earnings fell from $34.0 million to $31.6 million, representing a 10.5% operating margin. Clearly, this was not a good quarter for the company, which management acknowledged. To address the weakness, Applebee's will introduce a wave of "cravable" and "higher flavor" menu items over the next 18 months, while still emphasizing its value and convenience proposition. The company will also roll out new initiatives later in the year to boost sales during the underleveraged lunch and late night day parts. In our opinion, these new menu items and initiatives will help to reinvigorate the Applebee's brand. We would also note that comparable sales in January finished 6.3% higher (see our previous Analyst Note).
Thesis 02-13-2006
Applebee's should remain a leader in the fast-growing casual dining segment of the restaurant industry. The company is benefiting from economies of scale, an alliance with Weight Watchers WTW, and stronger carryout sales. In our opinion, the chain has plenty of room for expansion.
We think the $63 billion casual dining segment has good growth prospects. From 1996 to 2004, casual dining sales increased at a 6.2% compound annual rate, with chain restaurants growing at an even faster 9.4%. Gains in real disposable income and desire for convenience in a time-pressed society have driven the increased spending, and we expect the trend to continue.
As one of just two casual dining firms with an economic moat, Applebee's is well positioned to capitalize on this growth. The chain dominates the grill and bar segment with more than 1,700 domestic units, about 70% larger than leading rival Chili's EAT and more than twice as big as Ruby Tuesday RI. This scale provides Applebee's with tremendous marketing muscle, which has contributed to an impressive run of 30 consecutive quarters of comparable sales growth.
An exclusive five-year agreement with Weight Watchers, the world's leader in weight-loss services, gives the chain another edge over rivals. The Applebee's menu features 10 Weight Watchers items, with each selection listing calories, fat and fiber grams, and Weight Watchers points. Applebee's has also broadened its customer reach with an increased focus on Carside To Go service, which accounts for about 10% of sales at company-operated units, up from 5% in 2002.
With a potential universe of 3,000 domestic restaurants, Applebee's still has substantial opportunity for growth, in our opinion. The management team has proved very adept at development, opening at least 100 new restaurants for 13 consecutive years. The company has been particularly successful in seizing a first-mover advantage in small-town locations with a unit design that generates healthy returns. Over the past five reported years, the firm delivered a 23% average return on invested capital, well above our estimate of its cost of capital.
Despite its strong position, Applebee's still faces challenges in this highly competitive industry. About 65% of its company-owned restaurants are situated in the Midwest and New England, areas experiencing economic softness. This has taken a toll on the company, contributing to lackluster sales growth and lower profitability. Rising construction costs have also slowed development. We'd still recommend a margin of safety before investing in the shares.
Valuation
Our fair value estimate, based on a discounted cash-flow analysis, is $33 per share. Over the five years ending in December 2010, we project revenue will increase an average of 11% annually, fueled by expansion and modest growth in same-restaurant sales. In our forecast, the company opens around 40 restaurants per year, while franchisees annually roll out roughly 80 new units. From 2006 to 2010, we estimate the operating margin will average 12%-13%, compared with 14.7% in the prior five-year period. This estimated drop in margin is primarily due to incremental stock compensation expense, but also reflects a growing proportion of sales from company-owned restaurants (which have a lower margin than the franchise business) and higher restaurant operating costs, partly offset by positive leverage in general and administrative expenses. Our valuation is contingent upon the company continuing to secure attractive sites for new units at reasonable prices.
Risk
Applebee's operates in the highly competitive bar and grill segment. The chain must battle rivals for customers, locations, and franchisees. Rising food, labor, or energy costs could drag on profitability. Given steep gas prices and home heating bills and higher interest payments on credit cards and mortgages, some customers could forgo appetizers and desserts and stick to lower-price entrees and drinks. Others may stay home or trade down to fast casual and quick-service restaurants.
See Previous Analyst Reports
Close Competitors TTM Sales $Mil Market Cap $Mil
Applebee's International 1,188 1,774
* Brinker International 4,018 3,567
Ruby Tuesday 1,188 1,795
T.G.I. Friday's NA NA
* Darden Restaurants 5,504 6,258
* Outback Steakhouse 3,506 3,045
* Morningstar Analyst Report Available | Compare These Stocks
Data as of 06-30-2005
Strategy
Applebee's seeks to increase revenue by introducing new menu items, expanding carryout sales, cobranding with Weight Watchers, and increasing national television advertising. Management aims to expand the chain to at least 3,000 units domestically and 1,000 units abroad. The company occasionally acquires franchise units, though it does not expect to own more than 30% of the total chain.
Management & Stewardship
Applebee's recently announced it would split the roles of chairman and CEO, which we applaud. Accordingly, the company is seeking a new CEO to replace Lloyd Hill, who has held the job since 1998. Hill, who will remain chairman, has been a director since 1989 and a member of the executive team since 1994. During his eight years as CEO, Applebee's nearly doubled in size to more than 1,800 restaurants, and total returns to shareholders have averaged about 20% per year. In 2004, Hill was paid $1.3 million in salary plus bonus, which we view as reasonable. He also received a very generous package of restricted stock, options, and long-term incentive payouts. We think Applebee's has a strong and deep management bench and would not be surprised if the board tapped president and chief operating officer David Goebel to succeed Hill. Overall, the executives and directors have demonstrated good stewardship, in our opinion. We especially like the fact that executives are required to own a multiple of their salary in company stock, including 4 times base salary for the CEO. We do, however, take a dim view of the company's poison pill, staggered board elections, and other takeover defenses, which could favor the interests of management over shareholders.
Profile
The company develops, franchises, and operates restaurants under the Applebee's Neighborhood Grill & Bar brand, the largest casual dining concept in the world. Applebee's offers a full-service lunch and dinner menu with an average check per guest of $10-$10.50. As of December 2005, there were 1,804 Applebee's restaurants: 1,318 franchise and 486 company units. The chain has a presence in 49 states and 14 foreign countries.
Growth
Over the five years ending in 2005, Applebee's delivered 12.0% compound annual sales growth, primarily driven by expansion of company-owned and franchised restaurants. During the period, comparable-restaurant sales growth averaged 3.4% per year.
Profitability
From 2001 to 2005, Applebee's operating margin averaged 14.7%, but fell to 13.0% last year largely due to rising labor and occupancy costs. Lackluster same-store sales also weighed on profitability.
Financial Health
As of December 2005, the company held $188 million in net debt, which excludes hefty lease commitments and franchisee guarantees. The business generates strong free cash flow, leading us to believe the company is in good financial health.
