DIN - The Miracle in Glendale

I have got to hand it to Julia Stewart, CEO of DIN; she can spin a good story when she needs to. Two things happened that are completely out of left field and caught me by surprise. First, DIN manages to find a buyer for 110 severely underperforming Applebee’s stores. Second, the company reported that Applebee’s operating margins increased 220 basis points, allowing operating profits to grow by 13.8%. In this environment, this is nothing short of a miracle.

I’m focused on these two events, because it was game changer for the time being. My guess is that when people digest the reality of the situation the enthusasism will wane.

Operating Margins -

For 3Q08 Operating margin improved 220 basis points to 11.4% compared to 9.2% in 3Q07. Food costs increased by 30 basis points and labor decreased by 80 basis points primarily due to a reduction in hourly wage rates and lower management bonus payouts.

The first RED flag – in this environment it is nearly impossible to lower labor costs with a MSD digit decline is traffic trends. The math does not work! The customer experience will be compromised and it’s likely we will see further weakness in same-store sales.

Applebee's also experienced an approximate 170 basis point improvement in direct and occupancy costs primarily related to lower depreciation expense resulting from purchase price allocation adjustments.

The second RED flag – Nearly one year after buying the Applebee’s chain they are still making purchase price adjustments to manufacture improved margins?

Putting it all together, Applebee’s segment operating profits increased 13.8% to $30.0 million in the third quarter. For the Applebee’s chain to show this level of profit growth is truly amazing and completely unsustainable.

Asset sales

DIN also reported today the sale of an additional 66 Applebee’s restaurant, bringing the total to 110 stores, which the company expects to close before year-end. The incremental 66 new stores are being sold to three different franchisee groups and are not contingent on financing. All of the buyers appear to be currently operating of have been involved in the restaurant business. Additionally, it’s likely that all the stores were losing money. That is the good news.

The RED flag – These stores were sold at fire sales prices. Putting any value on something losing money is good news, but the next tranche will not be so easy. At some point unloading a significant amount of stores will require some financing. In this environment access to capital is getting harder and the cost of capital is rising, except for those that can borrow from the FED.

Summary

DIN is not out of the woods yet. DIN is levered at 7.1x, slightly below the 7.5x threshold at the end of November 2008. The company is in crisis mode as it is trying to save money by cutting employee bonuses and changing its travel and vacation policies. We already know that casual dining sales trends have continued to accelerate on the downside in September and October. The uptick in profitability at the Applebee’s chain appears to be unsustainable, given current sales trends and commentary from other competitors in the space. The company is desperately seeking liquidity and the realities of today will eventually catch up with the business.


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