Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 

(Mark One)

 

 

 

x

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended June 30, 2009

 

OR

 

o

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                  to

 

Commission File Number 001-15283

 


 

DineEquity, Inc.

(Exact name of registrant as specified in its charter)

 

Delaware

 

95-3038279

(State or other jurisdiction of incorporation or
organization)

 

(I.R.S. Employer Identification No.)

 

 

 

450 North Brand Boulevard,
Glendale, California

 

91203-1903

(Address of principal executive offices)

 

(Zip Code)

 

(818) 240-6055
(Registrant’s telephone number, including area code)

 


 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x  No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was Required to submit and post such files).  Yes o  No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer x

 

Accelerated filer o

 

 

 

Non-accelerated filer o

 

Smaller reporting company o

(Do not check if a smaller reporting company)

 

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o  No x

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

Class

 

Outstanding as of July 24, 2009

 

Common Stock, $.01 par value

 

17,597,734

 

 

 

 



Table of Contents

 

DINEEQUITY, INC. AND SUBSIDIARIES

 

INDEX

 

 

 

Page

PART I.

FINANCIAL INFORMATION

2

 

Item 1—Financial Statements

2

 

Consolidated Balance Sheets—June 30, 2009 (unaudited) and December 31, 2008

2

 

Consolidated Statements of Operations (unaudited)—Three and Six Months Ended June 30, 2009 and 2008

3

 

Consolidated Statements of Cash Flows (unaudited)—Six Months Ended June 30, 2009 and 2008

4

 

Notes to Consolidated Financial Statements

5

 

Item 2—Management’s Discussion and Analysis of Financial Condition and Results of Operations

17

 

Item 3—Quantitative and Qualitative Disclosures about Market Risk

40

 

Item 4—Controls and Procedures

40

PART II.

OTHER INFORMATION

41

 

Item 1—Legal Proceedings

41

 

Item 1A—Risk Factors

41

 

Item 2—Unregistered Sales of Equity Securities and Use of Proceeds

41

 

Item 3—Defaults Upon Senior Securities

41

 

Item 4—Submission of Matters to a Vote of Security Holders

41

 

Item 5—Other Information

42

 

Item 6—Exhibits

43

 

Signatures

44

 

1



Table of Contents

 

PART I. FINANCIAL INFORMATION

 

Item 1.  Financial Statements.

 

DINEEQUITY, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share amounts)

 

 

 

June 30, 2009

 

December 31, 2008

 

 

 

(Unaudited)

 

 

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

80,370

 

$

114,443

 

Restricted cash

 

68,514

 

83,355

 

Short-term investments, at market value

 

279

 

276

 

Receivables, net

 

81,595

 

117,930

 

Inventories

 

11,839

 

10,959

 

Prepaid income taxes

 

 

15,734

 

Prepaid expenses

 

16,660

 

17,067

 

Deferred income taxes

 

27,249

 

27,504

 

Assets held for sale

 

6,326

 

11,861

 

Total current assets

 

292,832

 

399,129

 

Non-current restricted cash

 

50,937

 

53,395

 

Restricted assets related to captive insurance subsidiary

 

4,590

 

5,573

 

Long-term receivables

 

268,037

 

277,106

 

Property and equipment, net

 

805,137

 

824,482

 

Goodwill

 

697,470

 

697,470

 

Other intangible assets, net

 

949,507

 

956,036

 

Other assets, net

 

139,423

 

148,026

 

Total assets

 

$

3,207,933

 

$

3,361,217

 

Liabilities and Stockholders’ Equity

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Current maturities of long-term debt

 

$

20,100

 

$

15,000

 

Accounts payable

 

33,527

 

48,983

 

Accrued employee compensation and benefits

 

31,682

 

44,299

 

Deferred revenue

 

50,278

 

95,532

 

Accrued financing costs

 

 

20,071

 

Other accrued expenses

 

63,473

 

55,249

 

Accrued interest payable

 

3,391

 

3,580

 

Total current liabilities

 

202,451

 

282,714

 

Long-term debt, less current maturities

 

1,718,473

 

1,853,367

 

Financing obligations, less current maturities

 

318,938

 

318,651

 

Capital lease obligations, less current maturities

 

157,470

 

161,310

 

Deferred income taxes

 

402,832

 

395,448

 

Other liabilities

 

117,488

 

119,910

 

Total liabilities

 

2,917,652

 

3,131,400

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

Preferred stock, Series A, $1 par value, 220,000 shares authorized; 190,000 shares issued and outstanding as of June 30, 2009 and December 31, 2008

 

187,050

 

187,050

 

Stockholders’ equity:

 

 

 

 

 

Convertible preferred stock, Series B, at accreted value, 10,000,000 shares authorized; 35,000 shares issued and outstanding at June 30, 2009 and December 31, 2008

 

38,461

 

37,332

 

Common stock, $.01 par value, 40,000,000 shares authorized; June 30, 2009: 23,810,117 shares issued and 17,594,551 shares outstanding; December 31, 2008: 23,696,950 shares issued and 17,466,355 shares outstanding

 

238

 

237

 

Additional paid-in-capital

 

168,435

 

165,315

 

Retained earnings

 

197,136

 

145,810

 

Accumulated other comprehensive loss

 

(25,289

)

(29,408

)

Treasury stock, at cost (June 30, 2009: 6,215,566 shares; December 31, 2008: 6,230,595 shares)

 

(275,750

)

(276,519

)

Total stockholders’ equity

 

103,231

 

42,767

 

 

 

 

 

 

 

Total liabilities and stockholders’ equity

 

$

3,207,933

 

$

3,361,217

 

 

See the accompanying Notes to Consolidated Financial Statements.

 

2



Table of Contents

 

DINEEQUITY, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(Unaudited)

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2009

 

2008

 

2009

 

2008

 

Revenues

 

 

 

 

 

 

 

 

 

Franchise revenues

 

$

90,514

 

$

87,421

 

$

188,724

 

$

177,355

 

Company restaurant sales

 

222,268

 

296,496

 

461,792

 

608,418

 

Rental revenues

 

32,544

 

32,568

 

66,253

 

65,533

 

Financing revenues

 

4,324

 

7,648

 

8,437

 

15,616

 

Total revenues

 

349,650

 

424,133

 

725,206

 

866,922

 

Costs and Expenses

 

 

 

 

 

 

 

 

 

Franchise expenses

 

23,736

 

22,384

 

52,034

 

45,761

 

Company restaurant expenses

 

192,181

 

259,742

 

394,037

 

536,317

 

Rental expenses

 

24,275

 

24,561

 

48,817

 

49,270

 

Financing expenses

 

339

 

2,548

 

346

 

5,887

 

General and administrative expenses

 

33,959

 

49,230

 

81,118

 

96,834

 

Interest expense

 

45,970

 

51,561

 

94,380

 

102,208

 

Impairment and closure charges

 

2,352

 

41,203

 

2,001

 

41,432

 

Amortization of intangible assets

 

3,018

 

3,080

 

6,037

 

5,979

 

Gain on extinguishment of debt

 

(12,449

)

 

(38,803

)

 

(Gain) loss on disposition of assets

 

(5

)

20

 

(5,142

)

(158

)

Other (income) expense, net

 

(94

)

26

 

129

 

(1,724

)

Total costs and expenses

 

313,282

 

454,355

 

634,954

 

881,806

 

Income (loss) before income taxes

 

36,368

 

(30,222

)

90,252

 

(14,884

)

(Provision) benefit for income taxes

 

(11,554

)

10,837

 

(28,297

)

9,353

 

Net income (loss)

 

$

24,814

 

$

(19,385

)

$

61,955

 

$

(5,531

)

Net income (loss)

 

$

24,814

 

$

(19,385

)

$

61,955

 

$

(5,531

)

Less: Series A preferred stock dividends

 

(4,750

)

(4,750

)

(9,500

)

(9,500

)

Less: Accretion of Series B preferred stock

 

(569

)

(535

)

(1,129

)

(1,056

)

Less: Net (income) loss allocated to unvested participating restricted stock

 

(719

)

930

 

(1,916

)

539

 

Net income (loss) available to common stockholders

 

$

18,776

 

$

(23,740

)

$

49,410

 

$

(15,548

)

Net income (loss) available to common stockholders per share

 

 

 

 

 

 

 

 

 

Basic

 

$

1.11

 

$

(1.42

)

$

2.93

 

$

(0.93

)

Diluted

 

$

1.09

 

$

(1.42

)

$

2.87

 

$

(0.93

)

Weighted average shares outstanding

 

 

 

 

 

 

 

 

 

Basic

 

16,929

 

16,768

 

16,886

 

16,735

 

Diluted

 

17,845

 

16,768

 

17,625

 

16,735

 

Dividends declared per common share

 

$

 

$

0.25

 

$

 

$

0.50

 

Dividends paid per common share

 

$

 

$

0.25

 

$

 

$

0.50

 

 

See the accompanying Notes to Consolidated Financial Statements.

 

3



Table of Contents

 

DINEEQUITY, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 

 

 

Six Months Ended June 30,

 

 

 

2009

 

2008

 

Cash flows from operating activities

 

 

 

 

 

Net income (loss)

 

$

61,955

 

$

(5,531

)

Adjustments to reconcile net income (loss) to cash flows provided by operating activities

 

 

 

 

 

Depreciation and amortization

 

51,662

 

55,369

 

Gain on extinguishment of debt

 

(38,803

)

 

Impairment and closure charges

 

2,001

 

41,432

 

Deferred income taxes

 

4,845

 

(38,420

)

Stock-based compensation expense

 

5,277

 

7,057

 

Tax benefit from stock-based compensation

 

376

 

945

 

Excess tax benefit from stock options exercised

 

(41

)

(315

)

Gain on disposition of assets

 

(5,142

)

(158

)

Changes in operating assets and liabilities

 

 

 

 

 

Receivables

 

35,384

 

28,336

 

Inventories

 

(1,009

)

(43

)

Prepaid expenses

 

6,070

 

26,090

 

Accounts payable

 

(13,931

)

(27,007

)

Accrued employee compensation and benefits

 

(12,617

)

(10,586

)

Deferred revenues

 

(45,254

)

(33,632

)

Other accrued expenses

 

14,328

 

12,439

 

Other

 

(3,620

)

840

 

Cash flows provided by operating activities

 

61,481

 

56,816

 

Cash flows from investing activities

 

 

 

 

 

Additions to property and equipment

 

(5,899

)

(23,216

)

Reductions (additions) to long-term receivables

 

1,029

 

(1,573

)

Payment of accrued acquisition costs

 

 

(10,063

)

Collateral released by captive insurance subsidiary

 

983

 

3,823

 

Proceeds from sale of property and equipment and assets held for sale

 

11,260

 

11,930

 

Principal receipts from notes and equipment contracts receivable

 

8,206

 

7,871

 

Other

 

(87

)

478

 

Cash flows provided by (used in) investing activities

 

15,492

 

(10,750

)

Cash flows from financing activities

 

 

 

 

 

Proceeds from issuance of long-term debt

 

10,000

 

 

Proceeds from financing obligations

 

 

333,617

 

Repayment of long-term debt

 

(101,701

)

(312,800

)

Principal payments on capital lease and financing obligations

 

(7,047

)

(3,167

)

Dividends paid

 

(9,500

)

(15,115

)

Payment of preferred stock issuance costs

 

 

(1,500

)

Repurchase of restricted stock

 

(287

)

(380

)

Reissuance of treasury stock

 

 

1,135

 

Proceeds from stock options exercised

 

308

 

989

 

Excess tax benefit from stock options exercised

 

41

 

315

 

Payment of accrued debt issuance costs

 

(20,030

)

(24,299

)

Payment of early debt extinguishment costs

 

(123

)

 

Restricted cash related to securitization

 

17,293

 

(13,666

)

Cash flows used in financing activities

 

(111,046

)

(34,871

)

Net change in cash and cash equivalents

 

(34,073

)

11,195

 

Cash and cash equivalents at beginning of year

 

114,443

 

26,838

 

Cash and cash equivalents at end of period

 

$

80,370

 

$

38,033

 

Supplemental disclosures

 

 

 

 

 

Interest paid

 

$

84,677

 

$

100,924

 

Income taxes paid

 

$

12,598

 

$

12,514

 

 

See the accompanying Notes to Consolidated Financial Statements.

 

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Table of Contents

 

DINEEQUITY, INC. AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

(Unaudited)

 

1. General

 

The accompanying unaudited consolidated financial statements of DineEquity, Inc. (the “Company”) have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three-month and six-month periods ended June 30, 2009 are not necessarily indicative of the results that may be expected for the year ending December 31, 2009.

 

The consolidated balance sheet at December 31, 2008 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by U.S. GAAP for complete financial statements.

 

These consolidated financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008.

 

2. Basis of Presentation

 

The Company’s fiscal quarters end on the Sunday closest to the last day of each quarter. For convenience, the fiscal quarters are reported as ending on March 31, June 30, September 30 and December 31. The first and second fiscal quarters of 2009 ended March 29 and June 28, respectively; the first and second fiscal quarters of 2008 ended March 30 and June 29, respectively.

 

The accompanying consolidated financial statements include the accounts of the Company and its subsidiaries that are consolidated in accordance with U.S. GAAP. All intercompany balances and transactions have been eliminated in consolidation. However, the subsidiaries have not guaranteed the obligations of the Company, and the assets of the subsidiaries generally are not available to pay creditors of the Company. Also, the Company has not guaranteed the obligations of the subsidiaries, and the assets of the Company generally are not available to pay creditors of the subsidiaries.

 

The preparation of financial statements in conformity with U.S. GAAP requires the Company’s management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, the Company evaluates its estimates, including those related to provisions for doubtful accounts, legal contingencies, income taxes, long-lived assets, goodwill and intangible assets. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results could differ from those estimates. Subsequent events have been evaluated through July 30, 2009, the date the financial statements are considered issued.

 

Reclassifications

 

Certain reclassifications have been made to prior year information to conform to the current year presentation. The most significant reclassification relates to certain operations acquired with Applebee’s International, Inc. (“Applebee’s”), a wholly-owned subsidiary of the Company, that were previously reported as discontinued operations. The losses from discontinued operations of $114,000 and $202,000, respectively, for the three- and six-month periods ended June 30, 2008, previously reported as a single net line item have been reclassified as follows:

 

 

 

Three Months Ended
June 30, 2008

 

Six Months Ended
June 30, 2008

 

 

 

(In thousands)

 

Company restaurant expenses

 

$

19

 

$

48

 

Loss on disposition of assets

 

49

 

8

 

Impairment and closure charges

 

123

 

277

 

Income (loss) before income taxes

 

(191

)

(333

)

Benefit for income taxes

 

77

 

131

 

Net income (loss)

 

$

(114

)

$

(202

)

 

These reclassifications had no effect on the net income or financial position previously reported.

 

5



Table of Contents

 

3. Accounting Policies

 

Recently Adopted Accounting Standards

 

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Accounting Standards (“SFAS”) No. 157, Fair Value Measurements (“SFAS 157”). In February 2008, the FASB issued FASB Staff Position (“FSP”) No. 157-2, Effective Date of FASB Statement No. 157, which delayed for one year the applicability of SFAS 157’s fair-value measurements to certain nonfinancial assets and liabilities. The Company adopted the requirements of SFAS 157 that had been deferred under FSP 157-2 on January 1, 2009. The adoption did not have a material impact on the Company’s financial condition, results of operations or cash flows.

 

In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations (“SFAS 141(R)”). SFAS 141(R) establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any noncontrolling interest in the acquiree and the goodwill acquired. SFAS 141(R) also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. SFAS 141(R) is effective for fiscal years beginning after December 15, 2008. The Company adopted SFAS 141(R) on January 1, 2009 and will apply the provisions of this statement prospectively.

 

In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities (“SFAS 161”). This statement requires companies to provide enhanced disclosures about (a) how and why they use derivative instruments, (b) how derivative instruments and related hedged items are accounted for under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, and its related interpretations, and (c) how derivative instruments and related hedged items affect a company’s financial position, financial performance, and cash flows. The Company adopted the new disclosure requirements on January 1, 2009. As SFAS 161 does not change current accounting practice, there was no impact of the adoption to the Company’s results of operations and financial condition..

 

In April 2008, the FASB issued FSP FAS 142-3, Determination of the Useful Life of Intangible Assets (“FSP FAS 142-3”). FSP FAS 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No. 142, Goodwill and Other Intangible Assets (“SFAS 142”). The intent of FSP FAS 142-3 is to improve the consistency between the useful life of a recognized intangible asset under SFAS 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS 141(R) and other applicable accounting literature. The Company adopted FSP FAS 142-3 on January 1, 2009 and will apply the provisions of this statement prospectively to intangible assets acquired after the effective date.

 

In June 2008, the FASB issued FSP EITF Issue No. 03-6-1, Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities (“FSP EITF 03-6-1”). FSP EITF 03-6-1 requires unvested share-based payment awards that contain rights to receive non-forfeitable dividends or dividend equivalents to be included in the two-class method of computing earnings per share as described in SFAS No. 128, Earnings per Share. The Company retroactively adopted FSP EITF 03-6-1 on January 1, 2009. The impact of the adoption on earnings per share as previously reported for the three- and six-month periods ended June 30, 2008 was not material.

 

In April 2009, the FASB issued FSP FAS 157-4, FSP FAS 115-2 and FAS 124-2, and FSP FAS 107-1 and APB 28-1, to address concerns regarding (1) determining whether a market is not active and a transaction is not orderly, (2) recognition and presentation of other-than-temporary impairments and (3) interim disclosures of fair values of financial instruments, respectively. The Company adopted these FSPs effective April 1, 2009. There was no impact of the adoption on the Company’s consolidated financial statements.

 

In May 2009, the FASB issued SFAS No. 165, Subsequent Events (“SFAS 165”). SFAS 165 establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. The Company adopted SFAS 165 effective April 1, 2009. There was no impact of the adoption on the Company’s consolidated financial statements.

 

New Accounting Pronouncements

 

In June 2009, the FASB issued SFAS No. 166, Accounting for Transfers of Financial Assets, an amendment of FASB Statement No. 140 (“SFAS 166”). SFAS 166 clarifies that the objective of paragraph 9 of Statement 140 is to determine whether a transferor and all of the entities included in the transferor’s financial statements being presented have surrendered control over transferred financial assets; limits the circumstances in which a financial asset, or portion of a financial asset, should be derecognized when the transferor has not transferred the entire original financial asset to an entity that is not consolidated with the transferor in the financial statements being presented and/or when the transferor has continuing involvement with the transferred financial asset; and removes the concept of a qualifying special-purpose entity. The Company will be required to adopt SFAS 166 effective January 1, 2010, and is currently evaluating the potential impact, if any, of SFAS 166 on its consolidated financial statements.

 

6



Table of Contents

 

3. Accounting Policies, continued

 

In June 2009, the FASB issued SFAS No. 167, Amendments to FASB Interpretation No. 46(R) (“SFAS 167”). SFAS 167 amends existing U.S. GAAP with respect to the consolidation of variable interest entities (“VIEs”). Among other things, SFAS 167 (i) amends existing guidance for determining whether an entity is a VIE; (ii) requires ongoing reassessments of whether an entity is the primary beneficiary of a VIE; and (iii) requires enhanced disclosures about an entity’s involvement in a VIE. The Company will be required to adopt SFAS 167 effective January 1, 2010, and is currently evaluating the potential impact, if any, of SFAS 167 on its consolidated financial statements.

 

In June 2009 the FASB issued statement No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles.  This statement replaces Statement No. 162 and establishes the FASB Accounting Standards Codification™ (Codification) as the source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with U.S. GAAP.  Rules and interpretive releases of the Securities and Exchange Commission (SEC) under authority of federal securities laws are also sources of authoritative U.S. GAAP for SEC registrants.  All guidance contained in the Codification carries an equal level of authority.  This statement becomes effective for the Company for the third fiscal quarter of 2009.  The Company does not expect that the adoption of this statement will have a material effect on the Company’s financial statements.

 

4. Impairment and Closure Charges

 

The Company assesses long-lived assets for impairment when events or changes in circumstances indicate that the carrying value of the assets may not be recoverable. For the six months ended June 30, 2009, the Company recognized impairment charges of $1.9 million and closure charges of $0.1 million. The charges related primarily to leasehold improvements and related assets of one IHOP restaurant closed during the period and an additional write-down to the estimated sales value, based on a current letter of intent, of one Applebee’s restaurant that had been closed in a prior period and was included in assets held for sale.

 

In May 2008, the Company entered into sale-leaseback transactions related to 181 parcels of real estate (land, buildings and improvements). Due to continuing involvement of the Company with the subject properties, the transaction was recorded under the financing method in accordance with U.S. GAAP covering sale-leaseback transactions involving real estate. The proceeds received by the Company from this transaction established the fair value of the properties, which was less than the net book value of the real estate assets by approximately $41 million. Accordingly, the Company has recognized an impairment loss of that amount in the Consolidated Statement of Operations for the three-month and six-month periods ended June 30, 2008.

 

5. Assets Held for Sale

 

The Company classifies assets as held for sale and ceases the depreciation and amortization of the assets when there is a plan for disposal of the assets and those assets meet the held for sale criteria as defined in applicable U.S. GAAP. The balance of assets held for sale at December 31, 2008 of $11.9 million was primarily comprised of seven Applebee’s company-operated restaurants in New Mexico expected to be franchised, four parcels of land previously acquired and held for future development, and property and equipment from closed stores.

 

The sale of five of the seven restaurants in New Mexico was completed in the first fiscal quarter of 2009.  During the second fiscal quarter of 2009 the Company sold certain property and equipment associated with closed restaurants and recognized an additional impairment on a previously closed restaurant as discussed in Note 4, Impairment and Closure Charges. The balance of assets held for sale at June 30, 2009 of $6.3 million was primarily comprised of two Applebee’s company-operated restaurants in New Mexico expected to be franchised (see Note 18, Subsequent Events), four parcels of land previously acquired and held for future development, and property and equipment from closed restaurants.

 

The following table summarizes the changes in the balance of assets held for sale during 2009:

 

 

 

(In millions)

 

Balance December 31, 2008

 

$

11.9

 

Assets sold

 

(4.7

)

Impairment charges

 

(1.0

)

Assets reclassified to held for sale

 

0.1

 

Balance June 30, 2009

 

$

6.3

 

 

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Table of Contents

 

6. Long-Term Debt

 

Long-term debt consists of the following components:

 

 

 

June 30, 2009
(unaudited)

 

December 31,
2008

 

 

 

(In millions)

 

Series 2007-1 Class A-2-II-A Fixed Rate Term Senior Notes due December 2037, at a fixed rate of 7.1767% (inclusive of an insurance premium of 0.75%)

 

$

600.7

 

$

640.6

 

Series 2007-1 Class A-2-II-X Fixed Rate Term Senior Notes due December 2037, at a fixed rate of 7.0588%

 

506.2

 

604.3

 

Series 2007-1 Class M-1 Fixed Rate Term Subordinated Notes due December 2037, at a fixed rate of 8.4044%

 

111.5

 

119.0

 

Series 2007-1 Class A-1 Variable Funding Senior Notes, final maturity date December 2037, at a rate of 2.98% and 3.86% as of June 30, 2009 and December 31, 2008, respectively

 

100.0

 

100.0

 

Series 2007-1 Fixed Rate Notes due March 2037, at a fixed rate of 5.744% (inclusive of an insurance premium of 0.60%)

 

175.0

 

175.0

 

Series 2007-2 Variable Funding Notes, final maturity date March 2037, at a rate of 0.46% and 2.1% as of June 30, 2009 and December 31, 2008, respectively

 

25.0

 

15.0

 

Series 2007-3 Fixed Rate Term Notes due December 2037, at a fixed rate of 7.0588%

 

245.0

 

245.0

 

Discount on Fixed Rate Notes

 

(24.8

)

(30.5

)

Total debt

 

1,738.6

 

1,868.4

 

Less current maturities

 

(20.1

)

(15.0

)

Long-term debt

 

$

1,718.5

 

$

1,853.4

 

 

For a complete description of the respective instruments, refer to Note 10 of the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2008.

 

During the six months ended June 30, 2009, the Company retired Series 2007-1 Class A-2-II-X Fixed Rate Term Senior Notes due December 2037 with a face amount of $94.0 million and Series 2007-1 Class A-2-II-A Fixed Rate Term Senior Notes due December 2037 with a face amount of $35.2 million for cash payments totaling $85.4 million. The Company recognized a gain on extinguishment of this debt of $38.8 million after the write-off of the discount and deferred financing costs related to the debt retired.

 

During the six months ended June 30, 2009, the Company received proceeds from disposition of assets and release of certain reserve funds totaling $8.8 million. As required by the terms of the Applebee’s securitization agreements, these funds were used to retire Series 2007-1 Class A-2-II-X Fixed Rate Term Senior Notes and Series 2007-1 Class A-2-II-A Fixed Rate Term Senior Notes at face values of $4.1 million and $4.7 million, respectively.

 

In January 2009, the Company began making scheduled monthly payments on the Series 2007-1 Class M-1 Fixed Rate Term Subordinated Notes due December 2037. Scheduled payments totaled $7.5 million during the six months ended June 30, 2009.

 

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Table of Contents

 

7. Financing Obligations

 

As of June 30, 2009, future minimum lease payments under financing obligations during the initial terms of the leases related to sale-leaseback transactions are as follows:

 

Fiscal Years

 

(In millions)

 

Remainder of 2009

 

$

15.8

 

2010

 

32.0

 

2011

 

32.3

 

2012

 

32.4

 

2013

 

32.4

 

Thereafter

 

453.8

 

Total minimum lease payments

 

598.7

 

Less interest

 

(271.6

)

Total financing obligations

 

327.1

 

Less current portion(1)

 

(8.2

)

Long-term financing obligations

 

$

318.9

 

 


(1)                                   Included in other accrued expenses on the consolidated balance sheet.

 

8. Segments

 

The Company’s revenues and expenses are recorded in four segments: franchise operations, company restaurant operations, rental operations, and financing operations.

 

As of June 30, 2009, the franchise operations segment consists of (i) 1,591 restaurants operated by Applebee’s franchisees in the United States, 14 countries outside the United States and one U.S. territory and (ii) 1,410 restaurants operated by IHOP franchisees and area licensees in the United States, Canada and Mexico. Franchise operations revenue consists primarily of franchise royalty revenues, sales of proprietary products, certain franchise advertising fees and the portion of the franchise fees allocated to intellectual property.  Franchise operations expenses include advertising expense, the cost of proprietary products, pre-opening training expenses and costs related to intellectual property provided to certain franchisees.

 

As of June 30, 2009, the company restaurant operations segment consists of 400 company-operated Applebee’s restaurants in the United States, one company-operated Applebee’s restaurant in China and 11 company-operated IHOP restaurants. Company restaurant sales are retail sales at company-operated restaurants. Company restaurant expenses are operating expenses at company-operated restaurants and include food, labor, benefits, utilities, rent and other restaurant operating costs.

 

Rental operations revenue includes revenue from operating leases and interest income from direct financing leases. Rental operations expenses are costs of operating leases and interest expense on capital leases on franchisee-operated restaurants.

 

Financing operations revenue consists of the portion of franchise fees not allocated to intellectual property, sales of equipment and interest income from the financing of franchise fees and equipment leases. Financing expenses are primarily the cost of restaurant equipment.

 

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Table of Contents

 

8. Segments, continued

 

Information on segments is as follows:

 

 

 

Three Months Ended June 30,

 

Six Months Ended June 30,

 

 

 

2009

 

2008

 

2009

 

2008

 

 

 

(In millions)

 

Revenues from external customers

 

 

 

 

 

 

 

 

 

Franchise operations

 

$

90.5

 

$

87.4

 

$

188.7

 

$

177.4

 

Company restaurants

 

222.3

 

296.5

 

461.8

 

608.4

 

Rental operations

 

32.5

 

32.6

 

66.3

 

65.5

 

Financing operations

 

4.3

 

7.6

 

8.4

 

15.6

 

Total

 

$

349.6

 

$

424.1

 

$

725.2

 

$

866.9

 

Interest expense

 

 

 

 

 

 

 

 

 

Company restaurants

 

$

0.2

 

$

0.3

 

$

0.5

 

$

0.5

 

Rental operations

 

4.9

 

5.0

 

9.9

 

10.2

 

Corporate

 

46.0

 

51.6

 

94.4

 

102.2

 

Total

 

$

51.1

 

$

56.9

 

$

104.8

 

$

112.9

 

Depreciation and amortization (1)

 

 

 

 

 

 

 

 

 

Franchise operations

 

$

2.5

 

$

2.5

 

$

5.0

 

$

5.0

 

Company restaurants

 

7.5

 

8.5

 

14.8

 

20.2

 

Rental operations

 

2.9

 

3.0

 

5.8

 

6.0

 

Corporate

 

3.3

 

2.8

 

6.8

 

5.2

 

Total

 

$

16.2

 

$

16.8

 

$

32.4

 

$

36.4

 

Income (loss) before income taxes

 

 

 

 

 

 

 

 

 

Franchise operations

 

$

66.8

 

$

65.0

 

$

136.7

 

$

131.6

 

Company restaurants

 

30.1

 

36.8

 

67.8

 

72.1

 

Rental operations

 

8.3

 

8.0

 

17.4

 

16.3

 

Financing operations

 

4.0

 

5.1

 

8.1

 

9.7

 

Corporate

 

(72.8

)

(145.1

)

(139.7

)

(244.6

)

Total

 

$

36.4

 

$

(30.2

)

$

90.3

 

$

(14.9

)

 


(1) Excludes amortization included in interest expense

 

9. Income Taxes

 

The Company or one of its subsidiaries files Federal income tax returns and income tax returns in various state and foreign jurisdictions. With few exceptions, the Company is no longer subject to Federal, state or non-U.S. income tax examinations by tax authorities for years before 2004 for Federal returns and years before 2000 for other jurisdictions.

 

At June 30, 2009, the Company had a liability for unrecognized tax benefits including potential interest and penalties, net of related tax benefit, totaling $18.4 million, of which approximately $1.9 million is expected to be paid within one year. For the remaining liability, due to the uncertainties related to these tax matters, the Company is unable to make a reasonably reliable estimate when cash settlement with a taxing authority will occur.

 

The total unrecognized tax benefit as of June 30, 2009 and December 31, 2008 was $12.4 million and $18.6 million, respectively, excluding interest, penalties and related income tax benefits. The decrease was due primarily to settlements with taxing authorities resulting in a decrease in unrecognized tax benefits related to prior year positions. The entire $12.4 million will be included in the Company’s effective income tax rate if recognized. The Company estimates the unrecognized tax benefits may decrease over the upcoming 12 months by an amount up to $1.5 million related to settlements with taxing authorities and the lapse of the statute of limitations.

 

As of June 30, 2009, the accrued interest and penalties were $13.4 million and $2.0 million, respectively, excluding any related income tax benefits. As of December 31, 2008, the accrued interest and penalties were $13.7 million and $2.9 million, respectively, excluding any related income tax benefits. The decrease of $0.3 million of accrued interest is primarily related to the decrease of unrecognized tax benefits due to settlements with taxing authorities, partially offset by the accrual of interest during the six months ended June 30, 2009. The Company recognizes interest accrued related to unrecognized tax benefits and penalties as a component of income tax expense which is recognized in the Consolidated Statements of Operations.

 

The Company has various state net operating loss carryovers representing $1.5 million of state taxes as of December 31, 2008. The net operating loss carryovers will expire, if unused, during the period from 2009 through 2027.

 

10



Table of Contents

 

9. Income Taxes, continued

 

The effective tax rate for the provision recognized was 31.4% for the six-month period ended June 30, 2009. The effective tax rate for the provision recognized is lower than the federal statutory rate of 35% primarily due to tax credits, partially offset by state income taxes. The tax credits are primarily FICA tip and other compensation-related tax credits associated with Applebee’s company-owned restaurant operations.

 

10. Stock-Based Compensation

 

From time to time, the Company grants stock options and restricted stock to officers, directors and employees of the Company under the 2001 Stock Incentive Plan (the “2001 Plan”) and the 2005 Stock Incentive Plan for Non-Employee Directors (the “2005 Plan”). The stock options generally vest over a three-year period and have a maturity of ten years from the issuance date. Option exercise prices equal the closing price of the common stock on the New York Stock Exchange on the date of grant. Restricted stock provides for the issuance of shares of the Company’s common stock at no cost to the holder and vests over terms determined by the Compensation Committee of the Company’s Board of Directors, generally three years. The restricted stock generally vests only if the employee is actively employed by the Company on the vesting date, and unvested restricted shares are forfeited upon either termination, retirement before age 65, death or disability, unless the Compensation Committee of the Company’s Board of Directors determines otherwise. When vested options and restricted stock are issued, the Company generally issues new shares from its authorized but unissued share pool or utilizes treasury stock.

 

The following table summarizes the components of the Company’s stock-based compensation expense included in general and administrative expenses in the consolidated financial statements:

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2009

 

2008

 

2009

 

2008

 

 

 

(In millions)

 

Total Stock-Based Compensation:

 

 

 

 

 

 

 

 

 

Pre-tax compensation expense

 

$

2.1

 

$

4.0

 

$

5.3

 

$

7.1

 

Tax provision (benefit)

 

(0.7

)

(4.2

)

(1.7

)

(4.5

)

Total stock-based compensation expense, net of tax

 

$

1.4

 

$

(0.2

)

$

3.6

 

$

2.6

 

 

As of June 30, 2009, $11.1 million and $8.0 million (including estimated forfeitures) of total unrecognized compensation cost related to restricted stock and stock options, respectively, is expected to be recognized over a weighted average period of 1.85 years for restricted stock and 2.48 years for stock options.

 

The estimated fair values of the options granted year-to-date in 2009 were calculated using a Black-Scholes option pricing model. The following summarizes the assumptions used in the Black-Scholes model:

 

Risk-free interest rate

 

1.93

%

Weighted average historical volatility

 

72.1

%

Dividend yield

 

 

Expected years until exercise

 

5.0

 

Forfeitures

 

11.0

%

Weighted average fair value of options granted

 

$

4.61

 

 

11



Table of Contents

 

10. Stock-Based Compensation, continued

 

Option activity under the Company’s stock option plan as of June 30, 2009, and changes during the six-month period then ended were as follows:

 

 

 

Shares

 

Weighted
Average
Exercise
Price

 

Weighted Average
Remaining
Contractual Term
(in Years)

 

Aggregate
Intrinsic
Value

 

Outstanding at December 31, 2008

 

933,939

 

$

36.37

 

 

 

 

 

Granted

 

961,750

 

$

7.57

 

 

 

 

 

Exercised

 

(14,500

)

$

21.82

 

 

 

 

 

Expired

 

(14,666

)

$

41.90

 

 

 

 

 

Forfeited

 

(169,074

)

$

22.93

 

 

 

 

 

Outstanding at June 30, 2009

 

1,697,449

 

$

21.47

 

8.19

 

$

21,861,000

 

Vested at June 30, 2009 and Expected to Vest

 

1,444,505

 

$

22.56

 

7.97

 

$

17,532,000

 

Exercisable at June 30, 2009

 

511,082

 

$

38.62

 

5.19

 

$

662,000

 

 

The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between the Company’s closing stock price on the last trading day of the second quarter of 2009 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on June 30, 2009. The amount of aggregate intrinsic value will change based on the fair market value of the Company’s stock and the number of in-the-money options.

 

A summary of restricted stock activity for the six months ended June 30, 2009 is presented below:

 

 

 

Shares

 

Weighted Average
Grant Date Fair Value

 

Nonvested at December 31, 2008

 

671,480

 

$

45.07

 

Granted

 

215,825

 

$

9.08

 

Released

 

(110,999

)

$

48.83

 

Forfeited

 

(80,133

)

$

32.61

 

Nonvested at June 30, 2009

 

696,173

 

$

37.74

 

 

11. Other Comprehensive Income

 

The components of comprehensive income, net of taxes, are as follows:

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2009

 

2008

 

2009

 

2008

 

 

 

(In millions)

 

Net income (loss)

 

$

24.8

 

$

(19.4

)

$

62.0

 

$

(5.5

)

Other comprehensive income, net of tax:

 

 

 

 

 

 

 

 

 

Interest rate swap

 

2.1

 

2.0

 

4.1

 

3.7

 

Temporary decline in available-for-sale securities

 

 

(0.3

)

 

(0.3

)

Total comprehensive income (loss)

 

$

26.9

 

$

(17.7

)

$

66.1

 

$

(2.1

)

 

The amount of income tax benefit allocated to the interest rate swap was $1.3 million and $2.1 million for the three months ended June 30, 2009 and 2008, respectively. The amount of income tax benefit allocated to the interest rate swap was $2.7 million and $2.3 million for the six months ended June 30, 2009 and 2008, respectively. The amount of income tax benefit allocated to the temporary decline in securities was $0.2 million for the three and six months ended June 30, 2008.

 

12



Table of Contents

 

11. Other Comprehensive Income, continued

 

The accumulated comprehensive loss of $25.3 million (net of tax) as of June 30, 2009 is comprised of $24.9 million related to a terminated interest rate swap and $0.4 million related to a temporary decline in available-for-sale securities. The accumulated comprehensive loss of $29.4 million (net of tax) as of December 31, 2008 is comprised of $29.0 million related to a terminated interest rate swap and $0.4 million related to a temporary decline in available-for-sale securities.

 

12. Net Income (Loss) Per Share

 

The computation of the Company’s basic and diluted net income per share is as follows:

 

 

 

Three Months Ended June 30,

 

 

 

2009

 

2008

 

 

 

(In thousands, except per
share data)

 

Numerator for basic and dilutive income—per common share:

 

 

 

 

 

Net income (loss)

 

$

24,814

 

$

(19,385

)

Less: Series A Preferred Stock dividends

 

(4,750

)

(4,750

)

Less: Accretion of Series B Preferred Stock

 

(569

)

(535

)

Less: Net (income) loss allocated to unvested participating restricted stock

 

(719

)

930

 

Net income (loss) available to common stockholders— basic

 

18,776

 

(23,740

)

Effect of unvested participating restricted stock in two-class calculation

 

36

 

 

Accretion of Series B Preferred Stock*

 

569

 

 

Net income (loss) available to common stockholders— diluted

 

$

19,381

 

$

(23,740

)

Denominator:

 

 

 

 

 

Weighted average outstanding shares of common stock

 

16,929

 

16,768

 

Dilutive effect of:

 

 

 

 

 

Stock options *

 

363

 

 

Convertible Series B Preferred Stock *

 

553

 

 

Common stock and common stock equivalents

 

17,845

 

16,768

 

Net income (loss) per common share:

 

 

 

 

 

Basic

 

$

1.11

 

$

(1.42

)

Diluted

 

$

1.09

 

$

(1.42

)

 

 

 

Six Months Ended June 30,

 

 

 

2009

 

2008

 

 

 

(In thousands, except per
share data)

 

Numerator for basic and dilutive income—per common share:

 

 

 

 

 

Net income (loss)

 

$

61,955

 

$

(5,531

)

Less: Series A Preferred Stock dividends

 

(9,500

)

(9,500

)

Less: Accretion of Series B Preferred Stock

 

(1,129

)

(1,056

)

Less: Net (income) loss allocated to unvested participating restricted stock

 

(1,916

)

539

 

Net income (loss) available to common stockholders— basic

 

49,410

 

(15,548

)

Effect of unvested participating restricted stock in two-class calculation

 

77

 

 

Accretion of Series B Preferred Stock*

 

1,129

 

 

Net income (loss) available to common stockholders— diluted

 

$

50,616

 

$

(15,548

)

Denominator:

 

 

 

 

 

Weighted average outstanding shares of common stock

 

16,886

 

16,735

 

Dilutive effect of:

 

 

 

 

 

Stock options *

 

184

 

 

Convertible Series B Preferred Stock *

 

555

 

 

Common stock and common stock equivalents

 

17,625

 

16,735

 

Net income (loss) per common share:

 

 

 

 

 

Basic

 

$

2.93

 

$

(0.93

)

Diluted

 

$

2.87

 

$

(0.93

)

 


*       The effect of adding shares from the assumed exercise of stock options and conversion of Series B Convertible Preferred stock to the denominator and the related add-back of the dividends on Series B Convertible Preferred stock to the numerator is anti-dilutive for the three months and six months ended June 30, 2008.

 

13



Table of Contents

 

13. Fair Value Measurements

 

The Company has one type of financial instrument that is measured on a recurring basis at fair value as defined by SFAS No. 157, investments held by Applebee’s captive insurance subsidiary. None of the Company’s non-financial assets or non-financial liabilities must be measured at fair value on a recurring basis. The Company has not elected to use fair value measurement on any assets or liabilities as provided by SFAS No. 159, The Fair Value Option for Financial Assets and Liabilities—Including an amendment of FASB Statement No. 115.

 

SFAS No. 157 establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. These tiers include: Level 1, defined as observable inputs such as quoted prices in active markets; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs in which little or no market data exists; therefore requiring an entity to develop its own assumptions.

 

The fair value of the investments held by the captive insurance company at June 30, 2009 and December 31, 2008 was $4.6 million and $5.6 million, respectively, and was determined based on Level 3 inputs using a risk-adjusted discounted cash flow model under the income approach. The cost basis of the investment was $5.0 million and $6.0 million, respectively, with a temporary impairment of $0.4 million recorded as a component of accumulated other comprehensive income. There was no gain or loss, realized or unrealized, during the three months and six months ended June 30, 2009.

 

14. Fair Value of Financial Instruments

 

We believe the fair values of cash equivalents, accounts receivable, accounts payable and the current portion of long-term debt approximate their carrying amounts due to their short duration.

 

The fair values of non-current financial liabilities are shown in the following table.

 

 

 

June 30, 2009

 

December 31, 2008

 

 

 

Carrying
Amount

 

Fair Value

 

Carrying
Amount

 

Fair Value

 

 

 

(In millions)

 

Long-term debt, less current maturities

 

$

1,718.5

 

$

1,408.0

 

$

1,853.4

 

$

1,177.2

 

 

 

 

 

 

 

 

 

 

 

Series A Preferred Stock

 

$

187.1

 

$

160.2

 

$

187.1

 

$

131.2

 

 

At June 30, 2009 and December 31, 2008, the fair value of the non-current financial liabilities was determined based on Level 3 inputs using a risk-adjusted discounted cash flow model under the income approach. The change in fair value as of June 30, 2009, compared to the fair value as of December 31, 2008 was due a change in the discount rate assumption utilized in the risk-adjusted discounted cash flow model.

 

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Table of Contents

 

15. Consolidation of Variable Interest Entities

 

In December 2003, the FASB issued FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities (“FIN 46(R)”), to clarify the application of Accounting Research Bulletin No. 51, Consolidated Financial Statements, to certain entities, called variable interest entities (“VIEs”), in which equity investors do not have the characteristics of a controlling interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support. Under FIN 46(R), an enterprise that absorbs a majority of the VIE’s expected losses, receives a majority of the VIE’s expected residual returns, or both, is considered to be the primary beneficiary of the VIE and must consolidate the entity in its financial statements.

 

In February 2009, the Company and owners of Applebee’s and IHOP franchise restaurants formed Centralized Supply Chain Services, LLC (“CSCS” or the “Co-op”) to manage procurement activities for the Applebee’s and IHOP restaurants choosing to join the Co-op. CSCS meets the definition of a VIE under FIN 46(R). Under the terms of the Co-op agreements, each member restaurant belonging to CSCS has equal and identical ownership rights and obligations. IHOP franchise restaurants to which the Company has provided financial support in the form of loans to purchase franchises and equipment are considered de facto agents of the Company for purposes of determining the primary beneficiary of the VIE. Company-owned Applebee’s and IHOP restaurants, in addition to the IHOP franchise restaurants deemed de facto agents, comprised only 33.6% of the CSCS membership as of the date of determination of the primary beneficiary of the VIE. Accordingly, the Company is not considered to be the primary beneficiary of the VIE and therefore does not consolidate the results of CSCS.

 

Under the Co-op agreements, the Company is obligated to make a one-time payment to CSCS for start-up costs of $6.3 million, $3.5 million of which has been paid as of June 30, 2009, with payments of $2.0 million and $0.8 million due in July 2009 and January 2010, respectively. The Company is not obligated to provide any support to the Co-op under any explicit or implied agreement beyond this $6.3 million.

 

The Co-op does not purchase items on behalf of member restaurants; rather, it facilitates purchasing agreements and distribution arrangements between suppliers and member restaurants. Because of this, it is anticipated that CSCS will acquire a minimal amount of assets and incur a minimal amount of liabilities. Each member restaurant is responsible for only the goods and services it chooses to purchase and bears no responsibility or risk of loss for goods and services purchased by other member restaurants. Based on these facts, the Company believes its maximum estimated loss related to its membership in the Co-op is de minimis.

 

16. Commitments and Contingencies

 

Litigation, Claims and Disputes

 

The Company is subject to various lawsuits, claims and governmental inspections or audits arising in the ordinary course of business. Some of these lawsuits purport to be class actions and/or seek substantial damages. In the opinion of management, these matters are adequately covered by insurance or, if not so covered, are without merit or are of such a nature or involve amounts that would not have a material adverse impact on the Company’s business or consolidated financial statements.

 

Gerald Fast v. Applebee’s

 

The Company is currently defending a collective action filed under the Fair Labor Standards Act styled Gerald Fast v. Applebee’s International, Inc., in which named plaintiffs claim that tipped workers in company restaurants perform excessive amounts of non-tipped work for which they should be compensated at the minimum wage.  The court has conditionally certified a nationwide class of servers and bartenders who have worked in company-operated Applebee’s restaurants since June 19, 2004.  Unlike a class action, a collective action requires potential class members to “opt in” rather than “opt out.”  On February 12, 2008, 5,540 opt-in forms were filed with the court.

 

In cases of this type, conditional certification of the plaintiff class is granted under a lenient standard.  On January 15, 2009, the Company filed a motion seeking to have the class de-certified and the plaintiffs filed a motion for summary judgment, both of which are pending before the court.  The Company believes it has strong defenses supporting the de-certification of the class, as well as strong defenses to the substantive claims asserted, and intends to vigorously defend this case.  Trial is currently set for September 8, 2009, in Jefferson City, Missouri. An estimate of the possible loss, if any, or the range of the loss cannot be made and, therefore, the Company has not accrued a loss contingency related to this matter.

 

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Lease Guarantees

 

As of June 30, 2009, in connection with the sale of Applebee’s restaurants or previous brands to franchisees and other parties, the Company has, in certain cases, guaranteed or had potential continuing liability for lease payments totaling $123.8 million. This amount represents the maximum potential liability of future payments under these leases. These leases have been assigned to the buyers and expire at the end of the respective lease terms which range from 2009 through 2044. In the event of default, the indemnity and default clauses in our sale or assignment agreements govern our ability to pursue and recover damages incurred.  No material liabilities have been recorded as of June 30, 2009.

 

17. Preferred Stock

 

The Certificate of Designations of the Powers, Preferences and Relative, Participating, Optional and Other Special Rights, and Qualifications, Limitations, and Restrictions Thereof of Series A Perpetual Preferred Stock  (the “Certificate of Designations”) requires that upon the occurrence of a Change of Control, unless prohibited by applicable law, the Company shall redeem all then outstanding shares of the Series A Perpetual Preferred Stock for cash at a redemption price per share corresponding to the timing of such Change of Control, as specified in the Certificate of Designations.  U.S. GAAP requires preferred securities that are redeemable for cash or other assets to be classified outside of permanent equity if they are redeemable upon the occurrence of an event that is not solely within the control of the issuer. Accordingly, the Series A Perpetual Preferred Stock is not included as a component of Stockholders’ Equity in the accompanying Consolidated Balance Sheets.

 

18. Subsequent Event

 

On July 1, 2009, the Company completed the sale of two Applebee’s company-operated restaurants in New Mexico. As discussed in Note 5, Assets Held For Sale, these restaurants were reported as part of Assets Held for Sale in the Consolidated Balance Sheet as of June 30, 2009. The Company received after-tax proceeds from this sale of approximately $5 million.

 

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Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

Forward-Looking Statements

 

The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements in certain circumstances. This report contains statements that involve expectations, plans or intentions (such as those relating to future business or financial results, new features or services, or management strategies). These statements are forward-looking and are subject to risks and uncertainties, so actual results may vary materially from those expressed or implied by any forward-looking statements. You can identify these forward-looking statements by words such as “may,” “will,” “should,” “expect,” “anticipate,” “believe,” “estimate,” “intend,” “plan,” and other similar expressions. You should consider our forward-looking statements in light of the risks discussed under the heading “Risk Factors” in our most recent Annual Report on Form 10-K, as well as our consolidated financial statements, related notes, and the other financial information appearing elsewhere in this report and our other filings with the U.S. Securities and Exchange Commission. We assume no obligation to update any forward-looking statements.

 

Overview

 

The following discussion and analysis provides information we believe is relevant to an assessment and understanding of our consolidated results of operations and financial condition. The discussion should be read in conjunction with the consolidated financial statements and the notes thereto included in Item 1 of Part I of this Quarterly Report and the audited consolidated financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2008. Except where the context indicates otherwise, the words “we,” “us,” “our” and the “Company” refer to DineEquity, Inc., together with its subsidiaries that are consolidated in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”).

 

The Company was incorporated under the laws of the State of Delaware in 1976. The first International House of Pancakes (“IHOP”) restaurant opened in 1958 in Toluca Lake, California. Shortly thereafter the Company’s predecessor began developing and franchising additional restaurants. In November 2007, the Company completed the acquisition of Applebee’s International, Inc. (“Applebee’s”), which became a wholly-owned subsidiary of the Company. We own and operate two restaurant concepts in the casual dining and family dining categories of the food service industry: Applebee’s Neighborhood Grill and Bar® and IHOP. References herein to Applebee’s and IHOP restaurants are to these two restaurant concepts, whether operated by franchisees or the Company. References herein to “system sales” include retail sales at restaurants that are owned by franchisees and area licensees and are not attributable to the Company. With more than 3,400 franchised or owned-and-operated restaurants combined, we are the largest full-service restaurant company in the world.

 

Restaurant Concepts

 

Applebee’s

 

We franchise and operate restaurants in the bar and grill segment of the casual dining industry under the name “Applebee’s Neighborhood Grill & Bar®.” With 1,992 system-wide restaurants as of June 30, 2009, Applebee’s Neighborhood Grill & Bar is one of the largest casual dining concepts in the world, in terms of number of restaurants and market share.

 

Generally, Applebee’s franchise arrangements consist of a development agreement and separate franchise agreements for each franchised restaurant. Development agreements grant to the franchise developer the exclusive right to develop Applebee’s restaurants in a designated geographic area over a specified period of time. The term of a domestic development agreement is generally 20 years. The development agreement typically provides for an initial development schedule of one to five years, as agreed upon by the Company and the franchisee. At or shortly prior to the completion of the initial development schedule or any subsequent development schedule, the Company and the franchisee generally agree upon supplemental development schedules providing for the development of additional Applebee’s restaurants in the franchise developer’s exclusive territory.

 

Prior to the opening of each new Applebee’s restaurant, the franchisee and the Company enter into a separate franchise agreement for that restaurant. Our standard franchise agreement has a term of 20 years and permits renewals for up to an additional 20 years upon payment of an additional franchise fee. Our current standard franchise arrangement calls for an initial franchise fee of $35,000 and a royalty fee equal to 4% of the restaurant’s monthly net sales. We have agreements with a majority of our franchisees for Applebee’s restaurants opened before January 1, 2000, which provide for a royalty rate of 4% and extend the initial term of the franchise agreements until 2020. The terms, royalties and advertising fees under a limited number of franchise agreements and other franchise fees under older development agreements vary from the currently offered arrangements.

 

We currently require domestic franchisees of Applebee’s restaurants to contribute 2.75% of their gross sales to a national advertising fund and to spend at least 1% of their gross sales on local marketing and promotional activities. Under most Applebee’s franchise agreements, we have the ability to increase the amount of the required combined contribution to the national advertising fund and the amount required to be spent on local marketing and promotional activities to a maximum of 5% of gross sales.

 

Since the completion of the Applebee’s acquisition on November 29, 2007, we have been pursuing a strategy which contemplates transitioning from our current 80% franchised system to an approximately 98% franchised system. Between November 

 

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29, 2007 and June 30, 2009 we have franchised 108 company-owned restaurants in the California, Nevada, Delaware, Texas and New Mexico markets. This heavily franchised business model is expected to require less capital investment and reduce the volatility of cash flow performance over time.  A range of factors including the overall market for restaurant franchises, the availability of financing, and the financial and operating performance of Applebee’s company-owned restaurants can impact the likelihood and timing of the completion of this strategy as well as the ultimate proceeds the Company will receive from franchising the company-operated restaurants.  The Company continues to monitor these factors and to assess their impact on possible franchise transactions.  The Company may choose to suspend or revise its franchising strategy if it does not believe that conditions will lead to satisfactory proceeds from the sale of its company-operated restaurants.

 

IHOP

 

Under our current business model (the “Current Business Model”), which was adopted in January 2003, a potential franchisee first negotiates and enters into a single store development agreement or a multi-store development agreement with the Company and, upon completion of a prescribed approval procedure, is primarily responsible for the development and financing of one or more new IHOP franchised restaurants. In general, we do not provide any financing with respect to the franchise fee or otherwise. The franchise developer uses its own capital and financial resources along with third party financial sources to purchase or lease a restaurant site, build and equip the business and fund its working capital needs. The principal terms of the franchise agreements entered into under the Company’s business model prior to 2003 (the “Previous Business Model”) and the Current Business Model, including the franchise royalties and the franchise advertising fees, are substantially the same except with respect to the terms relating to the franchise fee.

 

The revenues received by the Company from a typical franchise development arrangement under the Current Business Model include (a) (i) a location fee equal to $15,000 upon execution of a single store development agreement or (ii) a development fee equal to $20,000 for each IHOP restaurant that the franchisee contracts to develop upon execution of a multi-store development agreement; (b) a franchise fee equal to (i) $50,000 (against which the $15,000 location fee will be credited) for a restaurant developed under a single store development agreement or (ii) $40,000 (against which the $20,000 development fee will be credited) for each restaurant developed under a multi-store development agreement, in each case, paid upon execution of the franchise agreement; (c) franchise royalties equal to 4.5% of weekly gross sales; (d) revenue from the sale of pancake and waffle dry-mixes; and (e) franchise advertising fees.

 

IHOP franchised restaurants established prior to 2003 under the Previous Business Model were generally developed by the Company. The Company was involved in all aspects of the development and financing of the restaurants. Under the Previous Business Model, the Company typically identified and leased or purchased the restaurant sites for new company-developed IHOP restaurants, built and equipped the restaurants and then franchised them to franchisees. In addition, IHOP typically financed as much as 80% of the franchise fee for periods ranging from five to eight years and leased the restaurant and equipment to the franchisee over a 25-year period.

 

The revenues received from a restaurant franchised under the Previous Business Model include: (a) the franchise fee, a portion of which (typically 20%) was paid upon execution of the franchise agreement; (b) interest income from the financing arrangements for the unpaid portion of the franchise fee under the franchise notes; (c) franchise royalties typically equal to 4.5% of weekly gross sales; (d) lease or sublease rents for the restaurant property and building; (e) rent under an equipment lease; (f) revenues from the sale of pancake and waffle dry-mixes; and (g) franchise advertising fees.

 

The franchise agreements generally provide for advertising fees comprised of (i) a local advertising fee generally equal to 2.0% of weekly gross sales under the franchise agreement, which was usually collected by us and then used to cover the cost of local media purchases and other local advertising expenses incurred by a local advertising cooperative, and (ii) a national advertising fee equal to 1.0% of weekly gross sales under the franchise agreement. Area licensees are generally required to pay lesser amounts toward advertising. Beginning in 2005, the Company and the IHOP franchisees agreed to reallocate portions of the local advertising fees to purchase national broadcast, syndication and cable television time in order to reach our target audience more frequently and more cost effectively. In a few instances, we have agreed to accept reduced royalties and/or lease payments from franchisees or have provided other accommodations to franchisees for specified periods of time in order to assist them in either establishing or reinvigorating their businesses.

 

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The following table summarizes Applebee’s restaurant development and franchising activity:

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2009

 

2008

 

2009

 

2008

 

 

 

(unaudited)

 

Applebee’s Restaurant Development Activity

 

 

 

 

 

 

 

 

 

Beginning of period

 

1,992

 

1,986

 

2,004

 

1,976

 

New openings

 

 

 

 

 

 

 

 

 

Company-developed

 

 

 

 

1

 

Franchisee-developed

 

5

 

11

 

10

 

27

 

Total new openings

 

5

 

11

 

10

 

28

 

Closings

 

 

 

 

 

 

 

 

 

Company

 

 

(2

)

 

(3

)

Franchise

 

(5

)

(2

)

(22

)

(8

)

End of period

 

1,992

 

1,993

 

1,992

 

1,993

 

Summary-end of period

 

 

 

 

 

 

 

 

 

Franchise

 

1,591

 

1,484

 

1,591

 

1,484

 

Company

 

401

 

509

 

401

 

509

 

Total

 

1,992

 

1,993

 

1,992

 

1,993

 

Restaurant Franchising Activity

 

 

 

 

 

 

 

 

 

Domestic franchisee-developed

 

2

 

6

 

7

 

17

 

International franchisee-developed

 

3

 

5

 

3

 

10

 

Refranchised

 

 

 

5

 

 

Total restaurants franchised

 

5

 

11

 

15

 

27

 

Closings

 

 

 

 

 

 

 

 

 

Domestic franchisee

 

(2

)

(2

)

(18

)

(7

)

International franchisee

 

(3

)

 

(4

)

(1

)

Total franchise closings

 

(5

)

(2

)

(22

)

(8

)

Net addition (reduction)

 

 

9

 

(7

)

19

 

 

The increase in Applebee’s franchise closings in 2009 was due primarily to the closing of seven restaurants after the franchise agreements were terminated due to nonpayment of royalties and advertising fees.  The Company expects up to four of the seven restaurants to re-open under new ownership in 2009.  In addition, six of the restaurants closed in 2009 were originally planned to be closed in 2008.

 

The following table represents Applebee’s restaurant development commitments for 2009 and 2010. We have disclosed development commitments for only a two-year period as the Applebee’s development agreements generally provide for a series of two-year development commitments after the initial development period.

 

 

 

Contractual
Opening of
Restaurants by Year

 

 

 

2009

 

2010

 

Domestic development agreements

 

19

 

15

 

International development agreements

 

23

 

18

 

 

 

42

 

33

 

 

In 2009, we expect franchisees to open a total of 29 to 36 new Applebee’s restaurants including 17 to 21 domestic franchise restaurants and 12 to 15 international franchise restaurants. We do not currently plan to open any domestic company-operated restaurants. The actual number of openings may differ from our expectations due to various factors, including economic conditions, operating performance of existing restaurants, franchisee access to capital, and the impact of currency fluctuations on our international franchisees. The timing of new restaurant openings may also be affected by various factors including weather-related and other construction delays and difficulties in obtaining regulatory approvals.

 

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The following table summarizes IHOP restaurant development and franchising activity:

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2009

 

2008

 

2009

 

2008

 

 

 

(unaudited)

 

IHOP Restaurant Development Activity

 

 

 

 

 

 

 

 

 

Beginning of period

 

1,402

 

1,353

 

1,396

 

1,344

 

New openings

 

 

 

 

 

 

 

 

 

Company-developed

 

 

 

 

 

Franchisee-developed

 

20

 

14

 

31

 

25

 

Area license

 

3

 

1

 

3

 

1

 

Total new openings

 

23

 

15

 

34

 

26

 

Closings

 

 

 

 

 

 

 

 

 

Company

 

 

(1

)

 

(1

)

Franchise

 

(3

)

(4

)

(7

)

(6

)

Area license

 

(1

)

(2

)

(2

)

(2

)

End of period

 

1,421

 

1,361

 

1,421

 

1,361

 

Summary-end of period

 

 

 

 

 

 

 

 

 

Franchise

 

1,249

 

1,195

 

1,249

 

1,195

 

Company

 

11

 

10

 

11

 

10

 

Area license

 

161

 

156

 

161

 

156

 

Total

 

1,421

 

1,361

 

1,421

 

1,361

 

Restaurant Franchising Activity

 

 

 

 

 

 

 

 

 

Domestic franchisee-developed

 

17

 

13

 

28

 

24

 

International franchisee-developed

 

3

 

1

 

3

 

1

 

Refranchised

 

1

 

5

 

1

 

9

 

Total restaurants franchised

 

21

 

19

 

32

 

34

 

Closings

 

 

 

 

 

 

 

 

 

Domestic franchisee

 

(3

)

(3

)

(7

)

(5

)

International franchisee

 

 

(1

)

 

(1

)

Total franchise closings

 

(3

)

(4

)

(7

)

(6

)

Reacquired by the Company

 

 

(6

)

(1

)

(9

)

Net addition

 

18

 

9

 

24

 

19

 

 

As of December 31, 2008, we had signed commitments from franchisees to build 307 IHOP restaurants over the next nine years plus options for an additional 111 restaurants, comprised as follows:

 

 

 

 

 

Contractual Openings of
Restaurants by Year

 

 

 

Number of Signed
Agreements at 12/31/08

 

2009

 

2010

 

2011

 

2012 and
thereafter

 

Total

 

Single-store development agreements

 

18

 

12

 

5

 

1

 

 

18

 

Multi-store development agreements

 

80

 

74

 

55

 

43

 

165

 

337

 

International development agreements

 

7

 

8

 

6

 

5

 

44

 

63

 

 

 

105

 

94

 

66

 

49

 

209

 

418

 

 

In 2009, a total of 65 to 75 new IHOP restaurants are expected to open, consisting of 55 to 60 franchise restaurants, three to five area license restaurants in Florida and seven to ten restaurants outside the U.S. or in non-traditional channels. The actual number of openings in any period may differ from the number of signed commitments. Historically, the actual number of restaurants developed in a particular year has been less than the total number committed to be developed due to various factors including weather-related delays, other construction delays, difficulties in obtaining timely regulatory approvals and various economic factors, including operating performance of existing restaurants and franchisee access to capital financing.

 

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Restaurant Data

 

The following table sets forth, for the three-month and six-month periods ended June 30, 2009 and 2008, the number of effective restaurants in the Applebee’s and IHOP systems and information regarding the percentage change in sales at those restaurants compared to the same periods in the prior year. “Effective restaurants” are the number of restaurants in a given period, adjusted to account for restaurants open for only a portion of the period. Information is presented for all effective restaurants in the IHOP and Applebee’s systems, which includes restaurants owned by the Company, as well as those owned by franchisees and area licensees. Sales at restaurants that are owned by franchisees and area licensees are not attributable to the Company. However, we believe that presentation of this information is useful in analyzing our revenues because franchisees and area licensees pay us royalties and advertising fees that are generally based on a percentage of their sales, as well as rental payments under leases that are usually based on a percentage of their sales. Management also uses this information to make decisions about future plans for the development of additional restaurants as well as evaluation of current operations.

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2009

 

2008

 

2009

 

2008

 

 

 

(unaudited)

 

Applebee’s Restaurant Data

 

 

 

 

 

 

 

 

 

Effective restaurants(a)

 

 

 

 

 

 

 

 

 

Franchise

 

1,589

 

1,480

 

1,590

 

1,474

 

Company

 

401

 

510

 

403

 

510

 

Total

 

1,990

 

1,990

 

1,993

 

1,984

 

System-wide(b)

 

 

 

 

 

 

 

 

 

Sales percentage change(c)

 

(4.2

)%

0.3

%

(3.4

)%

1.6

%

Domestic same-store sales percentage change(d)

 

(4.3

)%

(1.7

)%

(3.6

)%

(0.6

)%

Franchise(b)(e)

 

 

 

 

 

 

 

 

 

Sales percentage change(c)(g)

 

3.1

%

0.8

%

3.9

%

1.7

%

Same-store sales percentage change(d)

 

(4.2

)%

(1.8

)%

(3.5

)%

(0.9

)%

Average weekly domestic unit sales (in thousands)

 

$

46.6

 

$

48.5

 

$

48.0

 

$

49.7

 

Company

 

 

 

 

 

 

 

 

 

Sales percentage change(c)(g)

 

(25.4

)%

(1.0

)%

(24.5

)%

1.1

%

Same-store sales percentage change(d)

 

(4.8

)%

(1.5

)%

(4.0

)%

0.3

%

Average weekly domestic unit sales (in thousands)

 

$

41.9

 

$

44.2

 

$

43.3

 

$

45.3

 

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2009

 

2008

 

2009

 

2008

 

 

 

(unaudited)

 

IHOP Restaurant Data

 

 

 

 

 

 

 

 

 

Effective restaurants(a)

 

 

 

 

 

 

 

 

 

Franchise

 

1,235

 

1,185

 

1,230

 

1,180

 

Company

 

11

 

10

 

11

 

10

 

Area license

 

160

 

158

 

159

 

157

 

Total

 

1,406

 

1,353

 

1,400

 

1,347

 

System-wide(b)

 

 

 

 

 

 

 

 

 

Sales percentage change(c)

 

3.6

%

6.3

%

4.6

%

7.1

%

Domestic same-store sales percentage change(d)

 

(0.6

)%

2.6

%

0.7

%

3.2

%

Franchise(b)(e)

 

 

 

 

 

 

 

 

 

Sales percentage change(c)

 

3.9

%

6.9

%

5.1

%

7.7

%

Same-store sales percentage change(d)

 

(0.6

)%

2.6

%

0.7

%

3.2

%

Average weekly unit sales (in thousands)

 

$

35.2

 

$

35.3

 

$

35.8

 

$

35.5

 

Company(f)

 

n.m.

 

n.m.

 

n.m.

 

n.m.

 

Area License(h)

 

 

 

 

 

 

 

 

 

Sales percentage change(c)

 

0.9

%

2.2

%

(0.3

)%

2.7

%

 

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(a)

 

“Effective restaurants” are the number of restaurants in a given fiscal period adjusted to account for restaurants open for only a portion of the period. Information is presented for all effective restaurants in the IHOP and Applebee’s systems, which includes restaurants owned by the Company as well as those owned by franchisees and area licensees.

 

 

 

(b)

 

“System-wide sales” are retail sales at IHOP and Applebee’s restaurants operated by franchisees and IHOP restaurants operated by area licensees, as reported to the Company, in addition to retail sales at company-operated restaurants. Sales at restaurants that are owned by franchisees and area licensees are not attributable to the Company.

 

 

 

(c)

 

“Sales percentage change” reflects, for each category of restaurants, the percentage change in sales in any given fiscal period compared to the prior fiscal period for all restaurants in that category.

 

 

 

(d)

 

“Same-store sales percentage change” reflects the percentage change in sales, in any given fiscal period compared to the prior fiscal period, for restaurants that have been operated throughout both fiscal periods that are being compared and have been open for at least 18 months. Because of new unit openings and store closures, the restaurants open throughout both fiscal periods being compared may be different from period to period. Same-store sales percentage change does not include data on IHOP restaurants located in Florida.

 

 

 

(e)

 

IHOP franchise restaurant sales were $564.3 million and $543.2 million for the three months ended June 30, 2009 and 2008, respectively, and $1,146.3 million and $1,090.4 million for the six months ended June 30, 2009 and 2008, respectively. Applebee’s franchise restaurant sales were $886.4 million and $859.7 million for the three months ended June 30, 2009 and 2008, respectively, and $1,826.3 million and $1,757.5 million for the six months ended June 30, 2009 and 2008, respectively.

 

 

 

(f)

 

Sales percentage change and same-store sales percentage change for IHOP company-operated restaurants are not meaningful due to the relatively small number and test-market nature of the restaurants, along with the periodic inclusion of restaurants reacquired from franchisees that are temporarily operated by the Company.

 

 

 

(g)

 

The sales percentage change for Applebee’s franchise and company-operated restaurants is impacted by the franchising of 103 company-operated restaurants during 2008 and five company-operated restaurants in 2009.

 

 

 

(h)

 

Sales at IHOP area license restaurants were $54.4 million and $53.9 million for the three months ended June 30, 2009 and 2008, respectively, and $110.9 million and $111.3 million for the six months ended June 30, 2009 and 2008, respectively.

 

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Significant Known Events, Trends or Uncertainties Impacting or Expected to Impact Comparisons of Reported or Future Results

 

Global Economic Contraction

 

Beginning in 2008 and continuing into 2009, economic conditions in both the U.S. and worldwide have experienced a downturn due to the compounded effects of the subprime lending crisis, the credit market liquidity crisis, and the collateral effects of each on the finance and banking industries. In addition, volatile energy costs, concerns about inflation and deflation, slower economic activity, softness in both the commercial and residential real estate markets, decreased consumer confidence, reduced corporate profits and capital spending and rising unemployment have combined to create generally adverse business conditions for most industries and sectors. While the liquidity crisis and its effects on the finance and banking industries have mitigated somewhat, we believe financial market volatility, rising unemployment, increasing foreclosures and lower valuations for residential real estate will continue to put pressure on consumer spending. These conditions make it challenging for us to accurately forecast and plan future business activities as the reduction in disposable income for discretionary spending could cause our customers to change historic purchasing behavior and choose lower-cost dining options or alternatives to dining out.

 

These economic developments may affect our business and operations in a number of ways, including but not limited to:

 

·                  lower profitability and cash flows from company-operated restaurants;

 

·                  reduced payments from franchisees due to both a lower sales base on which royalties and other payments are calculated and possible impairment of the ability of franchisees to make payments when due as a result of the economic effects cited above on their businesses;

 

·                  availability of financing for franchisees to fulfill their new restaurant development commitments;

 

·                  credit availability for potential purchasers of Applebee’s company-operated restaurants;

 

·                  lower proceeds from the franchising of Applebee’s company-operated restaurants due to both lower restaurant sales and profitability and/or inability to consummate transactions at all; and

 

·                  lower estimated fair values for goodwill, intangible assets and long-lived assets resulting in future non-cash impairment charges.

 

We cannot predict the effect or duration of this economic slowdown or the timing and strength of a subsequent recovery in the economy in general or the restaurant industry in particular. If our business significantly deteriorates due to these macroeconomic effects, our financial condition and results of operations will likely be materially and adversely affected.

 

Securitized Debt and Related Interest Expense

 

Certain of our subsidiaries incurred a substantial amount of indebtedness to finance the Applebee’s acquisition. As a result, our interest expense has increased significantly from that reported prior to the acquisition and is expected to remain as one of the largest components of costs and expenses in the future until such time that debt balances are repaid or otherwise retired. We estimate the interest expense for fiscal 2009 will be approximately $185 million to $195 million, which includes approximately $40 million of non-cash interest charges.

 

Significant Gains and Charges

 

There were several significant gains and charges affecting the comparisons with previously reported results. In the six months ended June 30, 2009, we recognized a gain on extinguishment of debt of $38.8 million, a gain on disposition of assets of $5.1 million and impairment and closure charges of $2.0 million. In the comparable period of 2008, we recognized impairment and closure charges of $41.4 million and a gain on disposition of assets of $0.2 million. These transactions are discussed in further detail under paragraphs captioned “Impairment and Closure Charges,” “Gain on Extinguishment of Debt” and “Gain on Disposition of Assets.”

 

We expect to continue to dedicate a portion of excess cash flow towards opportunistic debt retirement. Since the fair value of our debt is currently less than its carrying value and is likely to remain less than carrying value for the foreseeable future, it is reasonably possible that extinguishments of debt repurchased on the open market will result in gains in future periods.

 

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Financial Statement Effect of Franchising Company-Operated Restaurants

 

We have franchised 108 Applebee’s company-operated restaurants and plan to franchise a substantial majority of the remaining 401 company-operated Applebee’s restaurants when such transactions make sense for the business. As mentioned above in Restaurant Concepts — Applebee’s, the Company considers a range of factors that could impact the likelihood of future franchise sales and possible proceeds from such sales. The Company may suspend or delay its plans to sell company-operated Applebee’s restaurants if it does not believe the sales proceeds would be satisfactory. If the number of company-operated restaurants declines, the amount of Company restaurant revenues and Company restaurant expenses in future periods will decline as well compared to amounts reported in previous periods. Franchise royalty revenues and expenses will likely increase as company-operated restaurants are franchised, although not in the same magnitude as the Company restaurant revenues decline as franchise royalties are based on a percentage of the franchisee’s revenues. As a result, on a net basis, segment profit will likely decline.

 

Under the terms of our securitized debt agreements, all proceeds of asset dispositions must be used to retire debt on a pro-rata basis. Accordingly, franchising of additional Applebee’s company-operated restaurants will result in reduction of long-term debt and a reduction of related interest expense.

 

Segments

 

We identify our segments based on the organizational units used by management to monitor performance and make operating decisions. The Company’s revenues and expenses are recorded in four segments: franchise operations, company restaurant operations, rental operations, and financing operations.

 

The franchise operations segment consists of (i) restaurants operated by Applebee’s franchisees in the United States, one U.S. territory and 14 countries outside the United States; and (ii) restaurants operated by IHOP franchisees and area licensees in the United States, Canada and Mexico. Franchise operations revenue consists primarily of franchise royalty revenues, sales of proprietary products, certain franchise advertising fees and the portion of the franchise fees allocated to intellectual property.  Franchise operations expenses include advertising expense, the cost of proprietary products, pre-opening training expenses and costs related to intellectual property provided to certain franchisees.

 

The company restaurant operations segment consists of company-operated Applebee’s and IHOP restaurants and, from time to time, IHOP restaurants reacquired from franchisees that are operated on a temporary basis. Company restaurant sales are retail sales at company-operated restaurants. Company restaurant expenses are operating expenses at company-operated restaurants and include food, labor, benefits, utilities, rent and other restaurant operating costs.

 

Rental operations revenue includes revenue from operating leases and interest income from direct financing leases. Rental operations expenses are costs of operating leases and interest expense on capital leases on franchisee-operated restaurants.

 

Financing operations revenue consists of the portion of franchise fees not allocated to intellectual property, sales of equipment, as well as interest income from the financing of franchise fees and equipment leases. Financing expenses are primarily the cost of restaurant equipment.

 

Comparison of the Three Months ended June 30, 2009 and 2008

 

Results of Operations