Applebee's: A Fruitful Future


By Dennis Milton Standard & Poor's Equity Research believes Applebee's International (APPB

; recent price, $21.62) will continue to benefit from strong long-term fundamentals in the casual-dining industry.

With more than $4 billion in sales at company-owned and franchised units over the last 12 months, the Applebee's Neighborhood Grill & Bar concept is the largest chain in the fast-growing casual-dining segment of the restaurant industry.

In our view at S&P, the company's scale, sophisticated national marketing, and positioning within the fast-growing bar-and-grill segment of the casual-dining industry bode well for strong earnings growth. We think the recent decline in Applebee's share price offers an opportunity to invest in an industry-leading company with strong prospects for future growth (see BW, 9/19/05, "Applebee's Looks Appetizing"). Our recommendation on the shares is 5 STARS (strong buy).

GROWING PROFITABLY. While many of its casual-dining competitors operate multi-chain organizations, Applebee's has focused its efforts on its Neighborhood Grill & Bar concept since its 1999 divestiture of Rio Bravo. As of June 26, 2005, 1,722 Applebee's restaurants were operating in 49 states and 12 foreign countries. Systemwide sales (including company-owned units and franchisee units) totaled $3.9 billion in 2004, up 11% from 2003.

We believe Applebee's single-concept focus has given it an advantage relative to competitors, allowing it to concentrate on profitable expansion opportunities, establishing a successful national marketing program, improving economies of scale, and achieving systemic operational excellence, in our view.

As a result, over the past five years, Applebee's has achieved industry-leading profit margins (average of 9.5%) and returns on equity (average of 23%). During this time, revenues have grown at an 11.7% rate annually, and earnings per share have grown at a 14% annual rate.

STABLE EARNINGS. Franchisees operate approximately 73% of the chain's restaurants. The company receives royalty payments equal to 4% of sales at franchisee units. We believe the franchising model adds to Applebee's attractiveness in general, preserving capital while allowing the concept to grow rapidly.

The royalty model also acts to stabilize earnings during periods of rising costs. In recent years, Applebee's has, on occasion, bought out the interests of franchisees on a selective basis when it believes an attractive opportunity exists to improve financial performance. It expects to continue this policy but sees franchisees continuing to operate at least 70% of all Applebee's units.

After increasing 4.8% in 2004 and 4.1% in 2003, systemwide same-store sales have slowed significantly in the first eight months of 2005 and have turned negative for company-owned units. Applebee's has cited slower lunchtime sales and weaker consumer spending in Midwest markets, where approximately 50% of the company-owned stores reside.

As a result, in August, Applebee's reduced its sales expectations for the remainder of the year, and cut its 2005 EPS guidance to a range of $1.33 to $1.40, from a range of $1.44 to $1.47.

MANIFEST DESTINY. Nonetheless, given weaker same-store sales comparisons and our view of the company's well-run special promotions, we expect sales trends to improve in the fourth quarter of 2005. In 2006, we expect earnings to benefit from continued expansion, positive -- albeit tepid -- same-store sales growth, and lower food costs.

Applebee's believes it's well positioned to capitalize on a trend toward takeout orders, due to its value-oriented menu and developed store base. By early 2005, it had substantially completed the rollout of its Carside to Go initiative, in which customers place their order by phone, park in a designated spot at the restaurant, and have the meal delivered to their vehicle. Takeout food accounted for 10.4% of company-owned store sales in the second quarter of 2005, up from 9.3% a year earlier.

Applebee's has pursued what we view as an aggressive expansion strategy that has seen it open at least 100 restaurants annually in each of the past 12 years. It intends to continue this pace and believes its concept will allow for at least 3,000 stores.

VALUE/PRICE LEADER. In 2005, it plans to open at least 135 units, including 50 or more company stores and 85 franchised locations. Over the next five to seven years, we expect Applebee's to average revenue growth of 9% annually, based on continued expansion and same-store sales growth of approximately 2.5%. We project EPS to grow at a 13% pace over that time, with results benefiting from leveraging fixed costs against a rising sales base and from share-repurchase activity.

Given recent concerns regarding rising interest rates and energy costs and their potentially negative impact on the American consumer, shares of restaurant-industry stocks have fallen consistently over the past several months. APPB fell to a 52-week low of $19.86 in late September from its high of $29.19 in March, reflecting general economic concerns and slow same-store sales growth throughout the Applebee's chain. The shares recently traded at 16 times our 2005 EPS estimate of $1.36, in line with industry peers.

We believe that the shares make for a compelling value at this level. In our view, Applebee's International has successfully positioned itself as a price/value leader in the restaurant industry's growing casual-dining segment. Given what we see as the company's superior recent operating performance (which includes industry-leading profit margins and returns on equity), its strong balance sheet (with a debt-to-asset ratio of approximately 11%), and solid long-term growth prospects, we believe the shares warrant a premium valuation.

QUALITY EARNINGS. In the near term, we expect tepid same-store sales growth throughout the casual-dining industry. Higher energy prices and slower growth in general consumer spending should limit customer-traffic gains and menu-price increases. However, we expect Applebee's to benefit from continued geographic expansion and lower-than-expected food costs in the remainder of 2005 and in 2006.

We project 2005 EPS of $1.36, up from $1.33 in 2004, excluding one-time items. Our 2006 EPS estimate of $1.44 derives from our expectations for continued expansion, same-store sales growth of 2.5%, and lower average food costs, and includes 11 cents of projected stock-option expense.

Based on S&P Core Earnings methodology, we believe the quality of Applebee's earnings is high relative to competitors. The use of unexpensed stock-option grants to compensate managers and officers is widespread in the casual-dining industry, and we find Applebee's use of stock options to be in line with industry competitors.

GAINING MARKET SHARE. After adjustments to net income (on a generally accepted accounting principles, or GAAP, basis) to reflect the expensing of stock-option grants and the reversal of losses related to the sale of assets, Applebee's 2004 net income per share of $1.33 would have been reduced by 6%, to $1.25.

For 2005, we are projecting S&P Core EPS of $1.26, a 7% reduction from our operating EPS estimate of $1.36. In 2006, we project S&P Core EPS of $1.44, equal to our operating EPS estimate, as Applebee's will begin to expense its stock-option grants.

At 17 times our 2005 S&P Core EPS estimate, the shares recently traded in line with casual-dining peers. We're also impressed with what we regard as a high level of execution in implementing its expansion strategy, and we believe the casual-dining segment is gaining market share from fast-food and other outlets.

OUTSIDERS KEY. Our 12-month target price of $26 is based on a p-e multiple of 18 times, a slight premium to Applebee's industry peers, applied to our 2006 EPS estimate of $1.44. This valuation is supported by our

discounted cash-flow model.

Applebee's corporate-governance practices have many positive aspects, in our opinion. A supermajority of independent outsiders controls the board of directors, and its audit and compensation committees consist solely of outside directors.

The corporate-governance guidelines are available on Applebee's Web site. A simple majority vote can amend the company's charter and bylaws, and give merger approval. Furthermore, Applebee's has no poison-pill provision in place. Also, no recent "related-party" transactions have involved company officers or directors. On the negative side, shareholders don't have cumulative voting rights in electing directors.

Risks to our investment recommendation and target price include: the possibility that a spike in energy prices or a general weakening of the economy could have a substantially negative impact on customer traffic; a jump in food and energy costs or general wage inflation that could markedly narrow operating margins; poor marketplace reception to new menu selections; or unprofitable execution of Applebee's expansion.

Analyst Milton follows shares of restaurant companies for Standard & Poor's Equity Research Services


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