When Peter Lynch was asked why he wasn’t a strictly blue-chip investor, he responded: “Because there is a lot of money to be made when a business model goes from crappy to semi-crappy.” A corollary observation I’d like to add is that there are enormous cash flows coming your way when a business switches from directly running its operations to a franchise agreement that has franchisees run the operations and pay a royalty for a right to use the brand name.
Recently, I chided Applebee’s for becoming a stale, saturated brand and offering my view that any excellent returns that DineEquity (DIN) shareholders receive from this day forward will be the result of the enormous cash flows being generated at the International House of Pancakes (IHOP) subsidiary.
What is worth analyzing, though, is how much money could have been made for the studious investor that recognized the one-time cash flows created on behalf of shareholders between 2010 and 2015 as Applebees began to aggressively franchise nearly all of its 2,033 locations.
To become an Applebee’s franchisee, the terms are clear: You will be called upon to make an initial investment of $1,700,000 to $3,100,000. You need to have a net worth of at least $1,000,000 and cash on hand of at least $500,000. The franchising agreement requires you to pay a $35,000 franchise fee and a royalties amounting to 4% of your sale.
The short-term wealth is that DineEquity shareholders would be collecting $35,000 fees from the franchising of the 1,500+ locations that were not franchised at the start of the initiative. This is a one-time pure profit source of $50 million.
When you look at the DineEquity business model, you could see that it was making about $60 million per year before beginning its franchising push in 2010. As part of the franchising, annual profits shot up to $100 million.
If you were able to realize the breadth of the one-time cash flows coming to DineEquity shareholders, you could have participated in the stock price rise from $22 in 2010 to $114 in 2015. You could have participated in the 24% annual returns for five years from a business model that, frankly, isn’t exceptional enough to deliver returns anywhere near that magnitude.
DineEquity stock from 2010 to 2015 is the type of investment that can make it wise to consider the occasional medium-term value investment. It also provides a good example for why you should be slow to sour on directly-owned restaurant stocks that appear to be stagnating. If the growth doesn’t pick up within three to five years, franchising is often the next step to resuscitate the brand. The countervailing points to consider are the amount of debt on the balance sheet and whether the restaurant brand is strong enough to support a meaningful franchising fee.
The wealth accelerant of one-time franchising cash flows is a story that repeats a few times per decade among publicly traded stocks. In fact, there is one publicly traded restaurant chain under distress right now that the sedulous among you have already identified as a candidate for this type of investment consideration.