The roofs aren’t the only things that are blue at IHOP.
On the heels of the Aug. 20 resignation of IHOP Corp. Chief Operating Officer Dennis Leifheit, a number of franchisees have stepped up their criticism of operational decisions made by the Glendale-based chain. They see overly aggressive expansion in the midst of a flagging economy.
That pursuit of expansion is reflected in the substantial upswing in units over the past four years: IHOP, which added 36 restaurants in 1997, upped the number to 69 last year and franchised 27 restaurants in the second quarter of this year alone.
The company’s shares have jumped 35 percent since May, trading at $27 as of last week, due in large part to that expansion, according to Randall Hiatt, president of Costa Mesa-based restaurant consultant Fessel International.
“Ability to grow is critical,” said Hiatt. “Restaurant companies that don’t grow are severely punished (by the market).”
But what has helped drive the stock also has raised the ire of franchisees, who operate 80 percent of the nearly 1,000 IHOP restaurants worldwide. IHOP’s comparable store sales, which rose 2.7 percent in 1998, were down 0.2 percent for the quarter ended June 30 from the like year-earlier quarter.
Topping off?
One analyst thinks the expansion may have pushed shares to their limit.
Dennis Joe, a restaurant analyst at Sidoti & Co. in New York, shifted the company to a “neutral” rating in June from a “buy” in December, saying it was close to his $28 target price.
“If you take a look at how casual dining has been affected (by the economy), it’s been slumping, and third quarter will be dismal,” Joe said.
While Hiatt attributed the stock jump to expansion, Joe cited the potential for a cash influx from the sale of loans to franchisees as the primary driver.
Southeastern Asset Management, which holds a 17.4 percent stake in IHOP, has been pressuring the company to sell off its $287 million in long term loans it makes to its franchisees.
IHOP reported net income of $10.2 million (49 cents per diluted share) for the second quarter ended June 30, up from $8.3 million (41 cents a share) in the like year-earlier quarter.
Second quarter revenue was $82.8 million, vs. $70.3 million in the second quarter of 2000.
The combination of positive stock performance and flattening same-store sales highlights a longstanding conflict between IHOP and its franchisees. IHOP’s practice of identifying sites, financing build-outs and opening restaurants before selling them to franchisees gives the company complete control of expansion. As IHOP increases brand awareness and corporate royalties by opening stores, franchisees claim the policy eats into revenues and, more importantly, profits of existing stores.
Two franchisees mentioned IHOP’s practice of “backfilling,” saturating one particular market before moving on to another, as a particular problem.
For instance, while there are no IHOPs in Kentucky and Ohio, there are 14 within the nine-mile radius of central Los Angeles. “It’s important that the brand continues to grow, but we don’t want it to get bigger by taking our sales away,” said one franchisee, who requested anonymity.
IHOP tried to address this issue last October by administering a reimbursement policy for stores adversely affected by new openings. If a franchisee can prove that a new store opened within five miles of his has diminished revenues, IHOP will reimburse the existing store’s franchisee about 20 percent of the difference in sales. IHOP Chairman Richard Herzer estimated that a half dozen operators are on this program.
But franchisees said the five-mile minimum offers little protection. “They just don’t understand the encroachment issue,” said one. “They don’t think that five miles is a problem.” He added that existing multi-unit franchisees often feel pressured to buy a recently opened nearby store even if they were against the opening in the first place. “I’d rather compete against myself than someone else,” said the franchisee.
No pat answer
Herzer, however, is not ready to lay the blame for flattening sales solely on expansion. “Some of this is the fact that we were not executing,” he said. “We also put in high-volume units a year ago and are going against that. In order to peel the onion, you have to peel all the (layers). I’ve just given you two of 20.”
Hiatt also downplayed sales cannibalization as a primary reason for IHOP’s flattening comparable store sales, noting that flat sales are an industry-wide problem.
Indeed, the stock price of Advantica Restaurant Group Inc., the parent company of the Coco’s, Carrows and Denny’s chains, whose stock topped $10 in mid-1998, has traded at less than a dollar for much of the year. And while Denny’s reported a 2.2 percent comparable store increase for its most recently reported quarter, Advantica reported a $31 million in net loss on $264 million in revenues during the same period.
Herzer would not comment on whether operational issues contributed to Leifheit’s resignation, or the status of the search for a successor. He did say that IHOP is searching for a new president, noting that he would retain the chairman’s position and that the time frame was “near term.”
Leifheit, a former Pepsico executive, was praised by franchisees for his organizational skills, but his efforts to boost after-breakfast sales met with mixed results.
“So many things had to be straightened out instead of rolled out,” said one operator. Another franchisee believed that Leifheit’s focus on lunch and dinner items was a movement away from IHOP’s brand strength, noting that at least half of his after-breakfast sales were made up of breakfast items. He was hoping that Leifheit’s successor would return the brand to its breakfast roots.
