In a risky step, IHOP is bidding to acquire Applebee's

NEW YORK — IHOP's CEO Julia Stewart has been making bold moves to revitalize the 45-year-old chain known for its breakfast fare and blue-tiled roofs. With a $1.9 billion bid for the bar-and-grill chain Applebee's made on Monday, she may be taking her biggest risk yet.

The move comes as Wall Street analysts anticipate a difficult second-quarter earnings season in the restaurant sector as soaring commodity costs hurt profits and consumers worried over high gas prices ate out less frequently.

Combined, the company would have 3,250 restaurants and $6.8 billion in annual sales.

Stewart, a former Applebee's executive, said once the deal closes, IHOP would revive the Applebee's brand and increase its emphasis on franchises by selling most of the 508 company-owned stores at a rate of 40 per quarter, which could take until 2010 to complete.

In doing so, the company would reduce the percentage of company-owned stores to 5 percent from the current 25 percent, a transformation similar to the one she led at IHOP beginning in 2003.

"It's a great brand; it just needs to be revitalized," Stewart said Monday. "We will fundamentally change the company's business model, moving it nearly completely out of the role of owner-operator."

The changes, which are expected to cut costs by $50 million a year by 2011, reduce the company's risks in owning real estate, a strategy also taken by many hotel companies to stabilize profit growth.

From May 2002, the month Stewart took over as CEO, IHOP's share price is up roughly 75 percent. It closed May 1, 2002, at $35.25 and has since risen to the low $60s.

"She woke them up to a certain degree," Oppenheimer analyst Michael Smith said of IHOP. "It was a well-recognized brand name. It just needed somebody to slap it around a bit."

Stewart makes the move as Applebee's is pressured to improve shareholder return by the activist investor Richard Breeden and his Breeden Capital Management.

Analysts worry that the all-cash nature of the deal leaves Applebee's investors shut out of any benefit from upward stock movement should the transformation lead to better profits.

"The price and deal structure somewhat surprise us," CIBC World Markets analyst John Glass wrote to investors. Acquisitions are often made with a combination of cash and stock.

It remains to be seen whether Applebee's shareholders including Breeden's firm will endorse the deal, especially given past statements from Breeden that urge improving the business before considering a sale, Glass wrote.

"We expect many shareholders to push for more," JPMorgan analyst John Ivankoe told investors.

Applebee's put itself up for sale in February. First-quarter profit fell 65 percent, it reported last month.

"I think there's so much upside in the Applebee's brand, I don't worry about the category itself," Stewart told analysts.

Michael Gallo of C.L. King & Associates said buying Applebee's would be the biggest bet Stewart has made since joining IHOP. Stewart has also introduced new items, such as savory crepes and a more healthful menu called IHOP for me, as well as eliminating trans fats.

IHOP plans to open at least 30 to 45 new franchised Applebee's restaurants per year, IHOP Chief Financial Officer Thomas Conforti said. IHOP also plans aggressive share repurchases to increase shareholder value, executives said.

Conforti said the company does not anticipate any antitrust issues since they are not direct competitors.

The deal requires approval by Applebee's shareholders but not investors in IHOP, since it is an all-cash deal. If approved, the deal would close in the fourth quarter.

Under the deal, IHOP will pay $25.50 per share for Applebee's, a 4.6 percent premium over its closing price on Friday.

Applebee's has about 76 million shares outstanding. IHOP is also assuming about $155 million in Applebee's debt in the deal, boosting the total value of the transaction to about $2.1 billion.

Applebee's shares rose 53 cents, or 2.2 percent, to $24.91 in trading Monday. In an unusual move for the shares of a buyer, IHOP stock gained even more, rising $4.99, or 8.9 percent, to $61.24 after briefly reaching a new 52-week high of $63.39.

IHOP is funding the transaction through about $2 billion in securitized debt, and will pay down the debt with profit from the sales of company-owned stores, expected to generate about $550 million, and real estate sales estimated to be worth $400 million.

Applebee's, based in Overland Park, Kan., has 1,943 restaurants worldwide. Same-store sales are down more sharply this year for Applebee's company-owned restaurants than for its franchise locations.

Virtually all of Glendale, Calif.-based IHOP's 1,319 restaurants are now owned by franchisees.

In April, Applebee's struck a deal with Breeden, who is also a former chairman of the Securities and Exchange Commission, to add him and one other person to its board, amid pressure from his firm to improve operations.

Stewart, who was president of Applebee's domestic division from 1998 to 2001, will lead the management team of the combined company.

IHOP said it expects to continue paying a dividend and said the deal should add to earnings starting in 2008.