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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FORM 10-K

(Mark One)

 

 

x

 

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

 

For the fiscal year ended December 31, 2004

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


IHOP CORP.

(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

 

91203-2306

(Address of principal executive offices)

 

(Zip Code)

 

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

Securities registered pursuant to Section 12(b) of the Act:

Title of each class

 

 

 

Name of each exchange on which registered

Common Stock, $.01 Par Value

 

New York Stock Exchange

 

Securities registered pursuant to Section 12(g) of the Act: None

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

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

State the aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant as of June 27, 2004: $739 million.

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

Class

 

 

 

Outstanding as of February 28, 2005

 

Common Stock, $.01 par value

 

19,975,589

 

 

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the Annual Meeting of Stockholders to be held on Tuesday, May 24, 2005 (the “2005 Proxy Statement”) are incorporated by reference into Part III.

 




PART I

Item 1. Business.

a.   General Information

IHOP Corp. (referred to herein as the “Company”) was incorporated under the laws of the State of Delaware in 1976. In July 1991, the Company completed an initial public offering of common stock. There were no significant changes to our corporate structure during 2004.

IHOP Corp.’s principal executive offices are located at 450 North Brand Boulevard, Glendale, California 91203-2306 and our telephone number is (818) 240-6055. Our website is located at www.ihop.com. We make all of our filings with the Securities and Exchange Commission (referred to herein as the “SEC”) available free of charge on our website as soon as reasonably practicable after such reports have been filed with or furnished to the SEC. The information contained on our website is not incorporated into this Annual Report on Form 10-K.

This Annual Report on Form 10-K should be read in conjunction with the cautionary statements on page 14 under “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.—Forward Looking Statements.”

b.   Financial Information about Industry Segments

In January 2003, we announced significant changes in the way we conduct our business. These changes included a transition from Company-financed restaurant development (the “Old Business Model”) to a more traditional franchise development model, in which franchisees finance, develop and operate their new restaurants (the “New Business Model”). In order to reflect the change in our business model, we have also changed the presentation of our segment information. We identify our segments based on the organizational units used by management to monitor performance and make operating decisions. Our segments are recorded in four categories: franchise operations, rental operations, Company restaurant operations and financing operations. The franchise operations segment consists of restaurants operated by our franchisees and area licensees in the United States and Canada. Franchise operations revenue consists primarily of royalty revenues, sales of proprietary products, advertising fees and the portion of the franchise fees allocated to the Company’s intellectual property. Franchise operations expenses consist of advertising expense and the cost of proprietary products. Rental operations revenue consists of 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. The Company restaurant operations segment consists of Company-operated restaurants in the United States. Company restaurant sales are retail sales at IHOP-operated restaurants. Company restaurant expenses are operating expenses at IHOP-operated restaurants and include food, labor, benefits, utilities, rent and other real estate related costs. Financing operations revenue consists of the portion of franchise fees not allocated to the Company’s intellectual property, sales of equipment as well as interest income from the financing of franchise fees and equipment leases. Financing operations expenses are primarily the cost of restaurant equipment and interest expense not associated with capital leases. Prior period segment information has been restated to conform with the current year presentation. Please see Note 15 to the Consolidated Financial Statements in this Annual Report on Form 10-K for more details.

c.   Narrative Description of Business

General

IHOP Corp. and its subsidiaries develop, franchise and operate International House of Pancakes, or IHOP, restaurants, one of America’s best-known, national, family restaurant chains. At December 31, 2004, there were 1,186 IHOP restaurants. Franchisees operated 1,028 of these restaurants, area licensees

2




operated 148 restaurants, and the Company operated 10 restaurants. Franchisees and area licensees are independent third parties who are licensed by us to operate their restaurants using our trademarks, operating systems and methods. IHOP restaurants are located in 48 states and Canada.

IHOP restaurants feature table service and moderately priced, high-quality food and beverage items in an attractive and comfortable atmosphere. Although the restaurants are best known for their award-winning pancakes, omelets and other breakfast specialties, IHOP restaurants offer a broad array of lunch, dinner and snack items as well. They are open throughout the day and evening hours, and many operate 24 hours a day.

We seek to increase our revenues and profits by focusing on several areas of our business. These areas include: (1) franchising of new IHOP restaurants, (2) marketing, advertising and product development programs aimed at attracting new guests and retaining our existing guests, and (3) implementation of restaurant-level operating changes designed to improve sales and profitability.

Restaurant Development

Prior to January 2003, we financed and developed the large majority of new IHOP restaurants prior to franchising them (the “Old Business Model”). Under the Old Business Model, when the restaurant was ultimately franchised, we typically became the franchisee’s landlord and equipment lessor. Our new business model (the “New Business Model”) relies on franchisees to finance and develop IHOP restaurants. Under the New Business Model, we approve the franchisees’ proposed sites but do not contribute capital or become the franchisee’s landlord.

Under the New Business Model, substantially all new IHOP restaurants will be financed and developed by franchisees or area licensees in 2004 and thereafter. In 2004, we developed four IHOP restaurants under the Old Business Model, we developed two restaurants in our new Company operations market in Cincinnati, Ohio, and our franchisees and area licensees financed and developed 41 additional new restaurants.

Regardless of the business model, new IHOP restaurants are only developed after a stringent site selection process supervised by our senior management. We expect to add restaurants to the IHOP system in major markets where we already have a core guest base. We believe that concentrating growth in existing markets allows us to achieve economies of scale in our supervisory and advertising functions. We also look to strategically add restaurants in geographic areas in which we have no presence or our presence is limited.

Future Restaurant Development

In 2004, we entered into 46 franchise development agreements. As of December 31, 2004, we had signed commitments from our franchisees to build 252 restaurants over the next several years plus options for an additional 35 restaurants. This number includes 28 Single-Store Development Agreements and 45 larger Multi-Store Development Agreements.

In 2005, we expect to open 62 to 72 new restaurants. Our franchisees are expected to develop approximately 55 to 60 new restaurants, we will develop approximately two to four new restaurants in our dedicated Company market in Cincinnati, Ohio and our area licensee in Florida will develop approximately five to eight restaurants in 2005. We expect the majority of openings to occur in the second half of 2005.

3




The following table represents our development commitments including options as of December 31, 2004.

 

 

 

 

Scheduled Opening of Restaurants by

 

 

 

Number of Signed
Agreements at 12/31/04

 

2005

 

2006

 

2007

 

2008 and
thereafter

 

Total

 

Single-store development agreements

 

 

28

 

 

 

27

 

 

 

1

 

 

 

 

 

 

 

 

28

 

Multi-store development agreements

 

 

45

 

 

 

41

 

 

 

43

 

 

 

36

 

 

 

139

 

 

259

 

 

 

 

73

 

 

 

68

 

 

 

44

 

 

 

36

 

 

 

139

 

 

287

 

 

The Company believes that a total of 300-700 additional IHOP restaurant opportunities exist in the United States as of December 31, 2004, and is actively recruiting existing and new franchisees to develop these opportunities.

Franchising

Our franchising activities for the years ended December 31, 2004 and 2003 included both Company financed and franchisee financed development. For clarity of presentation, the discussion below is separated between those activities specific to the Old Business Model and those which apply to the New Business Model.

Old Business Model

Under the Old Business Model, when we developed a restaurant, we identified the site for the new restaurant, purchased the site or leased it from a third party, and built the restaurant and equipped it with all required equipment. We selected and trained the franchisee and supervisory personnel who would operate the restaurant. In addition, we financed approximately 80% of the franchise fee and leased the restaurant and equipment to the franchisee. In accordance with generally accepted accounting principles (herein referred to as “GAAP), the equipment lease between the Company and the franchisee was treated as a sale in our financial statements.

Our involvement in the development and financing of new restaurants allowed IHOP to charge a core franchise fee and development and financing fees totaling $50,000 to $500,000. The franchisee typically paid approximately 20% of the initial franchise fee in cash, and we financed the remaining amount over five to eight years. The financing of the initial franchise fee allowed the Company to derive interest income from the financing of the core franchise fee and development and financing fees, and the leasing of property and equipment to franchisees. We also continue to receive revenues from the franchisee as follows: (1) a royalty equal to 4.5% of the restaurant’s sales; (2) income from the leasing of the restaurant property and related equipment; (3) revenue from the sale of certain proprietary products, primarily pancake mixes; (4) a local advertising fee equal to about 2% of the restaurant’s sales, which is usually collected by us and then paid to a local advertising cooperative; and (5) a national advertising fee equal to 1% of the restaurant’s sales. In some cases, we have agreed to accept reduced royalties for a period of time from franchisees in order to assist them in establishing their businesses, where business conditions justify it.

New Business Model

Under the New Business Model, our approach to franchising is similar to that of most franchising systems in the foodservice industry. Franchisees can undertake individual store development or multi-store development. Under the single-store development program, the franchisee is required to pay a non-refundable location fee of $15,000. If the proposed site is approved for development, the location fee of $15,000 is credited against an initial franchise fee of $50,000. The franchisee then uses his or her own capital and financial resources to acquire a site, build and equip the business and fund working capital needs.

4




In addition to offering franchises for individual restaurants, the Company offers multi-store development agreements for certain qualified franchisees. These multi-store development agreements provide franchisees with an exclusive right to develop new IHOP restaurants in designated geographic territories for specified periods of time. Multi-store developers are required to develop and operate a specified number of restaurants according to an agreed upon development schedule. Multi-store developers are required to pay a development fee of $20,000 for each restaurant to be developed under a multi-store development agreement. Additionally, for each store which is actually developed, the franchise developer must pay an initial franchise fee of $40,000 against which the development fee of $20,000 is credited. The number of stores and the schedule of stores to be developed under multi-store development agreements are negotiated on an agreement by agreement basis. With respect to restaurants developed under the New Business Model, the Company receives continuing revenues from the franchisee as follows: (1) a royalty equal to 4.5% of the restaurant’s sales; (2) revenue from the sale of certain proprietary products, primarily pancake mixes; (3) a local advertising fee equal to about 2% of the restaurant’s sales, which is usually paid to a local advertising cooperative; and (4) a national advertising fee equal to 1% of the restaurant’s sales.

Beginning in 2005, we will charge a franchise renewal fee of approximately $50,000 per franchise agreement. This fee will be charged to existing franchisees who extend their franchise arrangement past the initial franchise period.

Area License Agreements

We have entered into long-term area licensing agreements covering the state of Florida and the southern-most counties of Georgia and the province of British Columbia, Canada. As of December 31, 2004, the area licensee for the state of Florida and certain counties in Georgia operated or sub-franchised a total of 136 IHOP restaurants and the area licensee for the province of British Columbia, Canada operated or sub-franchised a total of 12 IHOP restaurants. The area license agreements provide for royalties ranging from 0.5% to 2% of sales, and advertising fees of 0.25% of sales and give the area licensees the right to develop new IHOP restaurants in their territories. We also derive revenue from the sale of proprietary products to these area licensees and their sub-franchisees. We treat the revenues from our area licensees as franchise operations revenues for financial reporting purposes.

Company-Operated Restaurants

Company-operated restaurants are those restaurants newly developed by us that have not yet been franchised and those restaurants reacquired by us through negotiation or franchisee defaults. Although the type and number of Company-operated restaurants varies from time to time as we develop new restaurants, reacquire franchised restaurants and franchise reacquired restaurants, our strategic evaluation and repositioning has resulted in significantly fewer Company-operated restaurants.

At the end of 2004, the Company operated a total of 10 IHOP restaurants. In 2003, the Company announced its intention to develop and operate between 15 and 20 IHOP restaurants in Cincinnati, Ohio. While we anticipate the development of the 15-20 restaurants will be completed over the next five to seven years, only two were in operation at the end of 2004. The Company will operate these restaurants in order to highlight best practices in operations and training. Restaurants that we reacquire from franchisees typically require investment in remodeling and rehabilitation before being refranchised. As a consequence, a number of Company-operated restaurants are likely to incur operating losses during the period of their rehabilitation.

5




Refranchising Program

Restaurants that we reacquire are often underperforming as a result of having been poorly operated and physically neglected. When we reacquire a restaurant, we begin a multi-step rehabilitation program for that restaurant. First these restaurants are physically rehabilitated; then we hire, as necessary, and train the restaurant staff. After these first steps are completed, we implement new marketing and operations programs designed to regain the business of former guests and attract new patrons. After a restaurant has been rehabilitated, and its sales volume reaches acceptable levels, the restaurant is refranchised to a qualified franchisee.

Remodel Program

We require most of our franchisees, and strongly encourage all of our franchisees, to periodically remodel their restaurants. In most instances, we require that our restaurants be remodeled at least every five years. In 2004, we finalized our new icon remodel package. We believe that the new remodel design will play an important role in revitalizing the IHOP brand in the eyes of our guests, and create an environment they can enjoy throughout the day. Since the new remodel package was not completed until mid 2004, only 53 remodels were completed in 2004. However, we believe that our franchisees will complete 225 to 250 remodels in 2005.

Make-up of Franchise System

The table below sets forth information regarding the distribution of single-store and multi-store franchisees in the IHOP system. It does not include information concerning our area licensees or their sub-franchisees as of December 31, 2004.

Number of Restaurants
Held by Franchisee

 

Franchisees

 

Percent
of Total

 

Restaurants

 

Percent
of Total

 

One

 

 

213

 

 

 

55.8

%

 

 

213

 

 

20.7

%

Two to Five

 

 

133

 

 

 

34.8

%

 

 

372

 

 

36.2

%

Six to Ten

 

 

22

 

 

 

5.7

%

 

 

164

 

 

16.0

%

Eleven to Fifteen

 

 

6

 

 

 

1.6

%

 

 

78

 

 

7.6

%

Sixteen and over

 

 

8

 

 

 

2.1

%

 

 

201

 

 

19.5

%

Total

 

 

382

 

 

 

100.0

%

 

 

1,028

 

 

100.0

%

 

Restaurant Operations and Support

It is our goal to make every dining experience at an IHOP restaurant a satisfying one. Our franchisees and managers of Company-operated restaurants always strive to exceed guests’ expectations. We hold firm to the belief that a satisfied guest will be a repeat guest and will tell others about our restaurants. To ensure that our guests’ expectations are fulfilled, all restaurants are operated in accordance with uniform operating standards and specifications relating to the quality and preparation of menu items, selection of menu items, maintenance, repair and cleanliness of premises, and the appearance and conduct of employees.

Our Operations Department is charged with ensuring that these high standards are met at all times. We have developed our operating standards in consultation with our franchisee operators. These standards are detailed in our Manual of Standard Operating Procedures.

The Company has established a rating system whereby all IHOP franchisees are evaluated and graded. The evaluation consists of many factors including consultation, mystery shop and health department scores. The franchisee grades are on an “A” through “F” scale. Our Operations Department works closely with all of our operators in order to improve their scores and grades. However, in the cases of “D” and “F” operators, immediate improvement is expected or proactive efforts are undertaken to remove these operators from our system.

6




Each franchise restaurant is assigned a Franchise Business Consultant and an Operational Assessment Specialist. The Franchise Business Consultant regularly visits an assigned group of restaurants and is responsible for the achievement of budgeted sales, consultation with franchisees regarding financial, operational, marketing, and human resource objectives, including certification of trainers, and development of strategies and tactics for each franchise restaurant. The Operational Assessment Specialist visits each restaurant twice a year and is responsible for conducting operational audits, providing consultation reports, and assessing product quality, quality assurance, equipment, facilities, and management techniques.

Most of our franchise operations support is conducted from our Restaurant Support Center (“RSC”) in Glendale, CA. In 2004, the RSC began to utilize an automated call center to facilitate its support functions. This call center was established to improve our responsiveness to franchisee needs and guest inquiries. Our call center fields all guest and franchisee calls for quick resolution or routing to the appropriate individual for resolution. We also lease small executive suite space in various cities across the United States for limited regional office activities.

Training is ongoing at all IHOP restaurants. A prospective franchisee is required to participate in an extensive training program before he or she is first sold a franchise. The training program involves classroom study and hands-on operational training in one of our regional training restaurants. Each franchisee learns to cook, wait on tables, serve as a host, wash dishes and perform each of the other tasks necessary to operate a successful restaurant. New restaurant opening teams provide on-site instruction to restaurant employees to assist in the opening of most new IHOP restaurants.

The Company offers additional training courses from time to time on subjects such as suggestive selling, guest service, managing people, and limited time offer promotions.

The IHOP menu offers a large selection of high-quality, moderately priced products designed to appeal to a broad guest base. These include a wide variety of pancakes, waffles, omelets and breakfast specialties, chicken, steak, sandwiches, salads and lunch and dinner specialties. Most IHOP restaurants offer special items for children and seniors at reduced prices. In recognition of local tastes, IHOP restaurants typically offer regional specialties that complement the IHOP core menu. Our Product Research and Development Department works together with franchisees and our Operations and Marketing Departments to continually develop new menu and promotion ideas. These new items are thoroughly evaluated in our test kitchen and in limited regional tests, which include media support from time-to-time, before being introduced throughout the system. The purpose of adding new items is to be responsive to our guests’ needs and requests. In May 2005, IHOP’s promotional offerings will be supported by the system-wide roll out of a new core menu. The evolution of our menu will include new and exciting items for guests to enjoy throughout the day. All our efforts are based on consumer research, feedback and benchmarking, which help us identify opportunities for improvement to existing items as well as for developing new items.

Mystery Shop Program

Beginning in 2003, the Company engaged an independent firm to conduct unannounced and anonymous visits to each IHOP restaurant several times each quarter. These “mystery shoppers” provide the Company and our franchisees direct independent feedback at the restaurant on food quality, cleanliness, service and other aspects of the “guest” or “guests’” experience at IHOP restaurants. This on-going independent Mystery Shop Program is designed to give us a better understanding of how our restaurant teams operate and how we measure against our competitors. As a result, we are able to apply the individual feedback from each mystery shop visit at the restaurant level and work closely with our franchisees to develop a specific action plan to improve each restaurant’s performance. This program is incorporated into the Company’s rating system which evaluates and grades all IHOP franchisees. The

7




Company believes improved operations of each individual restaurant through this rating system will provide a basis for continued increases in same-store sales performance over time.

Marketing and Advertising

All IHOP franchisees and Company-operated restaurants contribute 2% of sales to local advertising cooperatives. The advertising co-ops use these funds to purchase television advertising time, radio advertising time and place advertisements in printed media or direct mail. In addition to television advertising, we encourage other local marketing by its franchisees. These marketing programs often include discounts and specials aimed at increasing guest traffic and encouraging repeat business.

In 2004, we devoted a substantial portion of our advertising budget to national television advertising, in recognition of the national scope of the chain and the economies of scale available to national advertisers. Continuing a successful launch of national advertising and our new advertising campaign in 2003, we implemented three promotions in 2004 supported with national advertising and three others supported with local media. The combined impact of the media, the creative campaign and the execution at the store level helped us achieve a system-wide same-store sales increase of 5.3% for the year, on top of the 4.8% increase in 2003.

In 2005, we plan to launch six promotions, four of which will be advertised on national television. We will continue to use our very successful “Come hungry. Leave happy.” campaign and will also continue our effective strategy of building on our breakfast strength while growing sales at lunch, dinner and other dayparts. With the appeal of limited time offerings unique to IHOP, the power of national advertising and the positive momentum in the field we expect to continue to drive increased same store sales throughout our system.

Purchasing

We have entered into supply contracts for pancake mixes and pricing agreements for most major products carried in IHOP restaurants to ensure the availability of quality products at competitive prices. We also have negotiated agreements with food distribution companies to limit markups charged on food and restaurant supplies purchased by individual IHOP restaurants. In some instances, the Company is required to enter into commitments to purchase food and other items on behalf of the IHOP system as a whole. At December 31, 2004, our outstanding purchase commitments were $0.5 million. The Company has developed processes to facilitate the liquidation of these commitments to minimize financial exposure. To take advantage of economies associated with system-wide volume purchasing, we developed an improved procurement process by collaborating with our franchisees. Through this process, we can secure pricing agreements based on system-wide ordering and ensure availability for most major products carried in IHOP restaurants. We expect this will generate savings in cost of goods sold for our franchisees in 2005.

Competition and Markets

The restaurant business is highly competitive and is affected by, among other things, changes in eating habits and preferences, local, regional and national economic conditions, population trends and traffic patterns. The principal bases of competition in the industry are the type, quality and price of the food products served. Additionally, restaurant location, quality and speed of service, advertising, name identification and attractiveness of facilities are important.

The acquisition of sites is also highly competitive. We and our franchisees often compete with other restaurant chains and retail businesses for suitable sites for the development of new restaurants.

Foodservice chains in the United States include the following segments: quick-service sandwich, chicken, pizza, fast casual, family restaurant, casual dining, dinner house, buffet, hotel restaurant and contract/catering. Differentiated chains competing within their segments against each other and local,

8




single-outlet operators characterize the current structure of the U.S. restaurant and institutional foodservice market.

Information published in 2004 by The Nations Restaurant News ranked IHOP 24th out of the top 100 foodservice chains based on estimated fiscal 2004 system-wide sales in the United States. The same publication included 10 family restaurant chains in its top 100 chains, and IHOP ranked second in this segment based on system-wide sales.

The Company also competes against other franchising organizations for new franchise developers.

Trademarks and Service Marks

We have registered our trademarks and service marks with the United States Patent and Trademark Office. These include “International House of Pancakes,” “IHOP” and variations of each, as well as “The Home of the Never Empty Coffee Pot,” “Rooty Tooty Fresh ‘N Fruity,” and “Harvest Grain ‘N Nut.” We also register new trademarks and service marks from time to time. We are not aware of any infringing uses that could materially affect our business or any prior claim to these marks that would prevent us from using or licensing the use thereof for restaurants in any area of the United States. We have also registered our trademarks and service marks and variations thereof in Canada for use by our current licensees. Where feasible and appropriate, we register our trademarks and service marks in other nations for future use. Our current registered trademarks and service marks will expire, unless renewed, at various dates from 2005 to 2012. We generally apply to renew our active trademarks prior to their expiration.

Seasonality

Our business, like that of most restaurant companies, is somewhat seasonal. Our restaurants generally experience greater guest traffic and sales in the summer months and during various holidays when children are out of school and family vacations are more frequent. Restaurants located in certain resort areas and warm weather climates tend to experience greater guest traffic and sales in the winter months.

Government Regulation

We are subject to various federal, state and local laws affecting our business as well as a variety of regulatory provisions relating to zoning of restaurant sites, sanitation, health and safety. As a franchisor, we are subject to state and federal laws regulating various aspects of franchise operations and sales. These laws impose registration and disclosure requirements on franchisors in the offer and sale of franchises. In certain cases, they also apply substantive standards to the relationship between franchisor and franchisee, including primarily defaults, termination, non-renewal of franchises, and the potential impact of new IHOP restaurants on sales levels at existing IHOP restaurants. Environmental requirements have not had a material effect on the operations of our Company-operated restaurants or the restaurants of our franchisees.

Various federal and state labor laws govern our relationships with our employees. These include such matters as minimum wage requirements, overtime and other working conditions. Significant additional government-imposed increases in minimum wages, paid leaves of absence, mandated health benefits or increased tax reporting and tax payment requirements with respect to employees who receive gratuities could, however, be detrimental to the economic viability of franchisee-operated and Company-operated IHOP restaurants.

Employees

At December 31, 2004, we employed 1,250 persons, of whom 282 were full-time, non-restaurant, corporate personnel.

9




Item 2. Properties.

The table below shows the location and status of the 1,186 IHOP restaurants as of December 31, 2004:

Location

 

 

 

Franchise

 

Company-
Operated

 

Area
License

 

Total

 

United States

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Alabama

 

 

14

 

 

 

2

 

 

 

0

 

 

16

 

Alaska

 

 

1

 

 

 

0

 

 

 

0

 

 

1

 

Arizona

 

 

31

 

 

 

0

 

 

 

0

 

 

31

 

Arkansas

 

 

9

 

 

 

0

 

 

 

0

 

 

9

 

California

 

 

212

 

 

 

1

 

 

 

0

 

 

213

 

Colorado

 

 

30

 

 

 

0

 

 

 

0

 

 

30

 

Connecticut

 

 

7

 

 

 

0

 

 

 

0

 

 

7

 

Delaware

 

 

2

 

 

 

0

 

 

 

0

 

 

2

 

Florida

 

 

0

 

 

 

0

 

 

 

135

 

 

135

 

Georgia

 

 

48

 

 

 

0

 

 

 

1

 

 

49

 

Hawaii

 

 

1

 

 

 

0

 

 

 

0

 

 

1

 

Idaho

 

 

8

 

 

 

0

 

 

 

0

 

 

8

 

Illinois

 

 

42

 

 

 

2

 

 

 

0

 

 

44

 

Indiana

 

 

11

 

 

 

0

 

 

 

0

 

 

11

 

Iowa

 

 

8

 

 

 

0

 

 

 

0

 

 

8

 

Kansas

 

 

11

 

 

 

0

 

 

 

0

 

 

11

 

Louisiana

 

 

16

 

 

 

0

 

 

 

0

 

 

16

 

Maine

 

 

1

 

 

 

0

 

 

 

0

 

 

1

 

Maryland

 

 

26

 

 

 

0

 

 

 

0

 

 

26

 

Massachusetts

 

 

12

 

 

 

0

 

 

 

0

 

 

12

 

Michigan

 

 

12

 

 

 

0

 

 

 

0

 

 

12

 

Minnesota

 

 

8

 

 

 

0

 

 

 

0

 

 

8

 

Mississippi

 

 

8

 

 

 

0

 

 

 

0

 

 

8

 

Missouri

 

 

23

 

 

 

0

 

 

 

0

 

 

23

 

Montana

 

 

1

 

 

 

0

 

 

 

0

 

 

1

 

Nebraska

 

 

5

 

 

 

0

 

 

 

0

 

 

5

 

Nevada

 

 

19

 

 

 

0

 

 

 

0

 

 

19

 

New Hampshire

 

 

2

 

 

 

0

 

 

 

0

 

 

2

 

New Jersey

 

 

33

 

 

 

1

 

 

 

0

 

 

34

 

New Mexico

 

 

10

 

 

 

0

 

 

 

0

 

 

10

 

New York

 

 

38

 

 

 

0

 

 

 

0

 

 

38

 

North Carolina

 

 

30

 

 

 

0

 

 

 

0

 

 

30

 

North Dakota

 

 

1

 

 

 

0

 

 

 

0

 

 

1

 

Ohio

 

 

17

 

 

 

2

 

 

 

0

 

 

19

 

Oklahoma

 

 

17

 

 

 

0

 

 

 

0

 

 

17

 

Oregon

 

 

8

 

 

 

1

 

 

 

0

 

 

9

 

Pennsylvania

 

 

15

 

 

 

0

 

 

 

0

 

 

15

 

Rhode Island

 

 

1

 

 

 

0

 

 

 

0

 

 

1

 

South Carolina

 

 

19

 

 

 

0

 

 

 

0

 

 

19

 

South Dakota

 

 

1

 

 

 

0

 

 

 

0

 

 

1

 

Tennessee

 

 

25

 

 

 

0

 

 

 

0

 

 

25

 

Texas

 

 

149

 

 

 

0

 

 

 

0

 

 

149

 

Utah

 

 

17

 

 

 

0

 

 

 

0

 

 

17

 

Virginia

 

 

41

 

 

 

0

 

 

 

0

 

 

41

 

Washington

 

 

24

 

 

 

1

 

 

 

0

 

 

25

 

West Virginia

 

 

2

 

 

 

0

 

 

 

0

 

 

2

 

Wisconsin

 

 

11

 

 

 

0

 

 

 

0

 

 

11

 

Wyoming

 

 

1

 

 

 

0

 

 

 

0

 

 

1

 

International

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Canada

 

 

0

 

 

 

0

 

 

 

12

 

 

12

 

Totals

 

 

1,028

 

 

 

10

 

 

 

148

 

 

1,186

 

 

10




As of December 31, 2004, two of the ten Company-operated restaurants were located on sites owned by us and eight were located on sites leased by us from third parties. Of the 1,028 franchisee-operated restaurants, 60 were located on sites owned by us, 779 were located on sites leased by us from third parties and 189 were located on sites owned or leased by franchisees. All of the restaurants operated by area licensees were located on sites owned or leased by the area licensees.

Our leases with our landlords generally provide for an initial term of 20 to 25 years, with most having one or more five-year renewal options in our favor. The leases typically provide for payment of rents in an amount equal to the greater of a fixed amount or a specified percentage of gross sales and for payment by us of taxes, insurance premiums, maintenance expenses and certain other costs. Historically, it has been our practice to seek and extend, through negotiation, those leases that expire without renewal options. However, from time to time we choose not to renew a lease or are unsuccessful in negotiating satisfactory renewal terms. When this occurs, the restaurant is closed and possession of the premises is returned to the landlord.

We currently lease our principal corporate offices in Glendale, California under a lease expiring in July 2010. We also lease small executive suite space in various cities across the United States for limited regional office activities.

Item 3. Legal Proceedings.

We are party to certain litigation arising in the ordinary course of business which, in the opinion of management, should not have a material adverse effect upon either the Company’s consolidated financial position or results of operations.

In February 2004, Darden Corporation and GMRI, Inc., the owners and operators of the chain of Olive Garden restaurants, filed a civil action for trademark infringement and unfair competition against IHOP Corp. and its subsidiary International House of Pancakes, Inc. in U.S. District Court, Middle District of Florida, Orlando Division. The plaintiffs claim rights to the advertising phrase “Never Ending Pasta Bowl,” and assert that IHOP’s use of “Never Ending Pancakes” and “Never Ending Popcorn Shrimp” violates their rights. In February 2005, the parties agreed in principle to settle the litigation. As of the date of the filing of this Report on Form 10-K, the parties have agreed upon a form of Settlement Agreement and expect it to be signed shortly.

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

There were no matters submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report.

11




PART II

Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchase of Equity Securities.

Our common stock is traded on the New York Stock Exchange (“NYSE”) under the symbol “IHP”. As of January 31, 2005, there were approximately 6,538 stockholders of record.

The following table sets forth the high and low prices of our common stock for each quarter of 2004 and 2003 as reported by the NYSE.

 

 

Fiscal Year 2004

 

Fiscal Year 2003

 

 

 

Prices

 

Dividends

 

Prices

 

Dividends

 

Quarter

 

 

 

High

 

Low

 

Paid

 

High

 

Low

 

Paid

 

First

 

$

39.30

 

$

32.78

 

 

$

0.25

 

 

$

25.14

 

$

20.98

 

 

$

 

 

Second

 

38.43

 

33.53

 

 

0.25

 

 

32.64

 

22.42

 

 

0.25

 

 

Third

 

38.49

 

34.51

 

 

0.25

 

 

36.65

 

31.31

 

 

0.25

 

 

Fourth

 

43.40

 

37.20

 

 

0.25

 

 

39.40

 

32.80

 

 

0.25

 

 

 

In March 2003, the board of directors declared a cash dividend of $0.25 per common share, which was paid on May 19, 2003, to stockholders of record as of May 1, 2003. At that time, the board of directors indicated its intention to declare and pay recurring quarterly dividends in the future, subject to the discretion of the board of directors and the Company’s earnings, financial condition, cash requirements, future prospects and other factors. The Company has paid regular quarterly dividends of $0.25 per common share since May 2003.

On January 18, 2005, the Company declared a quarterly cash dividend of $0.25 per common share payable February 22, 2005, to stockholders of record as of February 1, 2005.

The following table provides information relating to the Company’s repurchases of stock during the fourth quarter of 2004:

Period

 

 

 

Total
Number
of Shares
Purchased

 

Average
Price Paid
per Share

 

Total
Number
of Shares
Purchased as
Part of Publicly
Announced Plans
or Programs(1)

 

Maximum
Number of Shares
that May Yet Be
Purchased Under
the Plans or
Programs(2)

 

October 1, 2004—October 31, 2004

 

85,000

 

 

$

38.75

 

 

 

85,000

 

 

 

351,210

 

 

November 1, 2004—November 30, 2004

 

74,900

 

 

$

38.98

 

 

 

74,900

 

 

 

276,310

 

 

December 1, 2004—December 31, 2004

 

 

 

$

––

 

 

 

 

 

 

1,276,310

 

 

Total

 

159,900

 

 

$

38.86

 

 

 

159,900

 

 

 

1,276,310

 

 


(1)          Total number of shares repurchased through December 31, 2004 under the stock repurchase plan announced in January 2003 is 2,323,690. This includes 570,690 shares repurchased in 2003.

(2)          The above mentioned stock repurchase plan provided for the repurchase of up to 3.6 million shares, which includes a 1.0 million share increase authorized by our Board of Directors on December 13, 2004.

12




Item 6. Selected Financial Data.

Five-Year Financial Summary

 

 

Year Ended December 31,

 

 

 

2004

 

2003

 

2002

 

2001

 

2000

 

 

 

(In thousands, except per share amounts)

 

Revenues

 

 

 

 

 

 

 

 

 

 

 

Franchise revenues

 

$

157,584

 

$

140,131

 

$

123,050

 

$

111,129

 

$

102,624

 

Rental income

 

131,763

 

117,258

 

99,595

 

84,037

 

69,914

 

Company restaurant sales

 

31,564

 

74,880

 

74,433

 

68,810

 

72,818

 

Financing revenues

 

38,091

 

72,536

 

68,796

 

60,460

 

57,888

 

Total revenues

 

359,002

 

404,805

 

365,874

 

324,436

 

303,244

 

Costs and expenses

 

 

 

 

 

 

 

 

 

 

 

Franchise expenses

 

75,599

 

64,265

 

55,139

 

48,269

 

44,699

 

Rental expenses

 

95,392

 

86,620

 

73,812

 

59,882

 

48,026

 

Company restaurant expenses

 

34,701

 

81,737

 

78,422

 

72,819

 

76,961

 

Financing expenses

 

22,434

 

43,619

 

38,185

 

33,442

 

33,998

 

General and administrative expenses

 

59,890

 

54,575

 

49,526

 

41,964

 

37,991

 

Other expense, net

 

2,707

 

3,867

 

4,983

 

3,599

 

4,109

 

Impairment and closure charges

 

14,112

 

2,187

 

450

 

 

 

Reorganization charges

 

 

9,085

 

 

 

 

Total costs and expenses

 

304,835

 

345,955

 

300,517

 

259,975

 

245,784

 

Income before income taxes

 

54,167

 

58,850

 

65,357

 

64,461

 

57,460

 

Provision for income taxes

 

20,746

 

22,068

 

24,509

 

24,173

 

22,122

 

Net income

 

$

33,421

 

$

36,782

 

$

40,848

 

$

40,288

 

$

35,338

 

Net income per share

 

 

 

 

 

 

 

 

 

 

 

Basic

 

$

1.62

 

$

1.72

 

$

1.95

 

$

1.98

 

$

1.77

 

Diluted

 

$

1.61

 

$

1.70

 

$

1.92

 

$

1.94

 

$

1.74

 

Weighted average shares outstanding

 

 

 

 

 

 

 

 

 

 

 

Basic

 

20,606

 

21,424

 

20,946

 

20,398

 

20,017

 

Diluted

 

20,791

 

21,614

 

21,269

 

20,762

 

20,263

 

Dividends declared per share(a)

 

$

1.00

 

$

.75

 

$

 

$

 

$

 

Dividends paid per share(a)

 

$

1.00

 

$

.75

 

$

 

$

 

$

 

Balance Sheet Data (end of year)

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

44,031

 

$

27,996

 

$

98,739

 

$

6,252

 

$

7,208

 

Marketable securities

 

14,504

 

45,537

 

 

 

 

Property and equipment, net

 

326,848

 

314,221

 

286,226

 

238,026

 

193,624

 

Total assets

 

821,677

 

843,004

 

819,800

 

641,429

 

562,212

 

Long-term debt

 

133,768

 

139,615

 

145,768

 

50,209

 

36,363

 

Capital lease obligations

 

173,925

 

177,664

 

171,170

 

168,105

 

167,594

 

Stockholders’ equity(a)

 

339,764

 

382,360

 

364,389

 

312,430

 

259,995

 


(a)           In March 2003, the board of directors declared its first quarterly cash dividend of $0.25 per common share which was paid in the second quarter of 2003. The Company has paid regular quarterly dividends of $0.25 per common share since May 2003. The board of directors indicated its intention to declare recurring quarterly dividends in the future, however, any future dividend declarations will be made at the discretion of the board of directors and will be based on the Company’s earnings, financial condition, cash requirements, future prospects and other factors.

13




Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Forward-Looking Statements

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 notes thereto. Certain forward-looking statements are contained in this report. They use such words as “may,” “will,” “expect,” “believe,” “plan,” or other similar terminology. These statements involve known and unknown risks, uncertainties and other factors that may cause the actual results to be materially different than those expressed or implied in such statements. These factors include, but are not limited to: risks associated with the implementation of the Company’s strategic growth plan; the availability of suitable locations and terms for the sites designated for development; the ability of franchise developers to fulfill their commitments to build new IHOP restaurants in the numbers and time frames covered by their development agreements; the ability of the Company to franchise its remaining Company-operated restaurants; legislation and government regulation, including the ability to obtain satisfactory regulatory approvals; conditions beyond our control such as weather, natural disasters or acts of war or terrorism; availability and cost of materials and labor; cost and availability of capital; competition; continuing acceptance of the International House of Pancakes brand and concept by guests and franchisees; our overall marketing, operational and financial performance; economic and political conditions; adoption of new, or changes in, accounting policies and practices and other factors discussed from time to time in our press releases, public statements and/or filings with the Securities and Exchange Commission. Forward-looking information is provided by us pursuant to the safe harbor established under the Private Securities Litigation Reform Act of 1995 and should be evaluated in the context of these factors. We disclaim any intent or obligation to update these forward-looking statements.

General

In January 2003, we announced significant changes in the way we conduct our business. These changes included a transition from Company-financed restaurant development (the “Old Business Model”) to a more traditional franchise development model, in which franchisees finance and develop new restaurants (the “New Business Model”). It was the Company’s intention to complete the transition from Company development to franchisee development by the end of 2003. Due to construction delays, we completed the development and franchising of the final four restaurants under the Old Business Model in 2004. In addition, the Company developed two restaurants in our Company operations market in Cincinnati, Ohio.

On February 7, 2005, the Office of the Chief Accountant of the Securities and Exchange Commission (“SEC”) issued a letter to the American Institute of Certified Public Accountants expressing its views regarding certain operating lease-related accounting issues and their application under generally accepted accounting principles in the United States of America (“GAAP”). In light of this letter, the Company’s management initiated a review of its lease accounting and determined that its then-current method of accounting for leasehold improvements funded by landlord incentives or allowances under operating leases (tenant improvement allowances) was not in accordance with GAAP, including the accounting requirements under Emerging Issues Task Force No. 97-10, “The Effect of Lessee Involvement in Asset Construction” and related pronouncements. To correct the error in its method of accounting for leasehold improvements, the Company increased its property and equipment by approximately $20.5 million, and increased its other long-term liabilities by $20.5 million in its consolidated balance sheet at December 31, 2004. The increase in other liabilities was due to an increase in deemed financing obligations to our landlords. Since we determined the differences in prior years financial statements and the first three quarterly periods of 2004 were not material, we will not amend our previously filed Annual Reports on Form 10-K or Quarterly Reports on Form 10-Q.

14




Franchising

Our franchising activities for the years ended December 31, 2004 and 2003 included both Company financed and franchisee financed development. For clarity of presentation, the discussion below is separated between those activities specific to the Old Business Model and those which apply to the New Business Model.

Old Business Model

Under the Old Business Model, when we developed a restaurant we identified the site for the new restaurant, purchased the site or leased it from a third party, and built the restaurant and equipped it with all required equipment. We selected and trained the franchisee and supervisory personnel who would operate the restaurant. In addition, we typically financed approximately 80% of the franchise fee, and leased the restaurant and equipment to the franchisee. In accordance with GAAP, the equipment lease between the Company and the franchisee was treated as a sale in our financial statements.

Our involvement in the development of new restaurants allowed us to charge a core franchise fee and development and financing fees totaling $50,000 to $500,000. The franchisee typically paid approximately 20% of the initial franchise fee in cash, and we financed the remaining amount over five to eight years. The financing of the initial franchise fee allowed the Company to derive interest income from the financing of the core franchise fee and development and financing fees, and the leasing of property and equipment to franchisees. We also continue to receive revenues from the franchisee as follows: (1) a royalty equal to 4.5% of the restaurant’s sales; (2) income from the leasing of the restaurant property and related equipment; (3) revenue from the sale of certain proprietary products, primarily pancake mixes; (4) a local advertising fee equal to about 2% of the restaurant’s sales, which is usually collected by us and then paid to a local advertising cooperative; and (5) a national advertising fee equal to 1% of the restaurant’s sales. In some cases, we have agreed to accept reduced royalties for a period of time from franchisees in order to assist them in establishing their businesses, where business conditions justify it.

New Business Model

Under the New Business Model, our approach to franchising is similar to that of most franchising systems in the foodservice industry. Franchisees can undertake individual store development or multi-store development. Under the single store development program, the franchisee is required to pay a non-refundable location fee of $15,000. If the proposed site is approved for development, the location fee of $15,000 is credited against an initial franchise fee of $50,000. The franchisee then uses his or her own capital and financial resources to acquire the site, build and equip the business and fund working capital needs.

In addition to offering franchises for individual restaurants, the Company offers multi-store development agreements for certain qualified franchisees. These multi-store development agreements provide franchisees with an exclusive right to develop new IHOP restaurants in designated geographic territories for a specified period of time. Multi-store developers are required to develop and operate a specified number of restaurants according to an agreed upon development schedule. Multi-store developers are required to pay a development fee of $20,000 for each restaurant to be developed under a multi-store development agreement. Additionally, for each store which is actually developed, the franchise developer must pay an initial franchise fee of $40,000 against which the development fee of $20,000 is credited. The number of stores and the schedule of stores to be developed under multi-store development agreements is negotiated on an agreement by agreement basis. With respect to restaurants developed under the New Business Model, the Company receives continuing revenues from the franchisee as follows: (1) a royalty equal to 4.5% of the restaurant’s sales; (2) revenue from the sale of certain proprietary products, primarily pancake mixes; (3) a local advertising fee equal to about 2% of the restaurant’s sales,

15




which is usually paid to a local advertising cooperative; and (4) a national advertising fee equal to 1% of the restaurant’s sales.

While there is no specific profile for franchise candidates, the Company primarily markets franchises to existing operators who currently own and operate one or more restaurants in the IHOP system, and to operators in other non-competing segments of the restaurant business which meet our operating standards.

Segment Reporting

Our revenues and expenses are recorded in four categories: Franchise Operations, Rental Operations, Company Restaurant Operations and Financing Operations.

Franchise operations revenue consists primarily of royalty revenues, sales of proprietary products, advertising fees and the portion of the franchise fees allocated to the Company’s intellectual property. Franchise operations expenses include advertising expense, the cost of proprietary products and other franchise related 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 for franchisee-operated 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 and benefits, utilities, rent and other real estate related costs.

Financing operations revenue consists of the portion of franchise fees not allocated to the Company’s intellectual property, sales of equipment as well as interest income from the financing of franchise fee and equipment leases. Financing operations expenses are primarily the cost of restaurant equipment and interest expense not associated with capital leases.

Same-Store Sales

Beginning in the second quarter of 2003, we changed our methodology for calculating same-store sales from a 12-month basis to an 18-month basis. Under the new methodology, we compare year over year retail sales of restaurants which have been open continuously for 18 months or more. Prior year information has been restated for ease of comparison. The Company believes this provides a more accurate view of its system’s performance by excluding the impact of high sales levels typically seen during the first months of operations at new restaurants. All same-store sales information in this Annual Report on Form 10-K is presented using the 18-month methodology.

16




Restaurant Data

The following table sets forth, for each of the past three years the number of effective restaurants in the IHOP system, and information regarding the percentage change in sales at those restaurants compared to the same period 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 system, which includes IHOP restaurants owned by the Company, as well as those owned by franchisees and area licensees. Sales of 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 that are generally based on a percentage of their sales, as well as rental payments under leases that generally include a component that is 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.

 

 

Year Ended December 31,

 

 

 

2004

 

2003

 

2002

 

Restaurant Data

 

 

 

 

 

 

 

Effective restaurants(a)

 

 

 

 

 

 

 

Franchise(b)

 

993

 

919

 

832

 

Company

 

29

 

72

 

76

 

Area license(b)

 

145

 

140

 

134

 

Total

 

1,167

 

1,131

 

1,042

 

System-wide(c)

 

 

 

 

 

 

 

Sales percentage change(d)

 

11.4

%

14.6

%

9.9

%

Same-store sales percentage change(e)

 

5.3

%

4.8

%

0.9

%

Franchise(b)

 

 

 

 

 

 

 

Sales percentage change(d)

 

14.4

%

15.8

%

11.6

%

Same-store sales percentage change(e)

 

5.2

%

4.7

%

0.9

%

Company

 

 

 

 

 

 

 

Sales percentage change(d)

 

(57.8

)%

0.6

%

8.2

%

Same-store sales percentage change(e)

 

5.1

%

6.5

%

0.7

%

Area License(b)

 

 

 

 

 

 

 

Sales percentage change(d)

 

16.4

%

11.6

%

(3.2

)%


(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 system, which includes IHOP restaurants owned by the Company as well as those owned by franchisees and area licensees.

(b)    We historically reported restaurants in Canada as franchise restaurants although the restaurants were operated under an area license agreement. Beginning with 2004, Canadian restaurants are reported as “Area License.”  Prior period information has been restated to conform to the current period presentation.

(c)    System-wide sales are retail sales of IHOP restaurants operated by franchisees, area licensees and the Company, as reported to the Company. Sales of restaurants that are owned by franchisees and area licensees are not attributable to the Company.

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

(e)    “Same-store sales percentage change” reflects the percentage change in sales, in any given fiscal year compared to the prior fiscal year, 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 will be different from period to period. Same-store sales percentage change does not include data on restaurants located in Florida.

17




The following table summarizes our restaurant development and franchising activity:

 

 

Year Ended December 31,

 

 

 

2004

 

2003

 

2002

 

2001

 

2000

 

Restaurant Development Activity

 

 

 

 

 

 

 

 

 

 

 

Beginning of year

 

1,165

 

1,103

 

1,017

 

968

 

903

 

New openings

 

 

 

 

 

 

 

 

 

 

 

Company-developed

 

6

 

56

 

85

 

76

 

70

 

Franchisee-developed(a)

 

35

 

13

 

10

 

12

 

10

 

Area license(a)

 

6

 

5

 

6

 

5

 

4

 

Total new openings

 

47

 

74

 

101

 

93

 

84

 

Closings

 

 

 

 

 

 

 

 

 

 

 

Company and franchise

 

(26

)

(12

)

(13

)

(11

)

(16

)

Area license

 

 

 

(2

)

(33

)

(3

)

End of year

 

1,186

 

1,165

 

1,103

 

1,017

 

968

 

Summary—end of year

 

 

 

 

 

 

 

 

 

 

 

Franchise(a)

 

1,028

 

979

 

890

 

812

 

736

 

Company

 

10

 

44

 

76

 

72

 

71

 

Area license(a)

 

148

 

142

 

137

 

133

 

161

 

Total

 

1,186

 

1,165

 

1,103

 

1,017

 

968

 

Restaurant Franchising Activity

 

 

 

 

 

 

 

 

 

 

 

Company-developed

 

8

 

72

 

79

 

74

 

70

 

Franchisee-developed(a)

 

35

 

13

 

10

 

12

 

10

 

Rehabilitated and refranchised

 

33

 

19

 

10

 

9

 

15

 

Total restaurants franchised

 

76

 

104

 

99

 

95

 

95

 

Reacquired by the Company

 

(12

)

(11

)

(10

)

(12

)

(19

)

Closed

 

(15

)

(4

)

(11

)

(7

)

(7

)

Net addition

 

49

 

89

 

78

 

76

 

69

 


(a)           We historically reported restaurants in Canada as franchise restaurants although the restaurants were operated under an area license agreement. Beginning with 2004, Canadian restaurants are reported as “Area License.”  Prior period information has been restated to conform to the current period presentation.

Critical Accounting Policies

We prepare our Consolidated Financial Statements in conformity with GAAP. The preparation of these financial statements requires senior management to make estimates, assumptions and subjective or complex judgments that are inherently uncertain and may significantly impact the reported amounts of assets, liabilities, revenue and expenses during the reporting period. Changes in the estimates, assumptions and judgments affecting the application of these policies may result in materially different amounts being reported under different conditions or using different assumptions. We consider the following policies to be most critical in understanding the judgments that are involved in preparing our Consolidated Financial Statements.

Accounting for Long-Lived Assets

We regularly evaluate our long-lived assets for impairment at the individual restaurant level. Restaurant assets are evaluated for impairment on a quarterly basis or whenever events or circumstances indicate that the carrying value of a restaurant may not be recoverable. We consider factors such as the number of years the restaurant has been operated by the Company, sales trends, cash flow trends,

18




remaining lease life, and other factors which apply on a case by case basis. These impairment evaluations require an estimation of cash flows over the remaining useful life of the asset.

Recoverability of the restaurant’s assets is measured by comparing the assets’ carrying value to the undiscounted future cash flows expected to be generated over the assets’ remaining useful life or remaining lease term, whichever is less. If the total expected undiscounted future cash flows are less than the carrying amount of the assets, the carrying amount is written down to the estimated fair value, and a loss resulting from impairment is recognized by a charge to earnings. The fair value is determined by discounting the estimated future cash flows based on our cost of capital.

The Company may elect to close certain Company-operated restaurants. Typically such decisions are based on operating performance or strategic considerations. In these instances, we reserve, or write-off, the full carrying value of these restaurants as impaired.

Periodically, the Company will reacquire a previously franchised restaurant. At the time of reacquisition, the franchise will be recorded at the lower of (1) the sum of the franchise receivables and costs of reacquisition, or (2) the estimated net realizable value. The net realizable value of a reacquired franchise is based on the Company’s average historical franchise resale value during the prior five years. The historical resale value used in 2004 and 2003 was $220,000. An impairment loss will be recognized equal to the amount by which the reacquisition value exceeds the historical resale value. The remaining resale value is amortized ratably over the remaining life of the lease. The amortization expense is reflected in the Company Operations Segment in the Consolidated Statements of Income.

The following table illustrates the after tax decrease in net income for the year ended December 31, 2004 as a result of using lower estimated franchise resale values. The impairment evaluation for the year ended December 31, 2004 was based on a $220,000 franchise resale value.

After Tax Decrease in Net Income Resulting from Change in Assumptions

 

 

Decrease in

 

Franchise Resale Value

 

 

 

Net Income

 

$220,000

 

$

 

$150,000

 

85,435

 

$50,000

 

208,835

 

 

Judgments and estimates made by the Company related to long-lived assets are affected by factors such as economic conditions, changes in franchise historical resale values, and changes in operating performance. As the Company assesses the ongoing expected cash flows and carrying value of its long-lived assets, these factors could cause the Company to realize impairment charges which would be reflected in the Consolidated Statements of Income.

Self-Insurance Liability

We are self-insured for a significant portion of our employee workers’ compensation obligations. The Company maintains stop-loss coverage with third party insurers to limit its total exposure. The accrued liability associated with these programs is based on our estimate of the ultimate costs to be incurred to settle known claims and claims incurred but not reported as of the balance sheet date. Our estimated liability is not discounted and is based on a number of assumptions and factors, including historical trends, actuarial assumptions and economic conditions. If actual trends, including the severity or frequency of claims, differ from our estimates, our financial results could be impacted.

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Workers’ Compensation

The Company uses actuarial estimates as a basis for determining reserves for workers’ compensation losses. Actuarial studies are used to derive maximum remaining losses and most likely projected remaining losses for each plan year for which claims remain open. Due to the uncertainty of remaining losses, the Company uses a midpoint between most likely projected remaining losses and maximum projected remaining losses. As of December 31, 2004, the maximum projected remaining losses for all open years was estimated to be $1.8 million. The most likely projected remaining losses for all open years was estimated to be $0.8 million. The Company believes the estimate of workers’ compensation losses of $1.3 million as of December 31, 2004 is appropriate based on the methodology discussed above. However, if actual losses differ from those estimated, the resulting change may produce materially different amounts in Company restaurant expenses and/or general and administrative expenses in the Consolidated Statements of Income.

Income Taxes

We provide for income taxes based on our estimate of federal and state tax liabilities.  Our estimates include, but are not limited to, effective state and local income tax rates, allowable tax credits for items such as FICA taxes paid on reported tip income and estimates related to depreciation expense allowable for tax purposes.  We usually file our income tax returns several months after our fiscal year-end.  All tax returns are subject to audit by federal and state governments, usually years after the returns are filed, and could be subject to differing interpretation of the tax laws.

Deferred tax accounting requires that we evaluate net deferred tax assets to determine if these assets will more likely than not be realized in the foreseeable future.  This test requires projection of our taxable income into future years to determine if there will be taxable income sufficient to realize the tax assets.  The preparation of the projections requires considerable judgment and is subject to change to reflect future events and changes in the tax laws.

Tax contingency reserves result from our estimates of potential liabilities resulting from differences between actual and audited results. Changes in the tax contingency reserve result from resolution of audits of prior year filings, the expiration of the statute of limitations, changes in tax laws and current year estimates for asserted and unasserted items. Inherent uncertainties exist in estimates of tax contingencies due to changes in tax law, both legislated and concluded through the various jurisdictions’ tax court systems. Significant changes in our estimates could adversely affect our reported results.

Leases

We lease most of our restaurant locations.  We account for our leases under the provisions of FASB Statement No. 13, Accounting for Leases (SFAS 13) and subsequent amendments, which require that our leases be evaluated and classified as operating or capital leases for financial reporting purposes.  We recognize rent expense for our operating leases, which have escalating rentals over the term of the lease, on a straight-line basis over the initial term.  In addition, the lease term is deemed to commence when we take physical possession of the leased property. We capitalize the straight-line rent amounts during the construction period of leased properties.  Straight-line rent subsequent to the construction period and prior to the restaurant opening is recognized as expense.  We use a consistent lease term when calculating depreciation of leasehold improvements, when determining straight-line rent expense and when determining classification of our leases as either operating or capital.  Contingent rents are generally amounts due as a result of sales in excess of amounts stipulated in certain restaurant leases and are included in rent expense as they accrue.

Certain of our lease agreements contain tenant improvement allowances.  For purposes of recognizing incentives, we amortize the incentives over the estimated useful lives.  For tenant improvement allowances,

20




we also record a deferred rent liability or an obligation in our non-current liabilities on the consolidated balance sheets.

New Accounting Pronouncements

In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46R; “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51” (FIN 46). FIN 46 establishes a new and far-reaching consolidation accounting model. Although FIN 46 was focused on special purpose entities, the applicability of FIN 46 goes beyond such entities and can have applicability to franchise arrangements, regardless of whether the Company has voting or ownership control of the franchises. In response to a number of comment letters and implementation questions, in December 2003 the FASB issued FIN 46R, which delayed the effective date of FIN 46 for certain entities until March 31, 2004, and provided clarification regarding franchise considerations and other implementation issues.

We have performed assessments on all of our franchise arrangements to determine whether such entities meet the definition of a Variable Interest Entity (VIE) pursuant to the provisions FIN 46R. Based on our evaluation of each arrangement, we have concluded that none of our franchise arrangements is a VIE, as set forth in FIN 46R. Accordingly, none of our franchise arrangements requires consolidation in our financial statements.

On December 16, 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123 (revised 2004), Share-Based Payment, which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation. Statement 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends FASB Statement No. 95, Statement of Cash Flows. Generally, the approach in Statement 123(R) is similar to the approach described in Statement 123. However, Statement 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. Statement 123(R) must be adopted no later than July 1, 2005. We expect to adopt Statement 123(R) beginning in the third quarter of 2005. As permitted by Statement 123, the Company currently accounts for share-based payments to employees using Opinion 25’s intrinsic value method and, as such, generally recognizes no compensation cost for employee stock options. Accordingly, the effect of adoption of Statement 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had we adopted Statement 123(R) in prior periods, the impact of that standard would have approximated the impact of Statement 123 as described in the disclosure of pro forma net income and earnings per share in Note 1 to our Consolidated Financial Statements. Statement 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. The amount of operating cash flows recognized in prior periods for such excess tax deductions were $1.7 million, $3.1 million, and $2.0 million in 2004, 2003 and 2002, respectively. While the Company cannot determine what the exact amounts will be in the future because they depend on, among other things, when employees exercise stock options, the Company estimates the potential impact in 2005 would be $1.0 million to $1.5 million net of tax, assuming the date of implementation is the third quarter of 2005.

Comparison of the fiscal years ended December 31, 2004 and 2003

Strategic Direction and 2004 Financial Performance

In 2004, the Company executed strategies focused on two key financial levers of our business—development of restaurants and growth of same-store sales. They included: improving the operational performance of our restaurants, energizing the IHOP brand and driving the transition to franchise development.

21




In improving the operational performance of our restaurants, the Company established a rating scale for each of its franchisees, whereby all franchisees are evaluated and rated on a quantifiable “A” through “F” scale.  We are working to bring up the ratings of the IHOP system through the involvement of our field organization, and if necessary, through the targeted removal of poor performing franchisees (franchisees rated “D” or “F”). To accomplish this goal of improved restaurant performance, the Company is committed to building a "world class" training capability and improving the responsiveness and capability of our corporate support functions. In 2005, we will support operational excellence with a focus on improving our “C” operators.  We will influence our “C” operators to improve their restaurant operations by providing new and better tools for improved execution at franchised restaurants. In addition, we will continue to build new restaurants in our dedicated Company market in Cincinnati, Ohio so that we can share good ideas we learn with our franchisees.

To enhance the IHOP brand in 2004, we continued our advertising campaign created in 2003 called “Come hungry. Leave happy.” which we believe resonates positively with our customers. In addition, we believe we can improve the effectiveness of our advertising spending and drive same-store sales by continuing to shift advertising expenditures from local market spending to coordinated national spending. In 2004, we devoted a substantial portion of our advertising budget to expand our national advertising. We also continued with the regular product promotion schedule with six such promotions in 2004. Three of these promotions were supported with national advertising. We believe regular new product news will give customers new reasons to visit IHOP, which should improve same-store sales performance. Finally, we continued to strengthen our core menu—both the design of the menu and the appeal of items on the menu. We believe a more attractive “look and feel” of the menu coupled with better items on the menu will result in more visits to IHOP restaurants by customers. Our brand energizing efforts will also be supported by the implementation of our new remodel package during 2005. In 2005, we expect approximately 225 to 250 restaurants to be remodeled. The implementation of our new remodel package will play an important role in revitalizing the IHOP brand in the eyes of our guests, and create an environment they can enjoy throughout the day.

Finally, in driving the transition to franchise development, our goal is to maximize the number of restaurants that will be developed by our franchisees under our new development paradigm. To accomplish this, we plan to provide all the operational, marketing and financial analysis tools that prospective franchise developers need to maximize their development opportunity. We also plan to reach out to potential franchise developers both within and outside the IHOP system to help us achieve our unit development goals as quickly as possible.

Overview

Our 2004 financial results were negatively impacted by the reduction in the number of restaurants franchised under our Old Business Model, and by $14.1 million in impairment and closure charges. These impairment and closure charges were associated with our strategic repositioning of our Company-operated restaurants. These factors were partially offset by an increase in franchise operations profit resulting from increases in same-store sales and effective restaurants. In addition, our fiscal 2004 results were favorably impacted by the benefit of a 53rd week. Once every six years we utilize a 53-week fiscal calendar in order to align our fiscal year end to the calendar year. As a result of the 53rd week, we recorded an additional week of retail sales in fiscal 2004. A comparison of our financial results for 2004 to those in 2003 included:

·       Net income of $33.4 million, which decreased by 9.1% or $3.4 million from 2003;

·       Net income per diluted share of $1.61, which decreased by 5.3% or $.09;

·       An increase in same-store sales of 5.3%;

·       Cash flows provided by operating activities in 2004 of $67.0 million, compared to $71.3 million in 2003;

22




·       Additions to property and equipment in 2004 of $16.6 million, compared to $80.5 million in 2003;

·       An increase in pretax revenue of approximately $4.0 million as a result of a 53rd week in fiscal 2004; and

·       A gain of $2.3 million recognized on the sale of three real estate properties in 2004.

Franchise Operations

Franchise revenues consist primarily of royalty revenues, sales of proprietary products, advertising fees and the portion of the franchise fees allocated to the Company’s intellectual property. Franchise expenses include advertising expense, the cost of proprietary products and other franchise related expenses. Key factors which can be used in evaluating and understanding our franchise operations segment include:

·       Franchise retail sales; and

·       Number of restaurants franchised.

Franchise operations profit, which is franchise revenues less franchise expenses, increased by $6.1 million or 8.1% in 2004 compared to 2003. The 8.1% increase in franchise operations profit was due to the changes in franchise revenues and expenses discussed below. In addition, our franchise operations segment was impacted by the 53rd week in fiscal 2004 which added approximately $1.5 million in pretax profit.

Franchise restaurant retail sales are sales recorded at restaurants that are owned by franchisees and area licensees and are not attributable to the Company. Franchise restaurant retail sales are useful in analyzing our franchise revenues because franchisees and area licensees pay us royalties and other fees that are generally based on a percentage of their sales.

Franchise revenues grew by $17.5 million or 12.5% in 2004 compared to 2003. Franchise revenues grew primarily due to a 14.4% increase in franchise restaurant retail sales. This was partially offset by a reduction in the number of restaurants franchised in 2004 compared to 2003 and the fees associated with this franchising activity. In addition, our system-wide overall average royalty rate was 4.3% in 2004 compared to 4.4% in 2003. This was a result of our efforts to refranchise 36 Company-operated restaurants in the third and fourth quarters of 2003, which, in some cases, included lowered royalty rates. The 14.4% increase in franchise restaurant retail sales was primarily attributable to the following:

·       Effective franchise restaurants increased by 8.1%; and

·       Same-store sales for franchise restaurants increased by 5.2%.

“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. Effective restaurants increased by 74 or 8.1% due to new restaurant development and the substantial refranchising of Company-operated restaurants in 2004, and the annualized effect of restaurants developed in 2003. Same-store sales for franchise restaurants increased due to a combination of increases in guest check averages and guest traffic.

The Company believes the increase in same-store sales was driven by new product promotions, a third flight of national advertising and a focus on operations excellence. During 2004, the Company reintroduced several successful campaigns for limited promotions which included “Never Ending Pancakes,” “Stuffed French Toast” and “Paradise Pancakes.” The Company also launched several new campaigns for limited promotions which included “Sirloin Roundup,” “Never-Ending Popcorn Shrimp” and “Sweet Caramel Combos.”  The Company believes these campaigns contributed to increases in check averages and guest traffic by creating new product news and another reason for our customers to visit. In addition, in 2004 the Company continued its Mystery Shop Program which was initiated in 2003. Under this program, the Company has engaged an independent firm to conduct unannounced and anonymous

23




visits to each IHOP restaurant several times each quarter. These “mystery shoppers” provide the Company and our franchisees direct independent feedback at the restaurant level on food quality, cleanliness, service and other aspects of the guests’ experience at IHOP restaurants. A total of approximately 18,000 mystery shops were done in 2004 on all the restaurants in the IHOP system, averaging 16 shops for the year for each restaurant. This program is incorporated into the Company’s rating system which evaluates and grades all IHOP franchisees. The Company believes improved operations of each individual restaurant through this rating system will provide a basis for continued increases in same-store sales performance over time.

Franchise expenses increased by $11.3 million or 17.6% in 2004 compared to 2003. Franchise expenses such as advertising and the cost of proprietary products are related to franchise restaurant retail sales. The increase in franchise expenses was primarily a result of the 14.4% increase in franchise restaurant retail sales. In addition, franchise expenses were impacted by point of sale equipment subsidies paid to our franchisees, additional advertising expense, and bad debt expense. We are contractually obligated to pay 3% of retail sales towards advertising. The additional advertising expense that we contributed is above and beyond the 3% contractual obligation and is consistent with our strategic decision to strengthen our IHOP brand.

Rental Operations

Rental income includes revenue from operating leases and interest income from direct financing leases. Rental expenses are costs of operating leases and interest expense on capital leases on franchisee-operated restaurants. The number of operating leases on franchised restaurants is the key factor which can be used in evaluating and understanding our rental operations segment.

Rental operations profit, which is rental income less rental expenses, increased by $5.7 million or 18.7% in 2004 compared to 2003. The increase was due to the changes in rental income and expenses discussed below.

Rental income increased by $14.5 million or 12.4% in 2004 compared to 2003. The primary reason for the increase was an increase in the number of effective operating subleases associated with new restaurants opened in 2003 and 2004 as well as recently refranchised restaurants. The number of effective operating subleases increased by 11.3% to 561 in 2004 compared to 504 in 2003. In addition, the 53rd week in fiscal 2004 added approximately $2.0 million in pretax profit to this segment due to the collection of an extra week of rent. Since we pay our rent obligations monthly, there were no offsetting rental expenses in the 53rd week in fiscal 2004.

Rental expenses increased by $8.8 million or 10.1% in 2004 compared to 2003. The primary reason for the increase was due to an increase in rental costs associated with the increase in the number of effective operating leases. The increase in effective prime operating leases of 8.4% to 503 in 2004 from 464 in 2003 was a result of restaurants opened in 2003 and 2004 as well as recently refranchised restaurants.

Company Restaurant Operations

Company restaurant sales are retail sales at Company-operated restaurants. Company restaurant expenses are operating expenses at Company-operated restaurants and include food, labor and benefits, utilities, rent and other real estate related costs. Key factors which can be used in evaluating and understanding our Company operations segment include:

·       Same-store sales;

·       Labor and benefits costs;

·       Food costs; and

·       Change in effective Company-operated restaurants.

24




Company restaurant operations loss, which is Company restaurant sales less Company restaurant expenses, was $3.1 million in 2004 or 54.3% lower than the loss of $6.9 million in 2003. The reduced loss was due to the changes in Company restaurant sales and expenses discussed below.

Company restaurant sales decreased by $43.3 million or 57.8% in 2004 compared to the prior year. Company restaurant sales were impacted by the following:

·       Effective Company-operated restaurants decreased by 59.7% due to the refranchising and closure of Company-operated restaurants as a result of our strategic repositioning; and

·       Same-store sales of Company-operated restaurants increased by 5.1%. This partially offset the decrease in effective Company-operated restaurants.

Company restaurant expenses as a percentage of Company restaurant sales were 109.9% in 2004 compared to 109.2% in 2003. This 0.7% increase in 2004 was primarily attributable to increases in food costs including increases in pork, poultry, milk, coffee, soybean oil and wheat.

Financing Operations

Financing revenues consist of development and financing fees, which is the portion of the franchise fees not allocated to the Company’s 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 and interest expense not associated with capital leases. Key factors which can be used in evaluating and understanding our financing operations segment include:

·       Changes in franchise and equipment notes; and

·       Development and financing fees of franchise restaurants, which are based on the number and the average price of Company-developed restaurants franchised.

Financing operations profit, which is financing revenues less financing expenses, decreased by $13.3 million or 45.9% in 2004 compared to 2003. This 45.9% decrease was due to the changes in financing revenues and expenses discussed below. In addition, our financing segment was impacted by the 53rd week in fiscal 2004 which added approximately $0.5 million in pretax profit.

Financing revenues decreased by $34.4 million or 47.5% in 2004 compared to the prior year. The decrease in revenues was primarily due to a decrease in the number of Company-developed and franchised restaurants. In 2004, there were eight Company-developed and franchised restaurants; four of these were developed in 2004 as compared to 72 in 2003. This was a result of the transition to the New Business Model from our Old Business Model. The decrease was partially offset by an increase in interest income associated with franchise and equipment notes.

Financing expenses decreased by $21.2 million or 48.6% in 2004 compared to 2003. This is primarily due to a decrease in equipment costs associated with the decreased number of Company-developed and franchised restaurants.

General and Administrative Expenses

General and administrative expenses increased by $5.3 million or 9.7% in 2004. The increase in general and administrative expenses was primarily due to:

·       Increased travel and conference expenses related to the National Franchise Convention and the National Operations Meeting;

·       Increased depreciation expenses related to new information technology projects in 2003 and 2004;

·       Increased recruiting and relocation expenses related to relocation of various personnel for the Company Operations Market in Cincinnati, Ohio; and

·       Increased other professional services primarily due to the requirements of the Sarbanes-Oxley Act.

25




Impairment and Closure Charges

During the second quarter of 2004, we made a strategic decision to change our approach to refranchising restaurants in our Company-operated pool. Our prior practice was to take the time necessary and to spend the required resources to rehabilitate and refranchise a restaurant. Our new philosophy is to avoid reacquiring restaurants, and to refranchise any reacquired restaurants as quickly as possible. In the second quarter of 2004, we conducted a comprehensive analysis of our Company-operated restaurants which resulted in our determination that certain of our locations did not meet our new strategic requirements even though our analysis of them as a going-concern did not result in a determination that they were impaired. Our analysis included, but was not limited to, a detailed review by our Company restaurant management team, an analysis of current and possible sales levels for each restaurant and an analysis of the time and effort required to increase sales in order for these locations to meet our strategic requirements. As a result of our analysis, we recorded an $8.9 million charge for long-lived asset impairments on 14 restaurants in the second quarter of 2004. In the third and fourth quarters of 2004, we closed nine of the restaurants that we believed could not be franchised within a reasonable timeframe. In the third and fourth quarters of 2004, we recorded an additional $4.1 million in impairment and closure charges.

Provision for Income Taxes

Our effective tax rate for 2004 was 38.3% compared to 37.5% in 2003. The primary reason for the increase in our effective income tax rate was the reduction of the FICA tax credit associated with the decrease in the number of effective Company-operated restaurants.

Balance Sheet Accounts

Cash and cash equivalents at December 31, 2004 increased to $44.0 million from $28.0 million at December 31, 2003, primarily due to the maturity of highly liquid marketable securities.

Marketable securities at December 31, 2004 decreased to $14.5 million from $45.5 million at December 31, 2003, primarily due to the conversion of cash to repurchase shares in 2004 at an aggregate cost of $63.9 million under the stock repurchase program.

Long-term receivables at December 31, 2004 decreased to $337.2 million from $354.0 million at December 31, 2003 due primarily to the pay-down of principal by franchisees in the amount of $24.1 million. This was partially offset by an increase of $11.6 million in franchise fee and equipment leases receivable brought about through our refranchising of Company-operated restaurants.

Other assets at December 31, 2004 increased to $40.3 million from $27.7 million at December 31, 2003, primarily due to a $12.6 million increase in deferred rent on operating subleases. Rental income on operating subleases is reflected in the income statement on a straight-line basis in accordance with GAAP. Deferred rent on operating subleases is the difference between straight-line rent and the actual amount received. Deferred rent on operating subleases will continue to increase until the straight-line amounts equal the received amounts, after which deferred rent amounts will begin to decrease. As a result of its franchising efforts in 2004, the Company had 40 new operating subleases.

Other liabilities at December 31, 2004 increased to $58.7 million from $25.8 million at December 31, 2003, primarily due to the reclassification of $20.5 million in landlord incentives as required by EITF 97-10 and a $6.5 million increase in deferred rent on operating prime leases. Rental expense on operating prime leases is reflected in the income statement on a straight-line basis over the life of the lease excluding options in accordance with GAAP. Deferred rent on operating prime leases is the difference between straight-line rent and the actual amount paid. Deferred rent on operating prime leases will continue to increase until the straight-line amounts equal the paid amounts, after which deferred rent amounts will begin to decrease.  In addition, the lease obligations associated with surplus properties increased by $3.7 million. This was primarily related to existing lease obligations associated with several of the restaurants

26




closed in 2004, and was recorded in accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.”

Stockholders’ Equity

On December 13, 2004, the Company announced that the Board of Directors had approved a 1.0 million share increase in the Company’s total share repurchase authorization. This was in addition to the 2.6 million share repurchase authorization approved by the Board of Directors in January 2003. Since the inception of the program in January 2003, the Company has repurchased 2.3 million shares of its common stock, resulting in a total of $82.5 million spent on share repurchases. Also, in 2003, the Company began paying a quarterly cash dividend of $0.25 per share of common stock. See Note 10 to the Consolidated Financial Statements in this Annual Report on Form 10-K for more details.

Comparison of the fiscal years ended December 31, 2003 and 2002

Overview

Our 2003 financial results were negatively impacted by the reduction in the number of restaurants franchised and by $9.1 million in reorganization charges, both of which resulted from the transition to our New Business Model. These factors were partially offset by an increase in franchise operations profit. A comparison of our financial results for 2003 to those in 2002 included:

·       Net income of $36.8 million, which decreased by 10.0% or $4.1 million from 2002;

·       Net income per diluted share of $1.70, which decreased by 11.5% or $0.22;

·       An increase in same-store sales of 4.8%;

·       Cash flows provided by operating activities in 2003 of $71.3 million, compared to $78.1 million in 2002; and

·       Additions to property and equipment in 2003 of $80.5 million, compared to $141.7 million in 2002.

Franchise Operations

Franchise revenues consist primarily of royalty revenues, sales of proprietary products, advertising fees and the portion of the franchise fees allocated to the Company’s intellectual property. Franchise expenses include advertising expense, the cost of proprietary products and other franchise related expenses. Key factors which can be used in evaluating and understanding our franchise operations segment include:

·       Franchise retail sales; and

·       Number of restaurants franchised.

Franchise operations profit, which is franchise revenues less franchise expenses, increased by $8.0 million or 11.7% in 2003 compared to 2002. This increase was due to the changes in franchise revenues and expenses discussed below.

Franchise restaurant retail sales are sales recorded at restaurants that are owned by franchisees and area licensees and are not attributable to the Company. Franchise restaurant retail sales are useful in analyzing our franchise revenues because franchisees and area licensees pay us royalties and other fees that are generally based on a percentage of their sales.

Franchise revenues grew by $17.1 million or 13.9% in 2003 compared to 2002. Franchise revenues grew primarily due to a 15.8% increase in franchise restaurant retail sales because of the following:

·       Effective franchise restaurants increased by 10.5%; and

·       Same-store sales for franchise restaurants increased by 4.7%.

27




“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. Effective restaurants increased by 87 or 10.5% due to new restaurant development in 2003 and the annualized effect of restaurants developed in 2002. Same-store sales for franchise restaurants increased due to a combination of an increase in guest traffic and increased menu prices.

The Company believes the increase in same-store sales was driven by new product promotions, media buying strategies and a focus on operations excellence. During 2003, the Company launched several successful campaigns for limited promotions including “Never Ending Pancakes,” “Stuffed French Toast,” “Paradise Pancakes,” “Super Stackers” and “Stuffed Crepes.” The Company believes these campaigns contributed to increases in guest traffic and check averages by creating new product news and additional reasons for our customers to visit. In addition, the Company aired national advertising for the first time in 2003 which included the “Stuffed French Toast” and “Super Stackers” promotions. Prior to 2003, the Company’s advertising was limited to local advertising. In addition, the Company initiated a Mystery Shop Program in 2003. Under this program, the Company has engaged an independent firm to conduct unannounced and anonymous visits to each IHOP restaurant several times each quarter. These “mystery shoppers” provide the Company and our franchisees direct independent feedback at the restaurant level on food quality, cleanliness, service and other aspects of the guests’ experience at IHOP restaurants. A total of approximately 15,000 mystery shops were done in 2003 on all the restaurants in the IHOP system, averaging 13 shops for the year for each restaurant. This program is incorporated into the Company’s rating system which evaluates and grades all IHOP franchisees. The Company believes improved operations of each individual restaurant through this rating system will provide a basis for continued increases in same-store sales performance over time.

Franchise expenses increased by $9.1 million or 16.6% in 2003 compared to 2002. Franchise expenses such as advertising and the cost of proprietary products are related to franchise restaurant retail sales. The increase in franchise expenses was primarily a result of the 15.8% increase in franchise restaurant retail sales. Franchise expenses in 2003 were also impacted by these factors:

·       Additional advertising expense of $2.0 million; and

·       Financial assistance relief of $2.2 million.

We are contractually obligated to pay 3% of retail sales towards advertising. The additional amount of $2.0 million that we contributed to advertising expense is above and beyond the 3% contractual obligation and is consistent with our strategic decisions to strengthen our IHOP brand.

In addition, we sometimes offer financial assistance relief for a limited time to certain franchisees whose restaurants are not currently profitable. This short-term subsidy is aimed at minimizing the losses of these franchisees. In 2003, we granted $2.2 million in financial assistance relief to the operators of 38 restaurants as compared to $1.2 million granted to the operators of 28 restaurants in 2002.

In the third and fourth quarters of 2003, we refranchised 36 Company-operated restaurants. In order to refranchise many of these restaurants, we lowered royalty rates and accepted reduced franchise fees. Because of these transactions in 2003, we believe in 2004 our system-wide overall average royalty rate will be 4.3% compared with 4.4% in 2003.

Rental Operations

Rental income includes revenue from operating leases and interest income from direct financing leases. Rental expenses are costs of operating leases and interest expense on capital leases on franchisee-operated restaurants. The number of operating leases on franchised restaurants is the key factor which can be used in evaluating and understanding our rental operations segment.

Rental operations profit, which is rental income less rental expenses, increased by $4.9 million or 18.8% in 2003 compared to 2002. The increase was due to the changes in rental income and expenses discussed below.

28




Rental income increased by $17.7 million or 17.7% in 2003 compared to 2002. The primary reason for the increase was an increase in the number of effective operating subleases associated with new restaurants opened in 2002 and 2003 as well as recently franchised restaurants. The number of effective operating subleases increased by 20.0% to 504 in 2003 compared to 420 in 2002.

Rental expenses increased by $12.8 million or 17.4% in 2003 compared to 2002. An increase in rental costs associated with an increase in the number of effective operating leases was the primary cause of the increase in rental expenses. The increase in effective prime operating leases of 16.6% to 464 in 2003 from 398 in 2002 was a result of restaurants opened in 2002 and 2003 as well as recently franchised restaurants.

Company Restaurant Operations

Company restaurant sales are retail sales at Company-operated restaurants. Company restaurant expenses are operating expenses at Company-operated restaurants and include food, labor and benefits, utilities, rent and other real estate related costs. Key factors which can be used in evaluating and understanding our Company operations segment include:

·       Same-store sales;

·       Labor and benefits costs; and

·       Food costs.

Company restaurant operations loss, which is Company restaurant sales less Company restaurant expenses, was $6.9 million in 2003, or 71.9% greater than the loss of $4.0 million in 2002. The increased loss was due to the changes in Company restaurant sales and expenses discussed below.

Company restaurant sales increased by $0.4 million or 0.6% in 2003 compared to the prior year. Company restaurant sales were impacted by the following:

·       Same-store sales of Company-operated restaurants increased by 6.5%; and

·       Effective Company-operated restaurants decreased by 5.3%. This partially offset the increase in same-store sales.

Company restaurant expenses as a percentage of Company restaurant sales were 109.2% in 2003 compared to 105.4% in 2002. This 3.8% increase in 2003 was primarily attributable to the following:

·       Increases in performance incentives for restaurant general managers and assistant general managers due to increased same-store sales and special incentives for the refranchising of restaurants;

·       Increases in workers’ compensation expenses due to higher workers compensation insurance rates; and

·       Increases in labor expenses due primarily to the hiring of new Assistant General Managers.

Financing Operations

Financing revenues consist of development and financing fees, which is the portion of the franchise fees not allocated to the Company’s 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 and interest expense not associated with capital leases. Key factors which can be used in evaluating and understanding our financing operations segment include:

·       Increases in franchise equipment notes; and

·       Development and financing fees of franchise restaurants, which is based on the number and the average price of Company-developed restaurants franchised.

29




Financing operations profit, which is financing revenues less financing expenses, decreased by $1.7 million or 5.5% in 2003 compared to 2002. This decrease was due to the changes in financing revenues and expenses discussed below.

Financing revenues increased by $3.7 million or 5.4% in 2003 compared to the prior year. The increase in revenues was primarily due to an increase in franchise and equipment notes interest income associated with 72 newly Company-developed and franchised restaurants. On Company-developed and franchised restaurants, franchisees typically pay 20% of initial franchise fees in cash with the remaining franchise fee and equipment lease being financed by the Company. As a result of the 72 new Company-developed and franchised restaurants, interest income increased by $3.3 million.

Financing expenses increased by $5.4 million or 14.2% in 2003 compared to 2002. This is primarily due to $5.2 million in additional interest expense in 2003 associated with the senior notes issued in the November 2002 private placement.

General and Administrative Expenses

General and administrative expenses increased by $5.0 million or 10.2% in 2003. The increase in general and administrative expenses was primarily due to:

·       Higher corporate bonus expense which was $3.5 million in 2003, compared to zero in 2002 as a result of the Company’s failure to achieve certain performance targets;

·       Increases in salaries and wages of 3% due to normal increases in salaries and wages, which was partially offset by a reduction in headcount associated with the strategic reorganization announced on July 22, 2003; and

·       Increased expenses related to our Mystery Shop Program, which provides us with direct feedback at the restaurant level on how our guests experience our restaurants.

Reorganization Charges

In January 2003, the Company adopted the New Business Model, moving from Company-developed and financed restaurant growth to franchisee-financed development. As a result, 2003 financial results were impacted by certain transition and reorganization charges. In 2003, we incurred $9.1 million in reorganization charges, which consisted of:

·       $5.5 million in write-off of development costs associated with potential sites that we are no longer going to develop as a result of the adoption of our New Business Model; and

·       $3.6 million in management consulting, legal fees, severance costs and other expenses.

Almost all of the anticipated reorganization charges were incurred in 2003.

Balance Sheet Accounts

Cash and cash equivalents at December 31, 2003 decreased to $28.0 million from $98.7 million at December 31, 2002, primarily due to the purchase of highly liquid marketable securities of $45.5 million.

Marketable securities at December 31, 2003 increased to $45.5 million from zero at December 31, 2002, primarily due to the purchase of short-term investment grade corporate bonds maturing at various dates through December 2004.

Property and equipment, net at December 31, 2003 increased 9.8% to $314.2 million from $286.2 million at December 31, 2002, primarily due to new restaurant development.

Other assets at December 31, 2003 increased to $27.7 million from $16.1 million at December 31, 2002, primarily due to an $11.0 million increase in deferred rent on operating subleases. Rental income on operating subleases is reflected in the income statement on a straight-line basis in accordance with GAAP.

30




Deferred rent on operating subleases is the difference between straight-line rent and the actual amount received. As a result of its franchising efforts in 2003, the Company had 91 new operating subleases.

Other liabilities at December 31, 2003 increased to $25.8 million from $15.3 million at December 31, 2002, primarily due to a $7.0 million increase in deferred rent on operating prime leases. Rental expense on operating prime leases is reflected in the income statement on a straight-line basis over the life of the lease excluding options in accordance with GAAP. Deferred rent on operating prime leases is the difference between straight-line rent and the actual amount paid. As a result of its development efforts in 2003, the Company had an increase of 37 new operating prime leases.

Stockholders’ Equity

On January 13, 2003, the Company announced that the Board of Directors had authorized the repurchase of up to 2.6 million shares of IHOP Corp. common stock. For the year ended December 31, 2003, the Company repurchased 0.6 million shares of its common stock for a total of $19.4 million. Also, in 2003, the Company began paying a quarterly cash dividend of $0.25 per share of common stock. See Note 10 to the Consolidated Financial Statements in this Annual Report on Form 10-K for more details.

Liquidity and Capital Resources

Our cash from operations and principal receipts from notes and equipment contracts receivable allow us to pursue our capital investment strategies and to return cash to our stockholders. Accordingly, we have established certain well-defined priorities for our cash flow:

·       Repurchase our common stock in order to return excess capital to our stockholders and provide further capital return to our stockholders through dividends, which we began paying in fiscal 2003;

·       Invest in new assets related to the development of our Company operations market in Cincinnati, Ohio as part of our renewed focus on operational excellence by developing “best practices” operations initiatives and training programs; and

·       Invest in information technology which includes supporting Point of Sales systems in our franchise restaurants and improving franchisee relations and support at the Restaurant Support Center.

Sources and Uses of Cash

Our primary sources of liquidity are cash provided by operating activities, the redemption of investment securities and principal receipts from notes and equipment contracts receivable from our franchisees. Principal uses of cash are share repurchases, payments of dividends, capital investment, and payments on debt.

Cash provided by operating activities is primarily driven by revenues earned and collected from our franchisees. Franchise revenues are royalties and other fees which fluctuate with increases or decreases in franchise retail sales. Franchise retail sales are impacted by the development of IHOP restaurants by our franchisees and by fluctuations in same-store sales.

Cash provided by operating activities decreased slightly to $67.0 million in 2004 from $71.3 million in 2003. The decrease was primarily due to a decrease in deferred income taxes of $6.0 million, which was partially offset by better working capital management. The decrease in deferred taxes was caused by the tax effect of the impairment and closure charges associated with strategic repositioning of our Company-operated restaurants.

31




The following table represents the principal receipts on various receivables due from our franchisees as of December 31, 2004.

 

 

Principal Receipts Due By Period

 

 

 

2005

 

2006

 

2007

 

2008

 

2009

 

Thereafter

 

Total

 

 

 

(In thousands)

 

Equipment leases(1)

 

$

5,992

 

$

6,383

 

$

6,590

 

$

6,598

 

$

6,777

 

$

146,579

 

$

178,919

 

Direct financing leases(2)

 

1,788

 

2,071

 

2,510

 

3,118

 

3,691

 

113,020

 

126,198

 

Franchise notes and other(3)

 

11,459

 

9,788

 

8,868

 

7,575

 

6,027

 

7,583

 

51,300

 

Total

 

$

19,239

 

$

18,242

 

$

17,968

 

$

17,291

 

$

16,495

 

$

267,182

 

$

356,417

 


(1)          Equipment lease receivables extend through the year 2029.

(2)          Direct financing lease receivables extend through the year 2024.

(3)          Franchise note receivables extend through the year 2012.

The above decrease in principal receipts primarily reflects the associated decrease in long-term receivables attributable to the Company’s decision to no longer finance the development of franchise restaurants. The table reflects the contractual maturities of notes outstanding as of December 31, 2004.

Capital Investment

As a result of the Company strategically shifting its focus from the Old Business Model, where the Company developed and financed restaurants, to the New Business Model, where franchisees develop and finance restaurants, the Company significantly reduced capital expenditures and restaurant openings in 2004 compared with 2003 and 2002.

In 2004, total capital expenditures of $16.6 million included the cost of six Company-developed restaurants. This amount is down significantly from the $80.5 million in total capital additions in 2003 which included the cost of 56 Company-developed restaurants. Capital additions in 2004 and 2003 include capitalized interest in the amounts of $0.1 million and $1.1 million, respectively.

In 2005, the Company expects to develop two to four restaurants in our new Company operations market in Cincinnati, Ohio. The total capital expenditures associated with the development of these restaurants and our investment in information technology is expected to be approximately $11.0 million to $13.0 million.

Share Repurchases and Dividends

Based on our strategy to return cash to our stockholders, the Company repurchased approximately 2.3 million shares of common stock for $82.5 million beginning in 2003 under our stock repurchase program. In January 2003, our Board of Directors approved an increase in our stock repurchase program that permits the purchase of up to 2.6 million shares. On December 13, 2004, our Board of Directors approved a 1.0 million share increase in the Company’s total share repurchase authorization. As of December 31, 2004, we were authorized to repurchase up to 1.3 million shares under our stock repurchase program.

Also in 2003, the Company began paying a quarterly cash dividend of $0.25 per share of common stock. The Company has paid regular quarterly dividends of $0.25 per common share since May 2003. On January 18, 2005, the Company declared a quarterly cash dividend of $0.25 per common share paid on February 22, 2005, to stockholders of record as of February 1, 2005. Future dividends will be considered after reviewing returns to stockholders, profitability expectations and financing needs. Future dividends will be declared at the discretion of the Board of Directors.

32




Debt Instruments and Related Covenants

As an additional source of liquidity, we have a $25.0 million revolving line of credit which expires in May 2005. Borrowings under the revolving line of credit bear interest at the bank’s reference (prime) rate or, at our option, at the bank’s quoted rate or at a Eurodollar rate. There was no balance outstanding under this agreement at December 31, 2004 nor were there any borrowings under the agreement during the year.

Financial covenants in the purchase agreements governing our 5.20% senior notes, 5.88% senior notes and 7.42% senior notes, our leasehold mortgage term loans, and our revolving credit agreement require us to maintain minimum fixed charge coverage ratios. As of December 31, 2004, the most restrictive of our covenants with respect to fixed charge coverage ratios were contained in our purchase agreements for the 5.20% senior notes, the 5.88% senior notes and the 7.42% senior notes. These agreements require the Company to maintain on the last day of each fiscal quarter a fixed charge coverage ratio of at least 1.75 to 1.00 for the four immediately preceding fiscal quarters. At the end of the fourth quarter of 2004, IHOP’s fixed charge coverage ratio for the prior four fiscal quarters was only 1.74 to 1.00. This was primarily due to the impairment and closure charges associated with the strategic repositioning efforts of Company-operated restaurants incurred in the second and third quarters of 2004. The noteholders have issued a waiver, which reduced the fixed charge coverage ratio required for the fourth quarter of 2004 to 1.65 to 1.00. Since this covenant is calculated on a rolling four quarter basis, the impairment and closure charges in the second and third quarters of 2004 will continue to affect our fixed charge coverage ratio for the first and second quarters of 2005. As a result, we have obtained a waiver from the noteholders, which reduces the fixed charge coverage ratio required for these quarters to 1.65 to 1.00. As of December 31, 2004, the aggregate amount outstanding under the 5.20% senior notes, the 5.88% senior notes and the 7.42% senior notes was $115.6 million.

Disclosure of Contractual Obligations

The following are our significant contractual obligations and payments as of December 31, 2004:

 

 

Payments Due By Period

 

Contractual Obligations

 

 

 

Less than
1 Year

 

1-3 Years

 

3-5 Years

 

More than
5 Years

 

Total

 

 

 

(in thousands)

 

Debt excluding capital leases

 

$

13,785

 

$

53,199

 

$

45,335

 

$

65,274

 

$

177,593

 

Operating leases

 

59,408

 

118,390

 

118,697

 

841,779

 

1,138,274

 

Capital leases

 

23,043

 

46,138

 

46,582

 

273,290

 

389,053

 

Purchase commitments

 

467

 

 

 

 

467

 

Total minimum payments

 

$

96,703

 

$

217,727

 

$

210,614

 

$

1,180,343

 

$

1,705,387

 

Less interest

 

(27,016

)

(50,584

)

(43,499

)

(127,985

)

(249,084

)

 

 

$

69,687

 

$

167,143

 

$

167,115

 

$

1,052,358

 

$

1,456,303

 

 

Income Taxes

The Internal Revenue Service (“IRS”) has proposed adjustments in connection with its examination of the Company’s 2000 and 2001 federal income tax returns. The proposed adjustments would accelerate the tax years in which the Company reports initial franchise fee income for federal income tax purposes. If the IRS is successful, the Company would be required to report additional income for its 2000 tax year of approximately $45.2 million and additional income for its 2001 tax year of approximately $4.8 million. The Company’s federal income tax liability with respect to the proposed adjustments, exclusive of interest, penalties and any related state tax liability would be approximately $15.8 million for 2000 and $1.7 million for 2001. The Company is currently contesting the proposed adjustments through IRS administrative proceedings.

33




For the tax years under audit, and potentially for subsequent tax years, such proposed adjustments could result in material cash payments by the Company. The Company had previously recorded in its consolidated financial statements the expected federal and state deferred income tax liability. Therefore, the proposed adjustments relate only to a timing issue. Although the Company cannot determine at this time the resolution of this matter, we do not believe that the proposed adjustments, if upheld, will have a material adverse effect on our financial condition or results of operations.

Item 7A. Quantitative and Qualitative Disclosures about Market Risk.

The Company is exposed to interest rate risk for its investments in marketable securities. At December 31, 2004, the Company had $14.5 million in marketable securities maturing at various dates through 2005. The Company’s investments are comprised primarily of highly liquid investment grade corporate bonds. The Company generally holds investments until maturity, and therefore should not bear any interest risk due to early disposition. Any premium or discount recognized upon the purchase of an investment is amortized over the term of the investment. At December 31, 2004, the fair value of investments approximated the carrying value.

We are exposed to market risk from changes in interest rates on debt and changes in commodity prices. IHOP’s exposure to interest rate risk relates to its $25.0 million revolving line of credit and its $12.0 million mortgage term loan with its banks. Borrowings under the revolving line of credit bear interest at the bank’s reference rate (prime) or, at IHOP’s option, at the bank’s quoted rate or at a Eurodollar rate. There was no balance outstanding under the revolving line of credit at December 31, 2004 nor were there any borrowings under the agreement during 2004. Borrowings under the mortgage term loan bear interest at the London Interbank Offered Rate (“LIBOR”) plus the applicable margin. The applicable margin will be a function of the funded debt to EBITDA ratio, as defined in the loan agreement. The impact on our results of operations due to a hypothetical 1% interest rate change would be immaterial.

In March 2002, we entered into a $17.2 million variable rate term loan also included in leasehold mortgage term loans. This loan, which accrues interest at one-month LIBOR, will amortize over twelve years and has a maturity date of April 1, 2014. The outstanding balance as of December 31, 2004, was $14.6 million. The interest rate was 4.59% at December 31, 2004. The lending institution required us to enter into an interest rate swap agreement for 50% of the loan, or $8.6 million, as a means of reducing our interest rate exposure. This strategy will effectively use an interest rate swap to convert $8.6 million in variable rate borrowings into fixed rate liabilities. The interest rate swap agreement is considered to be a hedge against changes in the amount of future cash flows associated with interest payments on this variable rate loan.

Many of the food products purchased by the Company and its franchisees and area licensees are affected by commodity pricing and are, therefore, subject to unpredictable price volatility. We attempt to mitigate price fluctuations by entering into forward purchase agreements on all our major products. None of these food product contracts or agreements is a derivative instrument. Extreme changes in commodity prices and/or long-term changes could affect our franchisees, area licensees and Company-operated restaurants adversely. We expect that in most cases the IHOP system would be able to pass increased commodity prices through to its consumers via increases in menu prices. From time to time, competitive circumstances could limit short-term menu price flexibility, and in those cases margins would be negatively impacted by increased commodity prices. This would be mitigated by the fact that the majority of IHOP restaurants are franchised and our revenue stream from franchisees is based on the gross sales of the restaurants. We believe that any changes in commodity pricing that cannot be adjusted for by changes in menu pricing or other strategies would not be material to either our financial condition, results of operations or cash flows.

In some instances, the Company is required to enter into commitments to purchase food and other items on behalf of the IHOP system as a whole. At December 31, 2004, our outstanding purchase commitments were $0.5 million. The Company has developed processes to facilitate the liquidation of these commitments to minimize financial exposure.

34




 

Item 8. Financial Statements and Supplementary Data.

Index to Consolidated Financial Statements

Page
Reference

 

Consolidated Balance Sheets as of December 31, 2004 and 2003

 

36

 

 

Consolidated Statements of Income for each of the three years in the period ended December 31, 2004

 

37

 

 

Consolidated Statements of Stockholders’ Equity for each of the three years in the period ended December 31, 2004

 

38

 

 

Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 2004

 

39

 

 

Notes to the Consolidated Financial Statements

 

40

 

 

Reports of Independent Registered Public Accounting Firms

 

61

 

 

 

35




IHOP Corp. and Subsidiaries
Consolidated Balance Sheets
(In thousands, except share amounts)

 

 

December 31,

 

 

 

2004

 

2003

 

Assets

 

 

 

 

 

Current assets

 

 

 

 

 

Cash and cash equivalents

 

$

44,031

 

$

27,996

 

Marketable securities

 

14,504

 

45,537

 

Receivables, net

 

44,403

 

47,116

 

Reacquired franchises and equipment held for sale, net

 

1,116

 

1,597

 

Inventories

 

148

 

556

 

Prepaid expenses

 

2,412

 

4,279

 

Total current assets

 

106,614

 

127,081

 

Long-term receivables

 

337,178

 

354,036

 

Property and equipment, net

 

326,848

 

314,221

 

Reacquired franchises and equipment held for sale, net

 

 

9,153

 

Excess of costs over net assets acquired

 

10,767

 

10,767

 

Other assets

 

40,270

 

27,746

 

Total assets

 

$821,677

 

$

843,004

 

Liabilities and Stockholders’ Equity

 

 

 

 

 

Current liabilities

 

 

 

 

 

Current maturities of long-term debt

 

$

5,844

 

$

5,731

 

Accounts payable

 

17,133

 

13,840

 

Accrued employee compensation and benefits

 

9,185

 

11,962

 

Other accrued expenses

 

11,366

 

8,924

 

Deferred income taxes

 

2,800

 

1,760

 

Capital lease obligations

 

4,025

 

3,156

 

Total current liabilities

 

50,353

 

45,373

 

Long-term debt, less current maturities

 

133,768

 

139,615

 

Deferred income taxes

 

65,185

 

72,225

 

Capital lease obligations

 

173,925

 

177,664

 

Other liabilities

 

58,682

 

25,767

 

Commitments and contingencies (Notes 7 and 14)

 

 

 

 

 

Stockholders’ equity

 

 

 

 

 

Preferred stock, $1 par value, 10,000,000 shares authorized; no shares issued and outstanding

 

 

 

Common stock, $.01 par value, 40,000,000 shares authorized; 2004: 22,252,750 shares issued and 19,957,255 shares outstanding; 2003: 21,994,068 shares issued and 21,389,939 shares outstanding

 

223

 

220

 

Additional paid-in-capital

 

112,897

 

104,661

 

Retained earnings

 

308,173

 

295,448

 

Deferred compensation

 

(23

)

(191

)

Accumulated other comprehensive loss

 

(401

)

(545

)

Treasury stock, at cost (2004: 2,295,495 shares; 2003: 604,129 shares)

 

(82,015

)

(19,443

)

Contribution to ESOP

 

910

 

2,210

 

Total stockholders’ equity

 

339,764

 

382,360

 

Total liabilities and stockholders’ equity

 

$

821,677

 

$843,004

 

 

See the accompanying notes to the consolidated financial statements.

36




IHOP Corp. and Subsidiaries
Consolidated Statements of Income
(In thousands, except per share amounts)

 

 

Year Ended December 31,

 

 

 

2004

 

2003

 

2002

 

Revenues

 

 

 

 

 

 

 

Franchise revenues

 

$

157,584

 

$

140,131

 

$

123,050

 

Rental income

 

131,763

 

117,258

 

99,595

 

Company restaurant sales

 

31,564

 

74,880

 

74,433

 

Financing revenues

 

38,091

 

72,536

 

68,796

 

Total revenues

 

359,002

 

404,805

 

365,874

 

Costs and Expenses

 

 

 

 

 

 

 

Franchise expenses

 

75,599

 

64,265

 

55,139

 

Rental expenses

 

95,392

 

86,620

 

73,812

 

Company restaurant expenses

 

34,701

 

81,737

 

78,422

 

Financing expenses

 

22,434

 

43,619

 

38,185

 

General and administrative expenses

 

59,890

 

54,575

 

49,526

 

Other expense, net

 

2,707

 

3,867

 

4,983

 

Impairment and closure charges

 

14,112

 

2,187

 

450

 

Reorganization charges

 

 

9,085

 

 

Total costs and expenses

 

304,835

 

345,955

 

300,517

 

Income before income taxes

 

54,167

 

58,850

 

65,357

 

Provision for income taxes

 

20,746

 

22,068

 

24,509

 

Net income

 

$

33,421

 

$

36,782

 

$

40,848

 

Net income per share

 

 

 

 

 

 

 

Basic

 

$

1.62

 

$

1.72

 

$

1.95

 

Diluted

 

$

1.61

 

$

1.70

 

$

1.92

 

Weighted average shares outstanding

 

 

 

 

 

 

 

Basic

 

20,606

 

21,424

 

20,946

 

Diluted

 

20,791

 

21,614

 

21,269

 

Dividends declared per share

 

$

1.00

 

$

0.75

 

$

 

Dividends paid per share

 

$

1.00

 

$

0.75

 

$

 

 

See the accompanying notes to the consolidated financial statements.

37




IHOP Corp. and Subsidiaries
Consolidated Statements of Stockholders’ Equity
(In thousands, except share amounts)

 

 

Common Stock

 

Additional

 

 

 

 

 

Accumulated
Other

 

Treasury

 

 

 

 

 

 

 

Shares
Issued

 

Amount

 

Paid-in
Capital

 

Retained
Earnings

 

Deferred
Compensation

 

Comprehensive
Loss

 

Stock, at
cost

 

Contribution
To ESOP

 

Total

 

Balance December 31, 2001

 

20,918,283

 

 

$

209

 

 

$

79,837

 

$

233,920

 

 

$

 

 

 

$

 

 

$

(3,386

)

 

$

1,850

 

 

$

312,430

 

Net income

 

 

 

 

 

 

40,848

 

 

 

 

 

 

 

 

 

 

 

40,848

 

Unrealized (loss) on interest rate swap, net of tax

 

 

 

 

 

 

 

 

 

 

 

(680

)

 

 

 

 

 

(680

)

Comprehensive income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

40,168

 

Reissuance of treasury shares to ESOP

 

 

 

 

 

711

 

 

 

 

 

 

 

 

1,139

 

 

(1,850

)

 

 

Issuance of shares pursuant to stock plans