Hedge Funds Seen Targeting More Restaurant Chains in 2007

NEW YORK (AP) - Applebee's International Inc.'s announcement Tuesday that it will consider a sale of the company highlights the growing influence hedge funds are having on the restaurant industry — a trend that's expected to continue in 2007.

Activist hedge funds have been popping up more often across all sectors, but restaurants have been an especially hot target. They're attractive because they've been underperforming, they have a lot of cash on the books and they own a lot of real estate, which can be worked into deals that provide instant cash to shareholders.

"We expect to really see continued activity in '07, largely because we don't think the public markets are going to be there for restaurant chains," said Ron Paul, president of Technomic Inc., a Chicago firm that tracks restaurant-industry sales. "It's a business that throws off a lot of cash, and the multiples are down," he said. Investors seem to welcome the attention. Applebee's was up $2.45, or 10 percent, at $26.68 in afternoon trading Tuesday on the Nasdaq Stock Market.

Other restaurant chains that have been targeted by activist investors this year — actions that could lead to similar concessions — are Friendly Ice Cream Corp. and Back Yard Burgers Inc.

Friendly's stock rose 12 cents, or 1 percent, to $12.40 in afternoon trading Tuesday on the American Stock Exchange. Back Yard Burgers' stock was unchanged at $5.65 on the Nasdaq.

Applebee's, operator of the nation's largest casual-dining restaurant chain, said Tuesday that it will explore strategic alternatives including a possible sale of the company. The Overland Park, Kan., company has been under pressure from Breeden Partners, a hedge fund with a 5 percent stake, that's run by former Securities and Exchange Commission Chairman Richard Breeden.

Breeden Partners has been fighting for four seats on the company's 11-member board as a way to force changes that the fund thinks will enhance returns to shareholders. Specifically, Breeden has been agitating for Applebee's to re-franchise restaurants, reduce capital expenditures and dispose of real estate holdings.

Indeed, real estate has been a main draw for activist investors. Chains often own stores and land that could generate cash if sold and leased back to the company.

McDonald's Corp., CKE Restaurants Inc. and Lone Star Steakhouse & Saloon Inc. have all tussled with activists in recent years over real estate. McDonald's, for example, was pushed by Pershing Square Capital Management to borrow against 8,000 of its stores to fund a share buyback. The fast-food chain eventually agreed to sell 1,500 stores within three years.

McDonald's stock traded at $44.90 a share Tuesday afternoon. It's up by about a third since the end of 2005, when news first broke that Pershing had approached McDonald's.

Some observers question whether all this activity and attention to real estate is really in the best long-term interest of shareholders. Selling real estate to lease it back is a "lousy solution," said Malcolm M. Knapp, who produces a widely watched report on casual-dining restaurants called Knapp-Track. Real estate is a long-term investment that also helps cap expenses, he said. Sale-leasebacks provide immediate cash, but aren't good long-term strategy, he said.

Sale-leasebacks also hurt bondholders because they result in increased debt, said Wesley Moultrie, head of the food, beverage and tobacco group at credit rating firm Fitch Ratings Inc. And too much leverage can also be bad for stockholders, because it places companies in the position of using cash to pay for that debt, said Moultrie.

Hedge funds are also looking to persuade restaurants to spin off units or put themselves up for sale, a possible outcome at Applebee's. The strategy has been benefited at least some restaurant shareholders.

In 2005, two major shareholders waged a successful campaign to get Wendy's International Inc. to spin off its Tim Hortons doughnut chain, a move that helped push the stock higher. Hedge fund Pirate Capital LLC failed in it's attempt to get OSI Restaurant Partners Inc. to sell off some of its restaurant chains. But OSI shareholders still won out when, a few months after Pirate sold its stake, the Tampa company agreed to a buyout worth nearly $3 billion by a private-equity firm — a deal that sent the stock soaring.