Dine Brands Global - 10-Q quarterly report FY

IHOP CORP. AND SUBSIDIARIES

INDEX

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IHOP CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share amounts)
(Unaudited)

See the accompanying Notes to Consolidated Financial Statements.

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IHOP CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

See the accompanying Notes to Consolidated Financial Statements.

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IHOP CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.    General:   The accompanying unaudited consolidated financial statements of IHOP Corp. (the “Company”) have been prepared in accordance with U. S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U. S. generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and nine month periods ended September 30, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005.

The consolidated balance sheet at December 31, 2004 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by U. S. generally accepted accounting principles for complete financial statements.

For further information, refer to the consolidated financial statements and footnotes thereto included in IHOP’s annual report on Form 10-K for the year ended December 31, 2004.

2.    Reclassifications:   Certain reclassifications have been made to prior period information to conform to the current period presentation.

3.    Presentation:   IHOP’s fiscal quarter ends on the Sunday closest to the last day of each quarter. For convenience, we report all fiscal quarter endings on March 31, June 30, September 30 and December 31.

4.    Segments:   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 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 on franchisee-operated restaurants. The Company is a tenant under 785 leases and owns 61 properties which are in turn subleased to franchisees. For further information, refer to the consolidated financial statements and footnotes thereto included in IHOP’s annual report on Form 10-K for the year ended December 31, 2004.

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 restaurant operating 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. For further information, refer to the consolidated financial statements and footnotes thereto included in IHOP’s annual report on Form 10-K for the year ended December 31, 2004.

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Information on segments and a reconciliation to income before income taxes are as follows:

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The following table reconciles internal segment profit (loss) to external segment profit (loss):

5.    Stock Based Employee Compensation:   In accordance with the provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” we have elected to account for our stock-based employee compensation plans under the intrinsic value method which requires compensation expense to be recorded only if, on the date of grant, the current market price of the Company’s common stock exceeds the exercise price the employee must pay for the stock. The Company’s policy is to grant stock options at the fair market value of the underlying stock at the date of grant. Had compensation expense for our stock option plans been determined based on the fair value at the grant date for awards through September 30, 2005, consistent with the provisions of SFAS No. 123, our after-tax net income and after-tax net income per share would have been reduced to the pro forma amounts indicated below (in thousands, except net income per share data):

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6.    Income Taxes:   In 2004, the Internal Revenue Service (“IRS”) 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.

In April 2005, the IRS proposed a similar adjustment in connection with its examination of the Company’s 2002 federal income tax return. The proposed adjustment would accelerate the tax years in which the Company reports initial franchise fee income for federal tax purposes. If the IRS is successful, the Company would be required to report additional income for its 2002 tax year of approximately $4.2 million. The Company’s federal income tax liability with respect to the proposed adjustment, exclusive of interest, penalties and any related state tax liability would be approximately $1.5 million for 2002.

In June 2005, the IRS proposed a similar adjustment in connection with the Company’s 2003 federal income tax return. The proposed adjustment, if upheld, would accelerate the Company’s 2003 tax year franchise fee income by approximately $1.3 million. The related federal income tax liability would be $0.5 million.

For the tax years under audit, and potentially for subsequent tax years, such proposed adjustments could result in material cash payments by the Company. These cash payments aggregated are approximately $19.5 million exclusive of interest, penalties, and any state income tax liability. The Company has previously recorded in its consolidated financial statements the expected federal and state deferred income tax liability. The proposed adjustments relate only to the timing of when the taxes are paid. 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.

In addition, the Company has recorded contingency reserves for interest and any related state tax liabilities for the tax years under audit. As of September 30, 2005, the Company believes these tax contingency reserve estimates are adequate to cover interest and any related state tax liabilities for the years 2000, 2001, 2002 and 2003. However, inherent uncertainties exist in estimates of tax contingencies. Therefore, higher actual interest and any related state tax liabilities paid by the Company could adversely affect our reported results.

7.    New Accounting Pronouncements:   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. On April 14, 2005, the Securities and Exchange Commission adopted a new rule that amends the compliance dates for Statement 123(R). Under the new rule, the Company is required to adopt Statement 123(R) in the first quarter of 2006.

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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 5 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. 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 amount of operating cash flows recognized in prior periods for such excess tax deductions were $0.8 million, and $1.1 million for the nine months ended September 30, 2005 and 2004, respectively.

In October 2005, the FASB issued Staff Position FAS 13-1, “Accounting for Rental Costs Incurred during a Construction Period,” which  requires rental costs associated with ground or building operating leases that are incurred during a construction period to be recognized as rental expense. This Staff Position is effective for reporting periods beginning after December 15, 2005, and retrospective application is permitted but not required. The Company currently capitalizes rent incurred during the tenant construction phase. The Company plans to adopt this Staff Position in January 2006 and does not believe it will have a material adverse effect on our financial condition or results of operations.

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Item 2.                        Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Restaurant Data

The following table sets forth, for the current year and prior year, 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.

(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)          System-wide sales are retail sales of IHOP restaurants operated by franchisees, area licensees and the Company, as reported to the Company. Franchise restaurant sales were $460.1 million and $1,331.2 million for the third quarter and first nine months of 2005, respectively, and sales at area license restaurants were $47.1 million and $143.7 million for the third quarter and first nine months of 2005, respectively. Sales of restaurants that are owned by franchisees and area licensees are not attributable to the Company.

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

(d)          “Same-store sales percentage change” reflects the percentage change in sales, in any given fiscal period compared to the prior fiscal period, 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.

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The following table summarizes our restaurant development and franchising activity:

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 the Company’s 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; the Company’s 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 the Company’s press releases, public statements and/or filings with the Securities and Exchange Commission.

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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. In addition, the Company disclaims any intent or obligation to update these forward-looking statements.

This information should be read in conjunction with the consolidated financial statements and the notes thereto included in Item 1 of Part I of this Quarterly Report and the audited consolidated financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2004.

General

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 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 are negotiated on an individual basis. With respect to restaurants developed, 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.

The following table represents our development commitments including options as of September 30, 2005.

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Comparison of the third quarter and nine months ended September 30, 2005 and 2004

Overview

Our results for the third quarter and first nine months of 2005 were impacted by an increase in franchise operations profit, due to higher revenues associated with franchise restaurant retail sales and additional fees from franchising activity. In addition, general and administrative expenses decreased for the third quarter and first nine months of 2005. A comparison of our financial results for the third quarter and first nine months of 2005 to those in 2004 included:

·       An increase in net income of $4.3 million or 56.0% in the third quarter and an increase of $11.0 million or 48.1% in net income for the first nine months of 2005;

·       Excluding pre-tax impairment and closure charges of $3.1 million in the third quarter of 2004 and $13.1 million in the first nine months of 2004, net income increased by 25.4% to $12.0 million in the third quarter of 2005 and increased by 11.9% to $34.5 million in the first nine months of 2005;

·       An increase in franchise operations profit of $2.2 million or 10.8% in the third quarter and $5.9 million or 9.9% in the first nine months of 2005; and

·       A decrease in general and administrative expenses for the third quarter of 2005 of $0.9 million or 5.4% and a decrease of $0.5 million or 1.1% in the first nine months of 2005.

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 expenses, 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 $2.2 million or 10.8% in the third quarter of 2005 and by $5.9 million or 9.9% in the first nine months of 2005 compared to the same periods in 2004. The increase in franchise operations profit 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 $4.2 million or 10.7% in the third quarter of 2005 and by $8.6 million or 7.5% in the first nine months of 2005 compared to the same periods in 2004. Franchise revenues grew primarily due to an increase in franchise restaurant retail sales of 10.5% in the third quarter of 2005 and an increase of 7.6% in the first nine months of 2005. The increase in franchise restaurant retail sales was primarily attributable to the following:

·       Effective franchise restaurants increased by 5.6% in the third quarter of 2005 and by 5.7% in the first nine months of 2005; and

·       Same-store sales for franchise restaurants increased by 4.5% in the third quarter of 2005 and by 2.1% in the first nine months of 2005.

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“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 56 or 5.6% in the third quarter of  2005 and by 56 or 5.7% in the first nine months of 2005 due to new restaurant openings in 2005, the annualized effect of new restaurant development in 2004 and the refranchising of Company-owned restaurants in 2004 and 2005. The increase in same-store sales of 4.5% and 2.1% in the third quarter and first nine months of 2005, respectively, was primarily attributable to the positive guest response to our limited time product promotions in the third quarter of 2005.

Franchise expenses increased by $2.0 million or 10.7% in the third quarter of 2005 and increased by $2.7 million or 4.9% in the first nine months of 2005 compared to the same periods in 2004. Franchise expenses such as advertising and the cost of proprietary products are related to franchise restaurant retail sales.

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 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 $0.2 million or 2.6% in the third quarter of 2005 and decreased by $0.6 million or 2.4% in the first nine months of 2005 compared to the same periods in 2004. The changes were impacted primarily by the changes in rental income and expenses discussed below.

Rental income increased by $0.8 million or 2.4% in the third quarter of 2005 and by $1.8 million or 1.9% in the first nine months of 2005 compared to the same periods in 2004. The increase in the third quarter of 2005 was primarily due to the strong same-store sales performance for the quarter since a significant number of our lease agreements are tied to sales performance. In addition, rental income in the third quarter and first nine months of 2005 was impacted by an increase in the number of effective operating subleases associated with recently refranchised restaurants. The number of effective operating subleases increased by 3.7% to 583 in the third quarter of 2005 compared to 562 in the same period in 2004. In the first nine months of 2005 the number of effective operating subleases increased by 4.5% to 584 compared to 559 in the first nine months of 2004. Effective capital subleases decreased slightly to 210 in the third quarter of 2005 compared to 217 in the third quarter of 2004.

Rental expenses increased by $0.6 million or 2.4% in the third quarter of 2005 and by $2.5 million or 3.5% in the first nine months of 2005 compared to the same periods in 2004. This increase in rental expenses was primarily due to an increase in rental costs associated with an increase in the number of effective operating leases. Effective prime operating leases increased by 2.6% to 513 in the third quarter of 2005 from 500 in the third quarter of 2004, and increased by 2.8% to 515 in the first nine months of 2005 from 501 in the first nine months of 2004. The increase in effective prime operating leases was a result of restaurants opened in 2004 as well as refranchised restaurants in 2004 and 2005. In addition, rental expenses increased more than rental revenue in the first nine months of  2005 due to an increase in the number of effective leases and due to rent concessions that we extended over the intial periods of the leases on some refranchised restaurants. Effective prime capital leases increased to 294 in the third quarter of 2005 compared to 285 in the third quarter of 2004 and increased to 293 in the first nine months of 2005 compared to 283 in the same period in 2004.

Company Restaurant Operations

Company restaurant operations is comprised of two separate categories; restaurants in our dedicated Company-operations market of Cincinnati, Ohio and restaurants remaining from our Old Business Model,

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where the Company developed and financed restaurants. All the restaurants remaining from our Old Business Model were refranchised in the third quarter of 2005.

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 restaurant operating costs. Key factors which can be used in evaluating and understanding our Company operations segment include:

·       Change in effective Company-operated restaurants;

·       Labor and benefits costs; and

·       Food costs.

Company restaurant operations profit/(loss) is Company restaurant sales less Company restaurant expenses. Company restaurant operations had a profit in the third quarter of 2005 of $15,000 compared to a loss of $0.5 million in the third quarter of 2004. Company restaurant operations loss was $0.8 million in the first nine months of 2005 or 69.1% less than the loss of $2.6 million in the first nine months of 2004. The improvement in Company operations profit/(loss) in the third quarter and first nine months of 2005 was driven primarily by the decrease in effective Company-operated restaurants. Effective Company-operated restaurants decreased by 74.1% and 75.8% in the third quarter and first nine months of 2005, respectively. This was due to the refranchising and closure of Company-operated restaurants as a result of our strategic repositioning. In addition, Company-operations profit in the second and third quarters of 2005 were impacted by improved labor and food cost management in our dedicated Company-operations market in Cincinnati, Ohio.

Financing Operations

Financing revenues consist of development and financing fees (which is the portion of franchise fees, under our Old Model, 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 $0.4 million or 8.9% in the third quarter of 2005 and decreased by $1.6 million or 12.1% in the first nine months of 2005 compared to the same periods in 2004. The decrease in financing operations profit was primarily due to the decrease in franchise and equipment note interest as a result of declining long-term note balances.

Financing revenues increased by $3.7 million or 49.4% in the third quarter of 2005 and remained essentially flat in the first nine months of 2005 compared to the same periods in the prior year. The increase in revenues in the third quarter of 2005 was primarily due to the increase in financing and development fees associated with an increase in the number of Company-developed and rehabilitated and refranchised restaurants to 13 in the third quarter of 2005 compared to five in the third quarter of 2004. In the first nine months of 2005, there were 18 Company-developed and rehabilitated and refranchised restaurants compared to 16 in the first nine months of 2004. Financing revenues remained essentially flat in the first nine months of 2005 as a result of the decrease in franchise and equipment note interest due to the expected reduction in franchise fee note balances, which was offset by the increase in financing and development fees in the third quarter of 2005.

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Financing expenses increased by $4.1 million or 117.2% in the third quarter of 2005 and by $1.6 million or 13.4% in the first nine months of 2005 compared to the same periods in 2004. This is primarily due to an increase in equipment costs associated with the increased number of Company-developed and rehabilitated and refranchised restaurants. In addition, financing expenses were impacted by increased interest expense associated with our conventional debt.

General and Administrative Expenses

General and administrative expenses decreased by $0.9 million or 5.4% in the third quarter of 2005, and decreased by $0.5 million or 1.1% in the first nine months of 2005 compared to the same periods in the prior year. The decrease in general and administrative expenses in the third quarter and first nine months of 2005 were primarily due to the following:

·       Decreased travel and conference expenses;

·       Decreased management consulting expenses; and

·       Decreased recruiting and relocation expenses.

The decrease in general and administrative expenses in the first nine months of 2005 were partially offset by increased depreciation and amortization expenses associated with information technology investments and increased expenses related to our Performance Share Plans for Executive Management. The increased expenses related to our Performance Share Plans were due to the addition of a second cycle of performance share awards in 2005.

Impairment and Closure Charges

Impairment and closure charges decreased by $3.0 million or 97.3% in the third quarter of 2005, and decreased by $12.2 million or 93.3% in the first nine months of 2005 compared to the same periods in the prior year. Impairment and closure charges in the third quarter and first nine months of 2004 were primarily for the impairment of long-lived assets on 14 restaurants.  The decision to close or impair the restaurants was a result of a comprehensive analysis that examined restaurants not meeting minimum return on investment thresholds and certain other operating performance criteria and represented a change in strategy from prior practices. The assets for these restaurants were written down to their estimated fair value.

Provision for Income Taxes

Our effective tax rate for the third quarter 2005 was 37.4% and 38.0 % for the first nine months of 2005 compared to 37.5% for the third quarter and first nine months of 2004. In the first and second quarters of 2005, the Company’s effective annual tax rate was 38.3%. In the third quarter of 2005 the Company adjusted its effective annual tax rate to reflect its new estimated annual tax rate of 38.0%.

Liquidity and Capital Resources

Our cash from operations and principal receipts from notes and equipment contracts receivable are the sources of cash that 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 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.

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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 common stock 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 to $45.4 million in the first nine months of 2005 from $51.8 million in the same period in 2004. The decrease was primarily due to a cash flow adjustment for $13.1 million in non-cash pre-tax impairment and closure charges taken in the first nine months of 2004. In addition, the Company recognized a one-time cash benefit in the first quarter of 2004 from taxes prepaid in the fourth quarter of 2003, which we did not benefit from this year.

As an additional source of liquidity, we have a $25.0 million revolving line of credit which expires in May 2008. 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 September 30, 2005 nor were there any borrowings under the agreement during the year.

Share Repurchases and Dividends

On September 20, 2005, our Board of Directors approved a 1.0 million share increase in the Company’s total share repurchase authorization. The Company repurchased approximately 1.3 million shares of common stock for $56.4 million in the first nine months of 2005 under our stock repurchase program. As of September 30, 2005, we were authorized to repurchase up to an additional 0.9 million shares under our stock repurchase program.

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 October 11, 2005, the Company declared a quarterly cash dividend of $0.25 per common share payable on November 22, 2005, to stockholders of record as of November 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.

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 related to restaurant openings.

Capital expenditures were reduced to $3.5 million in the first nine months of 2005 from $11.6 million in the first nine months of 2004, as a result of the Company’s business model change. In the first nine months of 2004 the Company was in the process of completing investment in restaurant development under the Old Business Model. As of September 30, 2005, this process was completed.

In 2005, the Company expects to develop two to four restaurants in our Company operations market in Cincinnati, Ohio. The total capital expenditures associated with the development of these restaurants, our investment in information technology, and other miscellaneous capital expenditures are expected to be approximately $9.0 million to $11.0 million.

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Income Taxes

In 2004, the Internal Revenue Service (“IRS”) 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.

In April 2005, the IRS proposed a similar adjustment in connection with its examination of the Company’s 2002 federal income tax return. The proposed adjustment would accelerate the tax years in which the Company reports initial franchise fee income for federal tax purposes. If the IRS is successful, the Company would be required to report additional income for its 2002 tax year of approximately $4.2 million. The Company’s federal income tax liability with respect to the proposed adjustment, exclusive of interest, penalties and any related state tax liability would be approximately $1.5 million for 2002.

In June 2005, the IRS proposed a similar adjustment in connection with the Company’s 2003 federal income tax return. The proposed adjustment, if upheld, would accelerate the Company’s 2003 tax year franchise fee income by approximately $1.3 million. The related federal income tax liability would be $0.5 million.

For the tax years under audit, and potentially for subsequent tax years, such proposed adjustments could result in material cash payments by the Company. These cash payments aggregated are approximately $19.5 million exclusive of interest, penalties, and any state income tax liability. The Company has previously recorded in its consolidated financial statements the expected federal and state deferred income tax liability. The proposed adjustments relate only to the timing of when the taxes are paid. 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.

In addition, the Company has recorded contingency reserves for interest and any related state tax liabilities for the tax years under audit. As of September 30, 2005, the Company believes these tax contingency reserve estimates are adequate to cover interest and any related state tax liabilities for the years 2000, 2001, 2002 and 2003. However, inherent uncertainties exist in estimates of tax contingencies. Therefore, higher actual interest and any related state tax liabilities paid by the Company could adversely affect our reported results.

Critical Accounting Policies

We prepare our Consolidated Financial Statements in conformity with U.S. generally accepted accounting principals. 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.

Self-Insurance Liability

We are self-insured for a 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

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associated with this program is based on our estimate of the ultimate costs to be incurred to settle known claims and claims incurred but not yet 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.

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 September 30, 2005, the maximum projected remaining losses for all open years was estimated to be $1.1 million. The most likely projected remaining losses for all open years was estimated to be $0.3 million. The Company believes the estimate of workers’ compensation losses of $0.7 million as of September 30, 2005 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.

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Certain of our lease agreements contain tenant improvement allowances. For purposes of recognizing incentives, we amortize the incentives over the the shorter of the estimated useful lives or lease term. For tenant improvement allowances, we also record a deferred rent liability or an obligation in our non-current liabilities on the consolidated balance sheets.

New Accounting Pronouncements

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. On April 14, 2005, the Securities and Exchange Commission adopted a new rule that amends the compliance dates for Statement 123(R). Under the new rule, the Company is required to adopt Statement 123(R) in the first quarter of 2006.

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 5 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. 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 amount of operating cash flows recognized in prior periods for such excess tax deductions were $0.8 million and $1.1 million for the nine months ended September 30, 2005 and 2004, respectively.

In October 2005, the FASB issued Staff Position FAS 13-1, “Accounting for Rental Costs Incurred during a Construction Period,” which  requires rental costs associated with ground or building operating leases that are incurred during a construction period to be recognized as rental expense. This Staff Position is effective for reporting periods beginning after December 15, 2005, and retrospective application is permitted but not required. The Company currently capitalizes rent incurred during the tenant construction phase. The Company plans to adopt this Staff Position in January 2006 and does not believe it will have a material adverse effect on our financial condition or results of operations.

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Item 3.                        Quantitative and Qualitative Disclosures about Market Risk

There were no material changes from the information contained in the Annual Report on Form 10-K as of December 31, 2004.

Item 4.                        Controls and Procedures.

(a)          Disclosure Controls and Procedures. The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Based on such evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures are effective.

(b)         Changes in Internal Control Over Financial Reporting. There have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

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Part II. OTHER INFORMATION

Item 1.                        Legal Proceedings.

None.

Item 2.                        Unregistered Sales of Equity Securities and Use of Proceeds.

(a)–(b)Not applicable

(c)          The following table provides information relating to the Company’s repurchases of stock during the third quarter of 2005: