Word on the Street recently is that IHOP (NYSE: IHP), the well-known breakfast chain, is in talks to buyout or combine with popular East-Coast restaurant chain Applebee's (Nasdaq: APPB).

This could be a mixed blessing for shareholders, and there are several factors would-be investors should be aware of before even thinking about getting involved.

The Pros
Applebee's is a very popular restaurant and bar, particularly for 20-somethings and 30-somethings in the U.S. Northeast. It's also a decent place to go out with your family, and the prices are generally good. This fits well with IHOP's current business, which is also very family friendly and reasonably priced. IHOP would be getting into pretty familiar territory.

Also, an Applebee's acquisition would give the company much more exposure to the lunch and the dinner crowd (although technically, IHOP already does serve lunches and dinners). This is important because other big name chains including Starbucks (Nasdaq: SBUX), McDonald's (NYSE: MCD), Burger King (NYSE: BKC) and Wendy's (NYSE: WEN) have been actively introducing new breakfast menu items and fancy coffees which may impinge upon IHOP's breakfast business in the future. A merger could limit its risk.

Additionally, there's potential for cost savings. Surely the combined companies could eliminate a layer or two of middle management, and have much greater leverage with food suppliers. This seems like a "no-brainer" to me. These factors alone could provide a serious boost to margins. Another thing to take into account is the cost that goes along with running one public company versus two (making SEC filings, retaining two accounting firms, etc). There are surely a host of savings that could be realized here .

Finally, the company said that it's looking for ways to enhance shareholder value. Rumor has it that recapitalization or outright sale are among two potential solutions being considered by management.

The Cons
The downside to the equation is that Applebee's has been taking it on the chin lately. For the month of May, its total same store sales were down 2.1%. That's not overly impressive given that other major chains have been generating comps in the positive single digits. There is some concern that IHOP would have to pump money into advertising and the development of new menu items in order to boost comparable-store-sales results at the chain. This could be a major obstacle, particularly since IHOP is primarily a franchisor of restaurants, not an operator.

The shear size of such a deal must be considered as well. IHOP sports a market cap of about $983 million, while the market cap for Applebee's is almost $2 billion. How would a deal be structured or financed? And even if an agreement were consummated, would the synergies be worth the risk? These are questions that need to be answered.

The Bottom Line
I find the potential combination compelling, and I like to think that there could be some real synergies. That said, I want a little more information about how such a deal would be financed, and management's estimation of the potential for cost savings before I recommend buying either stock.

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Tickers in this Article: IHP, APPB, SBUX, MCD, BKC, WEN

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