JACK IN THE BOX

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Jack in the Box (JACK) – Post Conference Call Addendum

We wrote a piece this morning, prior to the conference call, in some degree of haste, in an effort to give timely information to our readers. In the 10-K filed this morning, some facts and figures were disclosed that we have now incorporated into our post as of this morning, in particular the fact that store level  “profit” as disclosed by JACK is AFTER depreciation, as opposed to most reporting restaurant companies. We thank Carol DiRaimo (Chief Investor Relations and Corporate Communications Officer at JACK) for alerting us to this oversight. We have adjusted this morning’s piece, provided below, to incorporate the necessary changes. Our conclusion remains the same, however, Qdoba is worth a lot less than it used to be, and it remains to be seen whether it will be sold. Either way it goes, JACK management has its hands full, whether it be with one brand or two.

As promised a couple of hours ago, the key ingredients from the conference call, aside from the publicly disclosed numbers in the earnings release, which you can access elsewhere, were as follows:

(1) It was repeated that the strategic review had “made substantial progress…with respect to Qdoba, as well as other ways to enhance shareholder value”. See our comments below regarding the potential value of Qdoba.

(2) Sales at Jack in the Box have firmed up in the eight weeks of their Q1 to date, with sales slightly positive vs. down 1.0% systemwide in Q4. Qdoba sales are still running down, as in Q4, which was down 2.1% systemwide. Transactions no doubt are still negative at both chains.

(3) Progress continues to be made toward franchising JIB  locations, soon to be 90% of the system, ultimately 95%, and corporate G&A is being streamlined as this program continues.

(4) Going to emphasize value in the near future, along with a number of premium items such as the Ribeye sandwich. Not going to give up ground to competitors in terms of a value message, but will not go to the “discount drug”.

(5) When questioned about commodity and labor expense expectations, analyst was “met half way” with an answer that commodity inflation would be about 3% in ’18 at JIB (higher than that in Q1) and about 1% at Qdoba. Wage inflation was not discussed, but we know the answer to that one.

‘(6)When questioned about unit growth within the JIB system, management said that first priority for franchisees is remodeling. New units will come later, perhaps a couple of years out.

(7)Which, aside from the possible (our italics) divestiture of Qdoba, leads to the last important element of the future equation, namely, in management’s words,  “the JIB store system has to be remodeled”. As the landlord  in about half of the system, JIB will be “helpful” to franchisees with tenant allowances, which of course will be reflected in the new rents. Management provided no details on the potential plan, but indicated that it would generate an “acceptable” sales lift, “nothing like 20%. Our guess is in the range of 5%-10%, but time will tell. JIB, as the franchisor, appropriately views the remodel program as a necessity, even with only a modest sales lift and return on invested capital, if the chain is to remain competitive. The new element of the equation, however, is that if $300,000 is spent on 2,000 stores, that would be $600M of capital that has to be spent by someone, a lot of money even spread over five years. We can’t know how much would be provided by JIB, but, as the landlord on half the system, it will likely impact “free cash flow” in a significant way. Management stated that “tenant improvement allowance is not ‘capital’ as it affects the balance sheet”, but there is no doubt of its effect  on cash available for other strategic purposes.

Jack in the Box (JACK) – Addendum to 10/31/17 Report – Subsequent to Yearend Report – Conference Call Pending: Will update this report after call

JACK reported yearend results last evening after the close, disappointing by most measures, especially the results at Qdoba, which has been reported to be for sale. Management has retained investment bankers to evaluate all “strategic alternatives”, including the possible sale of Qdoba. It has been reported in the press that Apollo Management is contemplating the purchase, with a potential transaction price approximating $300M.

With JACK trading down a relatively modest three points, on what we consider rather disappointing news, especially relating to the potential sale price of Qdoba, we provide the following summary to our readers in advance of the conference call scheduled for 11:30 this morning, EST.

Operating Earnings at JACK were $0.73 versus $1.03 YTY, about $0.16 less than the Street was expecting. In Q4,  Jack in the Box system sales were down 1.0% with transactions down 5.4%, affected just slightly by the hurricanes. Qdoba system wide sales were down 2.1% . Company stores  (385 vs. 341 franchised) had sales down 4.0%, with franchise sales flat. Most important, company transactions at Qdoba were down 6.4%.  For the year JIB company stores were down 1.1%, Qdoba company stores down 3.0%. For the year JIB franchised stores were up 0.9%, Qdoba franchised stores were up 0.4%. Most importantly, transactions at both brands were down materially, both company and franchised, for the quarter and the year.

Relative to the potential value of Qdoba:

Unit level economics continue to be of the utmost importance, of course. The yearend 10-K filed this morning shows development cost of a new Qdoba between 0.8M and 1.1M. The average company store volume was $1.164M for the year, just above franchisee AUVs of $1.146M. We don’t know franchise unit level profit (after depreciation) results, but company store level profit  was 13.6% in ’17, down from 18.1% of sales in ’16 (without royalty, of course). If you want a reason why franchise units only grew from 332 to 339 in ’17 (19 openings, 10 closings) it might be because store level profit of perhaps 15% for franchisees (assuming a little higher than the 13.6% for the company) only leaves 10% after royalty of 5%, perhaps only 6.9% (after 1.8% required local advertising and 1.3% national mktg. fund) and then maybe 2-3% after some local G&A. Depreciation allowance would add to short term “cash flow” but that has to be used over time to keep the stores physically current. We might be off modestly in these assumptions but franchisees vote with their pocketbook, and clearly they are not wildly enthused with their return on investment.

Roughly calculating the TTM EBITDA for Qdoba within JACK:

385 Company stores generated $448M of revenues with 13.6% store level profit, which is $61M at the store level. If we assume 7% G&A, including marketing,  that would leave about 30M company operated profit. If depreciation is 4% (which is not “free cash flow” over time, as demonstrated by the remodel needs of Jack in the Box), EBITDA would be about $48M.  Add to that a royalty rate of 5% on 341 franchise stores company stores that generate about $390M of sales, and you get royalty revenues of  $19.5M. If we assume an operating margin at the current rate of 72%) (we believe the expenses will need to be higher than that to properly support a system of over 300 locations, especially one that needs to be re-invigorated) that would be $14M of franchising profit, which would be a theoretical total of about $62M of approximate QDOBA TTM EBITDA. While 5x TTM EBITDA, or $310M  seems reasonable enough, we believe that higher G&A will be necessary and depreciation will not be “free cash flow”, especially with this troubled chain. With all the trends going the wrong way, sales, traffic, expenses, margins, etc., we question whether Apollo, or anyone else will be likely to step in to this equation. In either case, Qdoba is not the valuable asset under the JACK umbrella as was the case a few years ago.

Conclusion: We question whether Apollo Management, or anyone else, is going to step up to the plate here, with alll the trends are going the wrong way,  and their is no magic bullet to turn Qdoba around. If a P/E buyer thinks they are going to go “asset light” and franchise the company stores, I would counter “to whom?”.  I won’t be surprised if the “evaluation of strategic alternatives” winds up without a Qdoba transaction, and JACK management will have no alternative but to do their best to re-invigorate both concepts. See our report, written a month ago, for background, and our conclusion at that time, which still stands. At whatever multiple of EBITDA Qdoba trades it, if it trades, it will be well below the multiple that JACK as a whole currently trades. That would leave the remaining JACK system at a higher multiple of earnings and  EBITDA than is currently the case and is in serious need of remodeling, at a substantial capital cost.

 

The following article is, as published on 10/31, including the following table:

e, is, as published, on 10/31/17, including the table below:

CONCLUSION:

 Jack in the Box, Inc. (JACK) has performed well as a company, and as a stock, over the long term, and management is doing a workmanlike job of managing the business in a difficult environment. However, we feel that most of the “levers” have been pulled, to improve operating margins as well as the stock performance. The stock did especially well as Qdoba emerged within the fast casual segment over the 15 years prior to 2015. At the same time, the re-franchising program was initiated at Jack in the Box, along with substantial repurchasing of company stock. The underlying value of Qdoba clearly was viewed as supporting the total valuation of JACK, as analysts viewed Qdoba, a spinoff,  IPO, or sale candidate, as the “next Chipotle”, with the CMG analogy not so good tody (even before the recent slowdown at Qdoba).  Furthermore, it has to be a bit surprising, and disappointing,  that Qdoba has not shown more fundamental progress the last two years as CMG has stumbled. On the JIB side of things, the bulk of the re-franchising is behind them, a substantial portion of the capitalization has been bought back in the open market, with further purchases not so material as to build EPS, and the current leverage is not far from the top of a reasonable range. With sales at both chains challenged, labor costs continuing to rise materially, commodity costs now turning higher, these aspects are typical of  almost all restaurant chains. We don’t see how either JIB or Qdoba will differentiate itself materially, and establish a new higher trajectory for cash flow or earnings. While a multiple of 11.8x TTM EBITDA is not outlandish, and further stock repurchases may protect the stock and the reported EPS, the P/E multiple over 20X forward earnings seems more than adequate for a company with only modest growth prospects from this point forward. If Qdoba is sold, it is unlikely that it would be sold, in this restaurant industry environment,  for a multiple hiigher than the 11.8x TTM current corporate multiple which JACK sells at, which would leave the remaining JIB EBITDA multiple higher, rather than lower than the current valuation.

Lastly, as the proprietor of Roger’s (unfiltered) Review, I can’t help but wonder how $1.8M was spent (up front) with investment bankers, to evaluate the possibilities of unlocking the value of Qdoba. If a high powered M&A investment banker is billed out at $1,000/hour, how does a an investment banking firm justify 1,800 hours already spent, and a Company pay that kind of invoice?  If Qdoba is sold, no doubt a much larger “performance” fee will be paid. Personally, we have never been paid “up front” for investment banking services, always for performance. But, hey, that’s just me. I probably don’t understand.

COMPANY OVERVIEW (2016 10-K) and (2017 Q3 10-Q:

Jack in the Box is a restaurant company that, as of 7/9/17, operated and franchised Jack in the Box restaurants, one of the nation’s largest hamburger chains with 2,255 locations in 21 States and Guam. JACK also operates and franchises Qdoba Mexican Grill, a leader in the Fast Casual dining sector, with 720 locations in 47 states, the District of Columbia and Canada.

SOURCES OF REVENUE:

Jack in the Box’s primary source of revenue is from retail sales at Jack in the Box and Qdoba company operated restaurants. JACK also derives revenue from Jack in the Box and Qdoba franchise restaurants including rental revenue, royalties (based upon a percentage of sales) and franchise fees.  In 2016 Jack in the Box contributed 86% of revenue fund; Qdoba contributed 14%. In 2016 total revenue was $1,369,416,000. 75.3% was from company operated restaurants. 14.6% was from franchise rental revenues and 10% from franchise royalties and others.

Jack in the Box restaurant leases generally provide for fixed rental payments (with cost-of-living index adjustments) plus real estate taxes, insurance and other expenses. In addition, approximately 15% of the leases provide for contingent rental payments between 1% and 15% of the restaurant’s gross sales once certain thresholds are met. They have generally been able to renew their restaurant leases as they expire at then-current market rates. The remaining terms of ground leases range from approximately less than one year to 52 years, including optional renewal periods (see table below).

 

Consolidated Revenue Breakdown is as follows:

Company restaurant sales:                      75.3%

Franchise rental revenue:                        14.6%

Franchise royalty and other fees:         10.1%

100.0%

During 2016 the company opened 4 new JIB Restaurants and refranchised 1. Franchisees opened 12 new JIBs and closed 12 for system-wide end of year total of 2,255. (The breakdown was 417 company restaurants or 18% and 1,838 franchised restaurants or 82%). Net new store openings in 2016 was 6. In 2015 the company opened 2 new locations and refranchised 21. Franchisees opened 15 new locations and closed 13. End of year system total for 2015 was 2,249. 413 company stores or 18% and 1,836 franchise stores or 82%. Net new store openings in 2015 was 1; see table). During 2016 the company opened 35 new Qdoba restaurants, closed 4 and acquired 14 from franchisees. Franchisees opened 18 and closed 11. Total net unit growth was 38, representing 5.7% during calendar 2016. The following table summarizes the changes in the number and mix of JIB and Qdoba company and franchise restaurants in each fiscal year.

JACK IN THE BOX BRAND:

JIB brand first opened in 1951 in San Diego, CA where it is currently headquartered.

JIB is now 85% franchised and is the 6th largest operator in the domestic hamburger QSR space specializing in classic burgers & fries, breakfast menu, tacos, specialty premium sandwiches, salads and shakes. JIB is primarily located in the western United States and Texas with a presence in select large urban locations in the eastern United States.  JIB prides itself on its menu innovations – creating the Brunchfast meal time with its own separate menu (a cross between Breakfast and Lunch), All Day Breakfast, customize their entrees, and a continuing cycle of compelling LTO’s. 70% of sales come from the Drive Thru and average check is $7.38. The average size of a JIB is 2,500 sq. ft. with system franchise and company units in FY16 AUV of $1,530,000 ($612 per sq. ft.). Over the last 4 years AUV has increased from $1,379,000, a 2.6% CAGR (see table).

Most company JIB units are constructed on leased land, or land purchased and leaseback transactions. According to the company, the gross development cost for a typical JIB unit (minus land value) ranges from $1.2M-$2M. After netting out the sale & leaseback proceeds, the initial cash investment for a new unit is reduced to the cost of equipment which ranges from $0.3M-$0.5M. Over 1,600 of JIB and Qdoba franchised units are leased or sub-leased from the company.

QDOBA BRAND:

JACK purchased Qdoba Mexican Grill in 2003. Qdoba is a wholly-owned subsidiary of JACK. Qdoba is 47% franchised and is classified as a Fast Casual concept with a chef inspired menu featuring Mexican themed items: burritos, nachos, tacos, and quesadillas. A simplified pricing structure for protein selections is one of Qdoba’s most popular attractions. Qdoba prides itself with having large toppings so there is no need to order additional sides. The new protein structure was launched in 2015 and elevates the value perception. Qdoba has proven successful in nontraditional sites; such as airports and on or near college campuses.  In 2016, Qdoba’s average ticket was $11.75. Stores averaged 2,500 sq. ft. with system (franchise and company units) FY16 AUV of $1,179,000 ($491 per sq. ft.), increasing from $1,000,000 in 2012 a 1.5% CAGR.  8% of Qdoba sales were generated from catering in 2016.  Earlier in FY16 the company finalized a new store design after several years of testing various prototypes and design elements to drive traffic, sales, and brand awareness for new stores and re-models. In the 16Q4 conference call, management indicated test units opened in FY15 and FY16 were generating first-year AUV’s near system average, and that the development costs were about $1.1M, though it expected this cost to be engineered down. Unlike JIB’s franchised locations, virtually all Qdoba’s franchised locations are developed and financed by a third party or by the franchisees themselves.

 

LONG-TERM BUSINESS STRATEGY:

  1. Focus on Continued Growth – Part of this plan is to increase franchise ownership to 95% includes refranchising. Strategy over the last 5 years JIB has increased franchise ownership from 72% at the end of fiscal 2011 to 82% at the end of fiscal 2016, and 85% by Q3’17. The other component of the continued growth strategy is new unit growth through franchise restaurants. For 2017 the company was expecting to open 20-25 new JIBs (majority by franchisees), which has not been achieved.
  2. For the Qdoba brand, the focus is on an aggressive new unit growth at an accelerated pace over the next several years. This will increase market penetration which will improve brand awareness. For 2017 the company was expecting to open 60-70 new Qdoba restaurants, 40 of which were expected to be company operated, but there has been a shortfall here as well.
  1. Increasing AUV – The company’s research indicates they will be rewarded in sales increases more from improvements in food quality than from notable low margin promotions.

 For JIB – from that perspective, they have upgraded over 50% of its menu offerings in the burger, sandwich, and breakfast categories and point out the success of the premium “Buttery Jack” platform as validation of this approach. Additionally, during the Super Bowl, JIB launched its “Declaration of Delicious” campaign which involved giving away one million free burgers to stimulate trial of their improved menu. JIB has also improved late night offerings by introducing the “Munchie Meal” Box – served only after 10 PM.

In March of 2017, JIB launched its Delivery program in over 800 cities. It has partnered with DoorDash, Inc. to provide this service.

For Qdoba – The brand is moving away from the discount oriented and value menu items featured in the past and moving toward more bolder flavors and a simplified pricing structure featuring a set price based on protein selection with no additional charges for toppings; such as: sour cream, quacamole, queso and other sauces. This new pricing structure was introduced in early 2015. It has elevated the “value perception” at Qdoba. Additionally, the new pricing options allow a broader scale of meal customization without all of the complexity of a typical Mexican restaurant’s menu. Another initiative for improving AUV at JIB, they focus the majority of their marketing on Social Media. Since 2010, YouTube has been their main venue and has one of the highest following for a restaurant chain on YouTube (source: Google). In 2016 JIB began experimenting with interactive YouTube commercials.

  1. Improving Restaurant Profitability – part of this initiative is tied to the reducing amount of discount initiative. As discounts are reduced, profits will go up. Another part of this initiative is the improved burger line: premium “Butter Burgers”. This platform sells for a higher price point which provides better margins. Premium items such as these shift the overall product mix reducing costs. Average unit level food costs were reduced from 31.7% average in 2015 to 29.9% in 2016 due in part to the product mix shift. This is a net reduction of $29,856 per year per unit.
  2. Returning Cash to Shareholders – Through share repurchases and dividends, as described below.

 MENU:

Jack in the Box Menu: JIB prides themselves on their innovative menu enabling customers to customize their orders, go to breakfast anytime and purchase a variety of different products frequently through LTO’s. Highlights of their menu consists of a variety of burgers, chicken sandwiches, salads, Tacos, Fries, eggrolls, a large variety of hand-held breakfast sandwiches, a Brunchfast menu, Munchie Meals (which are designed for the late-night crowd), soft drinks, shakes and selection of desserts.

Qdoba Menu: Their food philosophy lies in crafting flavor combinations that will satisfy the biggest cravings. Main choices are knockout tacos, taco salads, burritos, nachos, burrito bowls and tortilla soup. The menu is designed for customers to “create their own” masterpiece with no additional charge for ingredients.  Qdoba has recently been pushing catering, representing 8% of total sales in ’16.  JIB has been exploring the possibility of selling Qdoba, recently abandoned. Morgan Stanley has helped them spend $1.8M in that process. (Discussed in our Conclusion, above.)

  SHAREHOLDER RETURN:

  1. Returning Cash to Shareholders – During 2016, Jack continued to return cash to shareholders in the form of share repurchases, an average price of  $75.29 per share, in the amount of $291.9 million, and declared a dividend of $1.20 per share totaling $40.5 million. The company did not repurchase any shares during Q3’17,  due to the evaluation of potential alternatives regarding Qdoba. The company did announce that on August 3, 2017 it declared a quarterly cash dividend of $0.40 per share payable September 5, 2017.

RECENT DEVELOPMENTS:

Per Q3 Earnings Release

https://seekingalpha.com/pr/16911892-jack-box-inc-reports-third-quarter-fy-2017-earnings-updates-guidance-fy-2017-declares

Per Q3 Conference Call

https://seekingalpha.com/article/4098280-jack-boxs-jack-ceo-lenny-comma-q2-2017-results-earnings-call-transcript

The 3rd quarter can fairly be described as less than impressive, though management points to progress through the quarter, and many initiatives expected to improve results in the future. Once again, analysts and reporting services, including Bloomberg, choose to report non-GAAP “Operating Earnings”, ($0.99 vs. $1.07), as shown in our table above. GAAP EPS was up nicely, actually, from $0.93 to $1.25, but that was a function of year to year comparisons in restructuring charges and gains from refranchising. In this case, the non-GAAP numbers are a better reflection of comparative results.

At JIB, Company store comp sales were down 1.6%, with a decline of 4.4% in transactions. Systemwide, JIB comp was a negative 0.2%. Qdoba Company stores’ comp sales were down 1.1%, with negative transactions of 2.8%. Qdoba systemwide comp was up 0.5%. Not surprisingly, Consolidated Restaurant Operating Margin, which reflects franchising activities as well as company store operations, was down 380 bp to 18.1%. This reflects store level EBITDA decreases of 320 bp at JIB, to 19.3% of sales, and a decrease of 420 bp at Qdoba, to 16.4% of sales. Typical of almost all restaurant companies, labor is heading higher, and cost of goods inflation is setting in. Combined with “sluggish” sales trends, operating margins are hard pressed to remain constant , let alone improve.

On the bright side from the reported result: Overall corporate Franchising Margin, as a percent of franchise revenues, improved by 120 bp to 54.0%. This was due to higher franchise fees after the refranchising of 118 JIB stores in Q2 and Q3, a decrease of franchise support and other costs, partially offset by the acquisition of 50 franchised JIB stores.

SG&A expense was down $4.4M, so decreased by 90 bp as a % of sales. This “contribution” to the bottom line was affected by “the company’s restructuring activities, a $3.5M decrease in incentive compensation, a $2.1M decrease in pension and postretirement benefits, and a $2.0M decrease in insurance costs. These decreases were partially offset by a $2.5M legal settlement benefit in the prior year related to an oil spill in the Gulf of Mexico in 2010, and $2.4M incurred while the 31 franchised JIB restaurants were taken back in Q3’17.”  So much for analysts’ ability to project G&A in the future. Less complicated, but difficult to model for the future, is that the tax rate was 33.2% in Q3, compared to 36.0% a year earlier.

In terms of “color” on the quarter, comps improved sequentially at both brands through the quarter, with Qdoba systemwide comps turning positive for the quarter, and JIB just slightly negative. The environment was described as continuing to be very promotional, hopefully to abate as cost of goods makes deep value deals more expensive for operators to produce. Most of the traffic loss has been taking place at the lower price points, so an effort is being made to improve the competitive positioning from that standpoint. Operating initiatives at JIB, while desirable and necessary, are very typical of all high quality operators. New menu items are being developed, on both the high and low end of the price spectrum. Door Dash is being employed for third party delivery, now offered at 37% of the system. Catering is being emphasized, up 11% in Q3. A mobile app is being developed, tying into an upgraded POS platform. Remodels, including kitchen innovations are expected to help build sales. Suffice to say, JACK management is doing everything they should be doing, but the competitive environment has not lessened, and the macro consumer headwinds still apply.

Reference was made on the call to the “return to shareholder” approach, and management pointed out that $327M of stock has already been repurchased, with a pause in Q3. Remaining authorization until November of 2018 is $181M. This would take the Company to the top end of their previously stated Debt to EBITDA.  While similarly established “asset light” franchisors have gone higher in this regard, time will tell for JACK.

In terms of guidance, Q4 and the full ’17 year, ending 9/30 were adjusted downward. Fourth quarter same store sales were expected to be flat to down 2% at both JIB and Qdoba. Commodity costs will be flat, at both brands for the year, obviously firming through the year and running up at yearend. Consolidated Restaurant Operating Margin will be 18.0-18.5% for the year, roughly the same as it’s been running, “depending on the timing of refranchising and the accompanying restaurant margins.”

Openings for the ’17 year will have been 20-25 JIBs and 45 Qdobas, the majority of both to be franchised. The tax rate will be about 37.0%.  “Operating Earnings Per Share”, which the company defines as Diluted EPS from continuing operations on a GAAP basis excluding charges and gains from re-franchising” will be $4.00-$4.15 (which includes $0.10 of costs related to the 31 previously franchised stores bought back in the Q3).

 Conclusion:  Stated at the outset of this article.

 

 

 

 

 

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