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JACK IN THE BOX – UPDATED WRITE-UP

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CONCLUSION:

Management has done a reasonable job, over the years, in managing the Jack in the Box brand within a difficult environment. Activists have periodically looked at this situation, so a transaction is always a possibility.

However, we feel that most of the obvious levers have been pulled in terms of building shareholder value. Qdoba has been sold, most of the refranchising has been done, and JACK is already levered to almost 4x the current EBITDA run rate. The capex requirement for this mature system is substantial and the franchisor will likely have to play a financial role to aid franchisees, so the free cash flow might not be quite so “free”. An activist would have to pay 13-15 times the current run rate of EBITDA, which we don’t view as a great bargain. Store level economics, at today’s real estate costs, don’t support rapid unit growth, at least domestically, and international growth takes time with its own set of challenges.

Remaining publicly held, the Board could take the leverage up by $4-500M, and that could retire perhaps 15% of the equity (at a premium to the current price). You would then have a mature franchisor selling at 10x the EBITDA run rate, not so attractive with the challenges stated above.

While not privy to all the details of the franchisee discomfort, management at JACK are stakeholders as well and they haven’t been consciously trying to bury the brand. It isn’t the first time that a franchisor hasn’t been sufficiently sensitive to the needs of their franchise partners (at JACK), especially when incubating a second, more rapidly growing brand (Qdoba). Even the McDonald’s system is going through a similar “therapeutic” process, nowhere as intensely as at JACK.   It is in everyone’s interest to settle this matter amicably,  so that will happen in time but it could be costly in various ways to the franchisor. Relative to strategic alternatives, and the value of The Brand, this sure doesn’t help.

Putting it all together, we’ll pass on this one.

COMPANY OVERVIEW (2018 10-K):

Jack in the Box was founded in 1951 in San Diego, CA and has since become one of the nation’s largest hamburger chains. Jack in the Box is the second largest QSR burger chain in 9 of the major markets and number 1 in another. These 10 markets comprise 70% of JACK’s total store count. As of September 30, 2018, there is a total restaurant count of 2,237 in 21 states and Guam, of which 137 are Company-operated and 2,100 are franchise-operated. The Company also formally operated the Qdoba Mexican Grill chain until December 2017 when Apollo Global Management bought the concept. As discussed below under “Unit Level Economics”, it is difficult to open economically attractive locations, with today’s real estate costs, especially for franchisees that are paying royalties, as evidenced by the fact that total systemwide units has been virtually flat over the last five years. In Fiscal 2018, only one company operated store was opened (with five closed), and franchisees opened just eleven (with twenty one closed), resulting in a net contraction, systemwide, of fourteen units. As a result, as discussed below, virtually all the company initiatives in recent years have related to improving productivity at existing locations and refranchising the existing company units. From fiscal 2014 to fiscal 2018 the number of company operated locations was reduced from 431 to 137.

Although JACK is best known for its hamburgers, their most popular menu item is the tacos. The restaurants sell approximately 554 million tacos a year. Other unique items found on JACK’s menu are Eggrolls and Teriyaki Bowls. In recent years, JACK has realized that a significant number of their core customers are heavy late night users and therefore introduced “Munchie Meals” specifically for this crowd. (Munchie Meals consist of a sandwich, 2 tacos, fries and a drink for a special price).

Another unique feature of the Jack in the Box brand is its iconic spokesperson. A fictitious character with a ping pong ball-like head of a clown cap and 2 blue eyes and dressed in a business suit. JACK has been the brand’s identity and spokesperson since the 1980’s, much like Ronald McDonald for McDonald’s. The character is so popular that during Christmas holidays the restaurants would sell an antenna topper for $1 that featured JACK in different attire. These antenna toppers were so popular that the restaurants typically sold out days before the promotion ended. JACK has won several industry advertising awards.

Jack in the Box is also known for its many other product innovations for a burger chain. Products such as Sirloin Burger, originally launched in 2007 and brought back on occasion, a Club Sandwich, Bacon Shake, Sourdough Buns, Ribeye Burger, Bonus Jack – burger using Ciabatta Buns, the Buttery Jack Burger platform, All-Day Breakfast (years before McDonald’s), the Food Truck Sandwich series, and recently the Pannidos (originally introduced in 2004). The significance of all this array of product innovation is that through the years this has become a part of JACK’s DNA and its core customers have grown to expect these additions as integral components of what Jack in the Box is all about.

The Qdoba Mexican Eats era – In 2003 Jack in the Box purchased Qdoba Mexican Eats, a fast casual restaurant chain from ACI Capital. In 2017, JACK sold Qdoba to Apollo Global Management.

LONG-TERM GROWTH STRATEGY (2018 10-K)

Jack in the Box’s primary long-term strategies are focused on meeting evolving customer needs, with emphasis on improving operations consistencies and targeting investments designed to maximize return. The key initiatives include:

  • Simplifying Restaurant Operations – through the following:

o   Back of the House simplifications including equipment, technology that can drive higher throughput, improve overall quality, and reduce labor costs.

o   Reduce redundancy in food stock units; simplification of all operating procedures.

o   Upgrade kitchen equipment.

  • Leverage Technology – Implement new technology such as Mobile applications to meet this growing need of consumers and technology to improve in-store efficiencies.
  • Differentiating through Innovation – JACK continues to focus on what makes them different by balancing premium and value innovation and leveraging the brands unique personality to differentiate creatively and focus mostly on their customers – menu and marketing focus; optimizing delivery and Mobile app.
  • Elevating the Brand Image – focusing on targeted investments designed to maximize returns.

o   Drive-Thru Enhancements – remodeling the Drive-Thru only. 70% of JACK’s customers use the Drive-Thru.

o   Restaurant Remodels – plans are for up to 600 mature restaurants to receive either a full remodel or Drive-Thru enhancements over the next 3 years.

o   Exploring a range of strategic and financial alternatives to maximize shareholder value. Potential alternatives to include a sale of the Company or executing on the Company’s previously announced plans to increase its leverage. As of February 18, 2019, JACK’s Quarterly Press Release – The Company’s Board has not set a timetable for the conclusion of this process nor has it made a decision related to any strategic or financial alternatives at this time. The Company has had discussions with potential buyers; however, there can be no assurance that the exploration will result in a transaction.

SOURCES OF REVENUE (2018 10-K)

In 2018, total revenues were $869,690,000 with 51% derived from Company-operated restaurants, 30% from franchise rental fees and from franchise royalty and other fees. Total revenue for 2018 represents a 21% drop from 2017 revenues. This was caused mainly by the refranchising of 135 Company-operated Jack in the Box locations during the year.  Revenue is derived from retail sales at Jack in the Box Company-operated restaurants and rental revenue, royalties (based upon a percent of sales), and franchise fees from franchise restaurants. In addition, they recognize gains or losses from the sale of Company-operated restaurants to franchisees, which are included as a line item within operating costs and expenses, net, in the accompanying consolidated statements of earnings.

The following summarizes the most significant events occurring in fiscal 2018, and certain trends compared to the prior year.

  • Same-Store and System Sales – System same-store sales increased 0.1% and system sales decreased $3.1 million, or 0.1%, compared with a year ago. A decrease in traffic at both Company-operated and franchise-operated restaurants was offset by menu price increases.
  • Company Restaurant Operations – Company restaurant costs as a percentage of Company restaurant sales improved to 73.5% from 75.8% in the prior year primarily due to the benefit of refranchising units that had lower AUVs than the average for all Company restaurants.
  • Franchise Operations – Franchise costs as a percent of franchise revenues increased to 40.3% from 39.2% in the prior year, primarily driven by incremental costs incurred in 2018 related to the implementation of a mystery guest program, and an increase in costs associated with franchisee restaurant remodels, partially offset by an increase in franchise restaurant AUVs.
  • Jack in the Box Franchising Program – Jack in the Box franchisees opened a total of 11 restaurants. As part of JACK’S refranchising strategy, they sold 135 Company-operated restaurants to franchisees in several different markets during 2018 and generated proceeds from the sale of restaurants of $96.9 million. The Jack in the Box system was 94% franchised at the end of fiscal 2018 as they completed their refranchising program.UNIT LEVEL ECONOMICS (2018 10-K)
  • The average net revenues for Company-operated stores is $2,193,000, the average food costs and packaging is 28.8%, payroll and employee benefits is 28.8% and occupancy and other is 16.0%. Total restaurant level costs of 73.6% leave an EBITDA of 26.4%. The high level of EBITDA is a function of efficient store level operations, good control of cost of goods as well as payroll, and relatively low “Occupancy and Other” as a result of locations opened many years ago with occupancy expenses that are low by current standards.The average investment in a Jack in the Box franchise is $1,481,500 – $3,336,000. The difference mainly being in land and building costs, combined with owning vs. leasing of same.
  •  SHAREHOLDER RETURN (2018 10-K):

     

    • Return of Cash to Shareholders – JACK returned cash to shareholders in the form of share repurchases and quarterly cash dividends. They repurchased 3.9 million shares of their common stock at an average price of $86.86 per share, totaling $340.0 million, including the cost of brokerage fees. JACK also declared dividends of $1.60 per share totaling $45.7 million.
    • Dividends – In fiscal 2018 and 2017, the Board of Directors declared four cash dividends of $0.40 per share each, and in fiscal 2016, declared four cash dividends of $0.30 per share each.
    • Stock Repurchases – In May 2018, the Board of Directors approved a stock buyback program, which provided a repurchase authorization for up to $200.0 million in shares of their common stock, expiring November 2019. In the fourth quarter of 2018 they repurchased 1.6 million shares of their common stock at an aggregate cost of $140.0 million. During fiscal 2018, JACK repurchased 3.9 million shares of their common stock at an aggregate cost of $340.0 million. As of September 30, 2018, there was approximately $41.0 million remaining under the Board-authorized stock-buyback program, which expires in November 2019.

     

    FRANCHISEE UNREST:

    On December 4, 2018, Jack in the Box’s National Franchise Association (NFA) which represents 2,000 of the Company’s total 2,237 restaurants, filed a lawsuit against the Parent Company. The suit is over access to marketing financials and franchisees’ costs when restaurants are remodeled.

    The Association has filed a Breach of Contract and implied Covenant of Good Faith and Fair Dealing in the suit. The dispute details the Parent Company’s “failure to perform its contractual obligations resulting in a negative impact on its franchisees’ financial business model as it pertains to the rights assured to franchisees under the current franchise agreement” according to the NFA.

    It is the third time the NFA has brought grievances with JACK’s management to light. The first was in July where the Association had a majority vote of no confidence in the current management team, and secondly in November the NFA filed a complaint with the California Department of Business Oversight regarding JACK’s new financial restructuring strategy.

    The NFA claims they have the right to review marketing income and expenditures as part of the 1999 agreement. In addition, the Association claims JACK is violating franchise terms by assigning some its costs of new roofs and the structural upgrades to franchisees when stores are remodeled.

    Franchisees are also seeking a seat on the Company’s Board of Directors.

    Recent discussions with several franchisees stated the legal action has grown out of frustration as management has ignored all previous attempts to discuss the franchisees’ concerns. The franchisees stated that on many occasions they have expressed their willingness to work with management to correct these issues, but management has disregarded their complaints as frivolous and unfounded.

    RECENT DEVELOPMENTS: Per First Fiscal Quarter, ending 1/20/19

    Systemwide same store sales were down 0.1%. Company locations were up 0.5%, including average check growth of 3.8% and traffic decline of 3.5%. GAAP Earnings from continuing operations were $1.19 per share in the quarter, after deducting losses from discontinued operations of $0.16 per share. Earnings from operations were $58.3M, down from $73.4M, but there were a number of non-comparable items, such as $5.4M additional Impairments in ’18, more than offset by $8.7M lower loss on the refranchising sale of company operated locations. There were some other less material differences resulting from new required Revenue Recognition standards relating to franchise advertising fees and other services. Adjusted EBITDA was reported to be $83.0M inQ1, compared to $85.4M a year earlier.

    In terms of line items for company operated stores, cost of goods was flat at 28.8%, Payroll expense was up 60 bp to 29.4%, Occupancy and Other was down 80bp to 15.6%, resulting in store level EBITDA of 26.2%, up by 20 bp.

    The commentary in the formal earnings release talked about the (modest) improvement of same store sales driven by a more value-oriented approach, while still avoiding deep discounting. While continuing the effort to improve store level productivity, the Company continues to be “focused on balancing the interests of all our stakeholders, including our franchisees, customers, employees and shareholders…..continue to explore a range of strategic and financial alternatives to maximize shareholder value. Potential alternatives could include….sale of the company or….increasing its leverage…the company remains committed to implementing a new capital structure as soon as practicable.” No further discussion of this aspect of corporate strategy was allowed on the conference call.

    Guidance was provided for the balance of ’19, virtually all of which was consistent with the line items from Q1. One item that caught our eye was the expectation that 25 to 35 new restaurants would open systemwide, which, while still modest and likely to be offset by at least a few closings, would be an increase from only 12 in ’18. This could be a function of new development requirements tied to the refranchising process. The guidance of $260-270M of adjusted EBITDA for ’19 is less than four times the $83M in Q1, but Q1’s sixteen weeks accounts for that.

    On the conference call, management talked about progress with the value driven product strategy, balanced with premium products such as the 100% Ribeye Burger. Delivery, now available through 85% of the system, using Doordash, Uber Eats (and others?), is helping, with a higher average check, two thirds of the orders at dinner and later, and the sales are considered largely incremental. A new mobile app is also helping, launched in Q1, and Apple Pay is functionable for the 100,000 unique users that have already placed at least one order. More than 50 restaurants have been remodeled in the last twelve months and there are 17 new franchised locations under construction. A major overhaul of the drive-thru experience will start to be rolled out later this year, to reach 85% of the system by the end of ’21.

    There were no shares repurchased in the first quarter. Nine new franchised restaurants opened, so full year guidance of 25-35 locations is on track. Second quarter sales were running “flat”, as of 2/21, despite record snowfall in the Northwest and trends improved over the prior two weeks with the introduction of the $4.99 Sourdough Patty Melt Combo and the $4 Fish Sandwich. Full year ’19 guidance continues to be 0-2% same store sales, so improvement is obviously expected. There was, predictably, quite a bit of discussion about other product initiatives, and also reference to the publicly disclosed “strains” with their franchisees. Management responded, also predictably, that they are bending every effort to support the franchise system in the quest for improved profitability.

    CONCLUSION: Provided at beginning of this article

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ASSET LIGHT FRANCHISING – COMPLAINTS FROM FRANCHISEES – LET’S CLEAR THE AIR!!

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ASSET LIGHT FRANCHISING – COMPLAINTS FROM FRANCHISEES – LET’S CLEAR THE AIR!!

The long term investment appeal of well established franchising companies is accepted by the investment community. Most of the prominent franchisors’ equities sell at price to trailing twelve month EBITDA multiples in the mid to high teens (Denny’s (DENN), Dine Brands (DIN), Dunkin’ Brands (DNKN), Pollo Loco (LOCO), McDonald’s (MCD), Restaurant Brands (QSR), Wendy’s (WEN), even higher in a couple of instances Domino’s (DPZ), Shake Shack (SHAK), Wingstop (WING), lower in a number of “challenged” situations like Jack in the Box (JACK), Red Robin (RRGB), Brinker (EAT), Fiesta Rest. (FRGI).

The attraction of asset light franchisors revolves around the presumably free cash flow for franchisors, a steady stream of royalty income unburdened by capital expenditures to build stores. The operating leverage is at the store level.  Franchisees are responsible for building the stores, then controlling food costs, labor, rent and all the other operating line items. Franchisors receive the royalty stream and have the obligation of supporting the system with brand development, site selection advice, marketing support, and operating supervision. These supporting functions, it should be noted, are optional to a degree, and we have written extensively about system support sometimes being short changed by corporate priorities such as major stock buybacks.

THE CURRENT WORD, IN THE FIELD, AS WE HEAR IT

We acknowledge that in every franchise system there will be some operators less satisfied than others. In the same way, customer reviews on Yelp or Facebook are more frequently written by critics. Bad news is more noteworthy and more customers are inclined to criticize than applaud, so we have to listen to the complaints but dig further for the reality. With that in mind, we hear the following from franchisees of various restaurant systems:

“I’ve been in this business for thirty years, and I’ve never seen it this bad. Everyone is making money but me; the landlords, the franchisor, the banks. My margins have been killed, and I’m up against my lending convenants”.

“All the franchisors want to do is build sales to build their royalties. The dollar deals are trading people down. My franchisor doesn’t care about my margins. I can’t maintain my margins, especially with the increasing cost of labor, let alone build it”.

“The franchisor is putting pressure on me to sell, even though I’ve always been considered a good operator, with high performance scores. I’m up to date on my development agreement, but they want somebody else to take me out, and the new buyer will agree to what I consider to be a ridiculously aggressive development contract”.

“The franchisor has replaced experienced long term field support with lower priced (and inexperienced) younger people. They’re cutting corporate overhead, but these kids, who never ran a store, are telling me to how to control costs.””

“I’m doing my best with the development objectives, but it is almost impossible to build stores with today’s economics. Rents are too high, labor costs are killing me, and I can’t raise prices in this promotional environment”.

“As if things aren’t tough enough, I’m being nickeled and dimed with demand for higher advertising contributions and fees on services (including software) that I thought would be provided”.

The valuations provided to the publicly held companies do not reflect the situation as described by the admittedly anonymous franchisees. The commentators quoted above don’t want to aggravate their franchisor, and we don’t want to be unfair or misleading to particular companies by relying on just a few conversations, though they do support one another. For the most part, franchisees are strongly discouraged from talking to the press or investment community. The companies will say that “competitive” issues require some secrecy, but there are few secrets in this industry.

The optimistic view, as represented by the valuations in the marketplace, is that the comments above are not typical or representative of the health of the subject franchise systems. Allow me to provide a short story which leads to a suggestion.

A SHORT STORY

Twenty six years ago, in 1992, IHOP had just come public. I was a sell side analyst, thought the numbers were interesting and the stock was reasonably priced. The company, led by the now deceased CEO Kim Herzer, invited me to attend their franchisee convention, which I did. I obviously had the opportunity to interface with many franchisees and it was clear that, while all was not perfect, the franchisor was providing a great deal of support that was embraced by an enthusiastic franchise community. IHOP stock tripled over several years for me and my clients who owned millions of shares. I attended several more of their annual conventions and maintain some of those relationships to this day. Obviously, the conviction I gained from their open attitude was critical to the success of the investment. I should add, that many of those buyers in 1992 owned the stock for many years, not living and dying on quarterly reports.

THE SUGGESTION

As you are no doubt by now anticipating, my suggestion to publicly held franchising companies: open up your franchisee conventions to the investment community. The companies may quickly respond that lenders are already invited to franchise conventions, but franchisees are unlikely to express their system oriented concerns when they are making a pitch to a potential lender. Companies may also respond that their lawyers think it would be a bad idea, not consistent with full disclosure and analysts would be getting “inside information”. Let’s not allow the lawyers to provide “cover”. A good lawyer will provide a solution to the problem, not just provide the pitfalls. Analysts attending a franchise convention are not being told what sales or profits are going to be. Attending a franchise convention is  a “channel check”, no more than talking to a supplier or customer of a manufacturing company, which any decent analyst will do.

The anecdotal critical comments, as described above, have likely been heard by others, but may be atypical of most restaurant franchising companies. There are no secrets in this business. One of the investment appeals of this industry is its transparency. Notable news is going to leak out anyway. The objective of any publicly held company is to build stock ownership by well informed investors. Investment analysts pride themselves on their ability to “build a mosaic”, enhance the information provided in quarterly reports, SEC filings, and conference calls, with “channel checks”. What channel check would be more pertinent than meeting the franchisees of a company that is dependent on franchisee success? Putting it another way, and taking the highest valuation relative to EBITDA as an example: Wingstop (WING) is a company I have the highest regard for. However, you could call it irresponsible to pay almost fifty times trailing EBITDA for Wingstop stock (and I haven’t) if I couldn’t talk to franchisees of my own choosing?

There’s no particular need to invite this writer if I’m not considered influential enough. I have not spoken to these analysts on this subject, but qualified industry followers such as David Palmer, Nicole Reagan, Matt DiFrisco, David Tarantino, Jeff Bernstein, Andy Barish, Bob Derrington, Mark Kalinowski, Michal Halen, Gary Occhiogrosso, Howard Penney, Jonathan Maze, Nicholas Upton, John Hamburger and John Gordon provide the beginning of an invitation list.  I rest my case.

Roger Lipton

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JACK IN THE BOX – POST EPS – STOCK DOWN, THEN UP – OUR LATEST WRITEUP

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INCLUDED IN YOUR ANNUAL SUBSCRIPTION:

  • Broad economic insight. As described in “Restaurants/Retail – Why Bother?” the restaurant and retail industries provide a leading indicator of far broader economic trends. You no longer have to be the last to know.
  • Two to three analytical pieces per week (“Roger’s Rap”) personally written by Roger Lipton describing corporate developments within his industry specialization, including their relevance to the broader economy.
  • Periodic “macro” discussions personally written by Roger Lipton, analyzing fiscal and monetary matters that will likely affect your investments and your business.
  • Opportunity to “Ask Rog” about your personal concerns, regarding individual companies or broader economic trends. Roger will use his best efforts to answer questions submitted, obviously limited by the number of requests . He may answer your question by email directly and/or include your question with his “Roger’s Rap” releases.
  • You are provided access to “Friends of Rog”, depending on your financial and operational needs. The outstanding individuals suggested here, have been personally “vetted” by Roger over decades. Roger receives no compensation based on whether or not use their services.
  • A free copy of the legendary best selling book, How you can Profit from the coming devaluation, as shown at right, written in 1970 by Harry Browne, which predicted the 2000% rise in the price of gold. This profound piece is more relevant today than ever, so Roger re-published it in 2012. This book will help you preserve the fortune you are in the process of accumulating.

(JACK) JACK IN THE BOX, INC. REPORTS TUESDAY — ANOTHER RETAIL SHOCK?

To access this content, you must purchase Website Subscription.

INCLUDED IN YOUR ANNUAL SUBSCRIPTION:

  • Broad economic insight. As described in “Restaurants/Retail – Why Bother?” the restaurant and retail industries provide a leading indicator of far broader economic trends. You no longer have to be the last to know.
  • Two to three analytical pieces per week (“Roger’s Rap”) personally written by Roger Lipton describing corporate developments within his industry specialization, including their relevance to the broader economy.
  • Periodic “macro” discussions personally written by Roger Lipton, analyzing fiscal and monetary matters that will likely affect your investments and your business.
  • Opportunity to “Ask Rog” about your personal concerns, regarding individual companies or broader economic trends. Roger will use his best efforts to answer questions submitted, obviously limited by the number of requests . He may answer your question by email directly and/or include your question with his “Roger’s Rap” releases.
  • You are provided access to “Friends of Rog”, depending on your financial and operational needs. The outstanding individuals suggested here, have been personally “vetted” by Roger over decades. Roger receives no compensation based on whether or not use their services.
  • A free copy of the legendary best selling book, How you can Profit from the coming devaluation, as shown at right, written in 1970 by Harry Browne, which predicted the 2000% rise in the price of gold. This profound piece is more relevant today than ever, so Roger re-published it in 2012. This book will help you preserve the fortune you are in the process of accumulating.