JACK underperformed the S&P 500 by 370bps and 210bps over the past week and month, respectively. The under-performance raises some alarm bells going into its earnings release on Thursday. All of the work done during the quarter suggests that the fundamentals have been shaping up well. Commodity inflation is one concern, as it is for the vast majority of restaurant companies, but we believe that the market has long taken this into account when assessing JACK.
The trends at JACK are getting better “on the margin” but the company is not in the clear just yet. As I see it, the current risk/reward is favorable. JACK is the last QSR company with a market capitalization over a billion that is trading below 6.0x EV/EBITDA. By comparison, the average multiple for the QSR sector is now at 10.3X EV/EBITDA. However, excluding CMG and GMCR and DNKN, the QSR average multiple drops to 8.7X EV/EBITDA.
I see FY3Q11 same-store sales growth guidance of +2-4% for Jack in the Box company units as reasonable, given the sequential improvement in two-year average trends during fiscal 2Q11 and the stable/improving QSR macro environment.
The following are some of the important forward-looking statements from the last JACK earnings call and our take on the current quarter trends.
THE BIG MACRO
“We're on track to substantially complete our restaurant re-image program system-wide by the end of the calendar year. And we're ahead of our timeline to increase franchise ownership to 70% to 80% of the Jack in the Box system.”
“Overall commodity costs are now expected to increase 4.5% to 5.5% for the full-year with Q3 inflation expected in the 6% to 7% range. Restaurant operating margin for the full-year is now expected to range from 12.5% to 13.5%, with better sales versus our prior guidance largely offsetting higher commodity inflation."
“We have not changed our full year guidance for diluted earnings per share of $1.40 to $1.65. Gains from refranchising are expected to contribute $0.70 to $0.83 to EPS, with the penny increase on the upper end due to the lower expected tax rate for the full-year.”
“Operating earnings per share, which we defined as diluted EPS on a GAAP basis less gains from refranchising, are expected to range from $0.70 to $0.82 per share. EPS includes approximately $0.10 to $0.12 of incremental re-image incentive payment franchisees in fiscal 2011 as compared to fiscal 2010. The incremental re-image incentive payments for Q2 were $0.02 higher and year-to-date $0.03 higher than in fiscal 2010, although re-image incentive payments were $2.7 million year to date versus $650,000 through Q2 of 2010.”
“We would expect that our restaurant operating margins at the conclusion of our refranchising strategy will be above 16% in a normalized inflationary environment. In addition, we have said previously that we expect G&A excluding advertising as a percentage of consolidated system-wide sales to be in the 3% to 4% range. And Q2 year to date, we were at approximately 4.3% of system-wide sales.”
“We’ve raised our full year same-store sales guidance for both brands. Same-store sales are now expected to increase approximately 1% to 3% at Jack in the Box Company restaurants versus our prior guidance of down 2% to up 2%. At Qdoba, we now expect system-wide same-store sales to increase 4% to 6% versus our prior guidance of a 3% to 5% increase.”
“For the third quarter, we expect same-store sales for Jack in the Box company restaurants to increase from 2% to 4% and system-wide same-store sales for Qdoba to increase 4% to 6%. Our guidance reflects the sales trends we've seen thus far in the quarter.”
“So, driving the AUVs in all of the system restaurants is going to be important. So if you look back at when we had the restaurant operating margins that I spoke about earlier, at 16% and then one year as high as – they were over 17%. That was with average unit volumes about 1.440 million. If you look at where our average unit volumes are annualized based upon current year performance, they're about 1.375 million. So we need to get those average unit volumes up, and I think that's going to be a significant piece. We need to continue to grow same store sales. I don't think it will be as simple as just refranchising all of those units; however that is going to be a significant portion of this."
HEDGEYE: The macro environment continues to be challenging for JACK, especially on the commodities side. However, the employment trends have been improving for JACK in the most important regions. The “less bad” macro environment, coupled with the SSS momentum that started in last quarter, suggests that this quarter should meet or exceed expectations. In particular, management has emphasized employment trends among young Hispanic males as being particularly important for Jack in the Box’s top-line trends.
“As we said on our February call, we expect that Q2 restaurant operating margins will be similar to Q1, which was 12.6%.”
“Based on the increases we've seen in most commodities since that time, we now expect full year commodity inflation to be 4.5% to 5.5%.”
“Beef accounts for more than 20% of our spending and is the biggest factor driving the change in our guidance. For the full year, we are now anticipating beef cost to be up nearly 14% versus our previous expectation of 9% inflation. We expect beef cost to be up approximately 14% to 15% in the third quarter. Our third quarter forecast for beef 90s, in the low $2 per pound range and for beef 50s; we expect prices to average in the $0.95 to $1.05 per pound range in Q3.”
“Pork accounts for about 6% of our spending. It's expected to increase 4% for the full year. Cheese also accounts for about 6% of our spending and we continue to expect a 15% increase for the year. We now have 100% coverage on cheese through the remainder of the fiscal year.”
“Dairy costs, which are over 3% of our spend, continue to be impacted by higher butter prices and are now forecasted to be up 6.5% for the full year versus our prior forecast of up 5%.”
“Bakery accounts for about 9% of our spending and we continue to expect a 1.5% decline for the year. We now have 90% of our bakery needs covered through December of 2011.”
“There has been no change in our outlook for chicken, which is about 9% to 10% of our spending, as we have fixed price contracts that run through March of 2012. Produce represents about 5% of our spending and Q3 and Q4 costs are expected to normalize after the weather-related inflation we experienced in Q2. We have fixed price contracts in place for potatoes, which accounts for approximately 8% of our spending; with 100% of our potato needs for the full year contracted with prices essentially flat versus last year.”
“We’re anticipating Qdoba margins to be about 50 to 60 basis points accretive to our back half margins for the full year.”
“Then getting back into more of your question on the restaurant operating margin, if we can go back to what our initial outlook was for the full year, back in November we were talking about flattish comps down 2 to plus 2. We talked about commodity inflation of 1% to 2% and that was going to drive restaurant operating margin expectations in the 14% range. And now that – the decline from that 14% to the midpoint of our range right now of 13% is largely driven by the commodity inflation, which we're now expecting to be 4.5% to 5.5%.”
HEDGEYE: One key to the bull case for the stock over the next 12-18 months will be the company’s ability to improve SSS and see incremental leverage to the margin structure of the company. If JACK can get to their goal of 16%, the stock will behave accordingly.
“We've increased our guidance of – for Qdoba unit growth this year and now expect 60 to 70 restaurants to open system-wide, as franchisees are now expected to open 35 to 45 restaurants.”
“And capital expenditures are expected to be $110 million or less, with the majority of that spend going towards new unit growth for both brands versus maintenance and remodel capital. In addition, the change in our business model should result in growing royalty and rental income streams, be less capital intensive, improved returns on invested capital, and EBIT margins and generate higher free cash flow.”
“We have $25 million available for repurchases under a Board authorization, which expires in November of this year. And last week our Board authorized an additional $100 million repurchase program, which expires in November 2012.”