We see $4-$8 of upside to Jack in the Box as the street gains more clarity on and becomes more comfortable with the company’s plan.
Jack in the Box is on the tail end of a major six-year restructuring of its business model to become more like other franchised QSR players. It has been a long six years and the stock has been trading sideways over that time. The goal of the restructuring was to lessen the volatility in the earnings stream from inflation and erratic sales trends. The question becomes when the street will become more comfortable with the “franchised” business model and potentially revalue the earnings and cash flow stream equal to other dominantly franchised companies.
The company is hosting its first analyst day since May 2008 in two weeks. We suspect the reason the company is deciding to host an analyst day now is so that it can communicate to the investment community what the new business model will look like and what should be expected from the company over the next five-to-ten years. We expect the broader scope of the presentation to include:
- Detail around the stability of earnings and cash flow going forward
- Long-term earnings target
- Goals for free cash flow generation
- Use of free cash flow going forward
- Qdoba’s growth profile
The stability of the new business model and visibility on consistent EPS growth is critical to convincing investors that the company’s stock is worthy of a higher valuation. During the restructuring period, the street has not been able to model the company consistently because of the timing of gains generated by the selling of the company store base. That lack of visibility and the significant investment the company has made assisting the franchise remodels has been a drag on earnings and, therefore, the stock has been subsequently penalized.
One of the most important characteristics of the franchised business model is the significant free cash flow generation. During the past six years, the significant investment Jack in the Box has been making in fixing the system has been impairing the company’s ability to generate free cash flow. In 2012, that seems likely to change with cash flow growing in FY13 and beyond. The absolute level of free cash flow will likely lag the company’s peer group due to the significant growth opportunity that Qdoba represents.
The analyst day could also prove to be a positive for the stock from a sentiment perspective. If the street walks away with the impression that the company has turned the corner, we believe that the stock price could appreciate significantly from that shift alone. In the short run, however, here are the goals we see as most important for the company to achieve.
- Getting to 16% margins for the balance of the company store base
- More disclosure on Qdoba profitability
- More disclosure on Qdoba’s growth prospects
- Sustainability of the Jack In the Box same-store sales trends
The sentiment on the stock has been improving on the name over the last two weeks, but its overall rating on the Hedgeye Restaurants Sentiment Score Card is very low. While short interest has risen slightly in the past couple of months that has been accompanied by a significant uptick in sell ratings.
JACK is coming off a strong FY2011 (year ended October 2, 2011) posting same-store sales and transaction growth in every quarter. For the full year, the 3.1% increase in company same-store sales for the full year was driven entirely by traffic. We expect the strong performance to continue into FY2012.
WHAT HAS CHANGED TO DRIVE BETTER SAME-STORE SALES TRENDS?
- Investments to improve the core menu (focused on classic burgers) and operational execution which should allow for more consistent performance. The net benefits are higher food quality and better speed of service
- The company is on the tail end of a six year restructuring of the business model to being primarily franchised and nearing the end of a comprehensive restaurant reimage program. At the end of 4QFY11, substantially all company restaurants and nearly 80% of franchise locations featured all of the interior and exterior elements of this program; the balance should be largely completed by the end of the calendar 2011
- JACK sold 332 restaurants during FY2011, leaving the Jack in the Box system 72% franchised at the end of fiscal 2011. The company completed the refranchising plan two years ahead of plan and has refranchised more than 1,000 stores over the past six years. Over the next couple of years Jack in the Box franchise ownership should approximately 80% of the system.
LOOKING BACK AT 4QFY11 SALES TRENDS
- In 4QFY11, same-store sales at company Jack in the Box restaurants increased 5.8% driven by an 8.5% increase in traffic; the fifth consecutive quarter of sequentially improving two-year sales trends
- Of the 5.8% increase in 4QFY11 company same-store sales, 8.5% was traffic, check was down 2.7% and price was up 2.7%, which leaves mix down -5.4%
- Every major markets posted strong same-store sales growth in 4QFY11 and positive across all day parts
- Average weekly sales for Jack in the Box company restaurants were up 14.9% in 4QFY11. Company AUVs for the full year were just over $1.4 million, up 8.3%; the increases in AUV benefited from increased SSS, the benefit of refranchising as well as the impact of store closures
- Breakfast was again the strongest day part, driven BY the $2.99 Jumbo Breakfast Platter
- Early in the 1Q12 Jack’s (first seven weeks) continued to see strong same-store sales growth despite more difficult comparisons
- Qdoba 4QFY11 same-store sales increased 3.1% system-wide
- In contrast to the Jack in the Box concept they continue to increase the percentage of company ownership of Qdoba restaurants; 42% of the system was corporate-owned compared to 36% at the end of last year and 31% at the end of fiscal 2010
- In 2011 67 new Qdoba restaurants opened system-wide including 25 company locations. Management also made opportunistic acquisitions of 32 franchise locations in 2011
- The plan is to aggressively build out the number of Qdoba Company Qdoba locations over the next several years and make opportunistic acquisitions at franchise locations
HEDGEYE: Coming out of the analyst meeting, we expect that the street will have more confidence in current trends and the growth prospects for Qdoba.
MARGINS AND EXPENSES
- In 4QFY11 restaurant operating margin was 13.5%, up 100bps YoY and sequentially from FY3Q
- Gross margins declined 190bps, but were more than offset by 290 basis points of improvement from refranchising and stores closed. Commodity inflation was about 7% vs. 3% inflation last year's. The increase was partially offset by pricing of 2.7% reflecting a 1.4% increase that was taken in mid-May, an incremental 1% price increase taken at the end of August.
- JACK sold 106 company-operated Jack in the Box restaurants in 4Q11 and 332 restaurants fiscal 2011
- To give you some perspective on the impact refranchising is having on our strategy to evolve to a higher margin company-operated footprint, our pro forma restaurant operating margins for fiscal year 2011 excluding the stores we refranchised this year, would have been approximately 100 basis points higher that we reported above 27%
- Commodity costs for the full fiscal year 2012 are estimated to be up by 5%, with higher inflation in the first half of the fiscal year. Almost everything in the commodity basket is forecast to be higher in FY2012
- Beef prices (about 20% of spending) will be up the full year 9%- 10%, with inflation in the high teens in the first quarter
- Chicken (about 9% of spending) is contracted for the year
- The company has 100% coverage on cheese (roughly 6% of spending) through the end of March 12thand 50% coverage through the end of fiscal 2012
- 90% of the bakery (about 8% of spending) needs are covered through December 2011, approximately 70% coverage through March 2012, and 30% coverage through May 2012
- Commodity costs for the first quarter are expected to increase by approximately 8%
HEDGEYE:The biggest negative facing JACK in terms of costs is the significant inflation in red meat.
COMPANY OUTLOOK FOR FY2012
- In 1QFY12, the company is guiding to same-store sales at Jack in the Box company restaurants to increase 4% to 5% lapping a 1.5%, putting the 2-year trend at 3%, up from 0.9% in 4QFY11.
- 1QFY12 system-wide same-store sales for Qdoba are expected to increase 2% to 3% versus a 6.4% increase in the year-ago quarter
- For the full fiscal year, same-store sales are expected to increase 2%-to-4% at Jack in the Box company restaurants and 3%-to-5% at Qdoba system restaurants
- SG&A margin is expected to be in the mid-10% range
- Capital expenditures are expected to decline to $90 million to $100 million in 2012 from $129 million in 2011
- The company’s full-year guidance for diluted earnings per share is $1.10-to-$1.43 with the range reflecting uncertainty in the timing of anticipated refranchising transactions, as well as same-store sales results and commodity inflation. Operating earnings per share, which we define as diluted earnings per share on a GAAP basis less gains from refranchising, are expected to range from $0.90-to-$1.10
- Operating EPS includes $0.07-to-$0.09 of reimage incentive payments to franchisees in fiscal 2012, which again are expected to occur mostly in the first quarter. Reimage incentive payments in fiscal 2011 were $8.2 million or approximately $0.11 per share
- Gains from refranchising are expected to contribute $0.20-to-$0.33 to EPS as compared to approximately $0.78 in fiscal 2011
- EPS sensitivity as follows: For every 1% change in Jack in Box system same-store sales we estimate the annual impact in earnings is about $0.08-to-$0.09 per share, approximately half of which relates to company operations depending on flow through and assuming stable costs, and the other half relates to franchise revenues which are not subject to commodity costs or other inflation. The impact of a 1% change in Qdoba same-store sales is approximately $0.01-to-$0.02
- For every 10 basis point change in restaurant operating margin the estimated annual EPS impact is approximately $0.01-to-$0.02 per share on a consolidated basis
HEDGEYE: The numbers JACK is guiding to are better than bad. The bulk of the capital spending on the system remodels is behind the company and should now be a tailwind from an earnings and sales perspective. The company’s business model is now in line with its industry peer group, approaching nearly 80% franchised by the end of this fiscal year. Qdoba is an important part of JACK’s business; approximately 28% of total company-operated units as compared with approximately 5% five years ago. Going forward, management’s plan is to grow the number of Qdoba company locations aggressively through opportunistic acquisitions from franchisees. Beef inflation is still an issue and will likely continue to be for the foreseeable future.
At 7.0X EV/EBITDA NTM, JACK is trading at a discount to WEN and SONC. Given JACK’s sales and earnings trends, the company should trade at a premium to SONC and more in line with WEN. Although, we might add, we view WEN trading at 8.9X EV/EBITDA as overvalued. That being said, there is $4-$8 of upside to Jack in the Box as the street gains more clarity on and becomes more comfortable with the company’s plan.