Editor's Note: Our Restaurants analyst Howard Penney added Jack in the Box (JACK) as a best short idea on 10/17/19. Shares were trading around $86 at the time. Shares are have fallen to around $78 today. If you are an institutional investor interested in accessing Howard's research, please email email@example.com.
As Penney wrote this morning:
The crux of our short thesis on JACK centers on the company’s inability to execute in a very competitive 2020 QSR restaurant environment. In 2020, WEN will be very aggressively trying to intrude on the breakfast daypart as well as other QSR brands will be spending more to be competitive in new product categories offering heavy promotions and discounts.
As the company highlighted yesterday, the financial engineering that has benefited the business model over the past five years is now in the past. Now the company needs to ramp up spending on remodels and restart new unit growth to have a viable long-term story. The underlying problem with this strategy is that the company is dependent on franchisees for unit growth. A franchise fee of $50,000 and a 5% royalty rate puts JACK at the higher end of the QSR space. Also, what does this say about how the company feels about the ROI of new units if they don’t want to build new stores? Either way, both of those initiatives come with an incremental cost to the P&L.
So that leaves us with the need for management to drive incremental success from restaurant operations, which is not going to be easy for a regional QSR operator. This is what JACK is facing from an operational perspective in 2020:
1. VULNERABLE TO DISCOUNTING - The average check grew 4% last year and is now $8.34. JACK has used price/mix aggressively over the years and is now paying the price. (CEO notes from the call: “this price-sensitive environment has not gone away, and I think that for the long-term health of the brand, we've done many years with attempting to grow through check. I don't think that's the overall healthy way to grow business over the long term.) CAKE & MCD are exposed to this same issue.
2. SAME-STORE SALES – On the 4Q earnings call JACK provided less disclosure around delivery, suggesting the one-time benefits are beginning to slow down. I suspect this can explain why the company is guiding to slowing sales trends in 2020. From our 1Q20 themes deck, comping delivery will be an industry wide problem in 2020. Same stores sales guidance of 1.5%-3% is disappointing and well below the rate of food and labor inflation.
3. EXPOSURE TO FOOD INFLATION - Food costs represent 29% of sales and are increasing at 4% (beef and pork represent approximately 18% and 7%, respectively, of commodity spend and “do not lend themselves to fixed price contracts.”) The company’s inability to fix its protein costs are a risk to 2020 earnings.
4. LABOR INFLATION – Labor is 30% of sales increasing at high single digits, with significant exposure to CA.
5. EXCESSIVE LEVERAGE – The new capital structure put debt/EBITDA at 5x. Returning excessive cash to shareholders is now in the past.
6. TAKING A LONG-TERM VIEW – The company altered communications to the street which is never to be taken as good news: “I think the marketplace is hyper-focused on what happens on a week-by-week basis, credit card data, quarter-to-date reviews and it is taking the eye off of some of the things that we and other players in the industry need to do over the long term that will positively impact the consumer and make the operation more efficient. And that's the reason why we've sort of drawn a line in saying that we're focused on the annual numbers versus the quarter to date.”
7. SPEED OF SERVICE – Improving the speed of service is an opportunity to improve SSS, but it requires incremental investments that take time - “What I will say is this, we are one of the slower players in the industry. And we need to make significant improvements, drive the overall throughput of our drive-thru business.”
Below is what Penney wrote on 10/17/19 outlining his concerns about the company.
In 3Q19, JACK posted strong top-line performance, sending the stock up 12.9% year-to-date. Traffic accelerated sequentially, to a positive 0.3%, the first positive quarter since 3Q15, but there is limited line of sight for further improvement beyond 4Q19.
While California and Texas (70%+ of total sales) will not be a big battle ground for WEN’s attack on breakfast, the significant uptick in promotional activity around breakfast and other day-parts will likely be a painful time for JACK. The company has recently taken on an operational turnaround and desperately needs to upgrade the asset base. The increased competitive nature of the industry will cause some sales issues in FY2020 for JACK.
If you are an institutional investor interested in accessing Howard's research, please email firstname.lastname@example.org.