Jack in the Box Is Likely To Continue Its Upward Momentum

By Ashish Sharma - July 17, 2012 | Tickers: JACK, MCD, WEN | 0 Comments

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Jack in the Box Inc. (NASDAQ: JACK) is a restaurant company that operates and franchises Jack in the Box (JIB) restaurants, one of the nation’s largest hamburger chains, with more than 2,200 restaurants in 20 states. Additionally, through a wholly owned subsidiary, the company operates and franchises Qdoba Mexican Grill, a leader in fast-casual dining, with more than 600 restaurants in 42 states and the District of Columbia.

The company’s stock price has significantly outperformed the broader markets year to date and has risen ~35%. The prospects for JACK are getting better, and it looks like a great stock to add to your portfolio. Its transitioning business model provided a major boost with strong cash flows.  According to the latest FY12 guidance provided by the management, SSS is expected to be in the range 3.5%-4.5%. The company looks set to post high returns in the coming 2-3 years.

Transitioning Business Model: Since the mid-2000’s, the company has been transitioning its JIB business to a higher return, less capital intensive and less risky franchise system. Management has successfully executed on an initiative to transform the more mature JIB system from 25% franchised to more than 73% franchised. This was accomplished through the sale of more than 1,000 restaurants, mostly to existing franchisees. The company reached its target two years ahead of schedule. Going forward, the company expects to refranchise 80 to 100 locations in F12, and another 70 to 80 in F13. This will ultimately bring the system up to 80% franchised. Franchise revenue is posting an accelerated growth in the last five years. The following chart shows the last five years of franchise revenue.

Also, the company is using its growing free cash flow to finance its highly successful Qdoba Mexican Grill subsidiary and share repurchase activity.

Annuity-like Cash Flow: Most franchise brands generate one cash flow stream from franchise operations to royalties. But, the JIB brand generates two: the royalty stream and also the rental income stream. The following charts show the trends of consolidated franchise revenue and consolidated EBITDA from franchising. 

Rental income generates more revenue than the franchise royalties. JACK generates this rental income stream from the real estate leased by their franchisees to operate Jack in the Box restaurants. In 2011, the EBITDA from the royalties and fees after the support costs totalled $109.2 million, and the EBITDA margin, which is the more traditional franchise operator margin, was 90% of the franchise royalties. Thus, the company’s target to generate annual free cash flow of approximately $75 million in 2012 looks easily achievable.

Both brands are positioned in segments where they can gain market share: JACK is positioned well with JIB in the QSR segment and Qdoba in the fast casual segment as quick service restaurants & fast casuals continue to take share from casual dining. This trend is likely to continue next year due to slow economic gains for the ~65% of US households with incomes <$65K. They prefer value, speed & convenience over experience.

Increasing restaurant margins: Store-level margins in the latest quarter expanded ahead of expectations with a 320 bps year-over-year increase to 15.5 percent. The company has posted increasing restaurant margins from 12.3% in 2Q11 to 15.5% in 2Q12. It seems that the benefits of refranchising are becoming clearer and further magnified by solid same store sales and declining food inflation. In addition, the company acquired 25 franchised Qdoba stores in the previous quarter. These acquisitions will further increase margins as Qdoba has lower food costs (as a percent of sales) than the JIB brand.

We believe JACK is undervalued with its EV/EBITDA of 8.70, which is least among its QSR peers of McDonald’s (NYSE: MCD) and Wendy’s (NASDAQ: WEN). Also the EV/EBITDA for its Qdoba’s fast casual peers is far higher and lies in the range 10-20.

Franchise operated stores constitute 73% of total stores as compared to more than 80% for McDonald’s, but the company will achieve the 80% mark soon, providing more visibility and less volatility with constant sources of revenue. Also, Jack has been better at executing its plans than Wendy’s. The company achieved its target of 70% franchised stores two years earlier than planned and is still going strong, whereas Wendys' reimage program lacks visibility and has enough loose ends to cause concern. Thus, we recommend carrying this JACK in your box (read portfolio).

Note: The article originally appeared on our blog TheAnalystHub.com. For more in-depth research articles please visit our site today.

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