Recently I have been seeing quite a bit about Jack in the Box (JACK) and its long term potential through a possible spin-off down the road of its subsidiary Qdoba, the entire company being bought out by one of the bigger fast food chains, or though growing its margins as JACK has been selling Jack in the Box restaurants back to franchisees. I have seen franchise royalty fees estimated to be as high as 80% margins at the high end.
After seeing all of the above and how undervalued everyone seems to think JACK currently is, I decided to research the company myself. Most of what I have read about JACK from other people is that it is undervalued because of the "future potential" of the company with what I talked about in the first paragraph given as reasons; there are a lot of ifs in every pro JACK article I have read thus far.
If you have read any of my previous valuation and analysis articles, you know that is not how I operate. For those of you who have not seen any of my previous articles, I do not base my buy or sell decisions on ifs. I value the company's assets and operations as it is now, and future potential is only icing on the cake to me in most cases. Here is an overview of my investment philosophy.
With the rest of this article I will be showing you why I think JACK is overvalued and give you reasons why I will not be investing in it at this time.
Jack In the Box Overview
JACK owns and operates a total of 2,247 Jack in the Box fast food restaurants, about 72% of which are owned by franchisees. Jack in the Box is one of the largest hamburger chains in the U.S. with operations in 19 states, with the vast majority of its operations in California and Texas. JACK also owns Qdoba and has 614 total restaurants, about half of which are owned by franchisees. Qdoba is a fast food Mexican restaurant with operations in 44 states currently. For further information on JACK please visit its website here.
Jack in the Box has recently finished up re-imaging some of its restaurants by changing the logo, updating the menu, and making its restaurants look more modern. The recent re-imaging of Jack in the Box restaurants has led to higher capital expenditures and sometimes lower revenues over recent years. Now that the bulk of the re-imaging is done, Jack in the Box is hoping to become even more profitable.
In recent years Jack in the Box has under gone the process of selling some of its restaurants to franchisees so it can get into the higher margin area of collecting royalty and franchise fees. Jack in the Box currently has around 72% of its restaurants owned by franchisees with plans to eventually have 80% of its restaurants owned by franchisees.
Qdoba has been going through a rapid growth phase since being acquired by JACK in 2003 and JACK management states that it believes there is future potential of between 1,800 and 2,000 Qdoba restaurants in the United States.
As of the most recent 10Q, JACK gets 56.9% of its revenue from sales at its restaurants, 27.7% from distribution sales, and 15.5% from franchise and royalties. Total company costs are 83.5% of total revenues which come from food and packaging 32.3%, payroll and employee benefits 28.7%, and occupancy and other 22.5%.
These valuations are done by me and are not a recommendation to buy stock in any of the following companies mentioned. Do your own homework. All numbers are in millions of US dollars, except per share information, unless otherwise noted. The following valuations were done using its 2011 10K and 3Q 2012 10Q.
I did my other normal valuations as well but from now on plan to only post the ones that I think are most relevant.
Low Estimate of Value:
|Assets:||Book Value:||Reproduction Value:|
|Cash & Cash Equivalents||10.8||10.8|
|Accounts Receivable & Other Receivables (Net)||84.9||72.2|
|Deferred Income Tax - Deferred Tax Liability||39||19.5|
|Assets Held For Sale & Leaseback||62.4||31|
|Other Current Assets||1||0|
|Total Current Assets||267.3||168|
|Other Assets Net||241||120|
Number of shares are 45
- Without goodwill: 783.3/45=$17.40 per share.
Base Estimate of Value:
Cash and cash equivalents are 10.8
Short term investments are 0
Total current liabilities are 266
Number of shares are 45
Cash and cash equivalents + short-term investments - total current liabilities=
- 10.8+0-266=-255.2/45=-$5.67 in net cash per share.
Jack in the Box has a trailing twelve month EBIT of 120.
5X, 8X, 11X, and 14X EBIT + cash and cash equivalents + short-term investments:
- 5X=610.8/45=$13.57 per share.
- 8X=970.8/45=$21.57 per share.
- 11X=1330.8/45=$29.57 per share.
- 14X=1690.8/45=$37.57 per share.
From this valuation I would use the 8X EBIT and cash estimate of intrinsic value, $21.57 per share.
High Estimate of Value:
|Average 5 year EBIT %:||7.50%|
|Estimated EBIT of:||162.4|
|Assumed Fair Value Multiple of EBIT:||11X|
|Estimated Fair Enterprise Value of JACK:||1786.4|
|Cash, Cash Equivalents, and Short Term Investments:||10.8|
|Estimated Fair Value of Common Equity:||1346.2|
|Number of Shares:||45|
|Equals:||$29.92 per share.|
I will explain my reasons for picking these valuations in the conclusions portion of this article, but by my estimates JACK Is currently either fairly valued or overvalued by almost every valuation technique I did, except for the valuations with very high multiples.
Margins and Debt In Comparison To Competitors
|Jack in the Box||Sonic (SONC)||McDonald's (MCD)||Yum Brands (YUM)||Chipotle Mexican Grill (CMG)||Company Averages|
|Gross Margin 5 Year Average||16.28%||34.30%||37.94%||26.20%||24.28%||27.80%|
|Gross Margin 10 Year Average||17.08%||43.38%||40.42%||35.59%||11.73%||29.04%|
|Op Margin 5 Year Average||7.46%||16.24%||27.42%||14.22%||12.76%||15.62%|
|Op Margin 10 Year Average||7.07%||18.05%||22.62%||13.50%||6.64%||13.57%|
|ROE 5 Year Average||20.16%||66.33%||30.26%||131.56%||18.55%||53.37%|
|ROE 10 Year Average||18.77%||43.71%||23.19%||105.85%||10.27%||40.36%|
|ROIC 5 Year Average||11.17%||3.38%||17.38%||24.97%||18.49%||15.08%|
|ROIC 10 Year Average||10.91%||8.97%||13.37%||23.54%||10.22%||13.40%|
|FCF/Sales 5 Year Average||-0.26%||6.48%||15.90%||7.70%||6.92%||7.35%|
|FCF/Sales 10 Year Average||0.80%||7.10%||12.86%||6.70%||2.26%||5.94%|
|Cash Conversion Cycle 5 Year Average||0.78||1.23||0.91||-36.35||-5.24||-7.92|
|Cash Conversion Cycle 10 Year Average||0.27||1.14||-1.22||-49.02||-5.21||-10.81|
|Insider Ownership Current||0.38%||6.12%||0.07%||0.50%||1.64%||1.74%|
|Total Debt as a % of Balance Sheet 5 year Average||30.78%||80.91%||35.28%||45.24%||0||38.44%|
|Total debt as a % of Balance Sheet 10 year Average||26.84%||50.77%||35.22%||40.72%||0.14%||30.74%|
|Current Assets to Current Liabilities||1.02||1.38||1.24||0.97||4.13||1.75|
|Total Debt to Equity||1.03||9.69||0.97||1.6||0||2.66|
|Total Debt to Total Assets||30.50%||71.20%||41%||37.21%||0||35.98%|
|Total Contractual Obligations and Commitments, Including Debt||$2.6 Billion||$1 Billion||$27.20 Billion||$11.42 Billion||$2.20 Billion||$8.88 Billion|
|Total Obligations and Debt/EBIT||21.67||8.85||3.15||5.4||5.82||8.98|
My thoughts on the above comparisons:
- McDonald's is by far the most profitable company of the five as it far outdistances the competition in gross margin, operating or EBIT margin, FCF/sales, etc.
- Sonic and Yum Brands' ROE and ROIC are astounding but are inflated by both companies high levels of debt in comparison to the other three companies.
- JACK's margins have generally declined in the last five years in comparison to the entire 10 year period. Most of the other company's margins during that time have been improving.
- Chipotle's margins are pretty amazing, especially when you see that it does not have any debt so the numbers are not inflated like Sonic and Yum.
- On an EV/EBIT basis Chipotle looks to be very overvalued currently with a ratio of 26.53.
- The insider ownership of all the companies is horrendous.
- The P/B of this industry is by far the highest I have seen since doing in depth research.
- The EV/EBIT ratios are also much higher than the companies I have been researching lately.
- The P/B and EV/EBIT ratios being much higher than what I have been finding lately leads me to believe that this entire industry is either fairly valued or overvalued currently.
- The entire industry has some very high debt levels due to the costs of food, restaurant leases, etc. Debt levels have risen quite a bit recently as all of the companies, with the exception of CMG and MCD, have taken on more debt in the past five years.
- MCD, YUM, and CMG's total obligations and debt/EBIT ratios look very sustainable into the future.
- JACK's total obligations and debt/EBIT ratio is dangerously high at 21.67. Especially of concern is that the bulk of its obligations and debt are due before 2016.
- Sonic's debt levels also seem to be too high to me.
- Helping out SONC, MCD, YUM, and CMG is that most of the four company's debt and total obligations are coming due after 2016.
Let us now get back to JACK.
- JACK has been buying back a lot of shares and has reduced its share count by 13 million since 2009, down to a total of 45 million as of the most recent quarter.
- JACK has decent margins that have been consistently positive over the past decade.
- Now that the re-imaging of Jack in the Box is done, cap ex should go down and profit margins should go up over time.
- Qdoba is a high growth asset that is also currently more profitable than Jack in the box.
- JACK's debt ratios, excluding total obligations, all look very good compared to its competitors.
- Selling restaurants to franchisees will get JACK into the higher margin business of collecting royalty and franchise fees.
- Fortunately most of JACK's debt has low interest rates.
- JACK owns the land underneath some of its restaurants which provides at least partial downside protection due to the possible sale of the land if it was facing dire problems and was forced to sell some of its assets.
- JACK's debt ratios above are very misleading as they do not include contractual obligations and commitments.
- JACK's total obligations and debt in comparison to its profitability levels are way too high in my opinion with a total obligations/EBIT ratio of 21.67, which is by far the highest of the group and dangerously high in my opinion.
- Most of its debt and obligations are due within the next 5 years further exacerbating the debt situation in my eyes.
- Margins have been declining at JACK over the past five years, in part due to the re-imagining of its Jack in the Box restaurants.
- JACK's margins while decent and relatively steady over the past few years, are also generally quite a bit lower than its competitors.
- JACK's FCF/sales margin is negative over the past five years while the industry average is 7.35% over that time.
- JACK is overvalued by almost every one of my estimates of intrinsic value.
- The entire fast food industry appears to be either fairly valued or overvalued at this time.
- About 85% of its revenues go towards paying costs, greatly affecting margins.
- JACK will continue to put a lot of its resources towards opening and running restaurants and food costs. Some of the cost of new restaurants is paid by the developer however.
- A 1% point increase in short term interest rates would result in an estimated increase of $3.6 million in annual interest expense. Interest rates can only go higher from where they are at now.
- Has a low amount of cash on hand.
- Managements pay seems too high to me.
- How JACK management structures the pay, bonuses, and awarding of options and restricted stock is very convoluted. The most recent proxy is longer than the most recent annual report, most of which is spent explaining how management is awarded some of its compensation.
- Horribly low insider ownership.
- I do not see any kind of moat or competitive advantages within JACK.
- Margins should rise now that the store re-imaging of Jack in the Box restaurants are done, which could eventually lead to a higher estimate of value.
- The total obligations and debt situation could be a negative catalyst if JACK should have any problems.
- As of the most recent proxy, Fidelity Management & Research Company owns 14.9% of JACK. If FMR decides to liquidate a portion or all of its position in JACK there could be a big sell off in the stock.
- If JACK management decides to sell or spin off Qdoba it would send the stock price higher.
- JACK could be bought out by a bigger fast food chain.
The reason I chose the above estimates of intrinsic value, that I am sure the JACK bulls will say are too low, are because of the problems I found with JACK as it currently stands: Its huge amount of total obligations and debt, the bulk of which is coming due before 2017, its relatively low and decreasing margins in comparison to its competitors, along with all of the other reasons I outlined above.
I need as big of a margin of safety as possible and for the most part only value what I see in the company as it presently stands. All of the other articles I have seen have been talking about how much JACK could be worth if it spun off or sold Qdoba, or the entirety of JACK gets bought out.
To my knowledge JACK management has not said anything about spinning off Qdoba so to me valuing a company on speculation of what could happen in the future is very dangerous. I saw an article the other day where someone wrote that if Qdoba was spun off could sell for 30X EV/EBITDA because that is what Chipotle sells for. Buying any company at 30X EV/EBITDA is insane to me, especially potentially Qdoba as I do not think it has any discernible sustainable competitive advantages. I do not even know how someone would make money on that transaction, especially since Qdoba would most likely not pay any dividend as it needs to grow its store count.
Even if JACK management does decide to spin off or sell Qdoba, the valuations and analysis that I laid out above were encompassing the entire company, and I still found JACK to be overvalued on almost every count. I do expect JACK's margins to rise over time now that the bulk of its re-imaging is done, but the debt and total obligations scare me too much to be a buyer even if that happens.
Speculating is no longer what I do when investing, and to me buying into JACK now is almost purely a speculation play in the hopes that it gets bought out or spins of Qdoba. In my opinion JACK is overvalued, has no discernible moat or competitive advantages, and has some huge problems with its debt and total obligations. Combined with the rest of my above analysis, I think JACK is a bad investment currently.
For me personally, how I invest, what I need as a margin of safety, and the problems I outlined in the article, lead me to the conclusion that the risks far out way the pros as JACK currently stands, and I will not be a buyer of it at this time.