Jack In The Box (NASDAQ:JACK) soared to an all-time high after reporting Q2 results that weren't very impressive after you analyze them on a deeper level. Sales increased 2.6%, beating estimates by $1.2 million, and EPS of $1.07 beat by $0.20. Company-wide same-store sales increased 1.1% and outpaced the sector, but this isn't saying much, and it seems the market is desperate for any kind of good news from the restaurant sector these days. JACK showed strength in its breakfast hour, which relieved some concerns about the firm's ability to compete with McDonald's (NYSE:MCD) all-day breakfast offering, but the strong EPS growth was largely the result of factors unrelated to improved productivity. At a trailing P/E of 27.6, JACK trades at a 16.5% premium to its historical average and we think the stock is overvalued.
With demand slowing, competition in the restaurant industry has increased, and it has led to discounting throughout the sector. This has taken a toll on same-store sales as comps at Jack In The Box company-owned stores fell 1%, driven by a 3.2% decline in pricing. The increased discounting from competitors has forced JACK to focus on providing better value through higher quality burgers and fries and new value price combinations, and we think JACK will continue to struggle with pricing going forward. JACK expects company-owned same-store sales to be flat-to-down 2% in Q3 (versus last year's 5.6% increase), and lowered its full-year guidance from flat to up to 1%. Things were a little better over at Qdoba, where comps grew 3.1%, driven by a 3.7% increase in transactions (average check fell 1.1%). But management expects comps to be significantly lower than last year in Q3 (flat to up 1% compared to 6.6% growth in Q3'15). JACK lowered its full-year guidance for Qdoba comps, and now expects growth of 1.5-2%.
Despite the pricing pressure, JACK was able to expand company-wide margins and grow operating EPS 23%. But this has little to do with sustainable productivity initiatives. Food and packaging costs as a percentage of sales fell 120 basis points y/y, providing a nice boost to the bottom line, and management expects full-year commodity price deflation of 2-3% at Jack In The Box and 5% at Qdoba. This will allow JACK to show higher margins over last year, but the company can't rely on low commodity prices forever, and JACK needs to find new ways to lower costs, now that wages are rising. The company also benefited from mark-to-market adjustments on various assets worth $0.04 of EPS, which lowered the tax rate and resulted in savings of $0.02 in EPS. But share buybacks were the biggest contributor to the EPS growth, in our view. Management repurchased $150 million worth of stock in Q2, and shares outstanding were 11% lower than the comparable period last year. JACK has $150 million remaining on its current buyback program, which management said would "continue to contribute to the EPS growth."
JACK's second quarter wasn't bad, but the rapid appreciation in share price wasn't justified. While JACK and its rivals should benefit from consumers trading down to fast food, competition has intensified and it will be difficult for JACK to grow same-store sales more than 1-2% for the fiscal year. Thanks to lower commodity prices and stock buybacks, we expect margins to improve over last year and EPS to grow as well. This could drive the stock even higher during the next two quarters, but it wouldn't be based on improved fundamentals. JACK is simply too expensive at these levels, and we think investors will be rewarded if they wait for a pullback.
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