Jack In The Box: What Worries Me?

Summary

• Despite recent positive developments, I am concerned about the company’s prospects.
• I find management’s commentary on SSS inconsistent.
• Altering capital structure and increasing leverage ratio may not be good strategy for the company.
• Valuations are expensive.

Jack In The Box (NASDAQ:JACK) is receiving quite a bit of positive commentary of late. Goldman Sachs's analyst has upgraded the stock twice since the beginning of this year; activist investor JANA Partners has reported a 7.3% stake in the company last month; and the company reported better-than-expected Q1 results. Inspired by these developments, I began analyzing the company as a prospective long candidate. However, after a closer look, I was forced to change my mind. In this article, I am discussing two of my major concerns about the company.

Inconsistent Commentary on Same Store Sales

Jack In The Box reported a slight decrease in 1Q18 same-store sales. Management commented that it saw sequential improvement in sales and traffic as the quarter progressed. Here are the relevant excerpts from its last quarter earnings call,

"System same-store sales decreased slightly in Q1 as we rolled over a 3.1% increase last year, which is our best quarter of fiscal 2017. But we saw sequential improvements in both sales and traffic in Q1."

Now, going forward, the comparisons are easing, and according to bulls/management, the company will end up posting 1% to 2% increase in SSS for the full year. While on the face of it, this argument makes sense, the numbers do not add up. Here is my math.

In November, on Q4 2017 earnings call, management provided a brief commentary on how the first eight weeks of Q1 2018 looked like,

"Through the first eight weeks of our first quarter, Jack in the Box system same-store sales are running approximately flat to slightly positive, despite lapping year-ago same-store sales growth of 4.7% for the comparable eight weeks and our competitors' ongoing focus on extreme value."

Now, Jack's 1Q18 consisted of 16 weeks ended January 21, 2018. Since first eight weeks comp sales were slightly positive, and the comp sales for the full 1Q18 were negative, it implies comp sales for the last eight weeks were negative.

Also, for the first eight weeks of 1Q17 (previous year), comp sales were up 4.7% and for the full quarter (Q1 2017), comp sales were up 3.1%. Therefore, sales for the last eight weeks of Q1 2017 were up ~1.5%.

This means that despite of comps easing 320 bps (4.7%-1.5%) from the first eight weeks of 1Q18 to the last eight weeks, SSS turned negative. Therefore, there was more than 320 bps slowdown in the comp sales as 1Q18 proceeded. So, I am having a hard time believing management when they are saying sales and traffic improved throughout 1Q18.

This is also reflected in the company's 2Q18 guidance which implies flat SSS at the midpoint despite 390bps of benefit from easing comps. While the management has kept its full-year guidance constant at 1% to 2% SSS growth, there is nothing which suggests that this comp deceleration and customer attrition, which the company has seen throughout 1Q18 and is expecting in 2Q18, would reverse in the back half of this year. So, I believe the company's SSS will miss management's full-year guidance.

Capital Structure

Another major bullish argument for the company is its potential to return cash to the shareholders through buybacks. Management has indicated that post-95% re-franchising, the company now has an asset-light model and can increase its leverage to 5x EBITDA versus 4x EBITDA currently. I have two problems with this argument.

1. Unlike other asset-light restaurants which receive royalty income from their franchisees, Jack also receives a substantial rental income as it owns many shops which are leased to its franchisees. In fact, Jack derives more than 60% of its revenues from rentals. The problem with this model is that the company often has to give its franchisees tenant allowance in the form of rent-free periods when its franchisees do a remodel. While this rent-free period is not capex in accounting terms, it effectively is Jack's investment in franchisee remodel. So, the company's business model is not completely asset light in the true sense.
2. While taking debt near the market peak and using it to buy back shares may work for an activist investor with short-term horizon, I don't think it is a good strategy to create long-term shareholder value. There is a lot of uncertainty with competition from McDonald's (MCD) intensifying and interest rate rising. Over-leveraging balance sheet at this point can be a recipe of disaster of the company.

Management has recently hired a consultant to advise it on capital structure. While I believe Qdoba sales proceeds could be used for buybacks, I don't think that taking additional debt to buy back stock will be a viable strategy. Some sell-side analysts and JANA Partners seem to be counting on the company increasing its leverage. Their estimate regarding buybacks may prove inaccurate.

Valuations

Jack is trading at more than 23x current year earnings. If we assume all of Qdoba's sales proceed and proceeds from re-franchising are used to buy back shares, we will still get the stock trading at ~19x PE. In a declining SSS environment, I don't believe that the stock deserves to trade at this multiple. I believe the stock can see ~15% downside as the year progresses, and the company disappoints in terms of SSS growth and its capital return plans.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[dstb]

Thanks for your work. I agree that buying back significant stock at the wrong time will be bad for shareholders. JACK isn't as pricey as some but valuing any of these companies when the industry is such a disaster is tough to do. Even now there is far too much expansion by almost every concept. It just won't work and I believe the worst is yet to come. We need to see concepts shrinking or going completely out of business and we just aren't there yet. Jana may be able to make a quick profit but like you said, that would hardly be good for LT investors.