Description

Illustrative Investment Idea – Long – Jack in the Box (JACK)

Jack in the Box is a quick-service restaurant (QSR) chain undergoing a pivotal transformation led by a dynamic new CEO.  JACK is shifting from a slow-growth, asset-heavy restaurant owner to a growing, asset-light franchisor.  We believe this transformation is not being appreciated by the market as investors are misconstruing the Company’s recent acquisition of Del Taco (TACO pre-acquisition) and the resulting temporarily lower franchised mix.  This is exacerbated by the fact that investors historically have overlooked the Company due to its limited unit growth and turbulent relationships with its franchisees under prior management.  We see the story quite differently as the acquisition is part of a grander vision by CEO Darrin Harris, who plans to transform the newly integrated company in a very shareholder-friendly fashion by monetizing real estate assets and refranchising the newly acquired Del Taco base.  Despite this significant value-enhancing opportunity, the shares are currently priced at a steep valuation discount to its QSR peers, trading at a 10.0x 2023 EV/EBITDA multiple versus the comparable peer group at 15.0x.

When the Company’s current CEO Darrin Harris arrived in mid-2020, he embarked on a multi-step plan to dramatically enhance shareholder value and change the culture.  He communicated this plan at the Company’s June 2021 investor day, which primarily involved reinvigorating unit growth at Jack in the Box by mending franchisee relationships and improving unit economics, while also generating a more consistent same store sales growth profile for the Company.  In essence, CEO Harris was building a more consistent and durable model for the longer-term.  Doing so would align the JACK investment thesis with premier QSR peers like Domino’s Pizza (DPZ) and YUM! Brands (YUM), which have epitomized this form of predictable growth.  Evidently the market was willing to ascribe value to this new plan, and JACK subsequently traded up to a high of $122.70 per share and an implied valuation of 12.2x EBITDA.

In late 2021 however, JACK frustrated the market with its acquisition of Mexican QSR chain Del Taco (purchased for $585 million).  Management saw this as an opportunity to accelerate the growth of the business, while also leveraging its core franchisor and technology infrastructure.  Investors, however, balked at the transaction, as acquisitions were not included in the Company’s initial stated strategic plan.  More significantly, investors worried that the acquisition would be regressive, by making JACK more “asset-heavy” due to Del Taco’s relatively low 50% franchise mix compared to JACK’s 93% franchise mix, at a time when labor and commodity inflation were pressuring industry margins.  Compounding the market’s concerns, JACK missed Q2 2022 earnings expectations from newly emerging inflation trends, ultimately driving shares down 55% below the 2021 highs to a level not seen since 2016 (excluding the pandemic).  

We however perceived the market’s reaction to the acquisition and earnings report as extremely myopic and saw an opportunity to initiate a position. While indeed lowering the franchise mix in the near-term, the Company on its earnings call clearly delineated its commitment to be asset-light over the long-term and was already actively looking to sell the newly acquired Del Taco stores to franchisees. Furthermore, the Company announced a new plan to monetize real estate assets, which when combined with refranchising, we estimated would generate over $550 million in proceeds, or 37% of its then market capitalization.  Adding to our conviction, we believed earnings expectations were reset to a very conservative level, particularly as inflation relief checks were scheduled to be sent to California citizens in the October-November timeframe. 

While the stock has since recovered 38% from those recent lows, we continue to see substantial upside to JACK shares from current levels as the Company executes upon the following catalysts: 1) sells real estate assets to generate $305 million of proceeds at an accretive multiple; 2) refranchises owned units bringing its franchise mix to over 90%, resulting in $251 million of proceeds and an upward multiple revaluation; 3) utilizes proceeds from real estate monetization and refranchising efforts to buy back an estimated $250 million of shares, or 15% of the current market capitalization; 4) accelerates unit growth and same store sales due to the California stimulus package; and 5) alleviates concerns surrounding the Fast Food Accountability and Standards Recovery Act and its impact on wage inflation.

As the transition to a more asset-light business model begins and the Company progresses towards its stated 4.0% unit growth target in 2025, JACK shares should close the valuation gap with peers.  This should drive the shares toward our target valuation multiple of 15.0x EBITDA, resulting in a value of $132 per share, representing 69% upside from current levels, and thus creating a very compelling investment opportunity.

Business Description and Overall Expansion Opportunity

JACK currently operates 171 and 291 Jack in the Box and Del Taco restaurants, respectively, and acts as the franchisor for 2,036 Jack in the Box and 303 Del Taco restaurants.  The Company also owns the land and building for 196 Jack in the Box locations that are operated by franchisees.  Jack in the Box and Del Taco are expected to generate $4 billion and $1 billion in system sales in the Company’s fiscal 2022, respectively.  Management describes Jack in the Box and Del Taco as “challenger brands” due to their relatively low market share in the QSR Burger and the QSR Mexican categories.  For reference JACK is currently dwarfed by much larger competitors like McDonald’s (MCD) Burger King (owned by Restaurant Brands International (QSR)) and The Wendy’s Company (WEN), which combined generate $72 billion in annual system sales, suggesting a potentially meaningful market share opportunity for the Company.  Del Taco as well faces a similar market share opportunity from its much larger QSR Mexican peers like Chipotle Mexican Grill (CMG) and Taco Bell (owned by YUM).

Under the prior management team, the Company struggled to grow its store base from 2014 through 2019.  We believe this has caused misplaced skepticism for the unit growth strategy of current CEO Darin Harris.  Our channel checks suggest quite the opposite, and we believe he has the right pedigree to execute upon this growth algorithm, having spent many years of his career on both the franchisee and franchisor sides of development.  His background has enabled Harris to develop credibility and trust with franchisees looking to deploy capital.  Moreso, the Del Taco acquisition presents an entirely new set of potential franchisees who can develop the Jack in the Box brand, while also allowing existing Jack in the Box franchisees to reignite growth with the newly acquired brand.  Our bottoms-up assessment shows that Jack in the Box and Del Taco units perform very well when placed in close proximity to one another.  Our research suggests minimal risk of cannibalization between the two brands even in very dense markets, and a strong opportunity for cross franchising between franchisees of either brand. 

New Management is Focused on Unlocking Value for Shareholders

While JACK does have the new management capability and opportunity to create value for shareholders by simply accelerating unit growth, we recognized that such a story would ultimately take years to develop.  What attracted us to JACK was management’s pivot towards asset monetization and refranchising, with the aim to return capital to shareholders through a share repurchase at an attractive valuation, signaling an alignment with the investment community.  In our view, this provides support for the shares in the near-term, but also has the potential to enhance the upside as the valuation gap closes.  We conservatively estimate the Company will use $250 million of the proceeds to buy back stock over time, which represents 15% of the current market capitalization.  Below, we outline the key steps of this monetization plan, and the pro forma Company’s EBITDA and balance sheet at each step. 

Monetization of Real Estate at an Accretive Multiple

We believe management is keenly focused on creating shareholder value by monetizing the real estate assets of the Company at an accretive multiple to where the stock is currently trading. The Company’s most recent 10-K indicates that JACK owns the land and building for 196 franchised sites, and collects $33 million in rental income from those franchisees.  The company does not disclose the expenses related to this real estate, but we can estimate the Net Operating Income margin of 75%, a margin in-line with real estate peers.  While the exact expense structure of the Company’s real estate is a factor in the ultimate proceeds, we believe the capitalization rate (“cap rate”) behind the sale of these assets is more relevant for investors.  Four Corners Property Trust (FCPT) and National Retail Properties Inc (NNN), real estate investment trusts who are active in property acquisitions, have disclosed that 2022 year-to-date transactions have occurred at an average cap rate in the 6.0-7.5% range.  A 6.0% cap rate equates to a 16.7x EV/EBITDA multiple, or 67% higher than the current multiple of JACK shares.  In fact, based on the valuation of JACK, any proceeds at below a 10.0% cap rate would be accretive, and the remainder of the business is implied to be trading at an even lower valuation, as shown in our analysis below.  Due to the recent rise in interest rates and management’s desire to act quickly, our analysis assumes that the sales occur at a weighted average 8.0% cap rate, implying a 12.5x EV/EBITDA multiple.  Conservatively assuming a 75% margin on the real estate implies $305 million in proceeds or $1.6 million per location. 

We can also extrapolate the value per property from the properties sold in 2020 and 2021 which are disclosed in the Company’s 10-K, though they represent a small sample size and occurred during a lower interest rate period.  Our base case value per store of $1.6 million per property is well below the $9.9 million sold in 2020 and modestly below the $1.9 million in 2021, giving us a solid margin of safety for our analysis.  For illustrative purposes, if we use the average of $5.9 million per property realized over the last two years, it would imply proceeds of $1.2 billion, or 70% of the Company’s market capitalization.  

While some of the cash may be trapped by the Company’s debt, which is uniquely structured as a whole business securitization and is common in franchised concepts, management is actively working with its debt holders to allow for as much capital as possible to be allocated to share repurchases.  However, even if all the capital is used for debt reduction instead of share repurchases, it would still widen the valuation gap at which Jack in the Box trades at relative to QSR peers from 10.0x to 9.8x.  

The Company has communicated that the 196 properties will first be offered to the franchisees who operate the restaurants.  Once this process is complete, the Company could pursue a multi-property sale to a retail real estate investment trust, which is a potential catalyst in the first half of calendar 2023. 

Refranchising Del Taco to Align with Asset-Light QSR Peers

In looking at the franchised QSR restaurant sector, investors tend to apply a higher multiple for companies that are above the 90% franchised perceived threshold, as it indicates more earnings consistency and durability, and also enables the corporate entity to support higher levels of financial leverage.  This mindset can sometimes be dogmatic, and in JACK’s case has led investors and analysts to point to its lower franchise mix as a justification for its steep valuation discount.  We believe this is obviously short-sighted as JACK at 83% franchised is already very close to this 90% threshold.  Additionally, management has indicated a desire to substantially refranchise Del Taco in order to be above 90% franchised as a company going forward.  Encouragingly, in JACK’s Q3 2022 earnings call, management referenced that they had in fact already received offers from franchisees to acquire two Del Taco markets.  Additionally, one Jack in the Box franchisee with which we spoke indicated that his organization had also submitted a proposal to acquire Del Taco units, signaling strong demand for the brand.

A sale of 90% of the 291 Del Taco restaurants in operation will allow JACK to be 94% franchised overall, and in line with peers considered to be asset-light.  Based on our conversations with operators, we estimate these stores can be sold at 5.0x EBITDA (adjusted for the royalty that the franchisee pays not reflected in the franchisor income statement) and generate $251 million in proceeds or just under $1 million per store.  While JACK will still collect a royalty from these assets once these assets are sold, we suspect the impact of the sale will lower JACK’s EBITDA by $50 million.

Company Post Transformation to Aggressively Repurchase Shares

Post these two transformative actions, JACK will have 34% of its market capitalization sitting on its balance sheet in cash and will be 94% franchised.  Based on our analysis, the monetization of real estate would largely offset the dilution from selling company-owned Del Taco restaurants.  Applying these changes to the Company’s balance sheet and forward EBITDA estimates results in JACK trading at an EV/EBITDA multiple of 10.7x, as compared to the asset-light QSR peer group at 15.0x.  Further, we estimate JACK will have over $600 million in cash on a pro forma basis and have a net leverage ratio of 4.5x.  We conservatively estimate that the Company will have the ability to return $250 million of capital to shareholders or 15% of the Company’s current market capitalization.  Doing so would result in a net leverage ratio of 5.5x, which is comfortably in line with its highly franchised peers who operate in the 4.0-6.0x leverage range. 

California Stimulus Should Drive Sales Acceleration 

We believe that the recently passed California Middle Class Tax Refund is a meaningful boost to JACK, providing a catalyst for same store sales acceleration at both brands and is being overlooked by the market.  The bill is expected to provide payments of $200-$1,050 to California households, with the benefit scaling down as incomes rise.  The state of California represents 43% and 60% of Jack in the Box and Del Taco locations, respectively.  We believe this upside is not factored into consensus estimates and could act as a positive near-term catalyst. 

The FAST Act Less Detrimental than Feared

JACK’s California exposure has been in focus for investors, not only due to the tax refunds just referenced, but also due to Fast Food Accountability and Standards Recovery Act (“FAST Act” or AB 257) which was signed into law by California governor Gavin Newsom on Labor Day 2022.  JACK shares traded down 9% the day after the Act was signed, however we perceive the reaction and overhang to be overdone.  The FAST Act gives a 10-person panel the ability to raise wages up to $22 per hour for fast food workers in the state, which is well above the 2023 expected minimum wage in California of $15.50.  While on a headline basis this provides the potential for wages to increase 42%, when looking at Jack in the Box job postings in California, the Company already pays in the $17-$18 per hour range, implying the increase is approximately half of what the headline suggests.  Furthermore, this bill has faced strong opposition from the restaurant industry and several large players are reportedly planning on spending millions of dollars in effort to oppose it.  

While annual wage inflation is common in the restaurant industry, we see the Fast Act in its current form having many unintended consequences that may in fact benefit JACK as the franchisor.  First, because the Fast Act is now signed, the Company’s franchisees have time to plan for the potential cost increases by pricing accordingly and pursuing automation initiatives in order to improve labor productivity.  As the franchisor whose revenue is based on a percentage of franchisee sales, JACK should benefit from higher average unit volumes as the Company and the QSR industry in California are forced to take outsized pricing to cover higher labor costs.  Second, it limits the prospects for competition to enter the state as companies with limited or no exposure are likely to pursue development elsewhere.  Finally, poorly capitalized competitors and independent restaurants may be hesitant to renew leases and may ultimately close.  

Longer-term, while the FAST Act specifically is focused on fast food restaurants, we expect higher wages will pull labor from the casual dining, leisure, and other services sectors which will improve labor availability for restaurants.  Given Jack in the Box had a substantial late-night business pre-COVID that has not fully recovered due to staffing shortages, the sales capture that is possible from adequately staffing late-night hours, could provide an additional benefit to JACK. 

Valuation and Conclusion

Jack in the Box represents a transformational story under a new CEO that is currently being overlooked by investors.  Upon execution of the asset monetization and refranchising efforts, we believe the newer, more asset-light JACK will close the trading gap with its highly franchised QSR peers, and the stock will rerate upwards towards 15.0x EV/EBITDA.  This would result in a value per share of $132, or 69% upside from current levels, and thus offers compelling returns for JACK shareholders.  Further, if JACK repurchases $250 million of shares at an average price of $90 per share, this would enhance our price target to $138 per share, implying 77% upside from current levels.

While we believe these actions will be appreciated by the market over time, restaurants have also been acquisition targets by both opportunistic financial and strategic buyers.  Recent examples include Sonic (SONC) and Dunkin’ Brands Group (DNKN) which were acquired at 15.0x and 21.4x respectively, meaningfully higher than JACK’s current valuation.  Applying the average of the transactions would result in $171 per share, or 119% upside from current levels.  In summary, we see a transformational story underway, with multiple catalysts for significant shareholder returns over time.

As always, we will continue to monitor JACK, conditions around the health of the consumer and any economic or regulatory changes within the industry, and will add to, or subtract from, the position as conditions warrant.  

Catalyst

4Q 2022 Earnings Call 11/22/2022

Monetization of Real Estate Assets

Monetization of Del Taco units