Roger Lipton

CoreLife Eatery— A Brand on the Move
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JACK reported yearend results last evening after the close, disappointing by most measures, especially the results at Qdoba, which has been reported to be for sale. Management has retained investment bankers to evaluate all "strategic alternatives", including the possible sale of Qdoba. It has been reported in the press that Apollo Management is contemplating the purchase, with a potential transaction price approximating $300M.
With JACK trading down a relatively modest three points, on what we consider rather disappointing news, especially relating to the potential sale price of Qdoba, we provide the following summary to our readers in advance of the conference call scheduled for 11:30 this morning, EST.
Operating Earnings at JACK were $0.73 versus $1.03 YTY, about $0.16 less than the Street was expecting. In Q4,  Jack in the Box system sales were down 1.0% with transactions down 5.4%, affected just slightly by the hurricanes. Qdoba system wide sales were down 2.1% . Company stores  (385 vs. 341 franchised) had sales down 4.0%, with franchise sales flat. Most important, company transactions at Qdoba were down 6.4%.  For the year JIB company stores were down 1.1%, Qdoba company stores down 3.0%. For the year JIB franchised stores were up 0.9%, Qdoba franchised stores were up 0.4%. Most importantly, transactions at both brands were down materially, both company and franchised, for the quarter and the year.

Relative to the potential value of Qdoba:

Unit level economics continue to be of the utmost importance, of course. The yearend 10-K filed this morning shows development cost of a new Qdoba between 0.8M and 1.1M. The average company store volume was $1.164M for the year, just above franchisee AUVs of $1.146M. We don’t know franchise unit level profit (after depreciation) results, but company store level profit  was 13.6% in ’17, down from 18.1% of sales in ’16 (without royalty, of course). If you want a reason why franchise units only grew from 332 to 339 in ’17 (19 openings, 10 closings) it might be because store level profit of perhaps 15% for franchisees (assuming a little higher than the 13.6% for the company) only leaves 10% after royalty of 5%, perhaps only 6.9% (after 1.8% required local advertising and 1.3% national mktg. fund) and then maybe 2-3% after some local G&A. Depreciation allowance would add to short term "cash flow" but that has to be used over time to keep the stores physically current. We might be off modestly in these assumptions but franchisees vote with their pocketbook, and clearly they are not wildly enthused with their return on investment.

Roughly calculating the TTM EBITDA for Qdoba within JACK:

385 Company stores generated $448M of revenues with 13.6% store level profit, which is $61M at the store level. If we assume 7% G&A, including marketing,  that would leave about 30M company operated profit. If depreciation is 4% (which is not "free cash flow" over time, as demonstrated by the remodel needs of Jack in the Box), EBITDA would be about $48M.  Add to that a royalty rate of 5% on 341 franchise stores company stores that generate about $390M of sales, and you get royalty revenues of  $19.5M. If we assume an operating margin at the current rate of 72%) (we believe the expenses will need to be higher than that to properly support a system of over 300 locations, especially one that needs to be re-invigorated) that would be $14M of franchising profit, which would be a theoretical total of about $62M of approximate QDOBA TTM EBITDA. While 5x TTM EBITDA, or $310M  seems reasonable enough, we believe that higher G&A will be necessary and depreciation will not be "free cash flow", especially with this troubled chain. With all the trends going the wrong way, sales, traffic, expenses, margins, etc., we question whether Apollo, or anyone else will be likely to step in to this equation. In either case, Qdoba is not the valuable asset under the JACK umbrella as was the case a few years ago.
Conclusion: We question whether Apollo Management, or anyone else, is going to step up to the plate here, with alll the trends are going the wrong way,  and their is no magic bullet to turn Qdoba around. If a P/E buyer thinks they are going to go "asset light" and franchise the company stores, I would counter "to whom?".  I won’t be surprised if the "evaluation of strategic alternatives" winds up without a Qdoba transaction, and JACK management will have no alternative but to do their best to re-invigorate both concepts. See our report, written a month ago, for background, and our conclusion at that time, which still stands. At whatever multiple of EBITDA Qdoba trades it, if it trades, it will be well below the multiple that JACK as a whole currently trades. That would leave the remaining JACK system at a higher multiple of earnings and  EBITDA than is currently the case and is in serious need of remodeling, at a substantial capital cost.

Seven Key Discussions from the Earnings Call: 

  1. It was repeated that the strategic review had "made substantial progress…with respect to Qdoba, as well as other ways to enhance shareholder value". See our comments below regarding the potential value of Qdoba.
  2. Sales at Jack in the Box have firmed up in the eight weeks of their Q1 to date, with sales slightly positive vs. down 1.0% systemwide in Q4. Qdoba sales are still running down, as in Q4, which was down 2.1% systemwide. Transactions no doubt are still negative at both chains.
  3. Progress continues to be made toward franchising JIB  locations, soon to be 90% of the system, ultimately 95%, and corporate G&A is being streamlined as this program continues.
  4. Going to emphasize value in the near future, along with a number of premium items such as the Ribeye sandwich. Not going to give up ground to competitors in terms of a value message, but will not go to the "discount drug".
  5. When questioned about commodity and labor expense expectations, analyst was "met half way" with an answer that commodity inflation would be about 3% in ’18 at JIB (higher than that in Q1) and about 1% at Qdoba. Wage inflation was not discussed, but we know the answer to that one.
  6. When questioned about unit growth within the JIB system, management said that first priority for franchisees is remodeling. New units will come later, perhaps a couple of years out.
  7. Which, aside from the possible (our italics) divestiture of Qdoba, leads to the last important element of the future equation, namely, in management’s words,  "the JIB store system has to be remodeled". As the landlord  in about half of the system, JIB will be "helpful" to franchisees with tenant allowances, which of course will be reflected in the new rents. Management provided no details on the potential plan, but indicated that it would generate an "acceptable" sales lift, "nothing like 20%. Our guess is in the range of 5%-10%, but time will tell. JIB, as the franchisor, appropriately views the remodel program as a necessity, even with only a modest sales lift and return on invested capital, if the chain is to remain competitive. The new element of the equation, however, is that if $300,000 is spent on 2,000 stores, that would be $600M of capital that has to be spent by someone, a lot of money even spread over five years. We can’t know how much would be provided by JIB, but, as the landlord on half the system, it will likely impact "free cash flow" in a significant way. Management stated that "tenant improvement allowance is not ‘capital’ as it affects the balance sheet", but there is no doubt of its effect  on cash available for other strategic purposes.
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