Jack in the Box, Inc. (NASDAQ:JACK)

vrk100 (< 20) Submitted: 2/25/2011 3:42:48 PM : Start Price: $22.09 JACK Score: +12.74

ack represents an opportunity to buy into a business at 7.5x CF which is undergoing a refranchising program where they are continuing to sell CF(even at these depressed levels) at an effective multiple of 12x. In addition the CF they are receiving in place is a more stable, royalty based CF which traditionally earns a much higher multiple.Investment Thesis:Attractive Valuation -7.5x EBITDA less Capex represents a discount to 5-year Jack trading multiple made even more compelling given the increasing contribution from Qdoba and now nearly 50/50 franchised/owned mix at Jack in the Box concept-Franchisors well positioned in an inflationary environment and likely to be outsized beneficiaries (if Joe the Plumber starts paying $6 for a value meal vs $5, the 5% is fixed)-Refranchising economics even at bottom levels still very accretive (12x effective cash flow multiple on sale) and provides for a natural catalyst-Significant potential for Geographic Expansion of Jack and Qdoba Concepts --69% of Jack units are in California and Texas and the brand is only represented 17 states --Even in depressed markets, new units yielding ~20%+ cash on cash run-rate returns-Qdoba while definitely not Chipotle still has significant room to run and has increasinginly become a larger contributor. The business has separate headquarters and is readily separable at an accretive multiple-CKE buyout is positive news but likely priced in and a low probabilty event. Jack and Qdoba are definitely stronger concepts than Carl's Jr/Hardees and also likely better positioned for the environment. Also as JACK shifts to the franchise heavy mix it becomes increasingly attractive to PE. That being said management is long entrenched and unlikely to pursue a buyout.Potential Reasons for Current Valuation:Liquidity Concerns There has been some concern related to the Jack's liquidity and ability to cover its interest etc. The business is a large producer of operating cash flow and the majority of its capex (related to re-imaging existing stores or building new ones) can be delayed to manage through any tightness fairly easily. Given the continued tough environment for commerical/real estate focused builders in CA/TX etc, builders are willing to accept rather agressive payment terms.Refranchising ConcernsThere is a very valid fear of terms continuing to deteriorate and Jack's further need to providde seller financing (whether in the form of deferred payments or breaks on royalties). In talks with a handful of QSR franchise brokers, it appears that valuations for Jack are holding steady and are held above a floor by the cost of new franchise build and the 15-25% cash on cash returns available to Jack franchisees. Furthermore, the brokers we spoke to say Jack has been prudent in screening potential buyers but did comment that most of the units being sold are re-imaged ones which is a slight negative but to be expected. I have assumes $580k net proceeds in my calc below which is slightly below with what Jack is stating publicly.Difficult Sales Environment -negative comps at both Jack and Qdoba in 2009 -Increased competitive discounting with QSR focusing on value and Casual Dining encroaching on QSR price points -Rising unemployment in California (12.3%) and Texas (8.0%) -Lower grocery prices coinciding with QSR downturn as families look to eat at home -Jack is strong in all day parts with lunch/dinner only representing 55% of Sales -Continued weakness in franchisee financing could delay expansion plans impact franchisee economicsOverview: Jack in the Box is a quick service restaurant (“QSR”) operator of two concepts, Jack in the Box, a 2,212 unit hamburger chain concept with operations in the Istern and SouthIstern US and Qdoba Mexican Grill, a national 500 unit fast casual mexican concept. The Jack Concept franchised/owned mix is 46%/54% and represents $385mm or 91% of the pre-corporate 2009 EBITDA of $422mm. Company owned EBITDA (Jack+Qdoba) represented $302mm or 72% of the 2009 pre-corporate EBITDA.Jack has been undergoing a refranchising strategy since 2005 when only 22% of its restaurants Ire franchised. The company has publicly announced a plan to refranchise 150-190 units a year with the ultimate goal of a having an 80%/20% franchised/owned mix which is in-line with the other public QSR operators. I believe the refranchising program is value accretive to the current trading price (once you factor in the increase revenue, cost savings and the proceeds). Furthermore, I believe as the cash flow mix shift more towards dollars generated from franchise fees the stock should experience multiple uplift.Refranchising Economics Fundamental to our investment thesis is understanding and correctly valuing the much discussed refranchising program. Given the public commitment to the program and the fact that the sell-side views these as recurring and therefore includes them in their earnings estimates, the company has been forced to induce sales with seller financing and significant rent and royalty breaks. Using conservative assumptions and discounts to the company’s historical guidance, I believe Jack can still achieve an effective sale multiple of 12x + which represents significant accretion to the current trading level. Furthermore, franchisor cash flow typically and rightfully earns a valuation premium to the more volatile restaurant operator cash flow.Average Company Operated Unit Sales 1,420 Unit Level Cash Flow 220 Field G&A (25) Maintenance Capex (32) Company-operated Cash flow 163Franchise Unit - Franchisor Cash FlowSales 1,420 Royalties 71 Average Rent Spread 39 Distribution 7 Field G&A (3) Franchise Cash Flow 114Cash Flow Hole (49)Effective Sale Multiple Average Proceeds (post tax) 580 Franchise Fee 50 Cash Proceeds 630 Cash Flow Hole 49 Implied Multiple 12.9x