Jack in the Box (JBX 21.04)

Higher gas costs, rising food prices, a jump in the unemployment rate, and heavy exposure to some of the hardest hit housing markets, namely California, Arizona and Nevada.   How does that sound if you're trying to run a consumer-oriented business?

The obvious answer is, "not good," which is why it should come as little surprise to hear that quick service restaurant company Jack in the Box (JBX 21.04), which is up against those hurdles, has seen its stock get clobbered since May 2007.  To be exact, shares of JBX have dropped 47%.

The kindest thing about bear markets, though, is that they provide a great opportunity for long-term investors to buy stocks at more reasonable prices.  We think such an opportunity has presented itself with Jack in the Box, which is trading at 12x trailing 12-month earnings or nearly a 20% discount to its 5-year average.

Background

The Jack in the Box business consists of 2,142 namesake restaurants, 749 of which are franchised.  In addition, it includes 423 Qdoba Mexican Grill restaurants (326 are franchised) and 61 Quick Stuff convenience store locations.

Including the 20% sales contribution from the company's distribution business, Jack in the Box restaurants provide almost 97% of total company sales and 95% of operating income.  That consideration is both a blessing and a curse these days.

It is a curse because 54% of all Jack in the Box restaurants are in the troubled areas of California, Arizona and Nevada. 

It's a blessing because we're now three years into the housing downturn and, presumably, much closer to the bottom than the top there.  As housing markets stabilize and ultimately rebound in these areas, and across the U.S., Jack in the Box is in a good position to benefit as consumer spending is apt to improve.

The company is doing a lot today, too, to ensure that is the case by pursuing a strategic plan built around four initiatives:

1. Increasing sales by opening new restaurants and increasing same-store sales
2. Re-imaging (i.e. remodeling) its restaurants to make them more inviting and efficient
3. Expanding its franchises with the sale of company-operated restaurants
4. Improving its business model

The strategic initiatives have the company on a good path to improve its long-term performance.  500 restaurants have been re-imaged thus far and the entire system is expected to be finished by 2011.

Approximately 35% of Jack in the Box restaurants are franchised.  The company's aim is to increase the total by 5% annually in an effort to reach the industry average of 70% to 80%.  The imbalance at Jack in the Box is why the company's operating margin of 6.3% is much lower than peers like McDonald's (24.3%), Burger King (13.0%) and YUM! Brands (12.6%).

Lightening the load of company-operated restaurants should boost operating margins as well as cash flow.

Look Out for Potholes

The road ahead won't be a smooth one for Jack in the Box.  It is up against tough comparisons in the near-term due to its past success and the challenging macroeconomic environment. 

Same-store sales at Jack in the Box slipped 0.1% in the second quarter, interrupting a string of 18 straight quarters of positive returns.

Same-store sales are projected to decline approximately 2% in the third quarter at Jack in the Box company restaurants after a 7.4% increase last year.  Qdoba same-store sales are anticipated to be flat to up 2%, on top of a 5% increase last year.

Despite the second quarter dip and third quarter view, Jack in the Box stood by its forecast for earnings to range from $1.98 to $2.08 per diluted share for its fiscal year that ends in September.  The midpoint of that guidance represents an increase of 8% from the prior-year period.

Like other restaurant operators Jack in the Box is feeling the pinch of higher food and packaging costs.  Fortunately, it has managed to offset some of those pressures by keeping SG&A expenses as a percentage of revenue in check.  Through the 28-weeks ended April 13, SG&A expenses totaled 9.8% of revenue versus 10.5% over the same period last year.

Eye on Long-Term Prize

The macro environment is the company's biggest hurdle right now.  It is driving increased competition in the industry and is prompting consumers to be more price conscious as they grapple with high gas prices and the depressed housing market. 

The latter factor works partially in Jack in the Box's favor as consumers trade down to quick service restaurants from higher-priced casual dining options.  However, high gas costs are a spending deterrent for many consumers. That is a limiting factor for a business like Jack in the Box, which gets about 70% of sales at company-operated restaurants from its drive-thru operations.

The near-term outlook for Jack in the Box can be characterized as murky at best given its geographic exposure.  An earnings disappointment is quite possible.  This understanding is reflected in the report that 12.1% of the company's float was sold short as of June 25, translating into a short ratio of 9.1 days (i.e., the number of days it would take to exhaust short position based on average daily trading volume).

Our focus here, though, is on the stock's favorable, long-term risk-reward profile.

At its current level, JBX is trading where it was two years ago.  A clear disconnect in that situation is that earnings per share have grown at a 15% compounded rate in that time (takes into account FY08 consensus estimate of $2.01).

The company's goal is to deliver 12-15% earnings growth per year for the next three to five years.  Using the midpoint of that range, and taking into account the stock trades at 10.5x estimated FY08 earnings, JBX sports a price-to-earnings growth ratio of 0.78.  A number below 1.0 is typically regarded as a value-based opportunity.

The caveat with any stock, and especially consumer-oriented stocks right now, is that further downside is possible.  Holders unwilling to ride out the near-term volatility may want to consider placing a stop-loss order 20% below the current price. 

However, with JBX down almost 50% from its high, the company's strategic initiatives gaining traction, and the economic cycle destined to turn upward, we think there is an acceptable level of risk at current prices for patient investors to buy the stock.

Applying the 5-year average trailing twelve month P/E of 14.8x to the consensus FY08 estimate of $2.01 produces a price of $29.75.  That's a near 40% increase from current levels.  That's not an official price target from us, but it goes to show that there can be ample upside in the stock in a better operating environment.

--Patrick J. O'Hare, Briefing.com