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Jack In The Box: A Short And Long-Term Top Idea

 November 17, 2012 02:23 PM
 


(By Mani) Restaurant operator Jack in the Box, Inc. (NASDAQ: JACK) appears well-positioned after disappointing results at McDonald's Corp. (NYSE: MCD), Chipotle Mexican Grill, Inc. (NYSE: CMG) and reduced buyside expectations drove short interest higher.

San Diego, California-based Jack in the Box operates and franchises Jack in the Box quick-service restaurants and Qdoba Mexican Grill fast-casual restaurants. As of July 8, 2012, it had 2,247 Jack in the Box restaurants, including 1,661 franchised locations; and 614 Qdoba restaurants consisting of 310 franchised locations.

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Comps at McDonald's, the no. 1 player in nine of JACK's top ten markets, have been weak, but reasons are specifically related to McDonald's. Jack in the Box possesses company-specific comp catalysts in conjunction with new-found brand momentum that pave a path for above-average comp growth.

"We view weak competitor results as misunderstood noise overshadowing a unique and compelling investment opportunity," Oppenheimer analyst Brian Bittner said in a client note.

Meanwhile, distribution sale provides unexpected cash boost to a transforming free cash flow positive profile. The distribution segment's divestiture will be completed by year-end which could lift consolidated operating margins by 400 basis points (bps) and free up $60 million of cash previously tied up in working capital.

[Related -McDonald's Corporation (MCD) Q3 Earnings Preview: Just Huggin’ It]

"Margins have recently trended above expectations and our work suggests the Street continues to underestimate improving four-wall profitability," Bittner said.

The company has transitioned focus from investing in brand turnaround towards improving operational throughput and core restaurant margins. Speed of service enhancements are the number one priority, and six incremental transactions per day drive a 1 percent comp improvement. Given many units are at operating leverage "tipping points", any comp growth could be leveraged nicely.

In addition, the street expects modest Qdoba margin expansion in fiscal 2013 followed by an odd contraction in fiscal 2014.

"We see upside catalysts over the next 2+ years as higher margin franchisees' stores are purchased and margins in the low-profit store base improves. Every 100bps margin improvement at Qdoba drives EPS $0.05," the analyst noted.

Moreover, continued re-franchising is also a restaurant margin tailwind. Re-franchising activity alone has boosted consolidated restaurant margins by 70 bps, on average year-to-date. The company would re-franchise another ~125 low-margin units by year-end fiscal 2013, which makes the Street's 50bp margin expansion estimate for the company appear low.

Overall, fundamentals continue to strengthen, and the street under-appreciates Jack in the Box's earnings trajectory and accelerating store-level profits. Comp strength at the company appears sustainable owing to successful turnaround initiatives.

"New unit returns at Qdoba (15% of profits) could improve nicely and drive multiple expansion as growth focuses on recently acquired markets (from franchisees) where volumes, margins and brand awareness are above average, yet growth opportunities remain robust," Bittner wrote.

Jack in the Box is expected to report its fourth-quarter results on Nov.19. Wall Street expect earnings of 37 cents on revenue of $488.79 million, according to analysts polled by Thomson Reuters.

"We expect earnings upside in F4Q12 (on 11/19) and see the Street's F13 "operating" EPS of ~$1.50 as underestimated. "Non-core" F13 tailwinds (lower reimage incentive costs, G&A reductions, accretive Qdoba acquisitions and share buybacks) could nicely supplement "core" comp and restaurant margin improvements and drive EPS upside," Bittner added.

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