JACK - Jack-in-the-Box is a $1.2B QSR chain, with a footprint skewed towards the Western region of the US.

The thesis in JACK is fairly straightforward, and is based on four key elements:

-Refranchising opportunity: operationally, JACK has been shifting its franchising mix.  It went from roughly 22% franchised in '04 to 33% in '07, 46% in '09, and 62% currently, with a goal of 70-80% by F2013 (Sept). Most QSRs are typically in the 70-90% range. Besides freeing up capital, as proceeds from sales, this would allow for a more steady revenue stream, which is typically awarded with a higher multiple.  In addition, the company has typically seen an increase in sales at the store level once it becomes franchised, perhaps due to the motivation of the owner-operator.  Importantly, owned units have historically been sold at an effective EBITDA multiple ranging from 8-10x (based on price per store plus royalty upfront payment divided by lost EBITDA), and most of the sales have been to existing franchisees. As far as proceeds from sales, another 8% of store base is still expected to be franchised, or over 175 stores.  Average proceeds, not including upfront royalty payment, has been $420K in F10 (compares to $780K in F08). So it is not unreasonable to expect over $80M in proceeds from sales.

-Improved CF as a multi-year remodeling effort comes to an end: JACK had undergone a significant reinvestment program, primarily uplifting the look of its relatively old store base. The company remains on pace to complete its system-wide re-imaging program by the end of the calendar year.  In its F08, capex peaked at ~$180M, or slightly over 100% of operating cash flow. It has been trending down since then, with $153M in F09 and a more sustainable $95M in F10 (the facility improvements component of capex has been declining from $116.7M in F08 to $50.7M in F10).  The company is indicating under 110M for F12 (seems more than half is for new stores, primarily Qdoba, which we'll discuss below, which had been growing units ~10%, so implying under $50M for maintenance capex).  Seems peers operate with a capex of roughly 30-70% of OCF. For comparison purposes, over the last 5 years, the average ratio of capex/CF has been 104% for JACK, compared to 62% for Sonic, 70% for Chipotle and 38% for MCD.  It has been the company's experience that a remodeled store will also perform better in terms of same-store sales.

The uses of cash that will be freed up from lower levels of remodeling capex and the increased franchising mix is prioritized as follows: 1) profitable growth (mainly expanding the Qdoba concept), 2) return of cash to shareholders (note than on May 2011, the Board authorized an additional $100M buyback program expiring November 2012; the Company has repurchased $710M in stock between F06 and F10), and 3) debt paydown.

-Focus on SG&A improvement: JACK has been running at an SG&A to sales ratio of over 10%, and we expect that number to come down by possibly 150 bps (on a normalized commodity inflation environment, the company was targeting an improvement in restaurant operating margins of over 200 bps) helped by several factors as a consequence of the refranchising trend.  Currently, the company has been facing a drag from lower levels of re-imaging credits to franchisees (for instance, this item is expected to cost $0.12-0.14/share in F11), accelerated depreciation upon sale of owned unit, as well as from initial royalty incentives for opening of new markets.

-The last pillar of the thesis is a potential monetization of Qdoba: currently about 10% of EBITDA, this is the 2nd largest Mexican casual food concept, after Chipotle, present in nearly all states (Jack In the Box is more concentrated, being present in 19 states, with CA and TX accounting for 42% and 28% respectively).  There are currently 549 Qdobas, compared to 2,220 Jack In the Boxes (and 1,084 Chipotles). The average check at Qdoba, at $9.88, is nearly 60% higher than that of Jack In the Box. The company has maintained that it is open to a possible monetization of this asset, but it would like it to achieve more scale before it pursues that path.  It also believes that the saturation level for Qdoba is somewhere between 1.8K to 2K stores, so there is still plenty of growth for the concept. 

It is also important to note that Blue Harbour Group, which has been involved in activist plays, owns 5.8% of JACK (having started building the position in 2010), and perhaps could act as a catalyst for an eventual separation of Qdoba. As an aside, Bill Stiritz, of Ralcorp and Macy's fame, also owns over 5% of the company.

We believe the market ascribes a lower multiple to JACK for various reasons, but mainly due to continuous weak trends in same-store sales.  We believe the weak SSS numbers have been due to geography (42% of units are in CA), demographics (relatively higher exposure to a younger and Hispanic population, which has been disproportionately impacted by unemployment trends), mix (breakfast constitutes a relatively higher proportion of sales to JACK than peers, and that has been a category that had been more impacted by unemployment trends), and store-level disruptions due to remodeling program, which has temporarily affected several stores.  However, we believe that these are in part macro related, and not indicative of a broken concept/dying brand.  In fact, several anecdotal checks have indicated that traffic has not declined in many of the stores, but the weakness is mainly due to price/mix - ie., people shifting to cheaper menu items. Also, the interest by existing franchisees to buy existing stores and build additional ones gives us additional comfort on that point. Furthermore, Jack In the Box is second only to McDonald's in terms of total advertising awareness in the states where it is present. 

In the last 2 quarters, SSS have turned positive for Jack In the Box, up 1.5% in F1Q11 and +0.8% in F2Q11 (Qdoba was up +6.4% and +6%, respectively). The guidance for company owned Jack In the Box for F3Q is +2-4% and +4-6% for Qdoba. We believe the conclusion of the remodeling and re-imaging program should help comp store performance, not only due to end of disruption from construction, but especially due to fresher look at the stores.

 Valuation, based on Bloomberg consensus numbers:

So what is JACK worth? Assuming the company reaches a 70% franchise mix for Jack In the Box and grows Qdoba at a 10% clip over the next year, a slight improvement in restaurant margins for Jack In the Box (but still below co's targets), we can get to EBITDA of $236M for Jack In the Box and $36M for Qdoba (13% of total - this should keep growing going forward, which should make the co more valuable as it should command a higher multiple).  Assuming 8x for JACK (to account for better earnings stream, yet still lower than peers) and a 12x multiple for Qdoba (still significant discount to Chipotle and even to Peet's Coffee (15x '11, 13.5 '12), which like Qdoba, is trying to expand after a dominant #1 player in the category: Starbucks/Chipotle). Including the proceeds from additional franchise sales, we get to a $40 stock, compared to the current level of $23.50.

Risks include continued softness in unemployment, affecting its key geographies and demographics (which could lead to continued deterioration in same-store sales); competition in the QSR industry (Burger King, in particular, had been very promotional with its $1 menu; perhaps post LBO, it may behave more rational); commodity pressure (beef represents over 20% of its commodity costs and is expected to be up 14% for the FY, ahead of prior expectations - JACK will in response seek to implement a 1.5% price increase to help mitigate this); Qdoba separation might not be in the cards for the near term, and there is also a risk that the early sales to franchisees could have represented the better stores, implying that future sales will be at lower prices and/or the owned portfolio could be left with worse-performing stores.