Emerging Value: Jack in the Box (JACK) is improving its model, slowly looking more like CMG
Jack in the Box (JACK), which was just added to our Emerging Value rankings last week, is a name that we think most investors would pass over thinking it's a boring, stale burger chain. However, when you dig into the story a bit, they are making some pretty big changes to their model which we think makes it pretty compelling. Our sense is that many investors are not aware of what's going on so we wanted to flesh out the story a bit.
We'll get into more details later, but two major initiatives have been underway at JACK, which owns Jack in the Box (JIB), one the largest hamburger chains in the US, and Qdoba Mexican Grill, which is very similar to Chipotle. The first initiative, which is the real key to the story, is the switching of JIB from a majority company-owned model to more of a franchise model while at the same time Qdoba is going the opposite way. It's moving from a franchise model to a company-owned model. The second initiative is a system-wide remodeling at JIB, which appears to already be starting to bear fruit.
This shift to a higher margin model for the burger chain coupled with strong growth at Qdoba is making JACK look more attractive and coincidentally it makes them look more like Chipotle (CMG), which has been a huge mover.
JACK operates two fast food restaurant concepts: its flagship Jack in the Box (JIB), one the largest hamburger chains in the US, and Qdoba Mexican Grill, which is very similar to Chipotle.
Jack in the Box (JIB): This fast food chain is mostly focused on hamburgers and fries but it also sells tacos, specialty sandwiches, drinks, smoothies, real ice cream shakes, salads and side items. Customers are able to customize their meals and order any product, including breakfast items, any time of the day. JIB was the first major hamburger chain to develop and expand the concept of drive-thru restaurants. Most of its restaurants have seating capacities ranging from 20-100 and are open 18-24 hours a day. Drive-thru sales currently account for about 70% of sales and the average check in 2011 was $6.25.
JIB is a huge chain, in fact, it's one of the largest hamburger chains in the US with more than 2,200 locations. However, many investors have probably never visited one. That's because they are very geographically concentrated. About 70% of JIB's are in California (the company is based in San Diego) and Texas. So if you live on the East Coast or Midwest, there's a good chance you may have never even seen one but they are huge in California and Texas. Altogether, JIB has a presence in just 20 states, mostly in the Western and Southern US. As such, management believes that the JIB brand has significant growth potential in new markets. In FY11, JIB opened 31 new locations, about half were franchises. In FY12, the goal is top open 25-30 more. As a side note, their mascot is a guy with a ping pong ball for a head which is a little scary if you ask us but we digress.
Qdoba Mexican Grill: If you've never been to a Qdoba, it's very similar to Chipotle but with more variety and a bit more expensive. While both offer staples such as burritos, tacos and salads, Qdoba's menu includes a number of additional items including meat quesadillas, meat nachos and a number of signature queso sauces. The restaurants look a lot like Chipotle's restaurants, modern and clean. Most of its restaurants have a seating capacity of 60-80 and the average check in FY11 was $9.74. There are currently about 600 locations but management believes there is long term potential for 1,800-2,000 locations in the US. In FY11, JACK opened 67 Qdoba restaurants, including 42 franchise locations. In FY12, the goal is to open 70-90 restaurants.
Changing the Model
JACK has been undergoing a significant transition over the last several years. It is turning its core JIB business from a company-owned model to a franchise model and it's building out its key growth vehicle, Qdoba, which is moving to a company-owned model from a franchise model.
Let's get into the details a bit. Several years ago, the JIB segment was an 80% company-owned business with about 20% franchise. That's getting completely flipped as it's now about 70% franchise and the goal is to get it to 80%. The thinking here is that franchise dollars are much higher margin and less risky than operating the restaurants. The main benefit is that it allows JIB to transfer the capital and operating costs to franchisees. JIB's sales numbers will take a hit as it will record only the royalties and upfront fees as revenue but this will be much higher margin revenue. At the end of day, when the refranchising strategy is complete with an 80% target, JIB will run about 500 restaurants around that time.
On the Qdoba side, JACK has been moving the other way: from a franchise model to a company-owned model. Currently, the split is about 52-48 franchise/owned but the goal is to not only significantly grow the overall store count to 1,800-2,000 from 600 but the large majority of them will be company-owned (CMG currently has 1,250 locations). The transition is not going to happen tomorrow but JACK is making progress as company-owned is up to 48% from 40% a year ago. Also, JACK recently announced plans to rather significantly increase the rate of growth for new Qdoba stores to +15-20% per year. Part of that is being done by acquiring franchised locations. For example, in MarQ, JACK bought a set of 25 franchised locations from a single franchisee for $33 million. The rationale behind the shift to a company-owned model is that Qdoba has stronger margins and a much higher average ticket ($9.74 vs. $6.25) relative to JIB.
On a final note, here are some of the details on the franchise fees. The JIB franchise agreement generally provides for an initial franchise fee of $50,000. Then franchisees typically pay a 5% annual marketing fee plus a royalty fee usually around 5% although it can range from 2-15%. For a Qdoba franchise, it's usually a $30,000 initial fee. Then there is a 2% annual marketing fee plus a minimum 2% marketing fee that franchisees must spend on local advertising. Royalty rates are then typically 5% of gross sales.
Re-Imaging and Other Improvements
Shifting its owned/franchise model as discussed above is not the only change going on at JACK. A big initiative over the past couple of years has been to re-image and modernize JIB restaurants. Qdoba is a newer concept and was in good shape, but many JIB locations were dated. As such, JIB and its franchisees spent about $150-160k per store to make a number of improvements in order to become more current and contemporary. This included new signage, new logos, installing eco-friendly lighting, remodeling the dining areas and restrooms. New floors, ceiling tiles, wall coverings, light fixtures, plumbing fixtures etc. were installed. Also, its ADA violations were brought up to code inside and out. The remodel program was essentially wrapped up in January 2012 and early results have been encouraging.
It hasn't just been the remodeling. The company also improved the menu and improved its customer service. In terms of the menu, JIB is using higher quality beef and bacon. It also made improvements to its french fries and coffee.
On the customer service side, as anyone who has eaten at a JIB can tell you, it used to take a long time to complete an order. JIB had been notorious for taking longer than McDonald's or Burger King. Part of the problem is that JIB offers a much more varied menu, including tacos and breakfast can be ordered anytime of the day. To help solve this, JIB has worked with franchisees to rely more on time-of-day forecasting. Rather than waiting for customers to enter the restaurant, JIB relies more on historical data for sales patterns to start cooking when history shows that a lot of a certain type of food is sold during certain hours even if the restaurant is not crowded. This has resulted in higher food waste but it also has improved overall sales and margins. Franchisees have started to buy into the concept. They still lag competitors in terms of speed but that have made progress in closing the gap. Another customer service improvement has been better order accuracy.
Another focus, which started in 1H12 and is expected to continue in 2H12, has been a comprehensive review of the overhead structure, including evaluating opportunities for outsourcing, restructuring of certain functions and workforce reductions. Some steps were taken in 1H12 and management expects more restructuring charges in 2H12.