LindaJoHeilman
Jack in the Box Inc. (NASDAQ:NASDAQ:JACK) has declined 24% over the last 12 months due to the strong headwinds facing the restaurant chain, namely the impact of 40-year high inflation on its margins, the impact of inflation on its valuation, and fears of an upcoming recession. On the other hand, the company has greatly improved its business performance in the last two years, primarily thanks to the initiatives of its new CEO. Therefore, the big question is whether Jack in the Box has become a bargain.
Business overview
Just like most restaurant chains, Jack in the Box is facing some strong business headwinds this year. First of all, the surge of inflation to a 40-year high has greatly increased its costs, and exerting pressure on its margins.
In the most recent quarter, the company incurred 13% wage inflation, 17% food inflation, as well as increased expenses for packaging materials and utilities. The company tried to offset its increased costs with material price hikes. However, this strategy caused a significant reduction in traffic, and thus sales decreased 1% over the prior year’s quarter. Even worse, the increased costs pressured operating margins, and thus the earnings per share of the restaurant chain dipped 16%. In addition, due to the sustained impact of inflation on its margins, Jack in the Box lowered its guidance for its operating margin in the full year from 17% to 16%.
Moreover, Jack in the Box is facing the risk of an upcoming recession. Due to persistent inflation, the Fed is raising interest rates aggressively. Consequently, it is likely to cause a recession in the upcoming quarters. Such a development will hurt the restaurant chain, as it will likely reduce consumer spending. The latter has already incurred a hit, as consumers have tightened their wallets due to the surge of inflation.
On the bright side, Jack in the Box has affordable menu offerings and hence it is more resilient in the highly inflationary environment prevailing right now than other companies. For instance, in the Great Recession, the company grew its earnings per share by 20% between 2007 and 2009. Of course, investors should not expect similar performance this time, as the company was in high growth mode back then. Nevertheless, given its affordable menu offerings, Jack in the Box is likely to exhibit decent performance in the event of an imminent recession.
It is also important to note that management is doing its best to improve the factors it can control. It launched a new grilled chicken sandwich during the fiscal third quarter while it also brought back some old items. In addition, management has stated that it expects significant business improvement in the running quarter thanks to its focus on the breakfast daypart. Overall, management seems laser focused on optimizing menu offerings in an effort to mitigate the impact of cost inflation on the bottom line.
As mentioned above, Jack in the Box is currently experiencing business deceleration due to the impact of inflation on costs and consumer spending and the impact of the ongoing economic slowdown on consumer spending. As a result, in the latest quarter, the company posted its first decrease in same-store sales after several quarters in a row. Notably, the company has grown its same-store sales for 10 consecutive years and has grown its earnings per share by 15% per year on average over the last five years.
As the Fed has prioritized the restoration of inflation to its long-term target of 2%, even at the expense of economic growth, it has adopted an exceptionally aggressive strategy, and hence it will almost certainly achieve its goal. As soon as inflation subsides, Jack in the Box is likely to return to its reliable growth trajectory. The company stagnated during 2016-2019 but it has returned to strong growth mode thanks to its new CEO, who has significantly enhanced the average check per person thanks to an optimization of menu offerings. Whenever the headwind from inflation abates, Jack in the Box is likely to return to solid results. Analysts seem to agree, as they expect the restaurant chain to grow its earnings per share by approximately 13% per year in 2023 and 2024, to a new all-time high.
Valuation
Due to the decline of its stock price, Jack in the Box is currently trading at a 10-year low price-to-earnings ratio of 12.6. This is much lower than the 10-year average earnings multiple of 20.3 of the stock.
The depressed valuation level has resulted from the double hit of inflation on Jack in the Box. First of all, high inflation reduces the present value of future cash flows, and hence it exerts pressure on the valuation of most stocks, especially growth stocks. In addition, inflation hurts the business performance of Jack in the Box due to its impact on consumer spending and on operating costs. To cut a long story short, the depressed valuation level of Jack in the Box can be partly justified by the impact of inflation on the company.
It is also worth noting that Jack in the Box has a leveraged balance sheet, mostly due to its aggressive share repurchases throughout the last decade. The company has reduced its share count by 52% since 2012, partly by issuing new debt, and thus its book value per share has become deeply negative (-$35.90) and its net debt (as per Buffett, net debt = total liabilities – cash – receivables) has climbed to $3.5 billion. This amount is more than double the market capitalization of the stock and hence it is undoubtedly high. However, given the reliable growth trajectory of the company and its decent interest coverage ratio of 2.9, it is safe to assume that the debt is manageable. Nevertheless, a somewhat lower price-to-earnings ratio vs. the historical average is justified in the ongoing downturn.
On the bright side, as soon as inflation begins to subside, Jack in the Box will almost certainly begin to revert towards its historical average valuation level. Given its depressed current valuation, the stock will have ample upside whenever the headwind from inflation abates. Nevertheless, given the vulnerability of the stock in the ongoing bear market, investors should probably wait for an even lower entry point, close to the technical support around $60. At that point, the stock will be trading at only 9.0 times its expected earnings in 2023, and hence it will be a great bargain.
Final thoughts
Jack in the Box is facing several business headwinds right now but it has a strong business model and a high-quality management. Therefore, if the stock falls towards its technical support around $60 due to high inflation and a potential recession, it will become a great bargain for those who can maintain a long-term perspective during the ongoing bear market.
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