Wendy’s: Great Fast Food, Bad Investment

About a month and a half ago I wrote an article stating that I believe Jack In The Box to be overvalued despite the recent positive hype around the company.  Lately I have been researching Wendy’s $WEN because it has had JACK’s opposite problem; very negative recent press and wanted to see if this might turn out to be a potential contrarian value play or a value trap.

I will be referencing and comparing Wendy’s to Jack In The Box and the other fast food companies I wrote about in my $JACK article so if you would like to see how Wendy’s compares to other fast food companies please reference my JACK article that I link to above.

Wendy’s Overview

Wendy’s is an owner, operator, and franchiser of 6,543 fast food restaurants, 1,447 of the restaurants are owned directly by Wendy’s with the remaining amount owned by franchisees.  Wendy’s offers hamburgers, chicken sandwiches, salads, wraps, fries, and the rest of the typical fast food restaurant offerings but at a higher quality profile than most of its other fast food competitors.  Higher quality also leads to higher prices for its individual product offerings and meals which greatly affected the company during the recession with customers generally looking for cheaper food.  In the past several years to combat the low cost offerings of its competitors, Wendy’s has brought out its own value and extra value menus with prices generally under $2 per item.

Since the recession Wendy’s has streamlined operations by selling off its Arby’s subsidiary, enacting cost cutting measures,  updating its menu to offer new products including breakfast at some locations, and has started reimaging some of its restaurants by starting its Image Activation Program.  The program has been put into place to update its restaurants making them look more modern, offering more amenities to get customers to stay longer at its restaurants, and making the food ordering and cooking process more efficient so customers can get their food faster.

Unlike JACK who has recently finished up its reimaging of its restaurants and who should see at least small margin growth due to lower capital expenditures, Wendy’s has only just started this process with only a few dozen restaurants having been updated thus far.  Wendy’s hopes that by 2015 about half of its company owned restaurants will be reimaged so this process is going to take a while.  As we saw with Jack In The Box that will lead to generally higher cap ex for the foreseeable future, most likely lower or stagnant margins, possibly more debt, and potential loss of sales due to having some of its restaurants closed for construction periods of as long as eight weeks currently.

Valuations

These valuations are done by me and are not a recommendation to buy stock in any of the following companies mentioned. Do your own homework.

All numbers are in millions of US dollars, except per share information, unless otherwise noted. The following valuations were done using its 2011 10K, 3Q 2012 10Q, and its 3Q 2012 investor presentation slides.

Asset Reproduction Valuation

Assets: Book Value: Reproduction Value:
Current Assets
Cash And Cash Equivalents 454 454
Accounts Receivable (Net) 65 55
Inventories 12 8
Prepaid Expenses & Other Current Assets 32 16
Deferred Income Tax Benefit 95 48
Advertising Funds Restricted Assets 75 50
Total Current Assets 734 631
Properties 1241 745
Goodwill 877 439
Other Intangible Assets 1315 658
Investments 118 89
Deferred Costs & Other Assets 57 29
Total Assets 4340 2591

Number of shares are 390

Reproduction Value:

With goodwill and intangible assets:

  • 2591/390=$6.64 per share.

Without goodwill and intangible assets:

  • 1494/390=$3.83 per share.

EBIT and Net Cash Valuation

Cash and cash equivalents are 454

Short term investments are 0

Total current liabilities are 344

Number of shares are 390

Cash and cash equivalents + short-term investments – total current liabilities=454-344=110.

  • 110/390=$0.28 in net cash per share.

WEN has a trailing twelve month EBIT of 120.

5X, 8X, 11X, and 14X EBIT + cash and cash equivalents + short-term investments:

  • 5X120=600+454=1054/390=$2.70 per share.
  • 8X120=960+454=1414/390=$3.63 per share.
  • 11X120=1320+454=1774/390=$4.55 per share.
  • 14X120=1680+454=2134/390=$5.47 per share.

TEV/EBIT and EV/EBIT Valuation

Total enterprise value is market cap+all debt equivalents (including the capitalized value of operating leases, unfunded pension liability, etc) -cash-long term investments-net deferred tax assets.

  • TEV/EBIT=3310/120=27.58
  • TEV/EBIT without accumulated deficit counted=2833/120=23.61
  • Regular EV/EBIT=2946/120=24.55

The average EV/EBIT in the fast food industry that I found when analyzing JACK was 15.68 and the only company to have a higher EV/EBIT than Wendy’s is Chipotle Mexican Grill $CMG which had an EV/EBIT of 26.53.

I usually like to buy companies that have an EV/EBIT multiple under 8 so the fast food industry as a whole appears to be massively overvalued to me.  Not only that but Wendy’s current EV/EBIT multiple is comparable to Chipotle’s which generally has very high margins, which is exactly the opposite of Wendy’s.  As we will see later Wendy’s margins do not even come close to Chipotle’s and are generally much worse than even the rest of the fast food companies margins, so its extraordinarily high EV/EBIT multiple is astounding and I will explain later why it is so high.

I also did my normal other valuations but they did not work because after you take out the company’s debt and or goodwill and intangibles from the other valuations you get negative estimates of intrinsic value for Wendy’s equity.

Margin comparison

Please reference my JACK article above to see my thoughts on each of the other company’s margins as I will only be commenting in this article about Wendy’s margins.  The below chart has been updated to include Wendy’s margins for comparison to the other fast food companies.  The industry averages are still only including the previous five companies I talked about.

All numbers in the table were put together using either Morningstar or Yahoo Finance.

Jack in the Box (JACK) Sonic Corp (SONC) McDonald’s (MCD) Yum Brands (YUM) Chipolte Mexican Grill (CMG) Company Averages Wendy’s (WEN)
Gross Margin 5 Year Average 16.28% 34.30% 37.94% 26.20% 24.28% 27.80% 25.70%
Gross Margin 10 Year Average 17.08% 43.38% 40.42% 35.59% 11.73% 29.04% 39.86%
Op Margin 5 Year Average 7.46% 16.24% 27.42% 14.22% 12.76% 15.62% -1.70%
Op Margin 10 Year Average 7.07% 18.05% 22.62% 13.50% 6.64% 13.57% 0.21%
ROE 5 Year Average 20.16% 66.33% 30.26% 131.56% 18.55% 53.37% -6%
ROE 10 Year Average 18.77% 43.71% 23.19% 105.85% 10.27% 40.36% -4.68%
ROIC 5 Year Average 11.17% 3.38% 17.38% 24.97% 18.49% 15.08% -3.77%
ROIC 10 Year Average 10.91% 8.97% 13.37% 23.54% 10.22% 13.40% -2.45%
FCF/Sales 5 Year Average -0.26% 6.48% 15.90% 7.70% 6.92% 7.35% 1.07%
FCF/Sales 10 Year Average 0.80% 7.10% 12.86% 6.70% 2.26% 5.94% -3.74%
Cash Conversion Cycle 5 Year Average 0.78 1.23 0.91 -36.35 -5.24 -7.92 -4.18
Cash Conversion Cycle 10 Year Average 0.27 1.14 -1.22 -49.02 -5.21 -10.81 -4.53
P/B Current 2.9 12.4 6.7 14.3 8.2 8.9 0.9
Insider Ownership Current 0.38% 6.12% 0.07% 0.50% 1.64% 1.74% 6.83%
EV/EBIT Current 14.25 9.65 12.16 15.81 26.53 15.68 24.55
Debt Comparisons:
Total Debt as a % of Balance Sheet 5 year Average 30.78% 80.91% 35.28% 45.24% 0 38.44% 34.03%
Total debt as a % of Balance Sheet 10 year Average 26.84% 50.77% 35.22% 40.72% 0.14% 30.74% 38.58%
Current Assets to Current Liabilities 1.02 1.38 1.24 0.97 4.13 1.75 2.13
Total Debt to Equity 1.03 9.69 0.97 1.6 0 2.66 0.81
Total Debt to Total Assets 30.50% 71.20% 41% 37.21% 0 35.98% 36.87%
Total Contractual Obligations and Commitments, Including Debt $2.6 Billion $1 Billion $27.20 Billion $11.42 Billion $2.20 Billion $8.88 Billion $1.9 Billion
Total Obligations and Debt/EBIT 21.67 8.85 3.15 5.4 5.82 8.98 13.33

As you can see from the above margin comparison, Wendy’s margins are almost all quite a bit worse or at best about even with industry averages in comparison to its fast food competitors.  Even if we were to exclude Wendy’s absolutely horrible 2008 from its numbers, its margins are still quite a bit lower than its competitors.

Especially of note are the horrible in comparison to its competitor’s margins: ROIC, ROE, FCF/Sales, EV/EBIT, and Total obligations and debt/EBIT ratios, which are all a lot worse than its competitor’s ratios.  Wendy’s EV/EBIT is especially inflated due to its high amount of debt in comparison to its profitability which is why it has a comparable EV/EBIT to the much higher margin Chipotle.  My calculations of ROIC are a bit different than Morningstar’s numbers and help out Wendy’s a bit, but even at 5.4% without goodwill and 3.85% with goodwill those numbers are still generally quite inferior to its competitors.

About the only thing that Wendy’s has in favor for itself out of the entire above table is that its P/B ratio of 0.9 is a lot lower than its competitors.  A P/B ratio that low generally means that the company could be undervalued. That P/B ratio in this case is a bit of a farce because goodwill and other intangible assets make up the vast majority of current book value as just those two combine for an estimated $2.2 billion in value.  After subtracting goodwill and intangible assets tangible book value is actually negative.  The $2.2 billion is actually more than the current market cap so I think that it is fair to say that those values are probably massively overstated and may soon have to be restated or written down to a more reasonable level, thus eliminating some further perceived value and bringing the P/B value up closer to its competitors.

I also think that Wendy’s debt levels and costs are too high in comparison to its profitability as 83% of operating profit (EBIT) goes to interest expenses.  Costs and other expenses, not including interest expense and loss on extinguishment of debt, take up 95% of total sales.  Other expenses include general and administrative, depreciation and amortization, etc.  If you include interest expenses and loss on extinguishment of debt that takes total costs and expenses over 100% of sales, which is why Wendy’s recent earnings have been negative.

Pros

  • Pays a dividend and recently upped it 100%.
  • After a lot of the stores are reimaged margins should improve due to lower cap ex and higher same store sales.  Of the stores that have thus far been reimaged Wendy’s says they have seen 25% increases in sales.
  • Has positive net cash.
  • Has a good amount of cash on hand.
  • Same store sales have risen for 6 straight quarters and a total of 2.3% in the past 9 months.
  • Wendy’s has recently paid off some of its 10% coupon debt by taking out lower interest debt, which should lead to lower interest expenses going forward.
  • Wendy’s recently overtook Burger King as the second biggest fast food burger chain.
  • Owns a lot of its restaurants and the property underneath the buildings so Wendy’s does hold some valuable assets in case it has some problems.
  • Just fewer than 80% of its restaurants are owned by franchisees that pay a 4% royalty to Wendy’s.  Collecting franchise royalty fees is a very high margin business.
  • The company produces positive FCF excluding cap ex.

Cons

  • Wendy’s is overvalued by every one of my valuations, sometimes in extreme cases, except when including the massive amount of goodwill and intangible assets.
  • Wendy’s margins overall are generally a lot worse than its fast food competitors.
  • Book value is only positive because of goodwill and other intangible assets.
  • The company has had recent negative earnings.
  • 83% of operating profit went to interest expense.
  • The company’s equity has negative value after subtracting goodwill and intangible assets on various valuations.
  • The company has been buying back a lot of stock at what I think are overvalued prices.
  • The company’s debt levels and costs are too high in my opinion in comparison to its profitability levels.
  • Wendy’s will have higher cap ex for the foreseeable future due to the reimagining of its stores.
  • The reimaging of Wendy’s stores could be going on for at least a decade if not more as it hopes to have around 750 stores reimaged by 2015 leaving around 5,750 stores to be reimaged after that, not including new stores that are opened by Wendy’s itself or its franchisees.
  • Cap ex this year has been around $225 million and will likely stay close to that elevated level for many years due to the reimagining of its stores and which should either lead to lowering or stagnating margins for the foreseeable future.
  • The company has negative FCF when including cap ex.
  • This year the company spent $126 million in cash on cap ex with the remaining $99 million coming from other sources.  To me that means Wendy’s will have to either increase its margins and FCF to pay the remaining cap ex costs, or more likely it will continue to have to issue debt to fund the reimaging of its stores.
  • While sales have been rising within Wendy’s, costs have also been rising at about the same amount which is why margins have not been increasing much as sales have improved.
  • The company has quite a few, what seem to me questionable related party transactions within the company, including with Mr. Peltz (former Wendy’s executive and current chairman) and Trian Partners the investment fund Mr. Peltz has formed with a couple Wendy’s other board members.
  • Just one example of the questionable transactions is that Wendy’s paid just under $640,000 in security costs for Mr. Peltz who is a billionaire and could easily pay these costs himself.
  • Trian Partners currently owns just under 25% of Wendy’s and has three members on Wendy’s board of directors so Trian could exert a lot of pressure on Wendy’s if it saw fit to do so.
  • Due to some of the what seem to me to be questionable transactions; I do not trust management to do what is right for shareholders and to increase shareholder value.

Potential Catalysts

  • The reimaging of its stores will most likely eventually lead to margin and sales growth.
  • If Wendy’s can get its costs under control, which it is trying to do now, it could achieve some margin growth.
  • In my opinion Wendy’s has overstated its goodwill and other intangible assets and may have to restate or write down some of the value of each.  Wendy’s warns it may have to do this in its most recent annual report, which would lead to less perceived value in the company, and would probably drop the price of the stock further.

Conclusion

Wendy’s has recently overtaken the number two spot for hamburger fast food chains in the United States from Burger King.  Growth in this case appears to be bad for shareholders as its costs have been rising about in line with sales which are why margins have not seen much growth as Wendy’s sales have been growing.  Wendy’s margins are also generally quite a bit worse than its other fast food competitors, in my opinion its debt levels and costs are too high, and I do not trust its management to do what is right for shareholders.

Wendy’s appears to be destroying shareholder value with its high costs and debt levels, buying back its stock at overvalued prices, and continuing to grow its restaurant count and sales but not improving its margins.  Because Wendy’s margins have not improved as sales have been rising, it looks like Wendy’s is growing at less than its cost of capital which in my opinion has led to value destruction for shareholders.  The destruction of shareholder value will not reverse unless Wendy’s can cut its costs and debt levels and or improve profitability which probably will not happen for a while due to some of the reasons stated above.  Unless something drastic happens, in my opinion shareholders of Wendy’s stock can only look forward to further value destruction of their shares into the future.

Having stated all of the above I would estimate Wendy’s intrinsic value to be my 5X EBIT and cash valuation of $2.70 per share.  Due to all of what I stated in the above article I do not think that Wendy’s is even worth its reproduction value and I would not even be a buyer of the company at my $2.70 per share estimate of value.

Even if Wendy’s margins and sales do rise after reimaging of its stores, which should happen, that will not take place for many years as Wendy’s has only recently started to reimage its restaurants.

I hope I am wrong about Wendy’s because food wise it is by far my favorite fast food restaurant.  I hope it can fix its problems, and hope that it starts to thrive as a company.  However, as an investment I think Wendy’s is the proverbial value trap and I plan to keep my investment funds far away from the company.

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Professional Analysis Versus My Amateur Analysis Of Jack in the Box

This first link from MarketFolly contains the presentation from the winner of the Value Investors Congress contest whose presentation and analysis was a bull case for Jack in the Box.

The above analysis is actually the one I voted for in the contest as I thought it was the best, and the analysis he did in his article is actually what led me to research JACK as a possible investment for myself as he laid out a very good bull case for the company.

This second link is my analysis which is a bear case for Jack in the Box.

We came to the same conclusions about future possibility which he counts on more than I like to.  I generally only count in my analysis what I can see now and do not base my valuations on speculation of what could happen in the future.

Please feel free to leave comments on the two articles: Where I might have gone wrong, what I could have done better, etc.  I would really appreciate your thoughts.

Jack In The Box Overvalued Despite The Recent Hype

Recently I have been seeing quite a bit about Jack in the Box (JACK) and its long term potential through a possible spin off down the road of its subsidiary Qdoba, the entire company being bought out by one of the bigger fast food chains, or though its margin growth now that it has about 72% of its Jack in the Box fast food restaurants being owned by franchisees.  Franchise royalty margins I have seen estimated as high as 80%.

After seeing all of the above and how undervalued everyone seems to think JACK currently is, I decided to research the company myself.  Most of what I have read about JACK from other people is that it is undervalued because of the “Future potential” of the company with what I talked about in the first paragraph given as reasons; there are a lot of ifs in every pro JACK article I have read thus far.

If you have read any of my previous valuation and analysis articles, you know that is not how I operate.  For those of you who have not seen any of my previous articles I do not base my buy or sell decisions on ifs.  I value the company’s assets and operations as it is now, and future potential is only icing on the cake to me in most cases.  Here is an overview of my investment philosophy.

With the rest of this article I will be showing you why I think JACK is overvalued and give you reasons why I will not be investing in it at this time.

Jack In the Box Overview

JACK owns and operates a total of 2,247 Jack in the Box fast food restaurants, about 72% of which are owned by franchisees. Jack in the Box is one of the largest hamburger chains in the US with operations in 19 states, with the vast majority of its operations in California and Texas.  JACK also owns Qdoba and has 614 total restaurants, about half of which are owned by franchisees. Qdoba is a fast food Mexican restaurant with operations in 44 states currently.  For further information on JACK please visit its website here.

Jack in the Box has recently finished up reimaging some of its restaurants by changing the logo, updating the menu, and making its restaurants look more modern.  The recent reimaging of Jack in the Box restaurants has led to higher capital expenditures and sometimes lower revenues over recent years.  Now that the bulk of the reimaging is done, Jack in the Box is hoping to become even more profitable.

In recent years Jack in the Box has under gone the process of selling some of its restaurants to franchisees so it can get into the higher margin area of collecting royalty and franchise fees.  Jack in the Box currently has around 72% of its restaurants owned by franchisees with plans to eventually have 80% of its restaurants owned by franchisees.

Qdoba has been going through a rapid growth phase since being acquired by JACK in 2003 and JACK management states that it believes there is future potential of between 1,800 and 2,000 Qdoba restaurants in the United States.

As of the most recent 10Q, JACK gets 56.9% of its revenue from sales at its restaurants, 27.7% from distribution sales, and 15.5% from franchise and royalties.  Total company costs are 83.5% of total revenues which come from food and packaging 32.3%, payroll and employee benefits 28.7%, and occupancy and other 22.5%.

Valuations

These valuations are done by me and are not a recommendation to buy stock in any of the following companies mentioned.  Do your own homework.  All numbers are in millions of US dollars, except per share information, unless otherwise noted.  The following valuations were done using its 2011 10K and 3Q 2012 10Q.

I did my other normal valuations as well but from now on plan to only post the ones that I think are most relevant.

Low Estimate of Value:

Assets: Book Value: Reproduction Value:
Current Assets
Cash & Cash Equivalents 10.8 10.8
Accounts Receivable & Other Receivables (Net) 84.9 72.2
Inventories 37 18.5
Prepaid Expenses 32.2 16
Deferred Income Tax – Deferred Tax Liability 39 19.5
Assets Held For Sale & Leaseback 62.4 31
Other Current Assets 1 0
Total Current Assets 267.3 168
PP&E Net 825.5 495.3
Goodwill 140.5 84.3
Other Assets Net 241 120
Total Assets 1474.3 867.6

Number of shares are 45

Reproduction value:

  • Without goodwill: 783.3/45=$17.40 per share.

Base Estimate of Value:

Cash and cash equivalents are 10.8

Short term investments are 0

Total current liabilities are 266

Number of shares are 45

Cash and cash equivalents + short-term investments – total current liabilities=

  • 10.8+0-266=-255.2/45=-$5.67 in net cash per share.

Jack in the Box has a trailing twelve month EBIT of 120.

5X, 8X, 11X, and 14X EBIT + cash and cash equivalents + short-term investments:

  • 5X120=600+10.8=610.8
  • 8X120=960+10.8=970.8
  • 11X120=1320+10.8=1330.8
  • 14X120=1680+10.8=1690.8
  • 5X=610.8/45=$13.57 per share.
  • 8X=970.8/45=$21.57 per share.
  • 11X=1330.8/45=$29.57 per share.
  • 14X=1690.8/45=$37.57 per share.

From this valuation I would use the 8X EBIT and cash estimate of intrinsic value, $21.57 per share.

High Estimate of Value:

Numbers:
Revenue: 2165
Multiplied By:
Average 5 year EBIT %: 7.50%
Equals:
Estimated EBIT of: 162.4
Multiplied By:
Assumed Fair Value Multiple of EBIT: 11X
Equals:
Estimated Fair Enterprise Value of JACK: 1786.4
Plus:
Cash, Cash Equivalents, and Short Term Investments: 10.8
Minus:
Total Debt: 451
Equals:
Estimated Fair Value of Common Equity: 1346.2
Divided By:
Number of Shares: 45
Equals: $29.92 per share.

I will explain my reasons for picking these valuations in the conclusions portion of this article, but by my estimates JACK Is currently either fairly valued or overvalued by almost every valuation technique I did, except for the valuations with very high multiples.

Margins and Debt In Comparison To Competitors

Jack in the Box (JACK) Sonic (SONC) McDonald’s (MCD) Yum Brands (YUM) Chipotle Mexican Grill (CMG) Company Averages
Gross Margin 5 Year Average 16.28% 34.30% 37.94% 26.20% 24.28% 27.80%
Gross Margin 10 Year Average 17.08% 43.38% 40.42% 32.59% 11.73% 29.04%
Op Margin 5 Year Average 7.46% 16.24% 27.42% 14.22% 12.76% 15.62%
Op Margin 10 Year Average 7.07% 18.05% 22.62% 13.50% 6.64% 13.57%
ROE 5 Year Average 20.16% 66.33% 30.26% 131.56% 18.55% 53.37%
ROE 10 Year Average 18.77% 43.71% 23.19% 105.85% 10.27% 40.36%
ROIC 5 Year Average 11.17% 3.38% 17.38% 24.97% 18.49% 15.08%
ROIC 10 Year Average 10.91% 8.97% 13.37% 23.54% 10.22% 13.40%
FCF/Sales 5 Year Average -0.26% 6.48% 15.90% 7.70% 6.92% 7.35%
FCF/Sales 10 Year Average 0.80% 7.10% 12.86% 6.70% 2.26% 5.94%
Cash Conversion Cycle 5 Year Average 0.78 1.23 0.91 -36.35 -5.24 -7.92
Cash Conversion Cycle 10 Year Average 0.27 1.14 -1.22 -49.02 -5.21 -10.81
P/B Current 2.9 12.4 6.7 14.3 8.2 8.9
Insider Ownership Current 0.38% 6.12% 0.07% 0.50% 1.64% 1.74%
EV/EBIT Current 14.25 9.65 12.16 15.81 26.53 15.68
Debt Comparisons:
Total Debt as a % of Balance Sheet 5 year Average 30.78% 80.91% 35.28% 45.24% 0 38.44%
Total debt as a % of Balance Sheet 10 year Average 26.84% 50.77% 35.22% 40.72% 0.14% 30.74%
Current Assets to Current Liabilities 1.02 1.38 1.24 0.97 4.13 1.75
Total Debt to Equity 1.03 9.69 0.97 1.6 0 2.66
Total Debt to Total Assets 30.50% 71.20% 41% 37.21% 0 35.98%
Total Contractual Obligations and Commitments, Including Debt $2.6 Billion $1 Billion $27.20 Billion $11.42 Billion $2.20 Billion $8.88 Billion
Total Obligations and Debt/EBIT 21.67 8.85 3.15 5.4 5.82 8.98

My thoughts on the above comparisons:

  • McDonald’s is by far the most profitable company of the five as it far outdistances the competition in gross margin, operating or EBIT margin, FCF/sales, etc.
  • Sonic and Yum Brands’ ROE and ROIC are astounding but are inflated by both companies high levels of debt in comparison to the other three companies.
  • JACK’s margins have generally declined in the last five years in comparison to the entire 10 year period.  Most of the other company’s margins during that time have been improving.
  • Chipotle’s margins are pretty amazing, especially when you see that it does not have any debt so the numbers are not inflated like Sonic and Yum.
  • On an EV/EBIT basis Chipotle looks to be very overvalued currently with a ratio of 26.53.
  • The insider ownership of all the companies is horrendous.
  • The P/B of this industry is by far the highest I have seen since doing in depth research.
  • The EV/EBIT ratios are also much higher than the companies I have been researching lately.
  • The P/B and EV/EBIT ratios being much higher than what I have been finding lately leads me to believe that this entire industry is either fairly valued or overvalued currently.
  • The entire industry has some very high debt levels due to the costs of food, restaurant leases, etc.  Debt levels have risen quite a bit recently as all of the companies, with the exception of CMG and MCD, have taken on more debt in the past five years.
  • MCD, YUM, and CMG’s total obligations and debt/EBIT ratios look very sustainable into the future.
  • JACK’s total obligations and debt/EBIT ratio is dangerously high at 21.67.  Especially of concern is that the bulk of its obligations and debt are due before 2016.
  • Sonic’s debt levels also seem to be too high to me.
  • Helping out SONC, MCD, YUM, and CMG is that most of the four company’s debt and total obligations are coming due after 2016.

Let us now get back to JACK.

Pros

  • JACK has been buying back a lot of shares and has reduced its share count by 13 million since 2009, down to 45 million as of the most recent quarter.
  • JACK has decent margins that have been consistently positive over the past decade.
  • Now that the reimaging of Jack in the Box is done cap ex should go down and profit margins should go up over time.
  • Qdoba is a high growth asset that is also currently more profitable than Jack in the box.
  • JACK’s debt ratios, excluding total obligations, all look very good compared to its competitors.
  • Selling restaurants to franchisees will get JACK into the higher margin business of collecting royalty and franchise fees.
  • Fortunately most of JACK’s debt has low interest rates.
  • JACK owns the land underneath some of its restaurants which provides at least partial downside protection due to the possible sale of the land if it was facing dire problems and was forced to sell some of its assets.

Cons

  • JACK’s debt ratios above are very misleading as they do not include contractual obligations and commitments.
  • JACK’s total obligations and debt in comparison to its profitability levels are way too high in my opinion with a total obligations/EBIT ratio of 21.67, which is by far the highest of the group and dangerously high in my opinion.
  • Most of its debt and obligations are due within the next 5 years further exacerbating the debt situation in my eyes.
  • Margins have been declining at JACK over the past five years, in part due to the reimagining of its Jack in the Box restaurants.
  • JACK’s margins while decent and relatively steady over the past few years, are also generally quite a bit lower than its competitors.
  • JACK’s FCF/sales margin is negative over the past five years while the industry average is 7.35% over that time.
  • JACK is overvalued by almost every one of my estimates of intrinsic value.
  • The entire fast food industry appears to be either fairly valued or overvalued at this time.
  • About 85% of its revenues go towards paying costs, greatly affecting margins.
  • JACK will continue to put a lot of its resources towards opening and running restaurants and food costs.  Some of the cost of new restaurants is paid by the developer however.
  • A 1% point increase in short term interest rates would result in an estimated increase of $3.6 million in annual interest expense.  Interest rates can only go higher from where they are at now.
  • Has a low amount of cash on hand.
  • Managements pay seems too high to me.
  • How JACK management structures the pay, bonuses, and awarding of options and restricted stock is very convoluted.  The most recent proxy is longer than the most recent annual report, most of which is spent explaining how management is awarded some of its compensation.
  • Horribly low insider ownership.
  • I do not see any kind of moat or competitive advantages within JACK.

Potential Catalysts

  • Margins should rise now that the store reimaging of Jack in the Box restaurants are done, which could eventually lead to a higher estimate of value.
  • The total obligations and debt situation could be a negative catalyst if JACK should have any problems.
  • As of the most recent proxy, Fidelity Management & Research Company owns 14.9% of JACK.  If FMR decides to liquidate a portion or all of its position in JACK there could be a big sell off in the stock.
  • If JACK management decides to sell or spin off Qdoba it would send the stock price higher.
  • JACK could be bought out by a bigger fast food chain.

Conclusion

The reason I chose the above estimates of intrinsic value, that I am sure the JACK bulls will say are too low, are because of the problems I found with JACK as it currently stands: Its huge amount of total obligations and debt, the bulk of which is coming due before 2017, its relatively low and decreasing margins in comparison to its competitors, along with all of the other reasons I outlined above.

I need as big of a margin of safety as possible and for the most part only value what I see in the company as it presently stands.  All of the other articles I have seen have been talking about how much JACK could be worth if it spun off or sold Qdoba, or the entirety of JACK gets bought out.

To my knowledge JACK management has not said anything about spinning off Qdoba so to me valuing a company on speculation of what could happen in the future is very dangerous.  I saw an article the other day where someone wrote that if Qdoba was spun off could sell for 30X EV/EBITDA because that is what Chipotle sells for.  Buying any company at 30X EV/EBITDA is insane to me, especially potentially Qdoba as I do not think it has any discernible sustainable competitive advantages.  I do not even know how someone would make money on that transaction, especially since Qdoba would most likely not pay any dividend as it needs to grow its store count.

Even if JACK management does decide to spin off or sell Qdoba, the valuations and analysis that I laid out above were encompassing the entire company, and I still found JACK to be overvalued on almost every count.  I do expect JACK’s margins to rise over time now that the bulk of its reimaging is done, but the debt and total obligations scare me too much to be a buyer even if that happens.

Speculating is no longer what I do when investing, and to me buying into JACK now is almost purely a speculation play in the hopes that it gets bought out or spins of Qdoba.  In my opinion JACK is overvalued, has no discernible moat or competitive advantages, and has some huge problems with its debt and total obligations.  Combined with the rest of my above analysis, I think JACK is a bad investment currently.

For me personally, how I invest, what I need as a margin of safety, and the problems I outlined in the article, lead me to the conclusion that the risks far out way the pros as JACK currently stands, and I will not be a buyer of it at this time.

Investment Philosophy Review For New Visitors And Setting Up My Next Article

Let me first set up my next article for anyone who might be new to the site.  I only take into consideration with my valuations and analysis what I can see now, and pay almost no attention to rumored future possibilities or estimates of revenues and margins.

The only time future possibilities play any role in my articles are in situations where there is a clear catalyst: Activist/value investing firm or individual involved, the company is undergoing some kind of strategic review and is owned and controlled by a few people as in the case with Dole (DOLE) before I bought it, or the company’s management is trying to figure out ways to unlock the companies undervaluation by asset sales or spin off as in the situation with Vivendi (VIVHY.PK) before I bought into them.  Even in the above situations I still only valued the assets and operations as they are presently.

Generally, any other future potential I see in the company plays no part in my valuations or analysis, and is treated as the proverbial icing on top of the cake.

I like as much of a margin of safety as possible as I am a very conservative investor.  I see future possibilities and analyst and company estimates of the future generally as highly and unrealistically optimistic, which makes them wrong a lot and is why I have learned not to pay much attention to them.

Having stated all of that, I have begun my next article which is on Jack in the Box.  I hope to have the article up as soon as possible.

Howard Marks Interview, Laura Templeton, Intrinsic Value, Seth Klarman’s Investment Framework, Vitaliy Katsenelson, and the Value Investing Challenge

Now that I am done with the overview of my portfolio I can get back to the business of researching companies.  Up first though are some links that I think can help us all learn.

Free download of an interview with Howard Marks from Oaktree Capital.

Laura Templeton on How to Retain Conviction When The Market Goes Against You.  This is a three minute video with some very good insights for value investors.

Intrinsic Value: A Range, Not a Precise Figure is a great write up from Greg Speicher’s blog on the dangers of trying to pin down a companies exact valuation.

Seth Klarman’s Investment Framework is something every self respecting value investor should probably read.

Value Investing Challenge links to download the three finalists analysis and valuation articles.  The detail in the articles and how clearly two of them put forth their analysis is absolutely amazing and something I hope to learn from.  Possibly a few companies to do further research on as well.

Helmerich & Payne Analysis is a fantastic valuation and analysis article from Vitaliy Katsenelson at Contrarian Edge.  Again, pay attention to the amount of detail, how he thinks, and his process, absolutely amazing.

Now that I have finished up doing my portfolio overview I am going to dive right back into researching companies.  I will update you when I find something interesting, and I already have a few companies in mind to research.