Why This Fast Food Chain Is in Danger

Based in San Diego, Jack in the Box  is a national casual fast-dining that sells hamburgers, French fries, sandwiches and other meals in 2,200 restaurants covering 21 states. It also owns Qdoba Mexican Grill chain, which comprises around 600 restaurants in 45 states.

With $1.77 billion in market capitalization, the company is currently valued at 24x earnings, well above McDonald's . However, unlike McDonald's, Jack in the Box has practically no presence overseas and may not have enough competitive advantages to keep its revenue growing at healthy rates. And with the hamburger market saturated in the U.S., Jack in the Box's last hope is Qdoba. Unfortunately, even Qdoba's growth rates may be in danger zone, since it operates in an industry with low barriers to entry and since it has already grown substantially after its acquisition in 2003.

Jack's shares did pretty well in the past 52 weeks (50% return). But because some of the worries mentioned earlier are gaining momentum among investors, in the past 30 days the stock produced negative returns. Will Jack in the Box succumb to fierce competition and market pressure?


Why Jack in the Box is in trouble

If we take look at the company's "consolidated franchise revenues" since 2008, at first glance it doesn't seem like there is a growth problem. Revenue has grown every single year.

Now, let's calculate the growth rate of consolidated franchise revenues: between 2009 and 2010 it was 19%, between 2010 and 2011 it was 22%, and between 2011 and 2012, 15%. This is a signal that the company might have reached its growth rate peak in 2011. And don't forget that according to Morningstar, year-over-year total revenue growth has actually been negative: -4.54% in 2011 and -29.56 in 2012!

 

Source: Jack in the Box, Investor Relations (Presentation slides, Oppenheimer 13th annual Consumer Conference)

Indeed, some of the consolidated franchise revenue growth we saw in the past years might have been caused only by the Qdoba business, which since the 2003 acquisition has grown from 85 units in 16 states to more than 550 units in 44 states. The Jack in the Box hamburger business practically stopped growing in the early 2000's.

The Qdoba business has been the main revenue growth driver so far. But some signs of market saturation and fierce competition even in this segment suggest it may not be able to sustain the same growth rates in the medium term. An example: the company recently announced its plan to close 67 of its company-owned Qdoba restaurants and refranchise 18 namesake restaurants.

Although the company plans to replace these 67 restaurants with nearly 60-70 new Qdoba restaurants in 2014, there is no guarantee that the new locations will have a positive influence on revenue growth rates. Qdoba may have reached a point where further expansion is simply not that easy.

Of course, closing 67 restaurants also has a negative impact on profitability, especially in the short run. The losses of such discontinued operations were estimated to be $36.7 million. So far this has caused the company to lose $5.7 million in the last quarter, amounting to an overall loss of $0.12 per diluted share, compared with $0.26 in the prior year.

As a matter of fact, net income has decreased considerably each year. Just in the latest quarter the operating margin for Qdoba decreased 270 basis points to 20.6%, as a result of higher food, labor and packaging costs.

Finally, many investors believe that the process of selling some of its company-owned restaurants to franchisees will increase margins. But the company already pushed its split of company-owned units to franchised units from 62%-38% in 2008, to 24%-76% in 2012. And margins did not increase meaningfully in the same period. Therefore, the main issue here is probably the absence of pricing power and competitive advantages.

There are plenty of better alternatives

In the hamburger business, I believe McDonald's is the best alternative. According to the latest top regional quick service restaurants ranking by number of in-store visitors in the U.S., McDonald's ranked first in every region. It's vast amount of resources and ability to be constantly changing its menu are some of its main competitive advantages.

Reference: Stocktwits

As a stock, McDonald's also has plenty of benefits. First, it has a more attractive price-to-earnings ratio. Then, it has increased its dividend in each of the last 35 years. Finally, it is one of the safest stocks in the world, because it owns more than 40% of the land and 70% of the buildings for its restaurants, and because it has one of the strongest brands in the globe.

In the Mexican food business, Chipotle Mexican Grill is one of the strongest competitors. The company is growing way faster than Qdoba: in the latest quarter, revenue and operating income grew 18.2% and 9.4% respectively, opened 44 new stores and provided great guidance: it will open another 165-180 new stores for 2013.

But even Chipotle is finding it hard to keep margins stable. The latest earnings report showed a decrease in restaurant operating margin of 1.6% compared with the same quarter a year ago. The official explanation relates the margin decrease to exogenous factors like price increases in salsa and chicken. At any rate, the fact that both Qdoba and Chipotle could not offset the negative effect of cost increases with menu price increases shows that achieving pricing power in this segment is extremely challenging for any party.

Final foolish thoughts

To become a bear, it's probably enough to recognize that Jack in the Box isn't growing and its margins remain very low. In the latest quarter, margins were as low as to produce negative EPS. Such a pattern indicates that the company lacks competitive advantages and pricing power in a highly competitive industry. Therefore, it is more vulnerable to rises in commodity prices and to competitors.

Deceleration in revenue growth rates, possible saturation in the hamburger market and the absence of pricing power in the Mexican food segment could cause the stock price to drop further in the short run. In this context, McDonald's and Chipotle are some alternatives to Jack in the Box that are totally worth exploring.

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The article Why This Fast Food Chain Is in Danger originally appeared on Fool.com.

Adrian Campos has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill and McDonald's. The Motley Fool owns shares of Chipotle Mexican Grill and McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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