The October conference of the Value Investing Congress just wrapped up in Las Vegas, where thousands of the world’s cheapest, most penny-pinching investors converged to talk value investing – the biggest gathering of value investors this side of the Berkshire Hathaway shareholders’ meeting in Omaha.
(Forgot what value investing is? Read our introductory investing post.)
Conference organizers hold a contest every year for the best value investing idea. All the entrants make a case, and then a team of experts winnow the entrants down to the top three. The three finalists get to make a “roadshow” type presentation to argue their case.
The winner this year? A 27-year old whiz kid named Ryan Fusaro. Ryan’s a Fordham University graduate who works as an analyst at a hedge fund called LionEye Capital.
Fusaro’s idea? Go long Jack-in-the-Box. The old burger chain – blessed with the ticker symbol JACK – is currently trading at $27.30, as of 8 October 2012.
The raw numbers seem to support the thesis that JACK is, indeed, undervalued. It would certainly pass most initial screens for value-oriented investors. The fast-food business model was good enough for cheeseburger fan Warren Buffett, who famously bought Dairy Queen years ago. JACK gives us the following valuation metrics:
- EPS (ttm): $1.50
- P/E of 18.25 – slightly cheaper than the 20.2 for the fast food industry.
- Price/Book of 2.9 – Industry average of 6.4.
- Price/Sales of 0.6, vs. the industry average of 2.1.
- Price/cash flow of 8.9, vs. an industry average of 13.9
- Per Morningstar, JACK is sporting a forward P/E of 16.2, and a PEG ratio of 31.7.
- JACK does not currently pay a dividend.
How does Fusaro get to his argument that JACK is the best bet – Fusaro’s thesis? Here are the basics:
1. First of all, Fusaro asserts that JACK is cheap on a cash-flow basis:
Fusaro likes the company’s transition from an operator of restaurants to a franchiser. JACK set out to refranchise all its Jack-In-The-Box restaurants beginning in 2005. They’ve sold over 1000 franchises since then, raising $440 million – a process they see continuing. JACK will also collect a 5 percent royalty from franchises going forward. The company is unjustly viewed as a “low-margin restaurant operator, rather than a high-margin royalty business,” Fusaro asserts. Central to his case:
“Franchise businesses feature high-margin (often >50% EBITDA margins), high free cash flow and highly scalable, recurring revenue streams that are less subject to commodity and other business risks. Franchise business models are extremely attractive in that they allow for growth with minimal if any capex investments. Their cash flows are also typically less volatile, more stable and predictable and are deserving of a higher multiple than pure restaurant operators. Indeed, due to these attractive characteristics, franchise business tend to trade a multiples of 10-12x EBITDA for more mature businesses like JIB, and at even higher multiples for rapidly growing concepts such as Qdoba (>15x).”
2. Second, he also believes that investors have not priced the value of Qdoba, a Mexican fast food chain and subsidiary of JACK, into the stock.
Too few people even realize that Jack-in-the-Box owns Qdoba, argued Fusaro. When they figure it out, JACK should pop.
Overall, Fursado holds that JACK is cheap compared to peers, at -7.6 x 2012 EBIDTA – while its peers are up at 10 to 12 times estimated 2012 EBITDA. He believes the Jack-in-the-Box intrinsic value at 10x 2012 EBITDA is around $936 million. He pegs the faster growing Qdoba line of restaurants at a higher 14x EBITDA valuation, or $315 million, and credits their real estate holdings with an 8 percent cap rate, resulting in a value of $970 million for the real estate alone. The company holds $480 million in debt, so that translates to a value of $2.2 billion, or $39 per share.
3. Takeaways for Everyday Investors
So why does this pricing anomaly exist? Are markets so inefficient? Well, as Warren Buffett famously quipped, “I’d be a bum on the street with a tin cup if markets were efficient!”
In this case, Fursado argues that the markets have not yet priced in JACK’s metamorphosis to a franchise model from a restaurant operator. Fursado likewise holds that many investors haven’t yet heard of QDOBA, but the chain has tremendous growth potential. New shareholders will benefit from substantial investments in reimaging since 2006, updating the restaurants’ look and feel. Fusaro believes the stock may well be trading at $57 by 2015, which would mean a 120 percent return.
Overall, Fursado builds an excellent, well-thought-out case. At a young age, he’s got some fundamental chops. His reasoning reminds us of John Neff, the old Vanguard value hand who ran Windsor in its heyday. Neff also looked for hidden value in franchises – as has Cheeseburger and Cherry Coke fan Warren Buffett, who famously invested in Dairy Queen… another undervalued burger chain with a household name – and which is still demonstrating fantastic growth by expanding into China.
Want to see what a contest-winning idea looks like? You can read Fusaro’s entry in its entirety here.
Should We All Buy JACK Stock? Not so fast…
Not everyone is so convinced, though. Jason Rivera, writing on Seeking Alpha, believes that JACK is overvalued by quite a bit. Why? Rivera has a different approach to valuation than Fursado, and develops a best case – middle-case – worst case matrix of valuation possibilities.
Rivera argues that JACK’s margins have actually been shrinking over the last five years, while other companies such as YUM and McDonalds’ are seeing expanding profit margins. He also points to “horrendous” insider ownership.
Further, Rivera argues that JACK’s debt picture is “very misleading” because it doesn’t take into account ongoing lease obligations, and most of its existing debt is due within five years. Plus, JACK doesn’t have much of a moat protecting its brand, compared to other restaurants. (Is it really that much different than Wendy’s?)
For these reasons, and for others you can read for yourself, Rivera believes that Jack quite possibly fairly or even overvalued. These were two excellent presentations by two young but disciplined and thorough thinkers, and both are a worthwhile, educational read by any fan of value investing.