Jack in the Box Inc. (JACK) Q2 2008 Earnings Report, Transcript and Summary

Good day everyone and welcome to the Jack in the Box, Inc. second quarter fiscal 2008 earnings conference call. Today’s call is being recorded. A replay will be available on the Jack in the Box web site starting today for those who could not attend the live event. (Operator Instructions) At this time for opening remarks and introductions I would like to turn the call over to Mr. Jerry Rebel, Executive Vice President and Chief Financial Officer of Jack in the Box, Inc. Please go ahead Sir.

Thank you. Good morning and welcome to the Jack in the Box conference call. Joining me today are Chairman and CEO, Linda Lang, and President and Chief Operating Officer Paul Schultz. During this morning’s session we will review the company’s operating results for the second quarter of fiscal 2008 and discuss guidance for the third quarter and full fiscal year. Following today’s presentation we will take questions from the financial community. Please be advised that our presentation contains forward-looking statements that reflects management’s expectations for the future which are based on current information. Actual results may differ materially from these expectations based on drift in the business. The Safe Harbor statement in today’s news release is also a part of this conference call. Material risk factors as well as information relating to company operations are detailed in our most recent 10K, 10Q and other public documents filed with the SEC. Now I’d like to turn the call over to Linda Lang. Linda?

Thank you Jerry. Good morning and thank you for joining us. We appreciate everybody making our call this morning. We started about half an hour earlier than usual. We are excited to host some of you at our investor’s conference here tomorrow in San Diego and hope the earlier start time for this call has helped with your travel schedule. At tomorrow’s conference which will also be web cast live from our website we plan to provide an in-depth look at our operations. A number of senior executives will be presenting information on both of our restaurant brands regarding franchising, growth, marketing and our financial outlook. As you can see in our news release this morning, Jack in the Box today reported per share earnings of $0.44 in the second quarter. While we experienced some softening in sales during the quarter as we rolled over high sales increase in fiscal 2007 our 2-year cumulative same store sales increase for Jack in the Box has been strong. Our restaurants in California, Las Vegas and Phoenix have been impacted by the housing downturn as well as higher fuel costs and unemployment. However, our restaurants in other parts of the country especially in Texas and the southeast performed well in the quarter. With economic pressures impacting consumer dining habits the tiered menu strategy at Jack in the Box provides our guests a wide selection ranging from premium products to value priced options. Our premium products are appealing to guests who are trading down from other restaurant segments. While our value menu appeals to guests who are feeling the pinch from the higher gas and grocery prices. In markets most affected by the slowdown in discretionary consumer spending we will continue to emphasize value in our advertising. In addition to promoting limited time, value priced offerings; our new product introductions planned over the remainder of the year includes two value priced additions. Menu innovation remains a major focus to Jack in the Box. Our recent introduction of real fruit smoothies and iced coffee demonstrates our ability to deliver the kind of flavor and high quality that our guests have come to expect from juice bar and coffee houses but with the added convenience of drive-thru service that only our segment of the restaurant industry can provide. Our real fruit smoothies are made from a blend of Minute Made fruit juice and nonfat frozen yogurt and come in three delicious flavors; Mango, Orange Sunrise and Strawberry Banana. Already our smoothies are proving popular as snacks as well as a breakfast add-on. We began rolling out this new beverage platform in April and expect it to be system wide by July. Coffee is another premium beverage platform that offers a lot of upside potential at Jack in the Box. This week we began offering three rich and delicious flavors of iced coffee at virtually all of our restaurants. Menu innovation along with upgrades to guest service and our restaurant facilities are the key elements of our strategic initiative to reinvent the Jack in the Box brand. Our comprehensive re-image program includes a complete redesign of the dining room and common area. Since the current re-image program was adopted in 2006 more than 500 company and franchise Jack in the Box restaurants, nearly a quarter of our system, have been re-imaged. In addition to brand reinvention another key initiative of our strategic plan is improving our business model. We are very pleased with the steps we are taking to control labor and other restaurant costs as well as general and administrative expenses. These steps are creating a cost structure that will have us well positioned when economic conditions improve. The two other key initiatives of our strategic plan are to continue growing our business and expanding our franchising activities. Through the first half of fiscal 2008 the company and our franchisees have opened restaurants in several new contiguous markets. Those restaurants are performing very well with sales exceeding our expectations. Their success demonstrates the strength of the Jack in the Box brand. Franchisees are also expanding the Jack in the Box brand into several other new contiguous markets in Texas such as Abilene, where the first Jack in the Box opened earlier this month. Construction is currently underway in new franchise restaurants in Odessa and San Angelo. The key initiatives of our strategic plan along with our ongoing success in controlling costs have us well positioned to continue growing our business in the years ahead. We realize there will be challenges to our business given the weak and uncertain economic climate in many of our western markets. However, with a dedicated, experienced team of employees and franchisees executing our plan we remain optimistic about the near term and long term prospects for our company. Now I’d like to turn the call over to Jerry for a closer look at the financial side of the business.

Thank you Linda and again good morning. Our second quarter earnings of $0.44 per diluted share exceeded the first call estimate. For the quarter same store sales at Jack in the Box company restaurants decreased .10% compared with a 6.4% increase a year ago. Same store sales at Qdoba increased 2.4% in the quarter on top of a 3.5% increase last year. Lower than expected sales and higher food costs reduced the second quarter restaurant operating margin to 16.5% of sales. Food and packaging costs for the quarter ran about 190 basis points higher than last year. Cooking oil was up about 50% versus last year, cheese up about 35% and egg up about 25%. Beef was up just under 1% versus the second quarter of last year. We expect the high cost of commodities will continue through the second half of our fiscal year. Our forecast for the second half of fiscal 2008 calls for about a 3% increase in commodities over fiscal 2007 and includes significant increases in the price of cooking oil and some moderation in the growth rate of eggs and cheese. We expect beef to be up in the range of 1-3% for the second half of the year. In the second quarter we locked in chicken prices with various suppliers ranging from 6-24 months at an average increase of just over 1%. Although commodity costs are significantly impacting our restaurant operating margins, our actions to control costs are mitigating their full impact and lowering our cost structure exclusive of commodities. For the quarter labor costs were down 40 basis points from last year due primarily to effective labor management including reduced overtime. The ongoing roll out of our kitchen enhancements including energy saving equipment is continuing to drive down energy costs by approximately 8% on average. We now have more than 1,100 of our restaurants with the new kitchen equipment. Our profit improvement program initiatives have helped reduce restaurant operating costs in the areas of packaging, supplies and small wares. Our re-franchising strategy and a strong focus on profit improvement program initiatives reduced fuel and other G&A expenses excluding advertising by approximately $3.4 million for the quarter versus last year. For fiscal 2008 we have lowered our same store sales estimates for Jack in the Box company restaurants. We now expect sales to be flat for the full year and down approximately 2% in the third quarter. The 2-year cumulative increase of 5.4% in our upcoming third quarter is down approximately 1% from the second quarter’s 2-year cum due primarily to continued softness in consumer spending. For fiscal 2008 we are affirming our full year earnings guidance of $1.98 to $2.08 per diluted share and with that let me turn the call back over to Linda.

Thank you Jerry. We will go ahead and take your questions now.

(Operator Instructions) Your first question comes from the line of Brian Moore with Wedbush Morgan Securities.

Some clarity maybe on the cost of sales, if you could help us understand some of the pressure from mix during the quarter? I know you had two value promotions at one point. As well, where do you stand on the beef trimmings for the second half of the year?

I heard the second part of that question. Let me answer that one first and then if you could re-ask the first that would be helpful. The beef trimmings for the second half of the year right now our forecast for the third quarter is about $0.70 per pound plus or minus a little bit. Last year for the third quarter we ran about $0.80 per pound. Where we think the pressure is on beef particularly for the second half of the year is in the imports on the 90’s. Right now we are covered for the third quarter at prices between $1.40 and $1.47. So we feel pretty good about the beef situation right now particularly compared to last year.

The first part of my question was actually to the pressure on dairy. Given the comments by some coffee restaurants and thinking about where the pressure was there. Was it from mix? Were there mix issues in terms of the value promotions that were being run during the quarter?

Pressure on cheese was primarily with respect to cost. We did not start to see our cheese increases last year until the beginning to mid third quarter of last year. So we’re rolling over relatively modest or low cheese prices last year. We had our cheese prices covered for about the first half of last year at somewhat lower than what market rates are.

A question on sales trends. I guess given the Q3 guidance would it be fair to assume the negative 2% guidance is based on the first month of the third quarter?

When we set the guidance for quarter three we considered several things. One is the strong roll over from last year, so quarter three prior year was up 7.4%. So a strong roll over number. We also did consider the most recent sales trends and felt that it was prudent to be somewhat conservative given really the uncertainty of the economic climate especially in our major markets in California, Arizona and Nevada. We have strengthened the promotional calendar later in the year. It is a little back-end loaded and we do believe that this two-tiered strategy makes sense for our brand where we have premium products as well as value priced products.

Any trend in terms of day parts or day of the week where you may have seen softness during Q2 or Q3?

No it was really across the board. What we have seen is what we call the mid-tier transactions. Those are things like Ultimate Cheeseburgers, Sourdough Jacks…they are not real high premium products and they are not the value products. Those are what we have lost sales on. Those are probably the construction workers who have lost their jobs or they are just simply trading down into value products our out of this segment.

Anything on the sales gap between remodels and the comps you reported? Has that been sustained or was the deceleration similar with the remodel restaurants during the quarter?

It really is more regional based. It is kind of hard to net out the two. We are just seeing weakness on a more regional basis regardless of whether there is a re-image or not.

On products, if I may understand correctly, I’m not sure if you are doing a $20 store value card…get $5 free, but I wonder what the value promotion is going to be during Q3. [Inaudible] How about on the sirloin burger, the line extension there. Can you just characterize the success of that item relative to previous line extensions of sirloin melts and patty melts?

I would say the sirloin steak melt was a little stronger product in terms of mix. It was a little more unique so that was probably a little more successful in terms of introduction. The Barbecue Bacon Sirloin Burger the mix was a little bit lower than what we had seen in our test results but still very solid. Those are both strong products for us. Again, it was not really our premium products that we were seeing the weakness it was more kind of mid-tier product line that we saw some weakness and actually a little bit of weakness on the value products as well.

Smoothies are in how many stores currently?

We have smoothies in 300 locations.

The expectation that the end of July that will be fully rolled out?

I’m sorry, we have 600 locations for the smoothies and the expectation is to have it completed by the end of July. Early results look good. They really are selling well.

Linda you certainly have been in the industry a long time. Can you give any kind of macro view on I guess what we’ve seen has been a trade down or deceleration of sales within fast food or QSR? It seems casual diners have suffered for so long and QSR has held up well. Now we just get negative retail sales numbers yesterday for restaurants QSR sales appear to be softening. Any thoughts on your experience during previous kind of downturns?

If you go back to 2000-2001 where some of it was self inflicted because we were doing aggressive discounting at that time and there is a little fear of that. If you have read about Taco Bell they are rolling out a very aggressive value menu. I think it is all related to the economic conditions and you have that coupled with the high fuel costs and the regionality of the low housing market. I think it is a little bit tougher. It is tougher than I’ve seen in my 20+ years in the industry.

On G&A for Jerry, a tremendous improvement on a dollar basis and percent. How should we think about that going forward 3-5 years? From a nominal basis as well as a percentage of sales basis.

It’s much easier to talk about the nominal basis rather than the percent of sales. We have a strong focus on continuing to drive down our overall cost structure not just G&A but all of our costs. We would expect to continue to see G&A reductions until we have reached that level of 78% franchise operated. I would continue to expect to see annual decreases in G&A over the next at least 3-4 years and probably beyond.

Could you remind us what the dollar number per store that maybe we could tie it to?

We were estimating $28,000 per restaurant and that has proven to hold up over the last year to 15 months.

The next question comes from the line of Lawrence Miller with RBC Capital Markets.

Some of your competitors out there have been talking about having some issues re-franchising stores. It looks like you got a lot done in the quarter but the flag came down a bit on the lower end. Can you kind of give us an update on the franchise finance world as you guys see it?

There is no question that our franchisees and the lenders are looking more closely at the deals and requiring more equity in the deals but to date we have not had a deal unwind due to financing.

And the pipeline still looks reasonably full?

At this point yes.

On your guidance I’m just trying to understand what is in your guidance and what is not for two areas, same store sales. Is there any same store sales expectations built in with the smoothies and the coffee program and any rebates at this point?

No, we really haven’t built anything significant in for either rebates for the coffee or smoothie programs.

On the EPS side, as it kind of trickles down to the PNL do you see anything built in for additional share repurchases?

We do not have anything in for new share repurchases.

On the food cost side it sounds like there is some push then pulls but generally I think is that sort of 1-2% inflation for the year still a good number Jerry?

For food costs?

Yes. How is that going? That is what you were talking about not too long ago.

Food costs for the full year would be up in the 3-4% range.

And that is jut a change…wasn’t that the first half more than you thought sort of the back half would be higher?

Yes.

The next question comes from the line of Steven Rees with JP Morgan.

On the full year earnings guidance with the same store sales range coming down to 2-3% I would have thought there would have been more earnings stems by just given how many company stores you do own. What drove the upside relative to your previous expectations or what surprised you in costs that allows you to keep that full year change?

Part of that is the roll over on the food costs. So we do expect some improvement in restaurant operating margin over where we were in the first half of the year because of the roll over effect of the higher food products last year. We’re expecting some improvement there and we expect continued lower operating costs, lower labor and lower G&A.

On menu mix some of your competitors are talking about negative mix. I thought it was interesting on your comments that you seem to be seeing more pressure sort of in the middle of the menu range and partially on the value side. Can you just talk about how your mix is trending for your system?

In terms of the mix impact on our same store sales?

Yes.

We don’t usually give a lot of detail around that.

Are you seeing pressure? Is the strength in the higher end enough to offset the value side or are you seeing pressure in your overall average check?

What we’re seeing, as Linda mentioned earlier, improvements and continued strength in the top tier. It is this middle-tier piece that we are losing and it is not necessarily related to a particular day part.

It is more traffic related and really the softness. We’re just seeing the mid tier transactions and some of the value transactions that we’re now addressing in our promotional calendar.

On value, it sounds like that is going to be more prevalent in the second half. How are you thinking about that? Are you engineering products specifically designed for value that aren’t going to be dilutive to margins or are you going to consider some temporary price reductions?

No. There are new product introductions that are value priced.

They are specifically designed for that?

Yes.

The next question comes from the line of Keith Siegner with Credit Suisse Securities.

I noticed in the long-term outlook there was some change in the language related to Qdoba and CapEx. I’m wondering if you could just tell me a little bit about are you thinking differently about that brand and how you might want to invest in it in the next 2-3 years. It sounds like you might be more open to accelerating company owned unit growth.

That is correct. We have in assessing the return on the investment in Qdoba company clearly the returns are very strong and it makes sense for us to go in and accelerate the growth of the Qdoba company restaurants and build out more rapidly those company owned markets. So we are accelerating the growth. We haven’t laid out those plans exactly yet. Traditionally we run only about 10 corporate or company locations a year. This year we are close to doubling that and then we’ll accelerate from that going forward.

Does that have any impact on your targeted growth for Jack in the Box or not?

No it shouldn’t. It is still a relatively small number. We’ve been shifting our growth on the Jack in the Box side from company growth to franchise growth so we will continue to do that.

On the re-franchising, I understand no deals have fallen through but it does seem that the gains on the re-franchising and the proceeds keep coming in higher than the long-term guidance for that program. Have you been focusing primarily on getting the deals done for the higher quality stores? Is this something we should think about possibly catching up next year when say the financing gets better for the lower performing stores? How should we think about that?

We have been targeting selling the restaurants in markets that we believe would be better served as franchise owned and operated. It is not around a sales volume target. What I would tell you is the reason the cash as well as the gains have been going up is really twofold. One is it is a function of the cash flows and of the restaurants that we are selling and so to some extent you could deduce we are selling the higher volume restaurants than what we had been. That is not by design. It is more designed around which market do we want to sell. The other thing is if you compare this to 3-4 years ago our average unit volumes are up quite substantially over that time frame so you would expect to get higher gains and higher sales prices from those restaurants as a result of the improved operations.

So it’s not really a function of the current environment? Is it possible for you to give us a little information about the trends throughout the quarter? Say the monthly trends and how that progressed on a comps basis?

I don’t think there was a significant difference from one period to the other.

The next question comes from the line of Jeffrey Omohundro with Wachovia Securities.

I’m interested in what you are doing in the kitchen both in terms of the enhancements referred to designed to handle increased product innovation and also in terms of what efficiency opportunities you might have in the kitchen.

There is two elements to our kitchen enhancements program. One is a refrigerated condiment rail modular in nature which allows us to keep high quality specialty condiments, toppings and sauces at the point of assembly rather than in a refrigerator that the employees would have to go to get the products from. So it enables menu innovation as well as creates some labor efficiency for us. The second element is an improved protein holding cabinet replacement to our patty staging system which provides for a higher quality product and as well creates some labor efficiencies and has delivered approximately 8% utility reduction.

The next question comes from the line of Joe Buckley with Bear Stearns.

In the last earnings release on the guidance the same range obviously $1.98 to $2.08 but you mentioned that included a variety of items…the contribution of the franchisees, the re-imaged restaurants, the facility charges, higher tax rate and so forth. Are all those items roughly the same or have any of those shifted? Is all that still included in the $1.98 to $2.08?

They haven’t shifted significantly. There has been some modification to it but we didn’t put it in there because we felt it was old news.

On the same store sales guidance assuming you do come in about 2% for the third quarter it looks like it implies a return of positive comps in the fours. Is that the right read on that? Is that kind of the game plan at the last of the year?

Modest increase, yes. If you do the math.

On the labor side, what are you doing to control labor costs? Jerry I think you mentioned overtime going down. Is that overtime for the managers, assistant managers? Can you just walk through what you are doing to control labor costs so well?

On the control side it is good old fashioned cost control. Really nothing more. It is better control over those restaurants that were using more hours and more overtime. It is predominantly crew overtime. The second piece is some labor efficiencies we have gained from the aforementioned kitchen enhancements.

The next question comes from the line of Christopher O'Cull with SunTrust Robinson Humphrey.

Linda during the quarter I know you ran the Ultimate Cheeseburger for about 3 weeks at $1.99 to address this demand for value. Do you think consumers are seeking value from fast food are more price point sensitive? Do you think you need to promote a $0.99 offering?

I don’t think it has to be $0.99. I think what customers and consumers are looking for is good value for the money. So if you look at, for example, Subway’s $5 foot long that is a pretty good value for the money. I think bundled deals, products that are designed at a fairly low price point…I think that makes more sense than doing an aggressive $0.99 or $0.89 or $0.79 price promotion.

Linda, how many remodels have been completed in California? If you can comment on how those remodels have performed relative to the remodels that were completed in areas like Texas?

We’ll have to get back to you on that. I don’t have that information on hand right now on California remodels.

Of the percentage of the systems done have they been primarily in California?

No. They have been really across the system. We did all of Seattle and we did Waco now a year and a half plus into the re-image. The rest of them have been some small markets across the system and then onsie-twosie in different areas.

Jerry, G&A was lower it looks like on a sequential run rate basis. Can you tell us what percentage of this improvement quarter-to-quarter relates to more permanent savings like associated with the re-franchising program versus temporary savings like bonus changes?

It is virtually all permanent. There was minor timing differences that were improved from quarter one’s run rate but primarily the vast majority of this was a permanent savings. I just want to also mention one perhaps minor adjustment to my response to Brian Moore. The $28,000 down on G&A, what I didn’t mention is every time that we re-franchise a restaurant that while we reduce G&A down 28 for that restaurant we add about $5,000 in support for the franchise restaurants. I just want to make that clear for your models.

I think that is a wrap. Thank you very much for joining us this morning. We’ll see some of you tomorrow.

Thank you for participating in today’s conference call. You may disconnect at this time.