Consumers have had a tough experience in the post-pandemic world, and corporations have had to contend with similar struggles. Quick-serve restaurants (QSR) reside in the unfortunate nexus of every post-pandemic pain point. Supply chain constraints, food inflation, a weaker mass-market consumer spending base, and labor shortages all disproportionally affect the QSR industry. Margins have predictably been compressed as QSR menu price increases trailed cost inflation. Rather than highlight weakness, this difficult economy shows the strength of these business models. As the US rolls towards a potential recession, investors should research the QSR industry, which we believe is well-positioned.
Quick-serve restaurants are a low-cost provider of food for consumers. In recessionary times, consumers tend to cut back on big-ticket items like travel and home-improvement projects, but a trip to the drive-thru remains a welcome treat. In fact, consumers also may “trade-down” in a recession, opting for fewer trips to expensive restaurants and more frequent meals at QSR. Currently, an insouciant US equity market undervalues recession resistance. However, the second half of 2023 should reignite urgency to protect from a cyclical downturn and QSR quality could shine.
QSR Quality in a Recession
Meanwhile, supply chain and food inflation are already abating. As large buyers of food and goods, the QSR industry can flex its muscle to squeeze supplier costs lower while continuing to raise prices and passing on costs to customers. Furthermore, worker availability will rise in a recession, putting these companies in a great position to grow margins. This setup is far better than the typical company, where in a recession, costs are difficult to control, revenue declines, and margins plummet.
Frank Capital’s Pick
The Frank Value Fund owns equity in what we believe is the best-positioned company within the great setup of the QSR industry: Jack-in the Box (NASDAQ: JACK). Jack in the Box may be unfamiliar to east-coasters, but according to Restaurant Business, Jack in the Box locations have a higher unit volume than Sonic, Burger King, and are approaching the second best player, Wendy’s. With a relatively new CEO and approximately 2,000 locations in 21 states compared to Wendy’s 6,000, JACK has expansion opportunities. The Restaurant Business article explains how Burger King is suffering from weak franchisee financial positions as unit volumes stagnate.
The power of JACK’s unit volume translates into a compelling franchising opportunity. Few companies can offer potential franchisees the power of a growing brand. Also, with higher interest rates, capital may increase towards franchising as this offers a faster cash-payback period than a long-term investment in an unprofitable private equity company. As compelling as expanding Jack in the Box restaurants would be, it is not the lowest hanging fruit in JACK’s opportunity set. That would be Del Taco.
In March of 2022 JACK announced its acquisition of nearly 600 Del Taco restaurants. The market reaction was unkind, but the strategy appears sound. Del Taco is only 50% franchised, compared to 90%+ for McDonalds, Wendy’s, and Jack in the Box restaurants. When the parent company sells its restaurants to franchisees, parent sales decrease but margins increase dramatically. This is where we believe the market is wrong. JACK stock is priced as if EBITDA margins will never return to the historical levels of 25%. Yet, in November 2022, management announced a refranchising strategy for Del Taco, with the hope of executing several deals in 2023.
The Bottom Line
With JACK trading at a lower valuation than McDonald’s, Wendy’s, and Restaurant Brands International, there is significant upside if the company can return to 25% EBITDA margins. The QSR industry can reclaim margins though supply chain management, food inflation abatement, and a potential increase in the labor pool. This should be a multi-year effort, but the recession resistance of the industry gives the investor strength to hold through economic turmoil.
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This publication does not constitute an offer or solicitation of any transaction in any securities. Any recommendation contained herein may not be suitable for all investors. Information contained in this publication has been obtained from sources we believe to be reliable, but cannot be guaranteed.
The information in this post represents the opinions of the individual portfolio managers and is not intended to be a forecast of future events, a guarantee of future results or investment advice. Also, please note that any discussion of the Fund’s holdings, the Fund’s performance, and the portfolio managers’ views are as of December 31, 2022 and are subject to change without notice.