Today, the stock is trading at roughly half that price, and its climb back has been mired with the challenges of declining revenue and increased competition in a fragmented market. The company went from its heyday straight into a five-year long hangover.
However, with 3,526 locations in the United States, Sonic is still a strong contender in the industry and its solid growth in the previous quarter reflects its strengths. Shares have risen more than 70% over the past twelve months – so is it time for investors to jump on the bandwagon?
A mixed second quarter
For its second quarter, Sonic earned 6 cents per diluted share, or $3.6 million, more than double the 3 cents per share, or $1.7 million, it earned the in the prior year quarter. Excluding one-time benefits and charges, Sonic earned 5 cents per share, matching analyst estimates on the same basis. However, revenue slid 3.46% to $111.1 million, missing the consensus estimate of $112.72 million.
The company attributed its robust earnings to lower expenses. During the quarter, payroll and benefits costs dropped 4%, food and packaging costs were reduced by 4.6%, and SG&A (sales, general & administrative) expenses declined by 3.0%. Drive-in margins also improved 140 basis points to 11.8%
A new menu and a revived marketing campaign
During the second quarter, Sonic revamped its menu. The Philly Steak Grilled Cheese Sandwich, BLT Ultimate Grilled Sandwich and premium chicken sandwich stood out as its most popular sandwiches. For its breakfast menu, Sonic added two new premium breakfast toasters. It also added Spicy Jumbo Popcorn Chicken to its lunch menu, and diversified its snack and drink menu with the new Sweetheart Shake, Lava Cake Sundaes and Sweet Potato Tots.
Although its new menu items show innovation, I am slightly concerned with the company’s weaker value menu options. Competitors such as McDonald’s Corporation (NYSE:MCD), Burger King Worldwide Inc (NYSE:BKW) and The Wendy’s Company (NASDAQ:WEN) offer far more comprehensive value menus, which have been considered a major asset during economic downturns.
Sonic Corporation (NASDAQ:SONC) also credited a revival of its “Two Guys” as a positive growth catalyst during the quarter.
Sonic’s total same-store sales were flat for the second quarter, but drive-in locations posted 1.9% growth. Excluding the impact of leap year, however, total same-store sales rose 1.3% while drive-in locations grew by 3.3%.
Lack of sales growth
My primary concern for Sonic is its lack of sales growth. In an industry where some rivals are having problems growing earnings on top of healthy revenue, Sonic Corporation (NASDAQ:SONC) faces the opposite problem – rising profit on a long-term decline in revenue. That is a far more dangerous situation, since margins can only be stretched so far. Therefore, I’m not too optimistic about Sonic’s growth prospects.
While margins have been expanding due to reduced costs, Sonic Corporation (NASDAQ:SONC)’s steep decline in revenue, which has continued through the second quarter, is too important to ignore.
The winter season is generally a slow one for Sonic, since its drive-in format is largely weather-dependent. As a result, Sonic’s top and bottom lines actually respectively decreased 11.83% and 54.55% from the first quarter.
A big dilemma – expand or raise royalties
When faced with this dilemma, fast food restaurants tend to boost sales by adding more stores, especially franchised locations. The problem is that nearly 90% of Sonic’s locations are already franchised – roughly in line with McDonald’s and Burger King Worldwide Inc (NYSE:BKW)‘s franchise saturation levels. Wendy’s has a slightly lower percentage of franchise stores, at under 80%.
That leaves Sonic with two options – to build more locations or to raise royalty rates on its franchises. Considering that Sonic only added three new franchised drive-ins during the quarter, it’s safe to say that Sonic is not keen to expand and increase its expenses, given its precarious situation.
Under that same logic, analysts at Credit Suisse believe that Sonic Corporation (NASDAQ:SONC) will prioritize raising rates on its existing franchisees. This could cause some of its 850 franchisees, up for renewal in 2015, to resign. Although Sonic management confirmed that raising royalty rates on franchisees was possible, it stated that it would offer special lower-rate franchise licenses to franchisees that built drive-ins within certain time periods. Sonic also plans to introduce more smaller locations, which lack the entire drive-in format and are cheaper to build or franchise.
The road ahead – higher margins and higher prices
Looking forward, Sonic Corporation (NASDAQ:SONC) management repeatedly emphasized margin growth in 2013. The company has already locked in the cost of over 80% of its commodities throughout the year, and anticipates food inflation to run 1% to 2% for the rest of the fiscal year – an estimate that is in line with its industry peers. Food and packaging costs are expected to moderately improve for the rest of the year. Drive-in margins are also expected to rise to an average of 14.5% to 15.0% for fiscal 2013.
All that talk of higher margins was expected, since the company’s sales growth has been lagging for the past three years, so profits have to come from somewhere.
However, Sonic plans to raise prices 1.5% to 2.0% in May. In my opinion, this is a dangerous move. Declining revenue and weak same-store sales indicate that even though market demand isn’t strong enough to grant Sonic pricing power, the company is willing to risk denting sales growth to expand its margins. Looking at the chart below, we see that Sonic is completely depending on margin and profit growth to carry it through 2015. There simply aren’t any longer term plans to grow its revenue back to pre-2007 levels.
Source: Zonebourse.com, based on Thomson Reuters’ estimates
Versus Competitors
Sonic competes with several larger competitors, such as McDonald’s (NYSE:MCD), Burger King Worldwide Inc (NYSE:BKW) and Wendy’s. Sonic Corporation (NASDAQ:SONC) is the smallest and lacks the international exposure of its rivals. In my view, that’s a major strength – since McDonald’s, the most globally diversified, has been hit hard by troubles in Europe, its largest market. Meanwhile, both Burger King Worldwide Inc (NYSE:BKW)’ and Wendy’s are exposed to Asian and Latin American markets, which have been hit by worries regarding stagnation and inflation.
Let’s see how Sonic stacks up against these rivals.
| Forward P/E | Price to Sales (ttm) | Debt to Equity | Profit Margin | Qty. Earnings Growth (Y-O-Y) | Qty. Revenue Growth (Y-O-Y) | Same-store sales (mrq) | |
| Sonic | 16.50 | 1.32 | 1,045.63 | 6.78% | 11.50% | -1.80% | +1.3% |
| McDonald’s | 15.54 | 3.58 | 89.14 | 19.82% | 1.40% | 1.90% | +0.3% |
| Burger King | 21.37 | 3.47 | 259.52 | 5.99% | 94.40% | -30.30% | +2.7% |
| Wendy’s | 28.85 | 0.91 | 73.40 | 0.28% | 562.30% | 2.40% | +1.6% |
| Advantage | McDonald’s | Wendy’s | Wendy’s | McDonald’s | Wendy’s | Wendy’s | Burger King |
Source: Yahoo Finance, 3/27/2013
In a nutshell, Sonic simply doesn’t measure up to the big boys. Wendy’s is dominating its peers in earnings and revenue growth. McDonald’s is still the king of high margins despite slow worldwide growth. Burger King Worldwide Inc (NYSE:BKW)’ is the industry’s favorite comeback kid, with the highest same-store sales growth of the bunch. Where does that leave Sonic?
Although Sonic Corporation (NASDAQ:SONC) appears fundamentally undervalued, the company’s long-term debt – at $508.65 million versus $42.73 million in cash and equivalents – is a bright red flag telling investors to stay away. That high debt-to-equity ratio, coupled with its poor ability to grow revenue, weather dependent business model, and risky plans to raise prices, tell me that Sonic’s post-earnings pop is way too premature. Stay away from this one, unless you enjoy cherry-limeade induced sugar hangovers.
The article Sonic’s Cherry-Limeade Induced Sugar Hangover originally appeared on Fool.com and is written by Leo Sun.
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