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Conclusion: Sonic Corp. (SONC) is a stable, relatively mature, franchised chain, with all the advantages of the fashionable asset light structure. They are here to stay, to be sure, but it is unclear when momentum relative to same store sales growth.  This is especially true in the continuing competitive environment and ongoing economic squeeze for middle class consumers. The Company continues to play the re-franchising and fleet modernization cards, as well as leveraging the balance sheet further to repurchase  a substantial amount of common stock. While unit growth is picking up modestly, it will no doubt require acceleration of comp sales to incentivize franchisees.  Earnings per share growth, in the short term at least, is dependent on fewer shares outstanding, as it has been in the last year. We consider SONC stock fully valued. The dividend could be increased at some point, which would protect a shareholder’s downside, but we fail to see the upside potential at this point.

Company Overview   (FY2016 10-K) (updated at Y/E 8/31/17, FY 2017 not yet filed)

Revenues Sonic Corp. operates and franchises a chain of 3,594 drive-in restaurants (about 95% franchised) in 45 states, serving about 3M customers daily and generating system-wide sales of about $4.5B.  In the TTM through SONC’s 17Q4 (ended 8/31/17), consolidated revenues were $477.3M, of which the company stores contributed $296.10M (62%), royalties & fees $170.5M (36%) and lease revenues from franchisees and other $10.6M (2%).

SONC has always been heavily franchised but in June 2016 it announced plans to increase the franchised percentage of the fleet from its traditional 88-89% levels to 95%, which has basically been reached.   This was accomplished through a mix of modest new franchised store growth and refranchising (with the company typically retaining a 25% minority stake of the refranchised units).  SONC has an unusual progressive rate royalty structure which effectively links rates to sales productivity.  The rate is 2% on the first $5,000 average monthly sales (AMS) increasing in steps to a top rate of 5% for AMS over $25K.  As such, the effective royalty rate had been inching up gradually to 4.12% in FY16, on positive sales productivity, but fell back to just under 4% in the last nine months of ‘17 on negative comps.

Menu and Dayparts The company offers a core menu of made-to-order burgers and chicken sandwiches, hot dogs, hand-made onion rings, tater tots and all day breakfast items such as breakfast burritos.  The brand is probably best known for its fountain beverage specialties, such as cherry limeades, shakes and ice cream slushies, which constitute 39% of sales, its largest food category.  Sonic serves in all dayparts, but unlike most QSR’s, where about 60% of sales are in the lunch and dinner dayparts, just under half of sales occur in the lunch and dinner dayparts, while nearly a quarter occur in the afternoon and about 16% in the after dinner daypart, both over 2X the QSR averages.  The higher proportion of sales outside lunch and dinner is driven largely by the beverage and fountain specialties.

Unit Level Economics The drive-in design of the restaurants is another distinctive feature of the chain.  At a typical traditional Sonic Drive-In (about 1,500 square feet), a customer parks in one of 16 to 24 covered drive-in spaces and orders through an intercom speaker system.  A carhop (on skates at some locations) then delivers the customer’s food directly to the customer’s vehicle.  It also includes a drive-thru lane and a patio and may include an enclosed patio or indoor seating.  Though official numbers have not been disclosed for ’17, based on the 3.3% negative systemwide comp in ’17, the systemwide comp was about $1,242 ($1,088 company, $1,221K franchised).  Though franchised store AUV’s are about 10% greater than company stores, we estimate their unit level EBITDA margins, net of royalties and fees, averaged about 15.1% in FY2016 compared with 16.2% for company stores.   We also estimate the cash outlay for a traditional drive-in including pre-opening costs ranges from about $1,042K to $1,139K.  At the range mid-point of $1,091K, the EBITDA cash-cash-on cash return is about 17.0% for company stores and about 18.0% for franchised units.

Company Strategy  Growth has been relatively tepid in the past 10 years, with system sales growing at a 2.8%  CAGR driven by growth in AUV’s and net locations at annual rates of 1.6% and 1.1%, respectively.  In the same period, margins are little changed.  To spur sales growth and margin expansion management has long utilized TV advertising which it is now augmenting with social media marketing initiatives.  It is investing heavily in new point of purchase technology (Point of Personalized Service or “POPS”) at its drive-in stalls to improve service, and also to communicate promotions and featured new or premium offerings.  Sonic is also developing its version of mobile order and pay. Like most other restaurant chains, Sonic’s applications will feature personalized messaging and offers.  As of 17Q2, POPS had been installed in 75% of system drive-ins, presumably higher at Y/E’17.

Also after several years of underperformance, the company is achieving modest but growing drive-in development, consisting of new stores, relocated and rebuilt stores.  In FY2018 it is guiding to 110-130 projects (40-50 relos & rebuilds, 70-80 new stores) up from 54 projects in FY2014 (14 relos & rebuilds, 40 new stores). 20-30 units will close, netting about 50 net new stores. These initiatives combined with technology investments represented franchisee investment of nearly $350M in FY2017 up from $106M in FY2014. Importantly, these investments reversed the contracting net store franchise store count.  The company also notes that the 25% minority stake retained in refranchised units reinforces its alignment with franchisees.

Balance Sheet and Cash Flow   SONC has increased debt by over $200M in the last 3 years, with its leverage still modestly below its highly franchised peers.  The company’s ratios of debt to TTM EBITDA is now about 3.9X, compared to the 4.4X of its 90% or more franchised peers.  With its new target of 3.5X to 4.5X net debt to EBITDA. With projected $60-65M of “free cash flow”, after capex but before about $25M of dividends, and the new $160M stock repurchase plan for ’18, the net debt to EBITDA ratio should be close to the top end by the end of fiscal ‘18. Though over $300M will have been spent during the last two years to repurchase stock, with most capex now behind it as the system has become almost entirely franchised, FCF should be able to bounce back to the range of $75 to $100M (prior to dividends and further stock buybacks), representing a more than respectable return on TTM revenue base of $477M. To management’s credit, SONC stock repurchases have been made at a valuation close to 10X trailing EBITDA, historically an attractive price for highly franchised companies. Too many companies, for one reason or another, leverage themselves up at much higher valuations.

Shareholder Returns As noted, the company has been very actively repurchasing shares. In the year ending 8/31/17 the company “returned to shareholders” $173M by way of stock repurchase plus about $23M in dividends.  In the same period, the basic shares outstanding (per balance sheets) were reduced by 11.4%.  At the end of FY’17 the remaining share repurchase authorization was $160M, and the company raised the quarterly dividend 14% from $0.14 to $0.16 per share.  In the same TTM, the share price was about unchanged. After a steady increase from under $10/share in early ’09 to a high over $30 in early ’15, over the last several years, the stock has generally traded in a several point range up or down from $25/share.

SONC: Current Developments: Per 8/31/18 Y/E Release and Conference Call

Fourth quarter results were, as expected, less than stellar. Same store sales were down again, with the decline attributed to intense competitive pressure, the effect of Hurricane Harvey, and a disappointing response to movie-linked promotions. Positive highlights included an improvement of company store margins, 27 new locations opened in Q4, and the repurchase of 1.8M shares. It is worth noting that the $.45 for the quarter and the $1.25 for the year were “adjusted Non-GAAP” numbers, after the effect of gain on refranchising and real estate transactions and the negative effect of restructuring charges. The most important ingredient in the YTY EPS comparison was the reduction of weighted average shares outstanding by 11.4%.  Overall, it seems fair to say that operating results were more or less “flat” for the year. Company operated store EBITDA margin improved by 230 bp, driven by the re-franchising effort and a one time surplus credit for workers’ comp. This was instrumental in keeping labor expense for the full year up “only” 100 bp to 36.2%.

On the conference call, management candidly described some of the shortfalls during the year, mostly including product emphasis and corresponding marketing. As corrections have been made, in terms of going back to core value driven products, the sales decline has improved by about 2 points in fiscal ’18 to date, most recently running about flat, absent the effect of weather. Management indicated that new stores are opening at encouraging volumes and the franchise development pipeline is up 7% YTY, hopefully precursors to moving to net new unit growth of 2-3% annually.   The pipeline of relocations and rebuilds also continues to be strong, up almost 400% since 2014 and AUVs at RELOs are sometimes up as much as 30%.    The current expectation for ’18 is 70-80 new stores, after 20-30 closures netting to 50 net new stores. New stores seem to be retaining about 90% of opening year sales in their second year, also very encouraging. These trends are no doubt encouraging the improving trend in unit development.

In terms of guidance for ’18, adjusted EPS is expected to be up 5-10%, which presumably is based on fewer shares outstanding, implying relatively flat net income. Same Store sales will be up 0-2%, with company drive in level margins of 15.1-15.7% depending on sales (vs. 15.6% in ’17). The commodity basket is expected to be up 150 bp for the ’18 year, closer to 200 bp in Q1.  Labor, obviously, will be a challenge to keep relatively flat, hopefully aided by the Labor Rescheduling Tool referred to below. Capex will be $38-40M, and free cash flow (before stock repurchase) will be $60-65M. Total Corporate SG&A will be $76-78M, down slightly from $78.7M in ’17. The tax rate should be about 35% vs. 33.3% in ’17.

The improved sales trend is presumably going to be achieved by a renewed emphasis on unique products, rather than a deep discounting approach. Discounting, when done, will be tied to core products, offered at an attractive price but packaged with add-ons (e.g.onion rings, drinks) that together build an adequate ticket. Advertising is being shifted toward digital and social channels, up 7% versus previous weighting, and TV commercials will more often be 15 seconds rather than 30 seconds while still generating higher GRPs. A new Labor Scheduling Tool has been rolled out systemwide in an effort to mitigate the industry wide upward pressure on wages.