SONC: BETTER BUT NOT OUT OF THE WOODS

Sonic is trading higher today on preannounced comps from yesterday and a sell-side upgrade this morning.

 

Yesterday, Sonic management indicated that sales for both company-owned drive-ins and the system were positive for the second fiscal quarter ended February 28, 2011.  The company estimates that system-wide sales for the quarter (2QFY11) increased by between 1% and 1.5% (company-operated stores up 2.2%).  While this is encouraging in that it is a positive number – the first since 2QFY08 – I would think it imprudent to chase this stock today. 

 

I struck a fairly positive tone when penning my last note on SONC titled, “SONC: LESS BAD IS GOOD”, on January 5th.  While I did state that the company was “not out of the woods” from a top line perspective, I was certainly becoming more positive on the margin.  The Street’s bearish sentiment on the name also made the name more attractive.  The system-wide comp for this quarter, assuming it falls at the midpoint of the estimate range provided by management, will imply deterioration in two-year average trends from 1QFY11 of 150 basis points. 

 

The reality is that over two months have passed since my aforementioned post on Sonic and much has transpired since then.   Coincident and lagging indicators, like employment and personal consumption, have shown some improvement and/or stabilization.  Commodities have increased greatly in the last two months, however, and I believe greater sales growth than +1%-+1.5% (versus a -13.2% year prior) will be required to absorb such cost inflation.

 

Guidance provided following results in January for FY11 top-line trends was suitably vague; management stated that “sequentially improving same-store sales throughout the fiscal year” would be based on “sales-building initiatives”.  While 2Q’s preannouncement certainly meets guidance from a one-year standpoint, the two year number is concerning because clearly the compare was easy and they become more difficult going forward, but also because commodity costs – as shown in the charts below – are through the roof.   For reference, to simply maintain, not improve, the 2QFY11 level of comp growth in 3QFY11 on a one-year basis, it would imply about a 350 basis point acceleration in two-year average system-wide comp trends.  To me, this seems aggressive.

 

Like a lot of restaurant companies, I feel that SONC is understating the real inflation numbers it is going to see.  The company previously guided to between 1% and 2% commodity inflation for the year and, while the majority of their basket items are hedged for the year, the company is purchasing beef on a short term basis. 

 

Regarding beef prices management stated that it expects, following mid-single digit gains in 1QFY11, “to see kind of a comparable year-over-year increase, maybe even flattening out in the third [fiscal] quarter”.   Beef prices have, although volatile, made higher highs and lower lows since early January.  Since the earnings call, beef prices are up 4%.

 

SONC: BETTER BUT NOT OUT OF THE WOODS - live cattle

 

Of course, commodity costs impact SONC’s operations in more ways than one.  Gasoline prices are up over 14% since the earnings call for 1QFY11 earnings was held.   This is obviously relevant for all QSR chains but given that SONC’s system is exclusively drive-in, the company is particularly exposed to gas price inflation.  The company will have approximately 0.5% of price on their menu in 2Q and 3Q; considering the cost of gasoline as part of the cost of a trip to SONC, I am confident that additional price won’t be well-received by the Sonic customer.   I think it is unlikely traffic will come to the rescue either – 2QFY11 comps flattered to deceive.

 

 

Howard Penney

Managing Director