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SONC reported fiscal 2Q11 earnings after the close yesterday.  The company had already preannounced comp results of +2.2% at company-owned drive-ins, which was the first quarter of positive same-store sales growth after 11 quarters of declines.  Earnings of $0.02 per share fell short of the street’s $0.03 per share estimate and despite the positive comp growth, restaurant-level margins still declined about 260 bps prior to non-controlling interest and 170 bps including the change to the company’s partner compensation structure, which includes non-controlling interest.   Even with positive comp growth, the company was not able to get any leverage during the quarter.

Higher commodity costs were a big factor for SONC during the quarter with food and packaging costs as a percentage of sales up 110 bps YOY due to higher beef and dairy costs and continued product quality investments.  The company had guided to a 25 to 75 bp increase in food and packaging costs for both the second and third quarters during its first quarter earnings call.  The company is locked in on most of its commodity needs, outside of beef and ice cream mix, and now expects third quarter commodity pressures to worsen with food and packaging costs as a percentage of sales up about 150 to 200 bps.  Although SONC management expects costs to mitigate somewhat during the fourth quarter as result of improved sales and the lapping of product quality investments from the prior year, food and packaging costs as a percentage of sales are still expected to increase 50 to 100 bps YOY.  As a result of these higher-than-anticipated food costs, management is now guiding to a decline in full-year restaurant-level margins relative to its prior guidance for flat fiscal FY11 margins.

The company now also plans to take a menu price increase during the fiscal third quarter, which will result in a 1.0 to 1.5% cumulative price increase (fully implemented in fiscal 4Q11) to help offset the increased commodity pressure.  As of the first quarter earnings call, the company had planned a less than 0.5% cumulative price increase for the third quarter.  Although management stated that this price increase has been tested and has not impacted traffic trends, I think a price increase of this magnitude is risky in this environment, particularly for a company that has underperformed its competitors and posted its first quarter of positive comp growth after about two and a half years, and will likely be detrimental to traffic trends.

The focus of yesterday’s earnings call was on management’s guidance for “continued improvement in same-store sales trends throughout the fiscal year.”  Although same-store sales improved during fiscal 2Q11 to +2.2% at company-owned drive-ins from -1.9% during 1Q11, two-year average trends decelerated about 85 bps.  The year-ago comparisons get increasingly more difficult with the company lapping a -6.3% comp from fiscal 3Q10 versus the -14.9% comp in fiscal 2Q10.  The guidance for sequentially improving same-store sales growth seems so unbelievable that about four different analysts questioned whether management was referring to better two-year trends rather than the implied 1-year trend.  Management finally just said that the guidance did, indeed, assume positive comp growth in both the third and fourth quarters as they layer on various initiatives and build on current momentum.

Given that two-year average trends continued to decelerate during the second quarter and only maintaining the same +2.2% level of comp growth in fiscal 3Q11 (rather than sequentially improving) implies a 430 bp improvement in two-year average trends, I think analysts and investors, alike, are right to be cautious.  This comp guidance is definitely aggressive.  With the stock trading up today, however, it seems that some investors are drinking the Kool-Aid.

It is important to remember that the company’s current margin guidance, particularly as it relates to the food and packaging expense line, takes into account this aggressive comp guidance so margins could come in much worse than current expectations should same-store sales trends fall short of management’s targets.  The company also guided to leverage on the labor and operating expense lines during the back half of the year as it laps the implementation of its new partner compensation structure in April of the third quarter and more importantly, as a result of the assumed continued momentum in top-line growth.  Time will tell.

SONC – DRINKING THE KOOL-AID? - sonc pod1

SONC – DRINKING THE KOOL-AID? - sonc pod2

SONC – DRINKING THE KOOL-AID? - sonc sigma

Howard Penney

Managing Director