SONC - Management seems disconnected from reality

SONC’s 1Q09 sales results came in worse than what the company guided to when it preannounced on December 15th. With the quarter having already been complete at that time, I guess we should not be surprised about how aggressive the company’s initial FY09 guidance (provided on September 23) is proving. Back in September, SONC issued its FY09 outlook, which included the expectation for 12%-14% EPS growth. Half of this growth was expected to come from refranchising gains as the company is undergoing a refranchising program to reduce its partner ownership to 12%-14% from about 20% over the next few years with the remainder of the growth coming from operations. By the time the company reported its fiscal 4Q08 results on October 17, this guidance was already called into question. SONC stated that the 5%-7% EPS growth from operations assumed 155-165 franchise openings in FY09 but that based on the turmoil in the credit markets, the timing of franchise development was less certain. Although management shed some doubt on its EPS guidance on that 4Q earnings call, it maintained its confidence in its 12%-14% goal, saying “if we felt like it made more sense to pull back and say we need to give you more conservative guidance, we would do that.”

Hindsight is 20/20, but based on yesterday’s fiscal 1Q09 earnings results (down 46% YOY) and management’s admitting that it cannot even say whether it expects to have positive earnings growth in FY09 (from prior expectation of up 12%-14%), the company should have pulled back its guidance last quarter. Consensus had already picked up on the company’s lack of confidence in its numbers and was only forecasting 2% EPS growth in FY09 prior to yesterday’s earnings results. And based on yesterday’s results, no earnings growth in FY09 is a real possibility.

To be clear, management stated, “We provided our initial 2009 earnings expectation in mid-September based on business and economic conditions present at that time. Subsequent to providing this outlook we have seen credit markets tighten significantly and consumer spending and confidence decline markedly. Our first quarter results reflect these changes and challenges and we anticipate subsequent quarters throughout fiscal 2009 will be effected as well. While there have been some positive developments such as indications of abating commodity cost increases and moderating energy prices, significant uncertainty remains. Given the unpredictable nature of the current environment we will not be providing updated expectations for fiscal 2009 at this time. We believe our near-term success will be based upon our ability to drive positive same store sales and that is where the majority of our efforts are currently focused.”

Relative to the half of the initial 12%-14% earnings guidance that was expected to come from refranchising gains, of the 17 partner drive-ins refranchised fiscal year-to-date, no material gains have been realized. Management refuted that it is selling these restaurants for less than they had previously expected, but rather, that the lack of gains stems from the fact that the company has thus far sold newer stores, which have a higher book value. Although this may be true, SONC continues to maintain that it will achieve a gain when it sells its older stores. This is not an easy market in which to sell restaurants at a premium and although the Sonic brand is not comparable to Applebee’s from a growth perspective, we have seen DIN continue to lower the expected proceeds from its sales.

Regarding the more important 5%-7% earnings growth that was expected to come from operations, SONC’s top-line results have started out the year significantly below expectations. System sales came in down 3.6% with partner drive-ins continuing to be a drag on the system with comparable sales down 6.6%. These lower sales, particularly at partner drive-ins, combined with higher commodity costs caused restaurant level margins to decline 430 bps YOY. Also hurting the company’s expected full-year results is the fact that the company said due to credit market conditions, it will fall short of its franchise development goal of 155-165 units (as management feared following its fiscal 4Q08 earnings).

Management is relying on lower YOY increases in commodity costs for the remainder of the year and its new value menu initiative to drive improved results going forward. In a change of strategy, the company added 11 value items to its menu with national cable support on December 29 in response to all of the QSR discounting already going on and the company’s research that over the past several months, QSR growth has come primarily from value offerings. In the 10 days since this national launch, the company has seen its comparable sales turn positive at both its partner and franchise drive-ins. Although this is a significant uptick from the fiscal 1Q same-store sales results, this is only 10 days so I am not yet convinced that the worst is over. I do think the value initiatives will have a positive impact on traffic but I am concerned about the margin impact as margins have already come down so much in the last 3 quarters alone. Management stated that in the last 10 days, the value menu has actually resulted in both positive traffic and higher average check and that it is not expecting to see a huge hit to either its margins or its average check. I will believe it when I see it. The company’s Happy Hour discounting initiative increased traffic while bringing down average check, and I would expect the same from this newly implemented discounting program.

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