SONC – THE PRICING VS. TRAFFIC BALANCING ACT CONTINUES

It was only 9 months ago when SONC reported its 3Q08 results that management was blaming overly aggressive pricing for the underperformance at its partner drive-ins…now, the company’s declining average check is the main concern.

SONC implemented its Everyday Value Menu on December 29th and has since experienced sequentially better traffic trends across multiple day parts. On a system-wide basis, traffic improved to only down 0.2% in 2Q09 (actually increased slightly excluding the extra day in February 2008 due to the Leap Year) from -1.7% in 1Q09. Despite this sequential pick up in traffic, system same-store sales declined 3.6%, even with the prior quarter. Again, last year’s Leap Year negatively impacted comparable sales growth by about 1% in 2Q09, but regardless, the new value menu put increased pressure on average check. On a reported basis, average check declined 3.4% relative to -1.9% and -0.6% in 1Q09 and 4Q08, respectively. So the company is giving away food to get people in the door…not a new concept within QSR.

Surprisingly, despite the damage the value menu has done to SONC’s average check, the company’s food costs as a percent of sales were flat with 1Q09. The value menu already accounts for about 10% of SONC’s sales so management has done a good job managing its costs to prevent margin erosion. Going forward, management expects the value menu to contribute 12%-15% of sales, a level that is comparable to that of its competitors. As the value menu becomes a bigger part of the company’s mix, I would not expect margins to remain immune from the pressure that is already hurting SONC’s average check. Management stated that the value menu is attracting incremental customers and has not yet materially cannibalized sales of other menu items. This translates to the company has been successful in attracting the bottom feeder customers, which if it continues, will eventually impact margins. MCD’s dollar menu has helped the company to post consistently strong comparable sales number, but its U.S. restaurant margins have declined for the last eight quarters. Increasing value menu contribution and growing margins just do not go hand in hand.

In an attempt to boost average check, management said it will split its advertising dollars between promoting both the Everyday Value Menu (almost all of the company’s ad spending has been allocated to the value menu since its introduction) and its more premium menu offerings. From both an average check and margin perspective, this is the right strategy for the long-term. In the near-term, however, I would suspect that any pullback on advertising of the new value menu could result in a slowdown in the traffic growth that we saw in the second quarter.

We have always been impressed with the SONC business model and management team. I suspect that we have 3-6 months before the concept can adjust and work through the new operating business model. As we begin to see some stabilization in the trends, the stock will work higher. I’m just not ready yet to pull the trigger.

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