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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.



Charting The Sharks: XLY (Consumer Discretionary)

As the market was selling off earlier this morning, we bought back our position in XLY. While we have been riding out our “MEGA” squeeze call for some time now in Consumer Discretionary (Mortgages Rates, Employment, Gas, and Assets), that doesn’t mean we need to own it at tops (we sold ours on 1/2/09).

The chart below outlines our the two quant levels that matter here: 1. The “Shark” line (the line where the shorts get eaten if closing above) at $21.22 and 2. The Breakout line (the line where the momentum community will chase it higher) at $22.41.

When Howard Penney and I break down our US “Sector” level risk management levels for our top tier macro clients, the XLY continues to shine as the group to be long for market up moves – the XLF (Financials) remains the weakest.

Keith R. McCullough
CEO & Chief Investment Officer

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ANNA’S DEALS

For the last week or so Anna Massion has been emailing me the offers she’s received from various Las Vegas casino hotels. Anna is one of our gaming/lodging gurus so of course, she has spent some time in Vegas over the last several years. It’s been years since either one of us have seen deals like this. I’ve included a few below:

• The Venetian: $119 per night with over $150 in resort credits – unless LVS is getting a cut of the airline fare, they can’t be making money on this deal. As Anna said, “it’s like they pay me to stay there”.
• Encore: $140 per night – not good for a new luxury hotel
• Wynn Las Vegas: $129 per night – can you say cannibalization?
• Four Seasons: $280 for one night plus a $150 credit – this isn’t coming out of the Four Seasons cut
• Mandalay Bay: $79.99 per night – sounds much better than $80

These are just the most recent promotions. What’s interesting is the progression over the past 3 months. Each promotion is more and more generous. Wait a few months and they’ll pay your mortgage too.

Eye on Credit and Housing

We wanted to highlight the 4.75% interest rate that JPMorgan Chase is advertising on their website for 30-year mortgages today. This is in conjunction with Freddie Mac reporting yesterday that market for 3-year fixed rate mortgages had reached 5.01%, down from a 5.10% a week earlier. This is the lowest rate going back to 1971, which is as far as the data is kept.

While low mortgage rates does not necessarily tell us how many mortgages are being approved, the declining interest rates do imply that credit is getting “unstuck” and that banks are underwriting mortgages. On the margin, this is obviously positive for the consumer and, if the velocity picks, up will clearly be positive for home values.

We’ve lightened up our Trade on consumer stocks over the last week or so because our quantitative models were flashing an overbought signal, but clearly the Trend of an improving consumer environment is supported by this mortgage data.

Daryl G. Jones
Managing Director

Eye on the Kansas City Fed

We wanted to highlight the comments yesterday from Thomas Hoenig, the President of the Federal Reserve Bank of Kansas City, as it relates to the possibility of inflation raising its ugly head in 2009 due to the large amounts to stimulus and record low interest rates both in the U.S., and abroad. We’ve excerpted some key comments of Hoenig’s from a Bloomberg article below:

“Hoenig said the Fed 'must design an exit strategy that at the appropriate time removes excess liquidity from the economy and allows it to withdraw as a significant intermediary.'

Failure to do so risks bringing on inflation and financial market 'excess,' setting the stage for yet another crisis, he said.

Hoenig said on Wednesday that he believes deflation is not a 'large possibility' in the United States, and cautioned that inflation could resume its upward trend once the stimulus measures to jump-start the economy start to work.

Inflation has come down ... but with the stimulus that is in place and if the economy does in fact pick up toward the end of the year, I think we will have pressures up because policy is very accommodative at this time,' he added.”

His statement is supportive of one of our key themes for 2009, which is that the cost of capital will begin to raise in the back half of 2009 and into 2010. This is because basic math suggests rates can only go up, as they are at all time lows in the U.S. With Volcker as an advisor President Elect Obama, we only have to look back to Volcker’s time as Chairman of the Federal Reserve to see how quickly interest rates could go up if and when inflationary concerns emerge, which is graphically depicted below.

Daryl G. Jones
Managing Director

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