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Given that SONC just preannounced its 2Q sales trends two weeks ago, the company did not say anything too incremental on its earnings call today.  Management would not comment on quarter-to-date trends but said it is comfortable with its 2H10 system same-store sales guidance of flat to -5%.  During 2Q, SONC estimates that its same-store sales came in -4% to -5%, excluding weather. 


Management stated that average check turned slightly positive during the quarter, which seemed somewhat expected given that the company lapped the implementation of its Everyday Value menu.  Management went on to clarify that the improvement in check did not come in January when it lapped the Everyday Value menu but instead, check turned slightly positive in February, which it attributed to the new promotion of free add-on onion rings with the purchase of the Steak Melt Toaster.  The company is running a similar promotion in March and thinks it should continue to drive average check higher going forward.


Sonic also commented on a change in compensation structure for its partner drive-in managers, which will cost an additional $1-$1.5M per quarter in labor expense.  As of April, most partner managers will transition to a more normal, stable compensation structure that includes a higher, more competitive base salary along with an incentivized bonus based on individual sales and profit performance.  Management explained that this provides more stable income for managers, which helps with retention, while still allowing for unlimited upside earnings potential.  When asked on the call, if this new compensation structure could cost more to the company when same-store stores growth and profits move higher, management joked that it would welcome that problem and discussion when it happens.



Notes from the call:




  • Difficult quarter for the average drive-in
  • Inclement weather in core markets
  • Recession taking hold much more intensely in core markets (lagging balance of country)
  • 1/3 of system in Texas and Oklahoma
  • Double-digit declines in state and local sales tax collections
  • Weather impact: analytical firm examined results, temperature, snowfall and concluded that 2/3 of decline in winter quarter was due to the harsh weather
    • SSS, ex weather, would have been -4% to -5%
    • Despite challenging environment, check turned positive for the first time in a good while
    • A year ago, everyday value menu was rolled out which impacted traffic
  • New promotions should lead to positive check going forward




Sales and profit growth

  • Value equation was previously focused on price
  • Going forward in FY10, more focus on the customer while maintaining achievements in price
    • Brand and business will be the better for it


4 components of strategy

  • High quality customer service experience at each drive in
    • Customer feedback has been sought out
  • Focus on product improvements in core menu items
    • LTO’s, core menu improvement, unique entrees and desserts et cetera
  • Marketing to drive home points of differentiation
    • Skating car hops etc.
  • New media reallocation of marketing dollars to maximize media impressions in trade areas of every store in the system (slight shift from national to local)
    • National spend will be $70m (one ad per hour)
    • Reallocation will be determined based on penetration and other metrics


Development growth has been challenged

  • Weather
  • Credit market
  • Franchisees uncertain
    • But continuing to reinvest in their assets
    • Remodels are high ROI opportunities
    • License incentive agreement for relocations or rebuilds expired, but investment continues
      • 150 or 4% of chain over the last two years
  • Sales and profit environment will lead to fewer than expected
    • 80 to 90 openings for FY10
  • First year sales continue to be strong
    • Opening volumes of 1.5m
    • 84 drive ins in new markets open for 1 yr
      • 1.4m average volumes
  • Continue to see construction prices fall and interest rates are low
    • Franchisees taking more time than usual to negotiate best deal so near term openings will continue to be constrained
  • Rate of closings remains low
  • Franchisees remain healthy





Sales deleveraging had impact on margins


Opened 17 drive-ins


Food improved slightly, commodities should be slightly lower in 3Q, higher in 4Q – flat 2H10

  • Higher costs with real ice cream and improved foot long chili cheese cone

Pricing: 2.5% price increase through 3Q (lapping 1.5%) may take pricing driving a 4Q cumulative increase of 1-1.5%


Higher labor costs


Other operating expenses were impacted because a large portion of them are fixed

  • Expecting improvement in 2H10


2010 Guidance:

  • EPS of $0.55 to $0.60
  • Restaurant level margins deteriorate slightly
  • SG&A $65-66m
  • DA $42-43M
  • Interest expense of $37-38m
  • FY10 positive operating cash flow of $25-30m, $52-53m in principal payments
  • Capex $25-30M
  • $100m in excess cash on hand
  • FCF flat to slightly positive





Q: Refranchised sales, were they in specific markets and what was the timing of those sales

A: Atlanta markets and a handful in Dallas. Lower performing and better performing drive-ins



Q: Change in partner compensation again? 1.5m on incremental labor expense? The upside is unlimited?

A: Sales and profit deterioration in partner drive in, disproportionate. Met with managers and supervisors and have given them chance to take different compensation structure. More predictable. Partner during summer months earn more in summer than winter. The idea is to provide stable compensation while retaining the upside that comes with driving the profits of the business.


1.5m in additional costs per quarter, health insurance, FICA, more stable based salary. We’d hope that this will result in a decrease turnover experience. Historically base comp has been on the lower end of market



Q: dollar amount received for refranchised stores?

A: slight loss on those transactions, lower performing and a small number of better performing drive ins. Partly why 2Q other revs came down. It’s also seasonal.



Q: G&A bad debt?

A: 1m increase attributable to bad debt. 3Q expectations for bad debt are built into 65-66m SGA annual guidance



Q:  Improvement in back half…where are we today? Within range of 0 to -5% to give that guidance?

A: When the weather has been comparable to the prior year (2Q and 3QTD) we are within that range.



Q: Bad debt expense…uncollectibles from franchisees? What’s that like yoy?

A: Some increase in delinquencies, small number of franchisees…not significant.  Majority of franchisees are in good shape



Q: Cash build, future uses. Talk about the decision not to buy back stock this quarter

A: Continue to evaluate that on a regular basis.



Q: Competitors with beverage innovation – big piece of your business – talk about % of sales from beverages vs 2 yrs ago…strategy?

A: Beverages are the best part of our business and beverage sales have held on better than other parts of the business.



Q: Ex-weather implying business improved, where is check, traffic?

A: As quarter progressed, lapped happy hour, we saw check turn positive. Not up by a huge amount but it is positive.



Q: Long term EPS growth target?

A: Key to growth is SSS turning positive. That’s our focus. Long term target is more contingent on SSS.



Q: Bad debt. What options do you have? Is it tacked on to rate you can charge franchisee over time? You write it off in entirety, future cash flows from that franchisee?

A: Through Feb 28th, we have recorded an appropriate amount. If business improves, it will decline. It is a larger amount than is typical. Suspect all franchisors have bad debt over time. This is a large amount attributable to terrible winter. Working out things with a franchisee on a case by case basis



Q: Given the new initiatives, how did you test the programs, which will be most meaningful?

A: Not possible to test some strategies (dollar marketing shift). The most important of the initiatives is improving product and service. People have to have a good experience and they have to enjoy the product.  Those are high priority and have to be steadfast. Creative and allocation of dollars are somewhat more transitory.  Those can change in a couple of quarters depending on market demands.



Q: Any impact from MCD dollar menu at breakfast?

A: No



Q: More color on COGs flat yoy in 2H. Product quality improvement, free tater tots in March, commodities flat? How do you get to flat?

A: Cost of goods being down in 3Q and up in 4Q include quality improvement. We did some discounting and promotions last year.  Some promotions are replacing promotions from last year



Q: Given more tip dependency on part of car hops, how are they dealing with SSS decline?

A: Don’t have exact figure but more skating gets more tips. Probably has been some offset but difficult to quantify.



Q: Turnover for car hops?

A: Declined slightly.



Q: Promotions with onion rings and tater tots, has this cannibalized combo meal sales?

A: there has been some trade-off but these promotions go out with a full price drink so penny profit isn’t diminished.



Q: How much of sales guidance in back half incorporates employment stabilization? Holding current rates steady?

A: Second quarter ex weather was at low end of range. Initiatives give us confidence that we should be able to offset or improve on current sales trend.



Q: New bundling with the free side, is there any trade away from value menu into that promotion?

A: Not sure. Value menu as % of sales has declined. Not promoting it this year vs last year. A year ago, customers wanted to know if we had a value menu. Now they seem to want a deal on regular items.



Q: Tweak value menu in light of moves by BKC and MCD?

A: We’d like to play on playing field where we have advantage – ice cream, conies, tater tots, onion rings. Not battling competitors on everyday value



Q: Do I have to request free attachments or is it automatically offered?

A: Offered if you order sonic cheeseburger



Q: What is the change in average check with change in promotion?

A: went slightly positive from negative.



Q: How important is it to broaden drink platform from happy hour and diversify away from high fructose corn syrup?

A: Drink sales are strong at breakfast…very big throughout day. Breadth of product offering is constantly being examined. Including types of drinks offered and times of day they are promoted.



Q: Store closures…would have expected more on franchisees, is there consolidation between franchisee base?

A: Historically that’s happened. Franchisees buying from company and each other. When a store gets in trouble it’s usually sold. That’s partly why closures are lower than one might expect.



Q: Average check now vs mid-07?

A: Running ~$5. Was around $5.35, $5.40.



Howard Penney

Managing Director


McCarran Airport released bad traffic numbers - down 6.2% in February. However, a Feb CNY and the easiest comparison of the year could contribute to positive growth.



Enplaned/deplaned passengers declined 6.2% y-o-y in February 2010.  The comparison was easy as air traffic declined 15.2% in February 2009.  Nevertheless, we believe revenue, assuming normal hold percentages, could actually grow over last year.


Due to the shift of Chinese New Year from January last year to February this year, the table game comparison is ridiculously easy.  Table drop and revenue declined 37% and 35%, respectively, in February 2009.  Slot hold percentage was a little low last year as well, easing the comparison.


In total, we think revenues could grow in the low single digits, again assuming normal table and slot hold percentages.  We would caution that due to the inclusion of the Chinese New Year in this month increases the volatility, substantially reducing the predictive power of our model.  In any event, we believe revenue growth anywhere near flat or higher will be viewed favorably.




FEB STRIP REVS COULD STILL BE POSITIVE - mccarran traffic chart feb

Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.51%
  • SHORT SIGNALS 78.32%


The propensity to play slots is much higher in Southeastern Asia than China. In fact, there were already slots in Singapore pre-RWS and they knock the cover off the ball.




Long-term margins in Singapore could be a little better than people think due to higher slot play than Macau.  A lot of people do not realize that there are already 76 slot clubs in Singapore some of which have been around for 30 years.  SE Asians are much more partial to slots than Chinese and Hong Kong visitors, which make up the majority of Macau's players.  Here are some fun facts:

  • 76 slot clubs, 71 of which run linked jackpots
  • The slot clubs vary in size from 5 to 40 machines with a total market size of ~1,600
  • Slots are mainly old “fruit style” machines with no machines on a TITO or other cashless systems
  • Payback of approximately 82% vs a legal minimum of 90% for the two casinos


Our Singapore sources indicated that the 1,600 or so slots generate approximately US$800 win per day each.  This compares to very favorably to the Las Vegas Strip at $155 and Macau at $178.  The Integrated Resorts - Resorts World Sentosa (RWS) and Marina Bay Sands (MBS) - will have an estimated 2,900 machines between them, bringing the total number of units in the marketplace to about 4,500. Each of the casinos has a maximum allowed number of 2,500 machines but are not expected to hit this high for the first few years.  The performance of the slot clubs suggests that the market will ultimately support the maximum.


The clubs are currently prohibited from operating the kind of games the casinos will offer. Casinos slots will primarily consist of the 25 and 50 multi-line games, which are much more volatile than the more basic games on offer at the clubs. It's possible that regulations will change to allow the clubs to offer similar games to their loyal customers as the casinos, but in that scenario its likely that they would also need to raise their payback to 90% from the current 82%.  We expect the local market, which has been strong for many years, will move to the IRs, given their better environments, better service standards, and larger mix of games; especially for the high end or VIP slot players.


Singapore is a very different slot proposition to Macau, where there is no history of playing slots and the interest in baccarat is so strong, be it low end mass or high end VIP, that it is not expected that slots will ever comprise more than a small percentage of total revenues.  Singapore however, has a long history of playing slots, and is more akin to the market in Malaysia at The Highlands, which has offered a wide range of games for the many decades they have been in operation. Early indications from RWS are that the limited numbers of machines they have available are generating daily wins per day of US$1,200.  While this can be expected to fall as more machines come online and the aggressive busing from Malaysia diminishes, slots will be a major contributor to the IRs.


Right now, we are projecting slot win per day of only US$400 for MBS, a number which will likely prove low.  Factors working against matching the $800 win per day at the slot parlors include the locals levy of $100, the aggressive busing by RWS from Malaysia, and the supply increase.  See the slot win per day comparisons of various properties/markets below.




The war for topline market share shows no sign of abatement.  Many management teams lament the aggressive discounting environment, yet are faced with no alternative but to comply.  Favorable food costs made this strategy largely accessible in 2009, but 2010 may be a different story.


Operational cost pressures are relatively benign for restaurant operators at present.  However, starting in the third quarter, QSR chains will face significantly more difficult compares in food and labor costs.  The chart below illustrates how QSR food costs are set to place increasing pressure on margins as 2010 rolls on.  Additionally, the CRB Foodstuffs Index is trending upwards.  Although the 4Q09 year-over-year change in the Index is 15.7%, the index troughed in 2Q09 and we expect food costs to be of little help to QSR earnings in 2010, particularly in the back half of the year (as commodity contracts are renegotiated).






Labor costs have historically increased and this trend is not expected to reverse any time soon.  Healthcare premiums have been rising and, while healthcare is front and center in Washington, D.C. at the moment, President Obama has made his support known for labor-related legislation such as the Employee Free Choice Act.  The trend of unionization poses a threat to the QSR industry, as we discussed in our 1/14/10 post, “QSR: DON’T MESS WITH MACRO”.  As the chart below indicates, labor costs as a percentage of sales also troughed in 3Q09 for QSR chains.  This implies a difficult compare for QSR labor costs in 3Q10.




Accordingly, EBIT margin trends are also reflecting the difficult scenario facing QSR in 3Q10.  Margins rose 295 bps in 3Q09 year-over-year and 226 bps in 4Q09.  Examining the food and labor trends, and taking into account the magnitude of the cost-cutting measures undertaken in 2009, it is clear that earnings growth is going to be far more tightly linked to top line trends in 2010 than in 2009.



QSR – A LOOK AT SALES AND MARGIN TRENDS IN 2010 - qsr ebit margin


Top line trends in the QSR segment have been showing weakness lately, partially caused by weather, but significantly driven by the issue of unemployment.  Unemployment is being cited as an issue by most management teams.  Some operators, such as Jack in the Box, have underlined the endemic levels of joblessness among certain demographics (young males, young male Hispanics).


The discounting environment persists as companies compete for traffic.  Even as BKC’s scheduled step-down from the $1 double cheeseburger approaches, MCD’s decision to sell all fountain drinks for $1 for 100 days from Memorial Day indicates that there will be no cease-fire in the QSR discounting war in the near-future. 


The chart below shows the steep drop in QSR same-store sales that began meaningfully in 2Q09.  The bifurcation of comps and margins shows that last year’s performance was driven by lower food costs and cost-cutting initiatives; this year, in the absence of an unlikely surge in same-store sales, the margin compares will negatively affect earnings in the QSR segment.  So far in 2010, weather has been affecting comps and the stock performance has been strong; though the FSR segment continues to outperform.  However, I expect margin compares to challenge QSR earnings growth from here – particularly in the third quarter.





Howard Penney

Managing Director


There are three data points on housing today:


(1)    CNBC is flashing breaking news - “Geithner: It will take a long time to heal damage from the housing crisis”

(2)    KB Homes reports earnings numbers that do not support a housing recovery. 

(3)    Existing home sales are at the lowest level in eight months.


If the housing recovery story is not working with significant government support in place, when is it going to work?


A picture of the housing "recovery" (or lack thereof) is shown in the two graphs below - supply and demand.  We have also included a six-month moving average to remove some volatility of late to see the trends more clearly.  Regardless of volatility, existing home sales have stagnated and the supply of new homes is starting to grow again.   


Today, the NAR reported that sales of existing U.S. homes fell 0.6% in February, declining for a third month.  The 5.02 million annual rate reflects the lowest level in eight months and is significantly below the 6.5 million annual rate seen in 2H09. 


Importantly, the number of previously-owned homes on the market jumped 9.5% to 3.59 million.  At the current annual run rate, the month’s supply moved to 8.6 months from 7.8 months last month.


We have been cautious on the housing recovery story and today’s news provides no evidence to change our stance.  The Consumer Discretionary (XLY) is up 8.4% over the past month (the best performing sector in the market) and the housing names have significantly underperformed.


There is basically one month left for consumers to qualify for the current government housing support program.  Given the lack of consumer acceptance for the current program (weather related issues or not), it is hard to see a light at the end of the tunnel for housing.


Howard Penney

Managing Director






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