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In its earnings release, SONC stated that it expects 4Q system-wide same-store sales growth of 2%-4%, with partner drive-ins performing somewhat below this range. On the conference call, we learned the magnitude of this underperformance, with the partner-drive-ins expected to remain 3%-4% below the system average, which is in line with the reported 3Q results (system same-store sales -0.4% relative to the -3.9% partner drive-in number).
  • Partner drive-in traffic was negative in each month of the quarter (almost flat in May), but even with trends improving sequentially (becoming less bad), management indicated that traffic is only growing in the afternoon, which is when the company is discounting the most around its Happy Hour promotion. So the only daypart that is experiencing any traffic momentum is coming at the expense of margins (restaurant margins were down 140 bps YOY in the quarter). The company began in May to adjust its value message by promoting more combo meals and premium sandwiches to drive traffic during the more profitable lunch and dinner dayparts, but I am not sure how quickly this will translate into improved results because the company has built up such a reputation through its national cable advertising as being the place to stop in the afternoon. It will be particularly difficult in the summer months to steer its guests away from $0.99 shakes.
  • More margin pressures. SONC will be facing increased labor costs on two fronts. As I mentioned yesterday, SONC pulled the goalie to make numbers by cutting back on labor to maintain margins. The company attributes part of the fall off in partner drive-in same-store sales to the resulting decline in service, so going forward, management will have a renewed focus on customer service, which will cost money (company expects its overhead costs to increase 8%-10% in 4Q). Additionally, margins will be hit with the second round of minimum wage increases in July. And this time around, these labor cost increases will be felt more proportionately because last year the company raised its prices by 4% to help offset the rising costs. Management also blames this overly aggressive price increase for the slowdown in partner drive-in same-store sales because franchise drive-ins did not raise prices as aggressively at that time. That being said, I was surprised to hear the company is going to increase prices an additional 1%-2% this year. Although the company said it will be more strategic in its implementation of this price increase by doing so on a market by market basis, judging from recent results, the consumer does not seem ready to digest any increase.
  • And if that is not already enough, company margins will be hurt even more by commodity costs. The company did not give too much visibility around FY09 expectations (said it will provide FY09 outlook in early September), but it did highlight the more difficult environment as it relates to locking in certain commodity costs. Management stated that it is currently buying its beef requirements on a month to month basis at double-digit YOY increases, and that although it has historically used longer-term contracts to lock in these prices, that the premium charged to do so today does not make it an economical option (Please see related post Eliminating Some Certainty to the Earnings Model of the Restaurant Industry regarding commodity costs and long-term food contracts).