SONC - More Clarity, More Concerns

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).

Eliminating some certainty to the earnings model of the Restaurant Industry

The increased volatility of the commodity markets is adding an increased level of complexity that most restaurant companies would rather not have to deal with. Today, both Darden and Sonic talked about floating some of their key commodity exposures.

Darden announced that given the environment, there is less opportunity to enter into long-term contracts with their food suppliers. Also, Sonic said that the cost of entering a long-term beef contract was prohibitive so they are now floating their beef exposure.

As it relates to Darden, the company will be buying futures contracts in the open market to hedge their exposure to certain commodities. While this is new to restaurants, companies like General Mills, Tyson and Kraft have long hedged their costs. From an accounting standpoint, Darden will be required to mark-to-market its futures contracts each quarter. The volatility of these future contracts will pass through the income statement and may overshadow the company's true underlying operating performance. The company would rather continue to lock in these costs though longer term contracts, but given the volatility of the commodity market, many of the suppliers to the restaurant industry don't want to take that risk. Naturally, this puts some of the risk back on the industry participants to manage the process and consequently, eliminates some of the certainty over commodity costs that many restaurant companies have enjoyed.

FED VIEW: Give Fisher Bernanke's Job...

No change to the Fed Funds rate.

So the easy money game in the US market lives to play another day. Dallas Fed President Fisher dissented. Fisher's timing is right, and Bernanke's continues to be off. Timing is everything. Bernanke remains in a political box, pandering to Washington and Wall Street.

Bernanke's confusion will ultimately breed contempt. Maybe not today, but soon enough. I am actually long the market for a "Trade", but will be selling into strength now. Bernanke wasn't in the area code of being hawkish enough here. It's going to be a long summer...

My call is that if Obama wins, Bernanke will be gonzo in 2009. Fisher wants Bernanke's seat, and he made the right call today by nudging his foot in the door.

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India Raises Rates For the 2nd Time in 2 Weeks

I recently covered my short position in the India Fund (IFN) as I thought, from a "Trade" perspective, after seeing a -19% two month swan dive in India's market, that it was finally oversold.

Today, India did what they needed to do, chasing down the inflation run rate, by raising interest rates by another 50 basis points to 8.5%.

At +11% year over year, inflation is running at least 300 basis points over India's slowing economic growth rate. This proactive move by India's central bank should, at the very least, stop the hemorrhaging that they continue to see in the value of their local Rupee currency.

Stocks are discounting mechanism of future news. Now that inflation readings and the appropriate rate hikes are yesterdays news, it's less obvious for me to be running aggressively net short India.

Spanish Inflation Spikes To A 23 Year High

More of the same today coming out of Europe on the inflation reporting front. This will beget further beating of the Wall Street consensus inflation war drums that have finally arrived!

Spain's Producer Price Index for May came in at +7.9% year over year, up from April, and hitting a 23 year high.


Asia Is Slowing? Really? Thanks

This morning, the head of the Asian Development Bank officially cut his estimates for Asian GDP growth in 2008. While our inflation call has morphed into consensus, our "global stagflation" call has not. This revised estimate is another nice admission however, taking consensus closer to reality.

A few weeks back, Goldman also downgraded their Asian Equity market view on select countries. After Vietnam lost 2/3 of its value, and China was down 50% from its October 2007 peak, we gave that a golf clap. That call, like many sell side strategy calls, was a revisionist and reactive one.

Since Q4 of last year I have been calling for Asian growth to be adversely affected by inflationary pressures and social unrest, in addition to the 2nd derivative effects of a US economic growth slowdown.

Asia's aggregate GDP growth for 2007 ended up close to +9% year over year. Look for the revisionist historians to pop into your inbox day by day now, reflected on that being the top in this global economic cycle's growth.

It is global this time, indeed.