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SONC – EARNINGS PREVIEW

SONC is scheduled to report fiscal first quarter 2010 results after the close today.  I think earnings could come in slightly better than the street’s $0.14 earnings per share estimate.  I don’t think investors will care too much about that number, however.  What will matter is what management has to say about top-line trends in the quarter and going forward.  Management told us during its fiscal 4Q09 earnings call that the first quarter did not start out strong as a result of “challenging weather” and that statement was made more than six weeks into the quarter. 

To that end, my partner drive-in same-store sales growth estimate of -5% comes in below the street’s -4.6% estimate and assumes no acceleration in 2-year average trends from the fourth quarter.  As in the most recent quarters, I am expecting most of this decline in same-store sales to be driven by continued weakening of average check.  This will be the case until the company laps the launch of its Everyday Value Menu in 2Q10. 

My more bullish stance on SONC is based largely on the fact that the company’s margins are moving higher in fiscal 2010.  Based on what we have been hearing from SONC’s peers, QSR trends are under increased pressure and SONC’s full-year same-store sales guidance for flat growth currently seems like a bit of a stretch.  For reference, management admitted that it might need to revisit this guidance, which was given in September, after 1Q10. 

Even if top-line numbers come in light (I am modeling -2% for the full year), EBIT margins should improve more than 250 bps during the year to a level more consistent with what the company achieved prior to fiscal 2008, with the biggest improvement coming in the first half of the year.  SONC is lapping extremely easy margin comparisons in the first half of the year as a result of the 6%-plus declines in partner drive-in comparable sales in 1H08, but the company’s refranchising initiative (refranchised 205 restaurants in FY09) will help a lot in this regard as well. 

Management is expecting food costs to be relatively flat as a percentage of revenues for the full year.  Although this guidance could be at risk as food costs have moved higher since this guidance was given and the company was still in the process of negotiating contract renewals, SONC was largely locked in on its food and packaging costs through the first quarter.  The company’s refranchising efforts should benefit both the labor and other operating expense line, particularly in the first half of the year; though this will be somewhat offset by continued sales deleveraging.

My full-year same-store sales estimate of -2% does assume some improvement in 2-year trends for the balance of the year so there is some risk to my numbers, but margins are moving higher even if it is not to the magnitude I have laid out.  Offsetting some of the top-line risk to earnings is the fact that SONC started the year with $125 million in excess cash investments over and above what the company calls its normal operating needs.  Management said it will use this money along with its free cash flow (I am modeling more than $120 million) to continue to pay down debt and increase shareholder value, which it said could include share buybacks.  My earnings estimates do not currently reflect the benefit of share repurchase.  I continue to believe that the company’s return on incremental invested capital bottomed in fiscal 2009, which should help SONC to outperform its peers going forward after consistently underperforming its peers in calendar 2009 (down 21% in the last year relative to its QSR peers’ average nearly 70% move higher).

SONC – EARNINGS PREVIEW - bhs