Sonic: A Restaurant with Risks


There is no question that Sonic Corporation (SONC) has arguably the most distinct business model in the quick-serve restaurant industry. However, is this enough to validate an investment in the franchise?

After lowering its outlook for the fiscal year, from between $0.55 - $0.60 to $0.50 - $0.55 per share, Sonic announced on June 21, 2010 that its earnings for the third quarter were a disappointing $0.18 per share. This figure is lower than what analysts predicted by 1 to 4 cents per share, and even includes a 3 cent tax benefit. Without including special items, this marks a year over year decline of almost 40%.

Without doubt, these numbers do not sound good. With a poor performance this quarter, it is doubtful whether the fourth quarter, typically Sonic's strongest, can be a successful one. Considering the cyclical nature of the company's business, the implications of poor summer sales are that the winter will be long and hard. The market has shown that it is fearful of what is to come; the stock has declined more than 16% in the last two weeks.

Justified or not?

Such a drop carries with it the question, is the business really deserving of such a downgrade, or did investors overreact? As a whole, Sonic's prospects are not all that bad. Its drive-in or drive-thru format, in which customers can either order through a speaker from their parked car in a booth or get their food to go, has developed quite a following. The self-acclaimed "Ultimate Drink Stop" serves very popular drinks and the rest of the menu has relatively good value. A new Chief Marketing Officer has been brought in from Pepsi, Danielle Vona, and she seems like a good gamble by the company.

It is difficult to say if Sonic can get back on track. Its business model says that it can. The franchise has room to grow, with only four locations in New York and two in Massachusetts, and so far it has shown success when it has tried its luck in new markets.

There are no guarantees, though. The debt situation is not the best; stockholder equity was negative until F1Q10 and net tangible asset value remains in the red. Management has taken steps to fix this and plans to eliminate more than $100 million of liabilities by the end of this calendar year. However, this means that if sales are not satisfactory, the deleveraging will find its way to the bottom line and make for further earnings disappointments. Adverse developments in the prices of beef or any other of Sonic's inputs could negatively impact the stock price as well.

But does everybody already know this?


It is possible the market has priced this in, as Sonic is below the industry averages at 12.8x earnings and 6.9x EBITDA. Still, as the winter months come and less people want to eat in their cars during snowstorms, the stock may take another tumble.

For investors with a longer investing time frame, this small cap has an interesting story and a possibility of strong growth. If the currently-depressed sales can recover and margins revert back to their historical levels, the current price will be looked back on as very cheap.

This is a big "if" though. Any steps in the wrong direction for the economy, prolonged depreciation, a double dip, etc., and sales might not recover. Without a strong conviction on where the United States is headed financially, investing in restaurants is a risky practice.

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Last updated: February 10, 2012: 02:17 PM

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