Try as it might, drive-in quick service restaurant (QSR) Sonic (Nasdaq:SONC) just can't seem to get everything working at top form in its business model. While the company has an innovative (some might say “quirky”) menu that really does stand out from the offerings at McDonald's (NYSE:MCD), Burger King (NYSE:BKW), and Wendy's (NYSE:WEN), and has looked to refine its promotional activity and value-priced offerings, the company has made only modest progress in terms of growth.
As it stands today, analyst expectations on Sonic are pretty bifurcated. There's a small group that believe that Sonic will regain its growth momentum and do significantly better from here, while the larger group is more pessimistic and calls for Sonic to basically bump along as it has for some time now. While these shares have been strong over the past year and have recently broken out to a multi-year high, further gains could well be in store if the optimists are right.
A Mixed Fiscal Second Quarter
In so many respects, Sonic's fiscal second quarter is reflective of the ongoing challenges at the company – while there were signs of progress, the news wasn't completely positive.
On an as reported basis, revenue declined 3% for Sonic with an underlying system-wide sales decline of less than 1%. Comps were reported flat on a system-wide basis, with 1.9% growth at company-owned restaurants offsetting a 0.3% decline at franchisees. On an adjusted basis, though (taking out the effect of the extra day in February last year), comps were up 1.3%.
Even with pretty mediocre revenue results, Sonic's margins looked better. Restaurant-level margins improved about 140bp from last year, though down 40bp on a sequential basis. Likewise, operating income increased 15% and operating margin improved 160bp as the company reaped the benefits of less input cost inflation and a greater focus on operating cost improvement.
Where's The Growth?
Far and away the biggest question in my mind is whether Sonic can reignite its growth. Management believes its potential store footprint is still highly under-penetrated (70% or less), and a new focus on smaller prototype stores does reduce the upfront investment of franchisees. Likewise, the company has what QSR customers keep saying that they want – a menu that offers interesting food items that they can't get elsewhere.
So why isn't it working? Sonic hasn't really grown much all in quite some time, as franchisee attrition and weak comp growth have taken their toll. Sonic isn't alone here, as companies like Wendy's and Jack in the Box (Nasdaq:JACK) have had their troubles too, but it seems like the QSR market is one where the strong (McDonald's and Subway, in particular) have been getting stronger. A few non-traditional rivals like Chipotle (NYSE:CMG) and Panera (Nasdaq:PNRA) have made their mark as well, but even mighty Chipotle's comps have weakened notably of late.
Maybe Sonic's prices and/or value menu still aren't right yet. Maybe the company's inconsistent promotional message has hampered sales. Whatever the case, even the adjusted comp growth of 1% for the quarter isn't great. Making matters worse, a substantial percentage (more than one-third) of the company's store base is in Texas and Oklahoma, where the economies have generally been stronger than the national average.
Looking For The Positive Catalyst
Sonic still has a few operational levers to pull. A new point-of-sale system should improve productivity and underpin some operating improvements over the next couple of years. There is also the possibility that the company has its promotional strategy ironed out now, and that a new royalty structure and smaller stores will appeal to franchisees.
That has to be set against the risks that are still evident in the story. A large number of the company's franchised stores come up for renewal in 2015, and I don't know if investors should assume that there won't be further attrition. Likewise, while the company's 2-year comp run rates aren't bad relative to the QSR industry, “not bad” isn't what investors want to hear with turnaround stories.
The Bottom Line
Sonic certainly doesn't look expensive relative to McDonald's, but then why should it? The comparisons are not entirely fair (McDonald's is international, much larger, etc.), but the reality is that Sonic has a lot of work to do in terms of improving its store footprint, comp growth, and margins. Still, relative to the likes of Wendy's and Jack, Sonic does look like it may still be getting the short end of the value stick.
A wide spread between analyst expectations can often reveal situations with substantial uncertainty, and that would seem to be the case for Sonic. The expectations are not very onerous here, as most analysts are looking for very low single digit growth in both sales and free cash flow. That suggests relatively low downside, provided the company doesn't see actual declines in comp sales. If the optimists are right, though, and Sonic can regain mid-single digit growth, these shares could continue to outperform from today's level.