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Sonic Corp. (NASDAQ:SONC)

Q1 2009 Earnings Call

January 7, 2009 5:00 pm ET

Executives

Pat Watson – Corporate Communications

Scott McLain – President

Clifford Hudson – CEO

Stephen Vaughan - CFO

Analysts

Joseph Buckley - Banc of America Securities

Jeffrey Bernstein – Barclays Capital

Steven Kron – Goldman Sachs

John Glass – Morgan Stanley

Matthew Difrisco – Oppenheimer

Steven Rees - JPMorgan

Nicole Miller – Piper Jaffray

Christopher O'Cull - SunTrust Robinson Humphrey

Sharon Zackfia - William Blair & Company

Tom Forte – Telsey Advisory Group

Keith Siegner – Credit Suisse

Greg Ruedy - Stephens Inc.

Fitzhugh Taylor – Thomas Weisel Partners

Operator

Good day everyone and welcome to the Sonic first quarter conference call. (Operator Instructions) At this time for opening remarks and introductions I would like to turn the conference over to Mr. Pat Watson.

Pat Watson

Good afternoon everyone. This is Pat Watson with Corporate Communications. Sonic is pleased to host this conference call regarding results issued this afternoon for the first quarter of fiscal year 2009 which ended November 30, 2008. Today's audio and video presentation may be accessed at the Investor section of the company's web site at www.sonicdrivein.com.

Before we begin I would like to remind everyone that management's comments in this conference call that are not based on historical facts are forward-looking statements. These statements are made in reliance on the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995 and are subject to uncertainties and risks.

It should be noted that the company's future results may differ materially from those anticipated and discussed in the forward-looking statements. Some of the factors that could cause or contribute to such differences have been described in the news release issued today and the company's Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, and in other filings with the Securities & Exchange Commission. We refer you to these sources for more information.

Lastly, I would like to point out that management's remarks during this conference call are based on time sensitive information which is accurate only as of today's date, January 7, 2009. For this reason and as a matter of policy, Sonic limits the archive replay of this conference call webcast to a period of 30 days. This call is the property of Sonic Corp. Any distribution, transmission, broadcast or rebroadcast of this call in any form without the express written consent of the company is prohibited.

With those announcements I'll turn the call over to Cliff Hudson, the company's Chairman, and Chief Executive Officer.

Clifford Hudson

Good afternoon Pat, thank you and welcome to all of you. We appreciate your participation in our conference call this afternoon and our discussion of our first fiscal quarter ended November. It was a particularly challenging quarter as you probably would have expected and as you have in more detail now.

In addition to the broader issues of the general declining consumer sediment and the consumer confidence we’ve also dealt with the challenges of commodity costs in the last year and more and even though those have become more favorable in the recent past, we’ll talk about that in a few minutes, but the challenges of higher commodity prices and declining sales particularly at partner drive-ins but declining sales across our system, have resulted in more unfavorable restaurant level margins on a year-over-year basis.

So it has been a very challenging time. The two primary areas of challenge that I would like to talk about today deal with the system same store sales challenges that we have and the initiatives we put in place to try to address that in the immediate term anyway, and then also the partnership drive-ins, the challenges that are there and the fix that we have put in place to attempt to address those challenges.

The focus that I wanted to bring to the everyday value menu in my discussion, not something that’s new to the industry obviously by any means, but new to Sonic from a standpoint of a shift in historical strategy.

You know that historically we have focused on product and service differentiation. That’s been our branding approach for a number of years. And though we periodically have items that we focus on that may have a pricing element or discount element to them, a $0.99 junior banana split, a $0.99 shake, a $0.99 regular size Coney, this has not been our primary focus.

Its something rather we put in so that the consumer sees that we have some sensitivity to that value driven consumer but in the more recent past we have seen challenges there as we look at calendar 2008 and the closure of calendar 2008, we look back to months throughout the year. We see that in May when we offered something more value driven, in November more value focused, the brown bag special, these are the months in which our sales performed the strongest.

And as the economy moved through the year looking at performance in the industry, specifically [Cress] data but also other QSR research, there’s been a strong indication in our industry segment over the past several months that the growth has come primarily from value messages and value offerings.

The experience that we had throughout the year reinforced that so we’ll give you more details in a few minutes about that value menu. But this is something of a shift in strategy for us but something we have implemented in the recent past.

The partnership drive-in piece also being a key challenge in the last several months, we’ve shared with you various initiatives that we’re pursuing to attempt to turn more positive the performance of our partnership drive-ins.

In the first quarter the same store sales of partnership drive-ins continued to lag but we have seen serious improvement in service in our partnership drive-ins versus the system average and we’ve also seen and had aspirations or hope that the value menu would be there to drive traffic and in fact that is occurring with the implementation of the value menu, that is the improvement in sales.

And so with the improvement in operations we would hope near-term, hoping to expect that we would also see the improvement in sales and profitability as well. So calendar 2008 really proved to be a very challenging year but our view is as a system and as a brand we have a very strong base in place and we have the right initiatives in place.

Now as to the same store sales specifically for the quarter you have that information, system wide same store sales declined 3.6%. The partnership drive-ins did lag considerably. Franchise drive-ins 2.9%, partnership drive-ins 6.6% so a difficult first quarter and one which we’re trying to address as I mentioned earlier with some sales driving initiatives.

The traffic piece in the first quarter and traffic declined 1.7%, average check declined 1.9% so these coming together for a tough picture of the negative 3.6% on the system wide same store sales. We did see positive traffic growth in the afternoon. Just to let you know and based on the value menu performance that we’ve seen to date, which is granted has only been 10 days, but it is addressing this traffic issue.

We have seen this and we have seen the way it is attacking the traffic issue and believe we will continue to see traffic growth in other day parts, not just the afternoon as we were seeing but we have seen growth in other day parts we believe will continue to as well.

Now the value menu we launched at the end of December, December 29 to be more specific, it includes a broad range of products across a variety of day parts, very moderate cost, aimed at a buck apiece and so it clearly is intended to go right at that consumer that is looking for that on our menu.

We have seen data in the recent past showing a substantial portion of QSR customers and potential QSR customers are going to look to see whether, almost half the potential customers will be asking is there a value menu even though with our competitors they may only be getting 12% to 15% of their sales from that value menu.

So we’re not looking at this to say well we’ll get a 12% to 15% [bump] nor a 12% to 15% short-term but we do view this as a solid area of sales growth for us and potential sales growth and as I said, the first 10 days of this month are very encouraging with multiple day parts going back to a positive comp basis.

Our objective of course would be that our same store sales growth with the implementation of this initiative would outstrip the use of the everyday value menu so as to not adversely effect margins but we have utilized items on this value menu, the cost of such and priced in such a way that it should not have that kind of negative impact with the assumptions we’ve made in terms of how it would contribute to sales.

We’ve also to help drive this, we have increased the national cable support in the month of January beyond what it would have been otherwise, and we worked to align local television, radio, and print media to support and build awareness of this new value menu.

Our expectation is as we have seen with other initiatives like happy hour, and breakfast, and so on and so forth, that it would build over time. Our expectation is it will attract new customers and the first 10 days that we have seen both as it relates to positive system wide comps and also solid traffic growth across the system are very encouraging to us and a belief that this is the right initiative in this time.

Now I mentioned at the outset in addition to the same store sales issues that we’re addressing on a system basis we clearly have some very significant issues to address on the partnership drive-ins and we have said about that some time ago, we have communicated that to you previously, that we’ve put in place a number of service initiatives to work to improve customer experience and the store operations results.

In fact we have moved to a point where we’re seeing speed of service scores comparable to those of franchise drive-ins. This is measured by our Mystery Shopper program so on a quantitative basis we have seen substantial improvement there and in some months even seeing our own stores, the partnership drive-ins surpass franchisees.

In addition to that the customer feedback system we’ve implemented in the recent past, month of October, we’re utilizing to continue to improve and refine our partnership drive-in performance so with some prior tools, new initiatives and the new tools we are working to improve the experience that customers will have there with the expectation then as we pursue initiatives to drive sales, drive traffic to our partnership drive-ins, the consequence will be a better experience then they would have had a year ago coming to a partnership drive-in.

In addition to that from a pricing standpoint we continue to look at what the pricing needs and pricing opportunities are with our partnership drive-ins. We completed an analysis of that this past calendar year and our partnership drive-ins in mid-November took an average of 1% to 1.5% price increase based on the analysis we’ve conducted.

We’ll continue to evaluate that in the coming year, this year 2009 and perhaps based on a broader context of mix and combos etc. we may be looking at additional pricing as the year goes ahead based on competition and based on market circumstances.

We have told you in the past that with our partnership drive-ins it was our objective to shift the mix. We are primarily a franchisor, restaurant franchisor. We have had in the more recent past 17%, 18% of the drive-ins in the system being partnership drive-ins. The remainder franchised. Historically we have been in that 20% range of partnership drive-ins.

It is our objective through modified growth rates and then also disposition or refranchising of those stores, it is our objective to shift that percentage down to 12% to 14% of the system being partnership drive-ins. By way of update the number of drive-ins in this fiscal year which we had refranchised totaled 17 and since we began this initiative in the fourth quarter of last fiscal year the refranchised stores total 28 so we will proceed on this at a steady pace and expect that over this fiscal year and beyond that we will work toward reducing the percentage of partnership drive-ins in the system to that 12% to 14% range.

There has been some question of us in the past whether as we have worked on those negotiations what was the interest level, what was the availability of financing, and with that broader environment keep that refranchising from occurring and our comment to you to date would be that in the continuing negotiations for several markets we’ve targeted for refranchising that to date financing has not been an issue and we have significant interest in each of the markets in which we are working to refranchise.

We think this shows good strength and confidence from existing and new franchisees in our brand and we’re very pleased to see the level of interest that there is in these partnership drive-ins as we look to refranchise them.

The excess cash generated from the sale of these 17 stores since the beginning of the year, our view is that we ought to use that cash opportunistically to pay down debt or for other shareholder value driving initiatives and we will inform you about that over time as we put that cash to use.

Going forward I would say as we work through these challenges and we will work to adapt in a very different consumer environment that’s a business operating environment different then it was a year or more ago but we also look to stay focused on continuing to transition our business and our brand from a regional to a national brand over the mid and long-term.

The other initiatives we’ve discussed such as the refranchising efforts and the moderation of our capital expenditures should provide us additional cash to either pay down debt or use for other purposes to ensure that we’re using capital efficiently and appropriately in this environment.

I would have to say that I believe that we’re very fortunate even particularly with this environment to not only have a solid group of existing franchisees but also very well capitalized and very experienced groups of newer franchisees that are very interested in getting into our business in a big way.

In each case given the history of operations that these folks have with our business and with others they tend to take a longer term view of the business and along with us are committed to working through the challenging times so that our brand can continue to grow and emerge as a more resilient and national brand.

That’s kind of the areas that I’d like to focus on today. I’d like to then turn it over, be available for questions later, but turn it over to Scott McLain, the President of our company.

Scott McLain

Thank you Clifford, I’d like to spend a few minutes updating you on our development activity which was pretty solid during the first quarter. We opened 39 new drive-ins in total including 34 by franchisees compared to 31 by franchisees in the prior year.

We also completed 21 relocations and/or rebuilds of existing drive-ins versus 15 in the first quarter last year and 141 retrofits were completed including 128 by franchisees which now puts us at roughly 65% of all of our drive-ins that have our new look.

Our pipeline for future development also continued to increase and at the end of November we had almost 1,000 drive-ins scheduled to open over the next several years, an increase from the same period a year ago and almost 50% over where we stood just three years ago.

All that being said it does appear that our near-term development efforts may be effected by the turmoil in the credit markets as well as general economic conditions. We have yet to lose a project because of financing and the majority of our franchisees use local banks for financing rather then national lenders.

However the slowdown in the credit markets in the first quarter resulted in significant delays in almost every current project which will effect our openings beginning with the second quarter. And while credit conditions are stabilizing those projects do require more equity and significantly more time and effort to get through the system.

We are adding more internal resources to help our franchisees navigate these challenges and as Clifford mentioned the increased credit standards we’ve put in place for new franchisees in 2006 have been a major benefit but its certainly a different world then it was a year ago.

As we’ve talked about on previous calls our existing franchisees have invested significant resources for relocations and rebuilds as well as retrofits which has slowed their rate of new store openings over the last couple of years. While we do expect that to pick back up over time, they will likely remain somewhat cautious on new store development until business conditions improve.

All this uncertainty makes it difficult to forecast the number of franchised new drive-in openings for the balance of this year. While it does appear that we’ll fall short of the 155 to 165 we expected in September we do seem well positioned to open as many as we did a year ago.

The performance of new drive-ins overall continues to be strong with average opening volumes in excess of $1.3 million, roughly 30% greater then what we were seeing just three to four years ago. We’re also beginning to see the cost of real estate along with construction costs decline in many markets and in some markets by a significant amount.

Franchisees are also able to buy land more often then leasing it which greatly eases the financing process. These trends as well as lower interest rates should only serve to increase the return on investment in new Sonic drive-ins and there’s no better indicator for future franchise development then a strong and increasing return on investment.

We ended the quarter with 3,505 total drive-ins and we opened our first store in the state of Wisconsin recently bringing us to a total of 38 states and continuing us on a path to becoming a truly national brand.

With that I’ll turn the call over to Stephen Vaughan, our Chief Financial Officer for his remarks.

Stephen Vaughan

Thank you Scott, as Clifford mentioned the first quarter was very challenging with our earnings per share declining 46%, lower then expected sales at partner drive-ins were compounded by restaurant level cost pressures and were a primary contributing factor in our disappointing first quarter performance.

Same store sales at our partner drive-ins declined by 6.6% during the first quarter and average unit volumes declined by 7%. As Clifford discussed earlier we have implemented a number of steps to address this lackluster sales performance including a stepped up focus on improving customer service through revised management incentive programs implemented in the summer, a new customer satisfaction survey which was implemented system wide in October, the full implementation of the new pricing initiative which was completed in our partner drive-ins during November, as well as the recent momentum in our refranchising initiative.

These efforts combined with last week’s system wide launch of the value menu give us a higher degree of confidence that partner drive-in performance over the remaining three quarters of our fiscal year should look much different then the previous three quarters.

However as a reminder in the second quarter of last year we had an extra day of sales due to leap year which will cause our comparison this year to be more difficult. Further the second quarter is always our most volatile quarter due to the potential impact of inclement weather.

As we move into the third and fourth quarters our same store sales comparisons at partner drive-ins will become increasingly easier. Our franchising income including franchise fees and royalties increased over $340,000 during the quarter. The net increase in franchising income was comprised of increased royalty revenue from new drive-in development offset the decline in franchisee same store sales.

This decline in franchisee same store sales resulted in a year-over-year royalty rate decrease of three basis points to 3.84% for the first quarter. A number of factors impacted our operating margins during the quarter, higher prices for several commodity items as well as the year-over-year increase in labor costs were exacerbated by a decline in same store sales and resulted in a decline in drive-in level margins of over 400 basis points during the first quarter.

We expect that the year-over-year increase in commodity costs will moderate slightly during the second quarter and third quarter in the low to mid single-digit range and then moderate further, perhaps slightly higher to flat as we move into the fourth quarter based upon current trends.

In November partner drive-ins implemented an average 1% to 1.5% price increase to partially offset commodity and labor cost increases. This puts our cumulative price increase at partner drive-ins in the 2% to 2.5% range for the past year.

As previously discussed under our new pricing strategy this represents an average, and actual price increases at individual drive-ins will vary. This is inline with our new pricing strategy to customize price increases and take smaller targeted increases throughout the year.

During the first quarter SG&A grew 8% while depreciation and amortization grew modestly by 6.7% reflecting the disposition of 19 stores during the fourth quarter of last year and the first quarter of this year.

In addition moderated capital investments in retrofits and new drive-in construction resulted in slower growth. As we previously mentioned we did refranchise eight drive-ins during the first quarter which did not result in a significant gain. We also completed the refranchising of another nine drive-ins earlier this month.

Both of these transactions involved newer stores in developing markets and did not result in a significant gain. Given the unpredictable nature and timing of these transactions going forward we will provide updates of any significant refranchising activity and discuss their impact on the income statement as they occur.

We did experience a slight decrease in net interest expense during the first quarter associated with the reduction of debt under the fixed rate notes. During this fiscal year we will make over $38 million of principal payments on the fixed rate notes which will result in lower net interest expense.

As of the end of the quarter we had $175 million outstanding under our variable funding notes. Subsequent to the end of the quarter we did draw down the remaining availability under our variable funding notes and now have $187.5 million outstanding and the interest expense on these notes is currently averaging approximately 3%.

Interest expense for fiscal 2009 for this portion of our debt will depend on changes in LIBOR and commercial paper rates. Under our current drawn amount we are carrying approximately $45 million in cash investments over and above our normal operating needs.

We do not anticipate needing to utilize any of our cash investments as our free cash flow after our planned capital expenditures of $60 million to $65 million and $38 million in mandatory principal payments is expected to be positive.

We continue to exceed our debt compliance covenants and we anticipate this compliance will continue into the foreseeable future. We did have a bump in our effective tax rate in the first quarter due to the combination of a one-time federal tax adjustment and lower then expected pre-tax income.

Looking forward we do anticipate that our tax rate over the remainder of the year will remain closer to historical levels however it may continue to fluctuate from quarter to quarter depending upon the resolution of individual tax matters.

We provided our initial 2009 earnings expectation in mid-September based on business and economic conditions present at that time. Subsequent to providing this outlook we have seen credit markets tighten significantly and consumer spending and confidence decline markedly.

Our first quarter results reflect these changes and challenges and we anticipate subsequent quarters throughout fiscal 2009 will be effected as well. While there have been some positive developments such as indications of abating commodity cost increases and moderating energy prices, significant uncertainty remains.

Given the unpredictable nature of the current environment we will not be providing updated expectations for fiscal 2009 at this time. We believe our near-term success will be based upon our ability to drive positive same store sales and that is where the majority of our efforts are currently focused.

We are optimistic about the outlook for our brand and continue to see significant growth opportunities at both the drive-in and the national levels in the latter half of the fiscal year and over the longer term.

This concludes our prepared remarks and we would be happy to accept your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Joseph Buckley - Banc of America Securities

Joseph Buckley - Banc of America Securities

You talked about the value menu and the impact on sales the first 10 days of the program could you give us a quarter to date update just how December was before the value menu went into play and then maybe with the value menu just talk about the mix of traffic and check and how comfortable you are from a margin perspective as you advertise the value menu.

Clifford Hudson

The progression I’ll give you, November December January and from a general trend standpoint, so November value because we did this brown bag special on a national television, two burgers, two fries, two drinks, something we’ve done historically a low price. We did $6.99 for that. Something we’ve done historically but we haven’t done with national television in a good while anyway but it clearly hit a value vein you might say with consumers because in that first fiscal quarter September, October, November, it was our best month from a comp standpoint.

We saw sales substantially negative from a comp standpoint in September without that value promotion in October so it improved October versus September and then boom, and then November with the value message on a nationwide basis it was our strongest month. It was widely negative but much improved over September and improved over October.

In December without the value message we went back negative. Historically we’ve done a full price, but the bigger thing is it’s a nicer fuller promotion, full price, unique sandwich, rings, steak and rings, etc. but it was not value and that strategically, we relied on what we’d done historically and this environment didn’t work.

January we’ve come back to the value menu. We anticipate sticking with that value menu and sales have gone, swung positive multiple day parts and so it is quite a contrast to December and its clear that that value message rings with certain customers in terms of their usage but it also is an enticement to a lot of customers who don’t use it when they come in anyway.

Stephen Vaughan

With regard to margins, we did craft that with the idea of giving our customers value so it does have a little higher due to packaging costs and with only 10 days of data we don’t have where we’ll end up in terms of a mix percentage of our sales but I would say that its probably, our best guesstimate is in the range of maybe a 50 basis point or less impact on operating margins, so not a significantly negative impact but still a nice value for the customer.

Operator

Your next question comes from the line of Jeffrey Bernstein – Barclays Capital

Jeffrey Bernstein – Barclays Capital

Can you give any color in terms of what the mix shift has been towards the value menu, whether in test or in the first 10 days, what kind of way you expect that to settle out. I know you mentioned sitting at 12% to 14% but I’m just wondering what you’ve seen thus far, whether through your test markets or just in the first 10 days just trying to see what type of traffic is being driven by this value menu.

Stephen Vaughan

It hasn’t gotten to the level where our competitors, we understand where they’re at in the 12 to 15% range but we’ve been very pleased to see it in the I think in the high single-digits so for something that’s just been in place now for 10 days, its really gotten off to a remarkable start.

Scott McLain

And its also across all of our day parts as well.

Jeffrey Bernstein – Barclays Capital

I know you talk frequently about the company or the partner stores underperforming by a few hundred basis points and it seemed like historically that was due to aggressive pricing taken by the partner stores as well as the happy hour promotion, with both of those now being lapped would you say those were the two main drivers and that the partner stores would close the gap or are you seeing that there are further or greater issues that are likely to keep that gap going forward for the foreseeable future.

Clifford Hudson

Part of the strategy has to have been to improve and it has been, to improve operations in those stores and then to draw the customers back. Whether this will be sufficient to draw those customers back will remain to be seen. I think some of those customers that, they’ve got plenty of options out there and to the extent the performance began to drop, I don’t think price alone brings those customers back but its probably a serious component.

So we will have a better sense certainly by the end of the quarter what the impact is in terms of closing the gap.

Jeffrey Bernstein – Barclays Capital

I think you mentioned at this point no guidance for the rest of fiscal 2009, just looking back it looked like the prior guidance was for 12% to 14% earnings growth and I think you had mentioned that half of it was driven primarily by operations more traditional operations and half of it was going to be from refranchising. Just wondering if you could give any color in terms of whether you would first still expect to see any earnings growth for fiscal 2009 and secondly how that pipeline is looking for the refranchising, whether you still expect to make the, I know you said things are getting delayed, but the magnitude of that, what you foresee for the rest of this year in terms of that refranchise.

Stephen Vaughan

Well I think the first quarter was disappointing and a lot of the performance on the second half of the year will be contingent upon these initiatives and will we be able to drive positive same store sales and that’s really why we decided we want to see how the next couple of months develop. With the introduction of the value menu we do have very high hopes for that particularly based on recent results and the research that we’ve done.

But in terms of whether we expect to have positive earnings growth, I wouldn’t be able to give you specifics on that at this point.

Operator

Your next question comes from the line of Steven Kron – Goldman Sachs

Steven Kron – Goldman Sachs

On the value margin response, it just seemed as though 50 basis points coming from a shift from one part of your menu seemed like a big number. If I assume 50 basis points and let’s say it does end up being around a 15% mix that would suggest that the margin differential would be somewhere in the 250 to 300 basis point range, is that the ballpark of what these products, the gross profit margin on these products are different from the core items?

Stephen Vaughan

I’m not sure I follow your math that you’re going through. We are assuming in that worst case of 50 basis points it would get into the 12% range but I’m not sure what you’re saying on the 250 basis point margin difference.

Steven Kron – Goldman Sachs

I’m just saying for that part of your menu if it is 15% for it to have an effect of 50 basis points on the full 100% of your sales, that part of your menu would have a much bigger margin disparity.

Stephen Vaughan

It does have a higher food and packaging cost. We are trying to create value.

Steven Kron – Goldman Sachs

Just on the refranchising side of things, no gains to date, are you selling these stores for I guess less then what you would have thought three or six months ago or are these stores that you sold at this point poorer performers then maybe what you have in inventory of units that you’re going to look to sell in the future.

Stephen Vaughan

We are not selling them for less then we would have thought. I think it really is the mix of stores that we’ve sold to date. They are not older stores, they’re newer stores in newer markets, and so they do have a higher book value. I think as we move forward with this older stores come into the mix and we will clearly have an expectation of achieving a gain on those.

Steven Kron – Goldman Sachs

On the G&A side you mentioned it grew by 8%, that was an uptick there. I assume that some of that is coming from higher marketing expenditures, can you just confirm that and then how should we anticipate the G&A line looking over the next couple of quarters as you really push on this value menu.

Stephen Vaughan

Well our marketing expenditures are reflected in our cost of restaurant operations. They’re not included in G&A and I think seeing our G&A grow in that 7% to 9% range, that should be what you would expect over the coming quarters. Some of it will depend upon timing of various factors but the 8% is not out of line with our expectations.

Steven Kron – Goldman Sachs

Can you just remind me what the driver is of that?

Stephen Vaughan

It’s a combination of just normal inflation, new headcount, its primarily people.

Steven Kron – Goldman Sachs

But as you refranchise would you expect to see some relief in that growth.

Stephen Vaughan

We would, yes.

Operator

Your next question comes from the line of John Glass – Morgan Stanley

John Glass – Morgan Stanley

You commented that you’re supporting the value menu with higher levels of national cable advertising so are you increasing advertising spend in total or just allocating more dollars toward this and if you are can you just maybe quantify what you’re spending incrementally on advertising.

Clifford Hudson

The amount that we are spending year-over-year is greater so there’s something of a natural increase year-over-year. In addition to that we have shifted some resources, not so much shifting by quarter as much as it is shifting by initiative, and shifting by time of the year.

So we have put slightly disproportionate resources toward this. It is a level we felt appropriate for a new initiative rather then simply a promotional item.

Scott McLain

And it is a nice healthy increase over what we spent last year in January and it will be in February as well.

John Glass – Morgan Stanley

I think in this industry people typically think of percentage increase, you think of a percentage of sales being spent in advertising and you have increased because sales have grown, sales aren’t growing actually now they’re declining slightly so are spending more then you would have, are you increasing the percentage spend for example or more the dollar spend then you had budgeted the first of the year.

Scott McLain

Our system is still growing so while same store sales may have been slightly negative we are opening up more and more stores and so the overall advertising spend is continuing to go up. So we have the benefit of more stores contributing to advertising which is helping drive the increase and then we’re looking at the entire budge and what we allocate that budget to and some of that allocation has been moved towards the value menu so that we can drive brand awareness early on as we roll it out.

John Glass – Morgan Stanley

Are you spending more as a percentage of sales on advertising then you initially planned to, to do this.

Stephen Vaughan

Not more then we initially planned.

John Glass – Morgan Stanley

Can you just describe the value menu a bit in terms of what’s on it, are there beverages and maybe what happened to happy hour.

Scott McLain

Eleven items in total. We have a junior burger, we have a chicken strip sandwich, we have a small fries, a small tot, we have a junior Frito chili cheese wrap, we have small drink and small slush, we have ice cream cones, we have a junior candy sundae, and we have a banana as well so we’ve got a wide array of items that are designed to appeal really across all day parts and one of the things that we’ve noticed early on as it pertains to happy hour, is that this has helped us actually build our average check at happy hour because people are adding these items on.

I forgot one item, a junior breakfast burrito.

John Glass – Morgan Stanley

So happy hour still stays in place.

Scott McLain

Happy hour does still stay in place but I think what we’ve seen is that the everyday value menu is actually an enhancement to happy hour because people are not only ordering a drink but they’re also taking the opportunity to order an item off the everyday value menu.

John Glass – Morgan Stanley

You had historically broken out core versus developing market sales, you stopped this quarter, can you comment on where the weakness has been relative to those two markets.

Stephen Vaughan

We did stop reporting that with the idea that our newer markets always are more challenged because they don’t have as much media support in terms from a same store sales standpoint. Scott did talk about the fact new stores in new markets continue to perform very well.

Scott McLain

As we continue to open up stores, we recently opened up a new store in Wisconsin. We recently opened up a new store in Michigan and they continue to perform at very high levels so that’s very encouraging for us.

Operator

Your next question comes from the line of Matthew Difrisco – Oppenheimer

Matthew Difrisco – Oppenheimer

November then was a, for the system was slightly negative, because I thought you said on December 15 that it turned positive.

Stephen Vaughan

We did say that our estimated system wide comps for November were positive. They did end up being slightly negative.

Matthew Difrisco – Oppenheimer

And then you’ve only said really that certain day parts are positive but you went positive in January, the first seven or eight days now you’ve turned positive in January.

Stephen Vaughan

Since the introduction of the value menu on December 29 we have had positive sales, correct.

Matthew Difrisco – Oppenheimer

That’s including the company owned stores?

Stephen Vaughan

That is.

Matthew Difrisco – Oppenheimer

But I guess given the absence of supporting the previous guidance one would suspect comps going positive but it seems like you’re forecasting significant margin down ticks from this value proposition.

Stephen Vaughan

No I don’t think that’s the case at all, I think we said as much as 50 basis points margin impact but if we’re able to drive positive same store sales with this initiative it will more then offset the 50 basis points that we would expect from the implementation of it.

Scott McLain

A lot of the margin deterioration that we had in the first quarter was because we didn’t have sales volume. If this can help us restore sales volume we won’t see the deleveraging effect that we saw in the first quarter which was a much more, much stronger contributor to the deterioration in margins then food costs.

Matthew Difrisco – Oppenheimer

Well food costs were 200 basis points, so I realize that the first quarter was the lowest quarter on a relative food cost basis, but then you’re suggesting on a food cost margin even though you’re going to a value meal for three months instead of just one month the second quarter on a year-over-year basis on cost of goods sold is not going to go up higher, greater then 50 basis points.

Stephen Vaughan

Well no, I’m not suggesting that. I’m saying versus what our expectation would have been without a value menu, it could be an additional 50 basis points. I did give guidance that in the second quarter we expect our commodity cost inflation to be in the mid single-digit range which is down significantly from the first quarter when our commodity cost inflation was about 9%.

Matthew Difrisco – Oppenheimer

If the franchisees are going to be doing a value oriented lower margin product is there any concessions on the royalty rate that they’re asking for or also with increased incremental dollars for advertising are they asking for, are you starting to hear requests for a lower royalty rate and should we expect the year-over-year decline in the royalty rate to continue or with positive comps does it resume to ascending again.

Scott McLain

No, they’re not asking for lower royalty rates nor are we considering them and yes, we do expect our average royalty rate to go up as our sales go up. That is the function of the license agreements.

Stephen Vaughan

And the intention of this initiative is to drive sales and profitability.

Scott McLain

That is right and I think one of the things that our franchisees are very good at is they don’t, they understand that they put dollars in the bank not percentages. And so to the extent that their food and packaging cost goes up 50 basis points or 30 basis points its really irrelevant of they’re putting more money in the bank at the end of the day. And the good thing about the everyday value menu is it drives people to our drive-ins at a time when a lot of people are really struggling financially and value is really driving people to all restaurants and gives us the opportunity to pick up a lot of business and by picking up a lot of business we’ll drive our volumes and maybe our percentages will look a little bit different.

But you know what, at the end of the day we’ll make more money and so will our franchisees.

Matthew Difrisco – Oppenheimer

Just on the refranchising effort to be clear the first quarter then did not have any benefit so was there any, it sounds like there wasn’t a line item that has a benefit or a gain in there, is that correct and then the 9 that you did in 2Q, is there a gain on those or did you sell those for a benefit that should be reflected in one of the line items.

Stephen Vaughan

Both of those transactions will have a slight gain but its not significant and its included in other under our revenue line item. But it is not significant enough to be broken out.

Matthew Difrisco – Oppenheimer

So other operating expenses?

Stephen Vaughan

No, other revenue.

Operator

Your next question comes from the line of Steven Rees - JPMorgan

Steven Rees - JPMorgan

Can you just address the new tip program, how far along you are with the rollout there, how its being received among the store level employees and what percentage of your staff are currently on the new program and when you expect it to benefit the labor line.

Scott McLain

We do have that in a lot of our company stores. We are rolling it in kind of on a phased basis so in other words we didn’t take every carhop that was working for us in July and say you’re now on tip wage. We’re rolling it in over time. That process continues. One of the things about company stores is that in order to get our customers back and to keep them coming we have to give great service.

And so tip wage is not put in as a way for us to save our way to prosperity by paying our carhops less or having less carhops. It’s a way to help us afford to have more people at the drive-in serving our customers. So we, it is in our system. We are trying to use it as a means to help us deliver better service. Our objective with tip wage is not necessarily to drive our labor percentage cost down but allow us a way to afford to actually take our service levels up.

Steven Rees - JPMorgan

Can you estimate what percentage of your staff would be on the new program say by year-end versus today.

Stephen Vaughan

Well they are all on the new program. If you were a carhop that was in employed before July 24 when we implemented this, you would be grandfathered in and making the old minimum wage so no less then $5.85 an hour. However if you came on board after that date, you would be brought in at a lower wage rate, not the [inaudible] dining tip wage rate, but probably $3.13 an hour or something in that range.

Steven Rees - JPMorgan

Historically I think you’ve given the total media expenditure by year, can you just talk about where you ended 2008, was it around $190 million and then do you still expect to spend $200 million in 2009?

Stephen Vaughan

Yes.

Steven Rees - JPMorgan

Can you talk about some of your sales trends by market, your important partner store market is Texas and Oklahoma, and then maybe address Florida which I think is a sizable franchise market for you also.

Stephen Vaughan

We continue to see more challenges in those markets that we’ve talked about historically like Florida. However we are pleased with this introduction of the value menu we actually believe that that could potentially have a disproportionately positive effect in some of those markets where the consumer may be hurting more then they are in some of our core markets.

Again its very early to give you any specific feedback on that but that’s certainly a good possibility.

Steven Rees - JPMorgan

I think you said you expected moderating commodity cost inflation by the end of the year, how contracted are you on beef and chicken and to what extent you could see some variability there.

Stephen Vaughan

Well we are locked in on chicken through the end of the calendar year so we feel pretty good about that. Our beef costs are basically locked in through the end of the second quarter now, so through the end of February and then we have locked in about half of the supply through the end of the fiscal year and so there is still some variability built into our forecast but a lot of that has now been taken out. A lot of the potential volatility so we feel pretty good that the forecast that I’m giving you absent some other, some type of catastrophic event should be achievable.

Operator

Your next question comes from the line of Nicole Miller – Piper Jaffray

Nicole Miller – Piper Jaffray

I think I earlier misunderstood partner comps down 6 6, what was the price that you mentioned for the quarter?

Stephen Vaughan

Well for the quarter it would have been probably about 1% to 1.5%. We took another price increase in mid-November that was about 1.5% so cumulatively we’re now running between 2%, 2.5% at pricing. But the majority of that wasn’t in place for the first quarter.

Nicole Miller – Piper Jaffray

It sounds like through all the conversation here that January comps turned positive but what is the spread now between franchise and company, has that changed?

Scott McLain

We did see in November for example our company stores perform better then they had been relative to our franchisees and we have, I don’t know exactly where the gap stands over the last 10 days, but our company stores have been performing well as have our franchise stores.

Nicole Miller – Piper Jaffray

So I think you answered earlier that both company and franchise were positive. Obviously in January if the system is positive then that spread’s changed. Am I drawing the right conclusion?

Scott McLain

It has not widened. I think its actually narrowed a little bit. Its been 10 days.

Nicole Miller – Piper Jaffray

And the G&A, it sounded like it went up from an allocation versus franchise support so is the $16.2 million-ish is that the right run rate going forward.

Stephen Vaughan

It is, however if we do end up refranchising a significant number of stores you could see some offset there.

Nicole Miller – Piper Jaffray

Is there anything else on the commodities that’s locked outside of the beef and chicken?

Stephen Vaughan

Well our largest cost item is our syrups for our drinks and those are on a long-term contract.

Nicole Miller – Piper Jaffray

They adjust with inflation?

Stephen Vaughan

They do and that adjusted January 1 so we do have an increase in that area. We’ve got really the majority of our contracts are now locked in through the end of the calendar year. As I mentioned we’re about 50% open on beef and then I think on dairy we’re about 50% covered on dairy. Cheese is locked in through the end of the fiscal year. Our packaging costs are locked in through the end of the fiscal year so those projections are pretty solid that we gave earlier.

Nicole Miller – Piper Jaffray

And poultry is relatively flat for this year?

Stephen Vaughan

It is, that’s correct.

Scott McLain

We’ve got a long-term contract on poultry.

Operator

Your next question comes from the line of Christopher O'Cull - SunTrust Robinson Humphrey

Christopher O'Cull - SunTrust Robinson Humphrey

What do you think the transaction increase needs to be in order to offset the lower dollar profit from the value menu?

Stephen Vaughan

Well actually when we look at the value menu, again this is early on, but the average check for the value menu for transactions that have a value menu item on them is higher then our average check is overall. And so we’re really not expecting to see a big impact on our margins or see a big decline in our average check. In fact the opposite has occurred to date.

Christopher O'Cull - SunTrust Robinson Humphrey

So when you see it needs time to build similar to happy hour, how do you reconcile that, what do you mean by that?

Stephen Vaughan

Well with happy hour I think that the month that we introduced it we saw a number of drinks increase something in the magnitude of 40 drinks per day. As we went along I think about three months out, that had more then doubled, the incremental drinks had more then doubled and it continued to build really for the first three or four months that we were promoting it.

So I think the awareness of this program, its not going to be a one month, one shot deal, it will continue to build over the coming months.

Christopher O'Cull - SunTrust Robinson Humphrey

How many months do you think it needs to build in order to reach that level of dollar profitability, where you increase the profitability with the program.

Stephen Vaughan

Well I think based on the way its started off—

Scott McLain

--we expect it to have a positive effect on our profit this month.

Clifford Hudson

Each transaction is intended to be profitable. What it does with margins is a different issue but the check issue is different from what Stephen is describing in terms of the growth and what we described earlier, we would anticipate that as a percentage of total sales, the growth would continue. Not that it would go from unprofitable to profitable. The program is designed to be profitable.

Stephen Vaughan

One of the differences between this program and happy hour, is happy hour we discounted a lot of items, drinks that we were currently selling in the afternoon. With a value menu what we’ve seen is the majority of the sales have been incremental, we have not been cannibalizing other items on the menu so I think there is a little bit of a difference in this program versus happy hour in that regard.

Christopher O'Cull - SunTrust Robinson Humphrey

And that’s what I was getting at, is more the economic profit, is there a trade-down occurring that you’ve got to make up the number of transactions in order to offset that trade-down.

Stephen Vaughan

To date its been very minimal.

Christopher O'Cull - SunTrust Robinson Humphrey

On the tip credit, the benefit, was there any benefit in terms of the labor cost for the quarter from shifting to the tip credit program?

Stephen Vaughan

Well there were some savings if you look at it on just an average wage rate, but to Scott’s point, what we encourage our management team to do is to invest those savings back in hours at the drive-in and so its pretty difficult to determine how much of that actually occurred. But we did see our average wage rate, it did not increase as much as it would have without that program in place.

Operator

Your next question comes from the line of Sharon Zackfia - William Blair & Company

Sharon Zackfia - William Blair & Company

You mentioned lapping leap year, is that going to be a point penalty to your comps like it was a point benefit last year?

Stephen Vaughan

It will in the second quarter, it will be a point penalty.

Operator

Your next question comes from the line of Tom Forte – Telsey Advisory Group

Tom Forte – Telsey Advisory Group

I wanted to know if you could provide details on two items, one was you talked about the new pricing model which would be done more on a location or area basis then system wide, I wanted to know if you felt like that had been more effective as far as the prices, the effective use of the higher prices and then you talked about slowing new unit development because of the tight credit markets. Was wondering if that was a slowing on a month basis or more like slowing on a quarter basis.

Scott McLain

What we’ve done on the pricing is we’ve gone out and contracted with a third party that has a tremendous amount of pricing expertise which allows us to approach our pricing significantly different then we did before. What I mean by that is instead of having one price for every company drive-in we are now pricing by trade area.

So we’re able, this company is able to provide us with data and recommendations to price appropriate to the area in which we’re operating in. That went into effect with the new menu that we put in later in the month in November and we expect that we will see a benefit from that but its probably a little bit too early for me to comment more fully on that.

From a development standpoint as I mentioned, the credit markets did become more difficult in September and October. That did result in projects taking longer to finance and requiring more equity from our franchisees and so projects basically got delayed particularly in September and October when the markets were basically shut for a period of time as you guys are well aware.

Those delays impact our development pipeline and will cause the number of stores which we open over the remainder of the fiscal year to be impacted by that and we’ll see over time how much the credit market opens up, if that process becomes easier and that will determine really the number of stores we get open before August.

All of the stores should open. Whether they all get opened before August is maybe a little harder to predict.

Tom Forte – Telsey Advisory Group

Generally speaking do you think that or is it too early to gauge if the delay will be closer to a couple of months or closer to a couple of quarters.

Scott McLain

Its too hard to tell right now to be honest with you.

Operator

Your next question comes from the line of Keith Siegner – Credit Suisse

Keith Siegner – Credit Suisse

You frequently have given a breakdown of your sales by product categories, frozen and fountain, burgers etc. can you give us an update to where that product category breakdown is now?

Stephen Vaughan

I don’t have that in front of me. We do typically put that in our investor road show but I don’t have that in front of me. I can tell you that with the implementation of happy hour we’ve continued to see our frozen and fountain increase as a percentage of the mix but other then that I can’t give you any specific numbers.

Keith Siegner – Credit Suisse

What I’m curious about is would the introduction of the value menu and the products that are on it, its definitely much more weighted towards traditional food items and I guess especially given what we’ve seen with discretionary spending, I’m just trying to see if you have more of a shift away from say the more discretionary products toward more of the traditional food products, if we need to think about any impact on your margins from that. As we lap the happy hour benefit and with the introduction of the value menu if you move more toward sandwiches and maybe away from drinks, how should we think about the margin delta from that shift.

Scott McLain

I think our afternoon business and our drink business is still strong. Its still growing.

Stephen Vaughan

It will benefit from this program. We may see more add-ons to somebody that was coming in in the afternoon and buying a half price drink but I don’t see that being a negative.

Clifford Hudson

In order words we see traffic and check. It wouldn’t be just afternoon check it would be traffic and check.

Keith Siegner – Credit Suisse

On the new contracts or any recent updates to your contracts for commodities that you had, have you had any adjustments to clauses for grain escalation costs or things along those lines or are they are still fixed price, officially fixed price.

Stephen Vaughan

At this point they are officially fixed price.

Operator

Your next question comes from the line of Greg Ruedy - Stephens Inc.

Greg Ruedy - Stephens Inc.

On the everyday value menu many of the items are junior items, could you talk to the importance in this environment of maybe adding new products, how is the pipeline and at some point should we expect maybe a rollout of a program similar to the coffee products of last summer.

Clifford Hudson

What you should expect in terms of specific new products, we’ll share that as we go forward. In terms of the nature of the promotional activity going forward if you were to watch our marketing this month you will see the emphasis being on this new initiative of value menu and as we commented earlier you would see the alignment of national television, local television, radio, etc. focusing on this new initiative.

However we would anticipate over time near-term and over time, that we will continue to focus on other aspects of our menu as well and that will include limited time offers that would not fit that value menu description.

That fact that we’re pursuing a value menu does not mean to the exclusion of the other parts of our menu.

Greg Ruedy - Stephens Inc.

I think in the past I think you’ve given the percent of system that’s been retrofitted, can you update us there, and at this point are we seeing any lift from the retrofits and the same store sales numbers?

Scott McLain

We have about 65% of the system that has been retrofitted. I think in terms of the retrofit we have said before and we continue to see that those markets that have the most of sales initiative including the retrofit completed tend to have the strongest performance relative to other markets.

I think its one of the things that’s happening is if you’re doing nothing, you’re probably not having a good result and if you’ve done some of the other things, the retrofit, LED signs, that we have, the other initiatives that we have, those markets are tending to have better performance.

Greg Ruedy - Stephens Inc.

Do you know what percentage of carhops are hired based on referrals from friends?

Scott McLain

No idea, no clue.

Operator

Your next question comes from the line of Fitzhugh Taylor – Thomas Weisel Partners

Fitzhugh Taylor – Thomas Weisel Partners

Along the lines of the new unit uncertainty is there any kind of uncertainty involving the retrofits particularly on the franchise side and maybe your goals for the year?

Scott McLain

Well I think we have about 65% of the system that’s been retrofitted and I think we do intend to complete the retrofit over the next couple of years—

Fitzhugh Taylor – Thomas Weisel Partners

But you haven’t given a specific goal that you’d like to have done.

Scott McLain

I think in some of the markets we are looking at also trying to get them to adopt other initiatives to help drive their profits in the interim before they do the retrofit, like an LED sign which has shown to be very beneficial.

Fitzhugh Taylor – Thomas Weisel Partners

Just to clarify in the 10 days since you launched the value menu have you been advertising it or is it still to come.

Scott McLain

No we are advertising it, the TV started on December 29.

Operator

Your next question is a follow-up from the line of Joseph Buckley - Banc of America Securities

Joseph Buckley - Banc of America Securities

I just wanted to clarify two things, the positive comps in January are they both the partner and the franchise comps?

Stephen Vaughan

Yes.

Joseph Buckley - Banc of America Securities

And then you mentioned the minimum wage, the minimum wage kicked up to $6.55 July 24, did you not kick up the people who are [inaudible] minimum wage to that level, did they go into some sort of modified tip credit wage at that point?

Stephen Vaughan

Yes, the carhops that were on board at the minimum wage that was in place prior to the July 24 increase we kept them at their existing wage rate. They did not go up to the new minimum wage.

Operator

Your next question is a follow-up from the line of Matthew Difrisco – Oppenheimer

Matthew Difrisco – Oppenheimer

In looking at and taking it to a further minutia here on the first 10 days or so of this rollout, is there anything abnormal as far as benefit from the holiday, with the eves falling on Tuesday rather then a Monday a year ago, did you see a stronger weekend business and then also just looking at one of your larger markets in Texas, it looks like the first week in January was about 30 degrees difference almost in 2008 versus 2009, did you see any regional disparities extremely strong sales in the first week in January potentially because of more favorable weather or anything.

Clifford Hudson

Believe it or not we have not gone through that exhaustive kind of analysis over the last 10 days. What we know is that our sales have been good since we, starting in January—

Stephen Vaughan

And on a broad basis—

Clifford Hudson

---across the day parts. It’s a good picture.

Scott McLain

Relative to what we have been seeing, its pretty good.

Matthew Difrisco – Oppenheimer

Because your conference call last year in 2Q of rehashing the December and January period you referenced that December was a bad weather period and I didn’t see anything being called out on January so I went online and looked at the temperature difference and I was just curious if there was any difference there.

Stephen Vaughan

Can you send us that research, give us a head start on that.

Operator

There are no additional questions at this time; I would like to turn it back over to management for any additional or closing comments.

Clifford Hudson

We do appreciate all of you participating today and we look forward as the quarter progresses, really meaning after the quarter of giving you an update on these new initiatives which we think are very positive for our business. We continue to be optimistic about the business. We’ve got a strong brand with good transition from regional to national. We’ve got a lot of folks interested in our business joining the system, new franchisees, existing franchisees growing.

We continue to be optimistic about our business in the long run and we will look forward to updating you at the end of the quarter as to these new initiatives and their progression. Happy New Year to all of you and we look forward to talking to you along the way.

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Source: Sonic Corp. F1Q09 (Qtr End 11/30/08) Earnings Call Transcript
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