Sonic: Not The Time To Invest

| About: Sonic Corp. (SONC)

This purpose of this article is to determine the attractiveness of ("Sonic Corporation (NASDAQ:SONC)") as an investment option. To do so, I will review SONC's current and past performance, most recent quarterly and annual reports, and trends in the industry to attempt to determine where the stock may be headed from here.

First, a little about SONC. SONC operates and franchises a chain of drive-in restaurants in the U.S., representing its two lines of operations. Sonic Drive-Ins feature hamburgers, hot dogs, ice cream, tater tots, and a variety of other fast food items. SONC also offers breakfast items and serves these items during all hours of operation. There are over 3,500 Sonic locations, the large majority of which are franchised. The company competes with large, international players such as McDonald's, Burger King, and Wendy's, as well as with any other local convenience food restaurant and smaller chains. This competition has intensified as consumers have restricted the amount they spend on take-out food and in restaurants.

Recently, the stock has performed quite strongly. SONC is currently trading at $14.30/share and is up over 37% year to date. Over the last 52 weeks the stock is up over 50%. These figures exclude any dividend payments because the company has never paid a dividend. While the stock has been doing well, the longer-term picture has been mixed. The company was hit particularly hard during the recession and struggled to regain its footing until the middle of last year. Over the past five years, SONC is down over 13%. Given this mixed performance and the fact that SONC's P/E ratio is over 21, making it more expensive than competitor McDonald's, which has a PE of 18, I want to take a closer look at the company's financial statements to see if there is any reason for this optimism.

I reviewed the company's 10-K report and noticed a few key elements. One, drive-in sales have decreased, albeit at under 1%. However, this was mainly due to the fact that SONC franchised off additional branches without adding new ones, so the firm was operating 9% less drive-ins than the year prior. Given that sales were only slightly down allows me to conclude that each existing drive-in is experiencing higher sales volume. Coupled with the fact that cost of sales was down at a higher rate than the decrease in sales volume, it points to a positive picture for existing outlets. There was also a sharp increase in franchising activity for SONC. Franchising fees increased by 16% year over year, providing a lucrative stream of revenue for the company. This is an area I will watch closely, as SONC experienced declining fees in this area for three consecutive years prior to this jump. If the following year also represents an increase, SONC may be well on its way to reversing this trend. If the downward trend continues, I will not be strongly encouraged by this one off event. However, the main takeaway for me is the increase in same-store sales. After a disappointing 2010 when same-store sales declined almost 9%, SONC experienced same-store sales growth of 1.8% in 2011 and now 2.8% in 2012. Given the increased competition in fast food, and the price wars that have followed, an increase in same-store sales is a welcome advancement that will bode well for the company if it can continue.

There are a few items in the reports that give me some concern. First, the royalty rate earned by the company has been declining consistently. While the decline has been minimal, down from 3.82% in 2010 to 3.79% and 3.72% in 2011 and 2012, respectively, this is not positive for the company. Second, while 2012 results were impressive to 2011, things have not been as rosy so far in 2013. First quarter company drive-in sales were down over 4% compared to first quarter sales in 2012. During this same period, franchise royalties and fees were essentially flat, so that was not able to make up for this lost revenue. On the flip side, SONC was able to decrease costs at a higher rate, so net income was able to climb during this period, even with the declining sales. While this is certainly a positive, companies can only cut costs so far and eventually sales revenue is going to have to increase for the company to be increasingly profitable. If the decrease in sales does not change, or at the very least made up for in the form of higher royalty payments, the stock price will not see continued gains.

Bottomline: SONC's stock has done very well in the short-term and the company has been able to boost net income in a difficult economic climate. Investors in the stock have been recently rewarded, and if the company continues to expand its number of franchises, that trend should continue. However, the stock currently seems overpriced to me. With slowing sales and a declining rate for royalty payments, SONC is obviously feeling the pain from tightening consumer budgets on discretionary food spending. Coupled with an added trend towards more health conscious meal alternatives, SONC is facing a double whammy now, and will continue to in the near future. With a U.S. market that is increasingly saturated with fast-food options, I feel there is a limit to the growth SONC can experience. International players such as McDonald's should fare better going forward. If SONC was priced at a steep discount, I would consider giving the stock a buy recommendation given its increasing net income. However, the stock is priced higher than its top competitor and is absent a dividend, which would help with attracting more classes of investors. Therefore, at this time, I would caution investors away from SONC.

Disclosure: I am long DVY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.