Fast-food franchise Sonic (NASDAQ:SONC) reported a lackluster third quarter as the firm dealt with lousy weather throughout the U.S. Revenue decreased a modest 2% year-over-year to $146 million, falling short of consensus expectations. Earnings per share increased 8% year-over-year to $0.26 per share, roughly in-line with consensus estimates. Management continues to anticipate that the firm will generate $45-$50 million in free cash flow for fiscal year 2013.
The story for Sonic during the third quarter was weak same-store sales growth. Aggregate same-store sales grew an anemic 0.1% year-over-year, with franchise-owned locations sales up 0.2% and corporate-owned sales down 1.1% year-over-year. The main culprit behind the decline was weather, which the firm believes accounted for 300-400 basis points of weakness. The Midwest and Northeast were particularly slow, while California and the West Coast performed moderately well.
Image Source: Sonic
In order to get more excited about Sonic's prospects, we'd like to see stronger same-store sales growth. However, even McDonald's (NYSE:MCD) has been struggling to post decent same-store sales growth, and we think the issue could be more secular than anything.
Nevertheless, the big boost to Sonic's profitability in the near term remains the potential for higher franchise royalty rates. Sonic hopes to convert 850 franchisees to higher royalty rates by fiscal year 2015, which we believe could lead to a strong increase in free cash flow generation.
Image Source: Sonic Q3 2013 Presentation
The above image implies that Sonic will get a solid boost from changing license types (as the royalty ranges are higher in new conversions to #6 or #7 licenses). We also think same-store sales at new license #6 and #7 stores could increase because owners will need to improve sales to increase net income, given higher take-rates from Sonic.
The firm also refinanced $155 million worth of fixed rate debt. The new notes will pay 3.75% and are due in 7 years. Importantly, the notes will lower annual interest payments $2 million to $2.5 million, providing a small boost to earnings. For perspective, Sonic paid $32 million in interest in fiscal year 2012 versus operating income of $89 million.
Looking ahead, Sonic reiterated its guidance of low single digit same-store sales growth during fiscal year 2013, as well as its target of $45 million to $50 million in free cash flow. Management also announced a number of initiatives ranging from advertising to new POS systems that could bring in traffic and improve productivity. Nevertheless, we believe raising royalty rates is the big opportunity for Sonic.
Sonic's plan to increase royalty rates could add some nice earnings upside, but we're not fans of the "burger and fries" fast-food restaurants at this time. With intense competition among rivals and increased penetration from healthier options such as Panera (NASDAQ:PNRA) and Chipotle (NYSE:CMG), we think it will be hard for Sonic to generate excess profits. Therefore, we won't be adding the name to the portfolio of our Best Ideas Newsletter at this time.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.