The combination of emerging market instability, weak US economic data in the month of January, and the commitment to tapering by the Federal Reserve has recently caused the market to drop about 5% from it's all time high, creating a few potential opportunities in a variety of industries and companies. One company that I believe has benefited from this is Sonic (SONC), America's largest drive-in food chain, which is down approximately 15% from it's recent high. With their diverse menu options, investments in new technologies, and location expansion plans, Sonic is well positioned to grow their unique brand. In this article, I will outline my investment thesis on why I believe Sonic provides growth at reasonable valuations for investors looking for exposure to the quick service restaurant (QSR) industry.
In it's first quarter of the fiscal year, Sonic reported a 2.2% increase in systemwide same-store sales and an 18% increase in earnings per share. In the next few years, Sonic is expecting to continue their low single digit growth in same-store sales and add 14%-20% growth in earnings per share. A major factor for this growth will be the implementation of technologies that will allow Sonic to cut operating costs and drive in new revenue. In 2014, Sonic will roll out their new Point of Sale (POS) system to the rest of their remaining company-owned locations, and then the franchise locations by 2016. This technology is designed to provide a whole enterprise of solutions for front-of-house management, back office applications, as well as customer service. The new POS system, coupled with Sonic's current Supply Chain Management, will help the entire chain lower operating costs over time. Another technological advancement that will help drive sales growth for Sonic is the implementation of their Point of Personalized Service (POPS) system. The POPS system is designed to give customers a more personalized and interactive experience when ordering from the drive-in menu. With the POPS system in place, combined with Sonic's physical drive-in format, they will have unique ability to maintain and connect with customers through targeted messaging and promotions in a way that a McDonalds (MCD), Burger King (BKW), or Jack In The Box (JACK) simply cannot. These technologies will be a driver in royalties and sales growth going forward.
Another major component of Sonic's future growth will be the expansion of drive-in locations in coastal regions. During the fiscal year 2013, Sonic opened up 27 drive-in locations. In 2014, Sonic is expected to open up an additional 40-50 drive-in locations, and going forward, their expansion plans will be focused towards the heavily populated coastal regions. The growth opportunities are exceptional considering how underdeveloped Sonic is in places such as California and New York. There are currently 61 stores in California (compared to 193 in Arkansas), and Sonic is planning to expand to 300 total stores in California by 2020.
The next major factor driving same-store growth is management's ability to invest in innovative food and drink product lines. Sonic can provide quality products that can rival fast casual or casual dining restaurants, at a more reasonable price. This really sets Sonic apart from their existing QSR competition, and allows them to compete against fast casual dining restaurants, which have seen their customer base erode over the years.
Valuation and Multiples
Looking at the QSR industry as a whole, Sonic's forward P/E, P/S, and PEG ratios are all trading at a discount relative to the industry, while also having an average earnings growth rate that is higher than a majority of their peer group. Sonic's management has done an excellent job at managing the company's assets and equity, as Sonic's ROE is very high relative to their peers and the ROA is right on par as well. Management has been able to achieve impressive profitability ratios by effectively managing their high operating leverage and debt payments, coupled with investing in effective media and national ad campaigns that have highlighted Sonic's diverse menu options. In 2013, Sonic's national media campaign was able to increase their share of voice by 40%, and is now the 5th strongest brand in the QSR industry. Going forward, the recent pullback offers a chance to buy Sonic at a much cheaper valuation than the end of last year, with higher expected growth rates.
Examining Sonic's earnings and capital expenditure estimates for the remaining of the fiscal year, Sonic is expected to create between $15-$25 million in free cash flow in the fiscal year of 2014. This number is slightly lower than what they have normally produced in the past, mainly due to higher than average capital expenditures as they continue to invest in new technology projects. Going forward, Sonic should be able to create $30 million in free cash flow per year, as capital expenditures will be much lower once their new technology is rolled out to all of their franchise and company owned locations. In a standard free cash flow model, with a long term growth rate of 4% and a cost of capital of 10%, I believe Sonic has over 30% upside from current levels and has an intrinsic value of $24.50 a share.
A couple of the major risk factors Sonic faces going forward are the competitive landscape in the QSR industry, and the ability to adjust to consumer demand. As mentioned above, the QSR industry has a lot of national chains that compete on price, service, products, and location. Compared to other major national chains, Sonic's media budget is also much smaller. There will also be different regional and local restaurants that will compete with Sonic on these same factors as well.
Another risk factor for Sonic will be the effect that weather has on sales and commodity prices. During the winter months, extreme weather events could prevent consumers from going out to eat. This is especially true for Sonic considering the "outdoor" nature of the drive-in experience. This was part of the reason Sonic sold off so hard in December and January during the Polar Vortex. Droughts, crop destroying storms, and volatile temperature shifts have the potential to elevate commodity prices, causing a reduction in profit margins. A labor dispute, or an increase in the minimum wage could also have the potential to cut into profit margins significantly.
In conclusion, Sonic's valuation relative to their peers, new cost saving technologies, and their innovative, diverse pipeline of food and drinks make Sonic a long-term buy in the QSR industry. Management has shown the ability to continue to grow their business in a very competitive industry, while also creating positive free cash flow and strengthening their balance sheet. I also believe Sonic's unique drive-in format and low costs have the potential to capture some of the weakness coming from the casual dining industry. Sonic is also supported by a new $40 billion stock repurchase plan, which will be done incrementally at management's discretion. Sonic has a proven record of returning money to their shareholders via buybacks, as management has repurchased $77.7 million worth of shares since the fiscal year 2012. All in all, the recent sell-off in Sonic has given investors an opportunity to buy a growing company at very fair valuations relative to it's peers in the QSR industry.