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Sonic (NASDAQ:SONC)

Q3 2011 Earnings Call

June 22, 2011 5:00 pm ET

Executives

J. Hudson - Chairman and Chief Executive Officer

Pat Watson -

W. McLain - President and President of Sonic Industries Services Inc

Stephen Vaughan - Chief Financial Officer and Executive Vice President

Analysts

Nicole Regan - Piper Jaffray Companies

Brad Ludington - KeyBanc Capital Markets Inc.

Sharon Zackfia - William Blair & Company L.L.C.

Keith Siegner - Crédit Suisse AG

Larry Miller - RBC Capital Markets, LLC

John Glass - Morgan Stanley

Jake Bartlett - Susquehanna Financial Group, LLLP

Jeffrey Bernstein - Barclays Capital

Operator

Good day, everyone. Welcome to the SONIC Third Quarter Conference Call. Today's call is being recorded. At this time, for opening remarks and introductions, I would like to turn the call over to Pat Watson. Please go ahead, sir.

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 third quarter and first 9 months of fiscal year 2011, which ended on May 31, 2011. Today's audio and slide presentation are available on the Internet. If you would like to view the slides during this presentation, please go to the Investor section of the company's website, www.sonicdrivein.com and follow the link to Events & Presentations under Investor Info.

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 risk. 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 this afternoon, in the company's annual report on Form 10-K, quarterly reports on Form 10-Q and in other filings with the Securities and 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 that is accurate only as of today's date, June 22, 2011. For this reason, and as a matter of policy, SONIC limits the archived 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 expressed written consent of the company is prohibited.

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

J. Hudson

Good afternoon, Pat, and good afternoon, everyone on the line. We appreciate your participating today, and I want to walk through our business in the recent past and then some discussion of it generally. Our business has improved over the past year, and we're pleased to be able to discuss the initiatives that have contributed to the improved performance, and also, give you a good sense of our outlook for the remaining part of the year and the things that will continue to drive our business.

So in the call, we're going to cover a number of topics, and this would include, as you can see here, an overview of the third quarter of our fiscal year 2011, a discussion of our strategic product and service initiatives that have played a key role in improved sales performance and initiatives that we've implemented to achieve, sustain -- achieve and sustained positive same-store sales and margin performance.

In turn, these things, of course, will drive the other components of our multilayered growth strategy and we'll talk through that. Also, Scott is going to provide an overview of our franchising revenue and the positive impacts of the ascending royalty rate that we have in our business, that's the second layer of our multilayered growth strategy. He's also going to talk about the development update, new store development in our business.

Steve Vaughan, our Chief Financial Officer, is also going to review then, the financial performance and also capital structure. So financial performance for the third quarter and our expectations for the remainder of fiscal year 2011.

Over the last year or 2 years, we worked to implement a number of new tools and also projects and integrate new management in some positions within our company. The product and service initiatives that we've implemented were designed to highlight the different or distinctive nature of our brand, both with respect to product and service differentiation that we've long offered, but also to establish a more solid foundation for improved performance in what are proved to be here in the last 2 or 3 years, much more challenging economic times.

So we're happy to report the initiatives that they're meeting our objectives and our sales have improved throughout fiscal year 2011. In the third quarter, the initiatives were complemented -- initiatives we'd had in the past were complemented by a very nice quality, distinctive promotion. This is their premium 6-inch hotdogs. They're offered at a very attractive price point. The line of hotdogs that we offered were introduced, I think, as a compelling value proposition for consumers, a really great-tasting product, nice service, obviously, associated with it. You get a SONIC good service experience at a very attractive price point. And as a result, our third quarter system same-store sales were particularly strong, almost 4%, up 3.9%, and our Company-owned Drive-Ins were much stronger at 6.5%.

The improved company drive-in performance continues to be one of the most impactful opportunities in the short term, something we've mentioned to you in the past with the sales and margin performance in the third quarter, demonstrating this. We are and will deal with external factors such as higher gas prices and low consumer confidence that may impact our business, but we continue to believe that the better positioning where we are today, we're in a better position to manage the factors that are external to our business, but not to manage our business against those external factors, and the initiatives we've implemented over the last couple of years. Because from our standpoint, with improved service, improved products, better tools that we're using to manage our business, new talent, both internally and externally, our brand and our business is in a better place than it was 2 or 3 years ago.

So we'll continue to refine and build on the strategic initiatives we've laid and in particular, as it relates to the drive-in level of execution and customer engagement, and our view is that these initiatives, combined with the new management and key areas of our business, will position our brand for success now and on a sustained basis.

So I want to talk a little bit about some historical growth drivers that have impacted our business. We've historically grown our business and shareholder value through a multilayered growth strategy, as we started building -- rebuilding the strength of our business, we started talking about this a few quarters ago. A multilayered growth strategy comprised of 5 key elements: Now the same-store sales and ascending royalty rate, operating leverage at the store level and in our company, higher return on capital and in new store development. And each of these components can drive a meaningful value to the bottom line and the components, all of them, each of them, were quite integral to our solid history of positive same-store sales growth and double-digit earnings growth before the recession.

So it is our view that each of these components are still important and relevant for achieving meaningful shareholder value growth over the next several years. And the most important element, the catalyst for driving improvements in the remaining layers continues to be same-store sales, and that's why we're very pleased, of course, to see a steady improvement in this year as the year has progressed, steady improvement in same-store sales.

Now the second layer of that, that I mentioned a moment ago, the ascending royalty rate, to highlight another distinctive aspect of our business is positive sales only result in increased revenues, but we get those revenues at an increasing rate that in turn, translates into a level of operating leverage and positive cash flow for our company. So that component contributed to our strong performance in this third fiscal quarter we just finished.

The third quarter, as it relates to operating leverage, the third quarter also highlighted the positive impact on that third layer, operating leverage. Positive same-store sales combined with effective margin management yielded a substantial improvement in operating margins. So thus, this multilayered growth strategy starts coming to life as positive same-store sales do as well.

The fourth element, that return on capital, so with respect to that, we successfully completed a refinancing transaction on attractive terms. It includes lower mandatory principal payments combined with -- when you combine that over time, that we would anticipate improved sales performance, this is going to result in increased cash flow, that we can then use opportunistically, to further increase shareholder value. The methodology that we used for a number of years, again pre-recession.

Now the other layer, the additional layer of new store development, continues to be an important component in the multilayered growth strategy. It's just one that's going to take a little longer to come into effect as we rebuild sales and profitability at the store level, and be more of a mid- to long-term play for us. We've expanded significantly over the last 5 years, with a presence now in 43 states. We saw plenty of unit growth potential available, and one system profits in sales is sustained period of improved performance, we expect that unit growth to accelerate in 2013 and beyond.

Now looking at 2011 and those growth drivers, of the 5 components that we see affecting our business, we expect to see the positive impact of 4 of those components in this business year. So as we look to 2011, there are 2 main drivers that are going to have that impact. The first is the company-owned store performance. And despite the fact that only 13% of our system is comprised of Company-owned Drive-Ins, their performance will have a disproportionate impact on us in a shorter period of time as their business continues to turn. The improved service and sales performance that we've seen recently, combined with improved profits, it has -- those things have the potential, the most meaningful near-term impact on stockholder value.

Separately, the system same-store sales would be the second driver that we expect to have the impact looking in this fiscal year. But over the long term, improved same-store sales will have the most meaningful impact on stockholder value, particularly as it relates to the ascending royalty rate and the system growth that we referred to earlier as other parts of the multilayered growth strategy.

With the system same-store sales of almost 4% in the third quarter, we saw the positive impact then of 3 of the 5 components of full -- in full effect, the same-store sales by themselves. The ascending royalty rate, in which we saw improvement in basis points in our royalty rate in the quarter and then the operating leverage. So a sustained positive sales performance combined with the favorable terms of refinancing, will yield strong results for us on our return on capital over time.

Now as to the Company Drive-ins, a number of company-specific initiatives have been implemented, including an added emphasis on customer service and skating, a reduction in the management layers between store operations and the corporate office and last year, new management compensation structure. So each of these have been holding -- are being implemented over time, not just in the last quarter but really over the last year or 2.

We focused on 4 goals for our Company Drive-ins. We have attained to one degree or another and also as others, we expect to attain over the next 1 to 3 years different degrees. First of all, we closed the gap between a service at Franchise Drive-Ins versus Company-owned Drive-Ins, and we now aim to achieve best-in-class service with the Drive-ins we own.

Secondly, we've closed the same-store sales gap, with Company-owned Drive-Ins outperforming franchisees for 4 consecutive quarters.

Thirdly, in this last quarter, we saw margin improvement in restaurant-level operating margins. And then fourth, with the Company-owned Drive-Ins, sales growth outperforming the other franchisees, we're working toward our fourth goal of narrowing the average unit volume gap between Franchise Drive-Ins and Company-owned Drive-Ins. That will be a progressive process as we're able to continue to grow the same-store sales disproportionately in company stores. That will be a progressive process, which we expect to take 1 to 3 years. And really, phasing toward the 3 years, we're not going to close that in a 12-month period. So over the next several years, we should be able to do that. Our Company-owned Drive-In team is very much committed to sustaining these first 3 goals and accomplishing the fourth over that several year period.

The revenue opportunity for our Company-owned Drive-Ins is very meaningful. To assess the potential impact of attaining those third and fourth components that I described earlier, even looked to the Company Drive-in volumes that we had in fiscal year 2007, because in 2007, our average unit volume was just more than $1 million at our owned Drive-Ins. So improving Company-owned Drive-Ins, average unit volume to $1 million will provide $45 million in corporate revenue, so we're pleased with the progress that we're making toward this goal and we'll continue aiming toward it.

Looking at the issue of margin opportunity, it's our view that with improved volumes, we can improve restaurant-level margins over the next few years and drive meaningful value to the bottom line for the stores and in turn, for our company. Accomplishing this may take 2 or 3 years, and it will be driven only by sales, but initiatives to more effectively manage food and packaging, as well as labor costs. And while we don't see ourselves returning to that 20% restaurant-level margins that we had before the recession, as a result of minimum wage increases in our investments in product quality, we think that returning to a 16%, 17% margin is achievable, and that third quarter experience that we had, we think, demonstrates the potential, because we had 240 basis point improvement in restaurant-level margins during that quarter.

From our viewpoint, the improvement reflects the leverage that we achieved a positive same-store sales but also, with effective margin management. So we also, in the quarter, overlapped or lapped over implementation of our new partnership compensation structure. We are very pleased with that, but we have, that is a year now since we implemented that to reduce management turnover, with the clear objective of improving customer service, and that improved customer service has occurred on a sustained basis, so we're very pleased with that result.

Now in the past, we talked about the value equation as we think about our business, and I'd like to spend a moment talking about that because our goal is to drive traffic, loyalty and check by improving that value equation for our customers. A consumer's perception of value, from our viewpoint, but I think you would agree, as a consumer is defined by the experience that you have overall, divided by the price you got to pay. What you get divided by what you got to pay.

And in fiscal 2009, as we talked about in the past, we spent more time on the denominator, the price piece of this, the introduction of our Everyday Value Menu and a number of other initiatives. But we began working simultaneously in that time period on some tools and initiatives to help us with a numerator. In fiscal 2010, we heightened the emphasis on numerator with initiatives to improve the customer experience like with skating car hops and the various product initiatives that we rolled out, new product news and new messaging. This year, we'll continue to build on that numerator, and we will, of course, as you would expect going forward, we're going to sustain our messaging emphasis on high-quality distinctive food and the fun spirit of SONIC Drive-In.

We based this on the belief that the elevated customers experience with the product and service differentiation will do more to contribute to sales and our earnings growth over the long run, more so, than simply offering food at a low price point. And our view is that the success of our new 6-inch premium beef hot dog is a good example of just this type of initiative.

Now I want to move to talking a little bit about other things that will help drive sales, and that has to do with operations execution. We've purposely developed and implemented initiatives that are aligned with the key strengths of the SONIC brand, providing a solid base for differentiating ourselves from other QSR players. Our view is that this positions us well for sustained positive performance over time.

The first component from our view of several for driving sales is providing consistent and high-quality customer service at the drive-in level. So we continue to see improved and sustained customer service scores for both Company-owned and franchised stores, and that's one of the reasons we're pleased, and it gives us some optimism about continuing momentum in our business.

That improved customer service, we've seen that and we've talked about this with you in the past in these conferences. Our overall satisfaction rate for Company-owned Drive-Ins moved from 59% in the fall of '08, November 2008 and moved from 59% to 78% for the quarter ended May 2011. Franchisees were operating at a different level as we again, yes but they too have improved materially moved from 69%, the fall of '08 to 77% in the quarter ending May 2011. So you can see how the implementation of our initiatives resulted in improved service over that 2-year period.

The system as a whole, has improved over the last 2 years, but Company-owned Drive-Ins have made disproportionate progress from underperforming franchisees to over, or at least, moving on par in operating with franchisees. So very nice transition for our brand, our business on a broad basis, company stores in particular, with particularly, a good news for our customers, because of what they can experience, what they get, when they come to SONIC.

Now shifting to high-quality products and the effect that the high-quality of products can have in our business, it is the second component from our viewpoint on sales-driving initiatives that we're putting in place, that is focusing on product quality with an emphasis on building, particularly, entree depth, more so than we've had in the past, narrowing our menu in many ways with entree depth with distinctive flavorful new products, focused on the entrees and also our Fountain and Frozen Favorites.

In all cases, we're moving to provide high-quality distinctive products with a unique value proposition in a total sense to our customers.

Now on this issue of entree depth, the March launch of this 6-inch 100% pure beef hot dog, sounds good, is a great example, I think, of how our emphasis has been on the numerator, that is the experience, the total experience that our customer has when they come on line, because with 4 different distinctive flavor combinations that we offered, the whole product line provided added depth to our hotdog line, and has the potential of growing traffic and checks at various day parts. So we're very pleased with the consumer reaction to this, and based on the test market results, we believe that this 100% pure beef hot dog would drive increased frequency and attract new customers both.

The fun thing is the dogs are driving transactions, traffic on the line but also transactions lunch, afternoon, dinner. It's across a variety of day parts, not just mealtime. And we have given the Drink business that we've had for a long time, we still have a fair number of drink-only orders. So this $1.99 dog is a very nice add-on, and has been very positive in the afternoon, giving us the potential of increasing check during that day part in particular.

So we'll continue to incorporate new product news around these products, I'll talk little bit more in a few minutes about the Baja Dog that we'll be showcasing in July. And that's Baja so we'll use that promotion to focus on driving traffic in combination with other new traffic, other new product from promotions just like the Loaded Burger promotion using each 2 out, in some cases drive traffic, other cases drive check. And our ability to use these different types of promotions based on consumer environment and consumer sensitivity and the work we've done on quality, pricing, and the value equation to prove our business, these combinations of things over the last few years, we think play well to our varying needs now.

It should also give you the sense of how the degree to which we have followed through on this emphasis on entrees and in building lunch and dinner day parts, where we believe we've had opportunity we've not capitalized on the last few years. Combined with the various improvements in our business, at this point, when you look at the items that we have improved on the menu, they make up about 1/2 of the sales with an average SONIC Drive-In. So a substantial improvement in quality, substantial step-up in quality improvements in items on our menu, the food items in particular.

Now on the Frozen and Fountain side of our business, we'll continue to innovate and emphasize this side of our business. It's a big part of our business, has been historically, will be going forward. This month's double stuffed OREO cookie Blast is an example of continuing new product news and fun elements with that business, and we will work to continue to build that going forward.

Now we've talked over time also about evolution of our business from a customer engagement standpoint, and we view this as kind of the third sales-driving initiative we've been focusing on this fiscal year, including everything from a messaging, the mediums we use to the products we promote. With a stronger foundation in the service and the products that we've put in place, what our focus will be going forward to place additional emphasis on engaging the consumer more efficiently and effectively. Over the last 6 months, we've been working to establish a portfolio of vendor partners to enhance various aspects of our marketing program from creative messaging to also optimizing media resources.

And these new vendors and their work, in our view, complement and build on the foundation that we've established to strengthen the brand by building awareness as SONIC's differentiated position in the QSR business, with high-quality products and personalized service. In addition, we expect that we'll continue to appeal to customers with our new product news, emphasizing distinctive food and drink flavor combinations.

This moves us to a recent initiative, that one of those vendors worked with us very closely on, that is a new menu that we're rolling out across the system. We work on this with one of our new partners that is Euro in their Chicago office. Euro is the largest direct and digital network in the country, and they're responsible for our menu design and online promotional material. They've been working with us on this new menu, which was implemented system-wide this month, earlier this month, and this new menu is focused on achieving these 3 things: First, from a design standpoint, it was intended to emphasize our food and beverage strengths and the uniqueness of the brand. The second point is intended to be a simpler menu, it will be easier for the customer to navigate, and if you're familiar with the Sonic drive-in menu, I think just looking at this, the use of colors and layout presentation will take you there and have the customer focus on the depth of product lines rather than just the wide variety.

Also it's intended to optimize the price points within certain product categories, and I think with some of the changes in the menu in the laddering of elements of our products, it takes us a long way there. Those 3 elements are the result of a lot of work and testing that we've done to determine not only what the best product mix would be for our menu, but also the optimum price points.

Now in a manner a little different from our prior practices, I'd like to spend a minute talking about the momentum of our business as of late, late in the last quarter and the early part of this current one. I mean during the month of June, our summer and fourth quarter. So we're just talking about a few weeks here, but given some of the feedback we've received regarding May and June sales, it felt to us that we ought to offer this perspective. So some of this and we'll put this in context and it may be a little redundant, but I think it's important to place this in context. Because one of the things that we've said for the better part of last year is that we're trying to build entree depth in our business. Over the years, it's our view that we've really done a very good job of building our Drinks and Ice Cream business, and at this point, we have an opportunity to strengthen all of our business, but particularly, the mealtime day parts.

So in the last few months, we've begun additional product focus on entrees in our promotions. And this includes increasing the size and quality of our Footlong Coneys, our hamburgers, and you know these things and these are the things we did in 2010.

This spring, we've rolled out the 6-inch dogs and followed this with our Loaded Hamburgers. The objective we have with each of these has been to build a path to a stronger Lunch and Dinner business, and we're confident that we're beginning to achieve this as we look at the mix that's occurring. Along the way, we're also working to refine the role of value just as we've talked about it here. What you get, what you pay, so including the role that laddered pricing and product line extensions will play in our promotions.

The one consequence of the meal and entrée focus is that our Evening business has been slower in the recent past than it was a year ago. So we're focusing on lunch and dinner in particular, and our Evening business, after 8, got slower than it was a year ago. A year ago, we placed a lot of the resources behind promoting the buy 1 get 1 free ice cream shake, that's what we did last year. And while the promotion was successful in driving traffic, it carried a pretty steep discount, buy 1 get 1 free, and negatively impacted margins. So we're not offering that promotion this year. And as a result, our business after 8:00 has become much more sluggish than it was a year ago, and much more sluggish than any other day part this summer.

The evening day part has been a primary contributor to the slowing of our business in the last few weeks. Last year, by the way, the buy 1 get 1 promotion ended at the end of June. So we'll continue to focus on building both traffic and check in our business using these attractive pricing -- price points along the way and laddering so we'll also have the full price with entrees. The purpose is to provide a path to a different place in terms of lunch and dinner sales and in turn, build average unit volume and profit for the average SONIC Drive-Ins. Our view is that what I've described to you, described is a current dynamic, amongst our day parts we're experiencing this moment, and that we also believe that this is the strategy, it's part of the strategy that will help our business to another level, and we'll find a mix over time that we can use at different parts of the year to use the promotion of different products, different prices, that fit various day parts to drive our business on the whole.

In the month of July, we'll shift our promotion, I made reference to this earlier, we’ll shift our promotion to another 6-inch hot dog that has new cheeses and flavorings, as the reference I made to the Baja Dog. It will be featured with a line of this other 6-inch dogs we rolled out previously. They'll be priced at $1.99 and backed by national media, and that comes out roughly with the move to July.

In addition, we'll have a new line of Real Ice Cream shakes along with those specific efforts aimed at driving deals, afternoon and evening day parts with these varied products. So with these initiatives and with the business as we see it, we expect sales to be positive for the fourth quarter. So one of the things I'd offer, we've got -- kind of gone through this unusual process here, I think of talking about how the business has transitioned late quarter into the fourth quarter. Usually, I think we gave you feedback to say, "Look, we'll give you the third quarter, we're not giving to give you the fourth quarter. But given the amount of feedback that we've had regarding the May, June sales, we thought we should offer this perspective." So when we finish the presentation, we're fairly confident that a number of people are going to say, "Well, give us the information about June? What are the sales?" And so I'm going to tell you right now, that what I've given you in this explanation is the explanation, and so as it's asked again, that will be the explanation again, but I won't go through the whole thing again.

So in conclusion of this kind of this review of the business here, our internal focus in 2011, as you would expect, remains on sustained improvement in our Company-owned Drive-Ins, in addition to the successful implementation or refinement of the strategic initiatives we began last year, all aimed at driving improved results, store level and in turn, as you would think, for our company.

The results year-to-date reflect that momentum, and while there are a number of external factors that have been the source of much focus over the last number of months, gas prices, continuing consumer confidence issues, unemployment, these things will, of course, have an impact on our business, but we'll remain focused on building the business to adapt to the consumer concerns, particularly in affecting this value proposition.

Our business and our ability to generate consistent, more stable results, are stronger today, as a result of the initiatives we've put in place over the last couple of years. In our view, our progress and future success won't result from any one initiative or any one promotion, but rather, a series of these, as they are effective, aligned initiatives that build our business, build our brand, showcases the differentiated nature of our concept.

And the improvement of Company-owned Drive-in and sales of system wide sales -- both in Company-owned Drive-In sales and systemwide sales can have the most meaningful impact on shareholders the next few years. Unit growth is still an important part of our story and it will be, that will have more meaningful impact in the next several years, 2013 and beyond after we're able to sustain improved sales and profits.

In addition to these sales initiatives, the recent completion of our refinancing provides a firm capital structure for our business in our view, favorable terms that we've received such as I've mentioned earlier, the reduced mandatory principal payments, the ability to pay proportion of our debt without a repayment premium. This will help our return on capital over the next several years.

With that, I would like to turn it over to Scott McLain. He's going to give us on update on franchising -- franchise revenues and also new store developments. Scott?

W. McLain

Thank you, Cliff. Our Franchise business remains solid, with positive same-store sales, translating into a $2 million increase in franchise royalties for the quarter. Since this incremental income has very little associated costs, it was a significant factor in our earnings growth both for the quarter and for the year.

Part of the growth in franchise royalties was due to an increase in the average royalty rate, resulting from our unique ascending royalty, which as Cliff mentioned, is a key part of our multilayered growth strategy. This feature should allow us to continue to get a disproportionate increase in royalty as our sales continue to grow.

Our franchisees were certainly pleased with the increase in sales, but equally, if not more important to them, has been the growth in store level profits, which have risen by roughly $6,000 per drive-in this year despite record pressure on commodity costs. This improvement has served to buoy their overall confidence in the business, which is the single biggest factor and their willingness to continue investing capital.

Our franchisees opened 12 new drive-ins during the third quarter, and completed rebuilds or relocations on another 4 drive-ins. We ended the quarter with 3,559 total drive-ins in 43 states, and we continue to be on pace for approximately 40 new drive-in openings this fiscal year.

We continue to see strong opening volumes from new drive-ins across all of our markets, particularly our newer markets. We opened our first drive-in on Long Island during the third quarter, and it's already surpassed $1 million in sales in less than 60 days.

We're also encouraged to see some of our new market drive-ins and new markets in general, beginning to show positive same-store sales in recent months. We've been working with our new media and menu agencies to implement new messaging strategies to foster ongoing brand awareness and usage to ensure we better sustain the strong opening volumes we're experiencing in newer markets.

We closed 6 drive-ins during the third quarter, less than last quarter and less than the same quarter a year ago. We continue to actively evaluate our lower volume drive-ins, and we do expect that additional closings will occur. However, at this point, we expect the magnitude of those closings to be consistent with what we've seen over the last couple of years. Although our rate of closings has increased somewhat, we believe that still remains relatively modest, given the tenuous current economic environment and the fact that we're a 57-year-old brand with more than 3,500 stores.

While some of our franchisees are experiencing financial challenges as a result of sales and profit declines, their overall fiscal health remains sound, with some of our long-term franchisees expanding their base. As our franchisees have begun to see our initiatives have an impact on their sales and profit, their future outlook has improved considerably. They're as passionate as ever about the SONIC brand and the strategic initiatives we've implemented. We fully expect the continued improvement in sales and profits will translate into a renewed emphasis on new drive-in development.

However, given the 12- to 24-month development cycle, it will likely be several quarters before we begin seeing a market increase in new drive-in openings and for the development portion of our multilayered growth strategy to become a major factor in our earnings growth. Now I'll turn the call over to Steve Vaughan, our Chief Financial Officer.

Stephen Vaughan

Thank you, Scott. For our third quarter of 2011, we reported $0.08 per share loss. However, excluding the $28.2 million loss recorded as a result of our refinancing transaction, our earnings would have been $0.21 per share. On adjusted basis, this represents a 40% increase in earnings per share. This growth highlights the disproportionate impact, growing our average unit volumes in both franchise and Company-owned Drive-Ins can have on our earnings.

I'll provide more color on the key line items of our income statement over the next few minutes. However, we are very pleased with the progress we have made on improving same-store sales and the positive impact it is having on our business.

Overall, operating income margins were favorable in the third quarter, with the leverage from higher sales more than offsetting higher food and packaging costs. This improvement demonstrates the leverage that is possible with solid sales growth, particularly at our Company-owned Drive-Ins. As we have done previously, in order to compare overall restaurant operating margins on an apples-to-apples basis, we combined the noncontrolling interest line with Company-owned Drive-In cost of sales.

Taking into account the change in the partner compensation program, our restaurant-level margins improved 240 basis points during the third quarter. This improvement is primarily driven by strong same-store sales growth at our Company-owned Drive-Ins.

Looking at each individual line items, food and packaging costs were unfavorable by 50 basis points, driven primarily by product quality investments and higher beef and dairy costs. Despite these cost pressures on food and packaging costs, we're better than we had expected due to less discounting and slightly more aggressive price increased timeline than we originally planned, and a favorable mix shift attributable to our introduction of the new hotdog product line.

We expect continued pressure on this line item in Q4. However, we will lap over a significant portion of our product quality investment this quarter and now, estimate the unfavorable variance in the fourth quarter will be approximately 50 basis points. We implemented a price increase of approximately 1.5% at our Company-owned Drive-Ins around the 1st of April. We also took a small increase in price when our new menus were rolled out earlier this month. These increases will put our cumulative pricing at approximately 2% for the fourth quarter. We do not anticipate taking any further price increases until at least next fall.

Payroll and employee benefits, inclusive of noncontrolling interests, which reflect the shift in expenses from noncontrolling interest to labor and benefits under the new partner compensation program implemented in April of 2010, showed significant leverage during the quarter. As we expected, the higher fixed component of manager compensation allowed for significant leverage during our seasonally stronger third quarter. These costs are now relatively flat on a year-to-date basis.

Looking to the fourth quarter, we believe labor costs will be favorable as a result of positive sales trends and more efficient labor practices, combined with no federal minimum wage increase. The extent of leverage will depend upon the degree to which we are able to sustain improvement in our sales same-store sales trends.

Other operating expenses were favorable by 120 basis points, primarily reflecting leverage from the 6.5% same-store sales growth Company-owned Drive-Ins. Looking forward, we expect to see continued improvement in this line item, again depending upon the degree to which we are able to sustain positive same-store sales.

During the third quarter, SG&A expenses were relatively flat. We have continued to manage this line item carefully over the past year, which has allowed us to show further operating leverage as sales trends have improved. Looking forward, we expect SG&A to be approximately $17 million to $18 million in the fourth quarter, as we continue to invest in resources to drive our business.

We were very pleased to complete the successful refinancing of our securitization debt during the quarter. While the refinancing resulted in a net charge of approximately $28 million, primarily related to a make-whole premium for early repayment of our debt, our capital structure is now well positioned for the next several years. We issued $500 million of 7-year fixed-rate notes, with a stated interest rate of approximately 5.5%. Including the loan origination costs, the effective interest rate will be approximately 6% for this portion of our debt. Our mandatory principal amortization going forward will be $15 million per year. This is much lower than our retired notes and provides us with a significant amount of flexibility in terms of excess cash available for opportunistic shareholder value-creating initiatives, which we will pursue on an opportunistic basis.

We also entered into a $100 million 5-year revolving credit facility. We initially drew down $35 million of the available amount. However, subsequent to the end of the quarter, we have paid off all but $5 million of this facility, leaving us $95 million of available borrowing capacity. This unused balance leaves us great deal of flexibility going forward. We continue to have a solid balance sheet and exceed our debt compliance covenants by a wide margin. We anticipate this compliance will continue into the foreseeable future.

Our business model is first and foremost focused on franchising. This is a distinct advantage from a return on capital perspective. Cash flow was more predictable and stable, while our capital expenditures are minimal, with an estimated $20 million to $30 million in annual CapEx requirements. The recent refinancing we completed further enhances our available cash flow with only $15 million in annual principal payments, we expect to generate a significant amount of excess cash flow. We plan to use this cash opportunistically to increase shareholder value.

Using our FY 2010 performance as an example, under the new debt terms, we would have had approximately $40 million in cash flow after CapEx and mandatory principal payments.

Another positive feature of our refinancing is the ability to pay down up to an additional $175 million of our debt at par. We believe our franchise business model, combined with an attractive and flexible refinancing structure, will allow us to improve our return on capital and increase shareholder value over the near and longer term.

As Chris stated earlier, we are pleased with the sales improvements we saw in the third quarter. While we may continue to see some choppiness in our sales due to external challenges, we believe the improvements we have made to our business will help us sustain positive same-store sales going forward.

For the fourth quarter, we expect positive same-store sales in the low-single-digits, approximately 15 new Franchise Drive-In openings, bringing openings to the year to 40; slightly favorable restaurant-level margins, reflecting increased commodity costs and investments in product quality, more than offset by efficiencies from labor costs and other operating expenses. The improvement will depend upon the degree to which same-store sales are positive. SG&A expenses in the range of $17 million to $18 million, depreciation and amortization expense of $10 million to $10.5 million; net interest expense of $8 million to $8.5 million and capital expenditures of $7 million to $9 million.

We are pleased to see the positive momentum in our business, and as Cliff stated earlier, we anticipate seeing positive same-store sales in the fourth quarter. I'll now turn it back over to Cliff for a discussion of a longer-term outlook for our business.

J. Hudson

Thanks, Steve. So our business, I think, it's fair to say it's stronger today than it was 3 years ago, as a result of pricing, service and price initiatives we implemented. Our positive same-store sales in our business are driving a layer into the multilayered growth strategy that we've talked about in the past and sort of laying out in the last few quarters. The third quarter is the perfect example of this.

We expect the various layers in the strategy to build shareholder value in different ways in the near term and in the long term. You can see that same-store sales growth is the primary engine that drives results for the remaining leverage. And for fiscal year 2011 and '12, we expect that the sales growth is going to drive the ascending royalty rate and operating leverage and the return on capital. And our most recent debt purchase helped the return on capital as well.

Now as it relates to development, as we've discussed before, the development is an outcome of positive sales and profit, and we still have a lot of room for growth as sales and profits stabilize and improve for sustained periods of time, we anticipate then that development will follow. And as a result -- as a result of the time involved in building a new store, the development pipeline is going to take anywhere from 12 to 24 months, once we initiate and once we reach that path of positive same-store sales on a sustained basis.

So at this reason, we expected that development will drive shareholder value, but it's going to be more of a long term and this will begin to pickup in 2013 and beyond. So this concludes our prepared remarks, and we'd be happy to answer, at least happy to accept any way, any other questions.

Question-and-Answer Session

Operator

[Operator Instructions] We'll take our first question from Jeffrey Bernstein with Barclays Capital.

Jeffrey Bernstein - Barclays Capital

Actually just Cliff, one clarification on your prepared remarks and then a question. You kind of went into a lot of detail on more current trends and we appreciate the color. I thought you had alluded to that you’d openly provide the color in terms of what May and June was looking like. I know you had preannounced 4% to 6% system comp in March and April. It seems like it would've fallen off in May, and it seems like that was the language you were using. I was wondering whether we can get more color in terms of the actual May in trends, and then I had a follow-up question.

J. Hudson

I think we've given you the explanation for what we did describe as some softer sale, driven by the evening and primarily, we'll leave it at that.

Jeffrey Bernstein - Barclays Capital

Okay, my misunderstanding then. And then just kind of broader question, you talked about the balance sheet and greater flexibility, greater short-term free cash flow. And on a number of occasions, you've alluded to enhancing shareholder value. Just wondering whether you can give some directional thoughts or bigger picture thoughts in terms of how you might go about doing that with all those excess cash?

J. Hudson

Well, what we have done historically in the period of time where we've had sustained positive same-store sales with the cash generated, we have used that cash opportunistically to best drive shareholder value, and the opportunistic path were to repurchase stock. At times in the last several years, we repurchased our outstanding debt, and also to acquire franchise stores. Those are the 3 primary uses we made of it, and I think we have used it prerecession, pretty effectively over time to drive shareholder value. So that's the context in which, I think you should take that comment now.

Operator

We'll take our next question from John Glass with Morgan Stanley.

John Glass - Morgan Stanley

First, just if you could talk about the 6.5% company comp, how much of that was transaction growth? And how much of it was just better mix because of the products? And more generally, could you address the issue of the tension between your desire for value and also driving better mix and higher margins to just higher ticket items? It seems like that's been a tension for a while now and you're revisiting it with the late night falling off with the -- without promoting the same item you did a year ago. What's the best way to extricate yourself from that? Is it just to let it run its course this year so you don't have any unfavorable promotional comparisons? Or do you plan on addressing this shortfall dinner and late-night period by re-promoting an item later this summer? How do you plan on addressing that specific issue?

Stephen Vaughan

Yes, so the first part of your question, John, about 4.5% to 5% of that 6.5% came from traffic. So the vast majority of it was traffic-driven, and we did have positive checks, which was a nice benefit as well from the hot dogs. As Cliff mentioned, we saw a nice add-on with those, that new product line has introduced, and so we attribute a lot of that benefit to that product line.

J. Hudson

The second portion of the question, to make sure I captured all of that, but I picked up that your question was, what would we think about is that from a promotional standpoint as summer progresses to address the evening sluggishness? So in response, I would say part of this will be from a promotional standpoint, the nature of the promotion at the end of the month, we will have Real Ice Cream shakes with new flavors, which you'll see in the immediate future. And with the promotion of those, to attempt to drive that business, it's not just an evening thing. Because in fact, we sell shakes across the series of day parts, but it is intended to focus on that aspect of our business during the period of time where it's more heavily used, and that is summer time. We are focusing on some other initiatives, particularly with the sluggishness of the evening, which I don't care to lay out right now, because we haven't -- because we haven't pulled the trigger yet and I'd rather pull the trigger and then talk about it, so.

John Glass - Morgan Stanley

Okay. I guess my question was around do you feel like you need to – are those shakes at a discounted promotional price? Were they full priced items and than just advertised? It seems like last year, you were getting some traffic because you're using your promotional price point.

J. Hudson

Yes. A year ago, I mean, the biggest focus, we were moving to Real Ice Cream, we're trying to get people, as we moved to Real Ice Cream in May, we're trying to capture a lot of attention and usage. And so we'll use varying methodology going forward. But the primary thing we will be focusing on is the quality of the product, and we'll use discounting selectively as we believe it can be of assistance.

Operator

We'll go next to Larry Miller with RBC.

Larry Miller - RBC Capital Markets, LLC

I have a couple of quick questions. You guys alluded to some other margin management opportunities. Can you talk more about that? Can you size it for us in basis points and exactly where those opportunities exist?

Stephen Vaughan

Yes. I think in terms of additional margin opportunities, we see a couple of key areas there. One would be further implementation of our supply chain management. Company-owned Drive-Ins have really done a good job of implementing the ideal food costs, which you saw kind of a payback of that this quarter. And we are continuing to roll that out system wide. So we think our franchisees will get some additional future benefit from that. The other area that we're more early on in is labor scheduling and the opportunity to manage that more efficiently. And again, I think on the company-owned side, we've been able to drive that with some manual tools, which again, we saw the benefit of that this quarter. But we are still working on developing that in a more systematic way and think that will be a big benefit to the entire chain as we look out 12 and 24 months.

Larry Miller - RBC Capital Markets, LLC

And can you guys also talk about some of the feedback that you're getting on this new marketing campaign? Have you been able to measure it? Is it meeting expectations? And the same with the menu board that you just rolled out?

J. Hudson

Well, the menu board, we tested another circumstances before utilizing and received positive feedback, both as to more limited items on the menu, as well as the menu layout itself. We're in a limited time that it's been out, we're feeling good in terms of what we're seeing from a customer feedback standpoint. And particularly, and also from the standpoint of positive check, which it does seem to be helping with in the short time it's been out. Now as it relates to the creative, a good part of that is relatively -- well, it's all quite recent. And so in terms of impact on the business and customer reaction, we're going to need to give that more time to get a sense of that. The testing that we have done with it before rolling out in terms of breakthrough and customer response from is more in a quasi-laboratory setting, has been very positive versus our traditional approach to the advertising. But some time, will be the test of that as to whether both as a breakthrough the messages that our competitors give and whether it's a call to action and drives the people online.

Operator

[Operator Instructions] We'll take our next question from Brad Ludington with KeyBanc Capital Markets.

Brad Ludington - KeyBanc Capital Markets Inc.

I just had a quick clarification and then a brief question with that. On the clarification part, you talked about the higher royalty rate. And it's always higher than the full year in the third quarter, so are you implying that the full year will be higher? And then the question is just on your value menu. Is the mix holding up since you increased some of the prices over $1? Or has that mix turned down a little bit?

J. Hudson

Well, as to your first question, because our volumes are higher in the third quarter, we would likewise expect our royalty rate to be higher in the third quarter relative to other quarters. And I think our average royalty rate is up for the year. It was up sharply in the third quarter, and I think it's up just slightly year-to-date. And if we have positive same-store sales in the fourth quarter, which we fully expect, then the same will be true for that quarter as well. So in terms of the value menu, we did make some changes to the value menu as we rolled out the new menu. But we have only had the new menus in for a very short period of time so we don't have enough information to give you feedback on that.

Operator

We'll take our next question from Keith Siegner with Credit Suisse.

Keith Siegner - Crédit Suisse AG

I just wanted to follow-up on the gross margins actually, which came in quite a bit different from what we were looking for, for the quarter. And with unfavorable 50 basis points and Steve, you mentioned how there's a little less discounting, a little more pricing and some mix shift. Less discounting presumably, you had some idea that would probably be the plan. More pricing was implemented at the beginning of the quarter so that presumably was in the original guidance as well. And I'm a little confused about mix shift because it sounds like the hotdogs did great, but maybe I was wrong, but I thought they had a slightly lower gross margin. Just if you could just give a little bit more color around the variance between the food costs and the original guidance, that'd be helpful.

J. Hudson

Absolutely. So a couple of things, Keith. Number one, the pricing was implemented in early April, so we did not anticipate -- well, at the time, we were debating whether we were going to take it in early April or late and do it with the new menu. We made the call to go ahead and take it in early April with the old menu at our Company-owned Drive-Ins, so we did move that up a couple of months earlier than when we were giving our guidance. And on the hotdogs, a couple of things. Number one, we -- the mix of the hotdogs, we actually, there's a pretty wide variety in the gross margin of those products. And so the blended mix on the 4 new hotdogs came in with a little better gross margin than our overall averages. So I think from an overall perspective, it came out a little better than we thought it might. And so we felt very good about where the quarter came out, even though it did come out quite a bit better than what we expected going into the quarter.

Operator

We'll take our next question from Sharon Zackfia with William Blair.

Sharon Zackfia - William Blair & Company L.L.C.

I don't want to belabor a point, but just on the after 8 p.m. business, as you're lapping the BOGO, is that your expectation then that that business picks up after you fully lap that at the end of June? And did you say that the other areas of the business or the other day parts are holding pretty steady? I may have missed that.

J. Hudson

Well, in a reverse order, we did address the other day parts. What we did say and I'm going to avoid getting into this by day part, what we did say was that the big contributor, the biggest contributor to some softness coming out of the fourth quarter into this quarter is the evening. So I'll just leave that as it is. And that was in -- look, the purpose in stating that was the background noise was a lot about hotdogs to hamburgers, and so we want to make clear that to the extent there's some softness, it is because of the evening. So that's why we're focusing on that point. As to your other point, would we expect -- I mean that is our expectation, that as we move into the summer, with a promotion that works for us, a variety of day parts, meaning from an ice cream standpoint, meaning the shake and it may have broader usage in this environment, meaning a little cheaper cost and so on than a Blast, that the effect of this could be to help that item. And in turn, that day part and from that standpoint, the mix of dogs promoted $1.99, gets traffic, got the special shakes. The mix of these, the dynamic that you'll see from a customer standpoint will yield better results than what we have seen this month, June versus a year ago June.

Sharon Zackfia - William Blair & Company L.L.C.

Okay. And then Steve, it's just been a long time since we've seen consistently positive same-store sales. So if you could remind us kind of what you're comp breakpoint is to see leverage on the restaurant-level P&L?

Stephen Vaughan

Well, I think it's pretty -- at this point in time, it's pretty low because we -- at our Company-owned Drive-Ins, we've got some of the initiatives from a control standpoint that are working nicely. So for example, the ideal food cost program, that was a mitigator of the cost increase but then also, better labor scheduling controls. So Sharon, really, to the extent that we have positive same-store sales, I would expect to see immediate kind of flow-through and then improvement in margins.

Operator

We'll go next to Nicole Miller with Piper Jaffray.

Nicole Regan - Piper Jaffray Companies

Back on the pricing, I just want to make sure that the price you took in April, I think, exiting the second quarter is about 0.5% price. And there was the fact of taking an incremental 1%. So since April then is the price you're running about 1.5%?

Stephen Vaughan

Yes. So we were running 1.5% in April and May, and then our new -- when our menus went up earlier this month, and that was kind of stays in the first couple of weeks of the month, we added an additional 0.5%. So now, we'll effectively be running about 2% for the fourth quarter.

Nicole Regan - Piper Jaffray Companies

And that carries, into next year until it starts rolling off again in the summer then?

Stephen Vaughan

Yes, it will start rolling off in the spring really next year.

Nicole Regan - Piper Jaffray Companies

Spring rather in April, okay.

Stephen Vaughan

Yes.

Nicole Regan - Piper Jaffray Companies

And I'm just going to ask a question in fact, to just to make sure I'm understanding this the right way, so I apologize. But the dinner business being soft, is it because this new pricing platform is working and you're bringing people in at different times of the day, because there's different entry price points? And as soon as you improve the frequency of those loyal guests, and they start coming for that snack hotdog and back for dinner, this all evens out in terms of both traffic and margins. Is that correct?

Stephen Vaughan

Yes. I mean, we really didn't talk about dinner being soft, Nicole. We're really talking more about evening.

Nicole Regan - Piper Jaffray Companies

So after dinner?

Stephen Vaughan

Right. We could call that after 8:00, I guess, it's really an evening business. So I'm not sure. Can you -- so what's your...

Nicole Regan - Piper Jaffray Companies

I guess we're just asking why after 8:00? Why? And I guess it's just lapping some of the promotions in the prior year?

J. Hudson

Yes, that's the big part of it.

Stephen Vaughan

That was much more aggressive promotion last year it ended at the end of June last year. We are coming out with this new line of shakes, and so I think looking to July and August, we'll have an easier comparison on that evening business, and then we've got this new line of products. So we feel good about what we have laid out.

J. Hudson

If we're able in the recent past, I mean we've done a good job, we've done a better job as we have the Loaded Burger et cetera with check. And spring we did a better job with traffic. July, we'll come back with a new dog and we'll have their whole line of dogs, with the Baja Dog as well, and it will be at $1.99. The hope and expectation, we'll have to see if it will, plays out, it will have a better drive of traffic. Then we'll also have a new line of shakes that is a good add-on when they come online. And that's all how shakes are handled. I mean, people may come to get a shake, but it's often something they add-on when they're there. So we'll have to see if the blend of these work, July forward, but we'll -- I mean, this is our basis for saying we expect that some improvement as the quarter goes along.

Nicole Regan - Piper Jaffray Companies

And just so, maybe you already said this, but just so we're on the same page, what was the actual timeframe of the promotion last year? So we know when you started lapping it and when you stopped lapping it?

Stephen Vaughan

The BOGO shake?

Nicole Regan - Piper Jaffray Companies

Yes.

Stephen Vaughan

It was mid-May and May to the end of June. So we promoted it for 6 weeks.

Operator

We'll go next to Rachael Rothman with Susquehanna International Group.

Jake Bartlett - Susquehanna Financial Group, LLLP

This is Jake Bartlett in for Rachael. I was wondering, there's kind of a lot of moving parts here with the COGS. If you could kind of break it down to just food cost inflation, what you saw in the third quarter, what you expect in the fourth quarter? And then we're getting pretty close to 2012 here, if you can give an idea of what you have locked in and what your expectations are and just for overall inflation? That would be helpful.

Stephen Vaughan

Okay, yes. So food cost inflation for the third quarter came in a little lower than we expected. Again, this was related to somewhat to the mix shift. I think we ended up somewhere between about 5% and 6%. That includes the product quality investments. We expect that in the fourth quarter, that will be a little bit less. So it's going to be higher year-over-year but slightly less. And we have, for the most part, everything is locked in at least through the end of the fiscal year, with the exception of V. Now V, we have kind of a collar around the cost of that and so we don't expect that, that's going to be going any higher in the fourth quarter. It could actually come down so we feel pretty good about where we're out on V. And then ice cream is the other area that we're still kind of in the cash market on. So those are the 2 items that we have some potential in the fourth quarter. In terms of outlook for fiscal 2012, we will update -- we're in the process of kind of going through our budgeting process. But we have a number of items. The contract will be renewing on either September 1 or January 1, 2012, September 1, 2011. And so we'll get more color on our outlook for 2012 in the next few months.

Jake Bartlett - Susquehanna Financial Group, LLLP

So in terms of in larger contracts like chicken, can you just remind us what your -- how far out you're contracted?

Stephen Vaughan

Yes, so chicken's about 10% of our cost of goods, and it's locked in through February of 2012. Our cola contract is a long-term contract. It adjusts on January 1 of each year. Generally, we see low-single-digit kind of inflationary type adjustments to that contract. I mentioned the cheese. We are locked in 75% locked in, I think, through the end of the fiscal year. We have a little bit of cash price exposure on cheese, but not much. So combined, I think cheese is about 5%, ice cream's about 7%. I talked about ice cream and then it drops off quite a bit. I think the next biggest item would be potatoes, so fried products. And those will renew, I think, in September 1. So September 1, so that's a big open question mark right now in terms of renewal. And so we'll -- those are the key items and we'll give you more color around the 1st of September.

Operator

And with no further questions in the queue, I would like to turn the call back to Cliff Hudson with any additional or closing remarks.

J. Hudson

Well, we appreciate your participation in the conference call today. And we look forward to visit with you along the way as to these -- continuing these new initiatives, continue to play out. And we do see our business in a different position versus where it was 1 and 2 years ago, a much better foundation laid. We appreciate your continuing interest in the development of business. We look forward to talking to you about it along the way. Thank you very much.

Operator

This does conclude today's conference. We thank you for your participation.

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