Sonic (SONC) Q4 2016 Results - Earnings Call Transcript

| About: Sonic Corp. (SONC)

Sonic Corp. (NASDAQ:SONC)

Q4 2016 Earnings Call

October 24, 2016 5:00 pm ET

Executives

J. Clifford Hudson - Sonic Corp.

Claudia S. San Pedro - Sonic Corp.

Analysts

Matthew DiFrisco - Guggenheim Securities LLC

Nicole Miller Regan - Piper Jaffray & Co.

Will Slabaugh - Stephens, Inc.

Sharon Zackfia - William Blair & Co. LLC

Brian Bittner - Oppenheimer & Co., Inc. (Broker)

Brett Levy - Deutsche Bank Securities, Inc.

John Glass - Morgan Stanley & Co. LLC

Alexander Russell Slagle - Jefferies LLC

Jeffrey Bernstein - Barclays Capital, Inc.

Joseph Terrence Buckley - Bank of America Merrill Lynch

Operator

Good afternoon and thank you for standing by. Welcome to Sonic Corporation's Fourth Quarter Fiscal Year 2016 Earnings Call. As a reminder, today's presentation is being recorded.

Before we begin, I would like to remind everyone that the comments made during this conference call are not based on historical facts and 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 on the company's Annual Report, Form 10-K, Quarterly Reports on Form 10-Q and in other filings with the Securities and Exchange Commission. The company would like to refer you to those sources for information.

Lastly, I'd like to point out that the remarks during this conference call are based on time-sensitive information that is accurate only as of today's date, October 24, 2016. The archived replay of this conference call will be available through October 31, 2016. This call is the property of Sonic Corporation. Any distribution, transmission, broadcast or rebroadcast of this call in any form without the expressed written consent of the company is prohibited.

The company has posted their fiscal fourth quarter earnings slide show presentation in the Investors section of their website for you to review, both during this conference call and after this conference call for up to 30 days. They have also scheduled this call, which includes a question-and-answer portion, to last about one hour. If they have not gotten to your question within the time slot, please contact Corey Horsch at 405-225-4800, and he will make the appropriate arrangements to answer your question.

I would now like to turn the conference over to Mr. Cliff Hudson, Sonic Corporation's Chief Executive Officer. Mr. Hudson, you may now begin.

J. Clifford Hudson - Sonic Corp.

Thank you Catherine and thank all of you all for joining us today. Today we're going to talk about the highlights of the quarter. Talk about – a bit about how our business evolved since the Great Recession, outline now where we believe we're headed for the next several years. And then we'll wind up by walking through outlook for 2017 and taking any questions you may have.

So first, you see pictured here the earnings growth per share grew 17% for the year and 5% for the fourth quarter. The quarter was impacted by lower-than-expected same-store sales and the resulting operating deleverage.

For the quarter, same-store sales fell 2% versus a 4.9% increase in the fourth quarter of last year. For the fiscal year 2016, system comps improved 2.6%. Traffic declined in the quarter; it was partially offset by an increase in average check.

And as we've previously discussed, same-store sales were negatively impacted by a persistent industry-wide slowdown that began in late April, and in addition to that, some share losses that we experienced lapping our strong same-store sales historical – strong meaning absolutely strong, but also relatives same-store sales in the last few years, and we'll dive more into this later in this discussion.

In the fourth quarter, we continued to return cash to our shareholders by repurchasing $38 million in stock during the quarter and $148 million for the fiscal year. As of the end of August, we had about $173 million remaining on our share repurchase authorization, including the $40 million approved by our board last week.

So 2016 marked a year of strong progress toward accelerating net new drive-in growth. The system opened 53 new drive-ins during the year and closed 22. This is for a net of 31 total drive-ins for the year or almost a 1% unit growth rate. We continue to target a 2% to 3% net unit growth rate over time toward the end of the decade.

So, decent year overall, though it clearly did not end as we had planned. And now five months into a more difficult environment, broader environment, I can tell you that, first, well, we don't believe we're at the beginning of any kind of long downturn for our business or the industry. We've seen pockets of weaknesses before and now we can manage through it. And also I would say, I believe we have a better understanding of this new value equation of the marketplace and the interplay between cost deflation, competitive activity, consumer channel shifts and the like, and we're doing a better job of driving traffic via value. We're doing this right now, particularly in dinner and evening. We're going to be expanding it near-term, as we modify our approach to this BLADE framework that we have, breakfast, lunch, afternoon, dinner and evening, to improve our performance throughout the day. So we have some work to do in fiscal 2017 to consolidate the gains we've made in the system since the prior recession and we'll discuss this in some depth.

Now, this slide shows average unit volume gains that we have made over the last several years and lends some context for our same-store sales performance in 2016. We posted a 2.6% same-store sales increase in 2016 on top of 7.3% comp in fiscal 2015. The system compounded drive-in volume is at 4.7% from 2012 through 2016. Even with the recent comp slowdown, to give you some perspective here, May, June and July of 2016, May, June and July of 2016 represented three of the top six volume months for our brand in its entire 63-year history. So I'm hoping to kind of give you a sense of the context here of the strength of the performance this past year, even moving into summer, as we are challenged by some strong historical comps. So we really had very high volume for the history of our system.

So our sales volumes are at a different place than they were five years ago and franchisee profits have grown significantly with this trend in same-store sales over the last several years. And while this is great news for our system, a big priority of ours in 2017 is to make sure our stores have sufficient crew resources and infrastructure as we provide that leadership – thought leadership for our system, sufficient infrastructure to maintain high levels of service, and to position our drive-ins for continued AUV growth in the future.

So as a result, we hope and expect our operators are continuing with additional labor investments, including putting greater emphasis on hiring full-time crew members and increasing compensation for our store managers. This is an ongoing focus for us and our discussions with our operators across the system.

Okay. This, what you should see here, gains in development activity, it shows a nice ramp-up in the development activity since 2014. In 2016, we achieved our goal of 50 to 60 new units and saw the system complete a combined 47 relocations and rebuilds, which really reflects a high level of confidence of operators across our system. Both new units and these relo/rebuilds really have nice high AUVs above the system average, and so they're accretive to our objective of growing system AUVs to that $1.5 million by the end of the decade.

To consolidate these gains and lay the foundation for a higher rate of growth in the future, we've continued to invest in our development team, including the recent hiring of a new VP of Construction and a new Senior Director of Franchise Sales.

Okay. We feel very confident in the pipeline for 2017. Last year, at this time, we had 1.1 stores, 1.1 stores under contract or construction for every unit that we intended to open during the year. That's 1.1 stores. This year, at this point in time, we have greater than 1.5 stores under contract or construction for targeted opening.

This slide or chart you see here shows the progress we've made in our commitment pipeline over the past year. With this degree of incremental commitment, if we simply grow this incremental level year-by-year, it will be sufficient to hit our 3% net growth rate at the end of the decade. So we're very pleased with this progress in the last year.

Our profitability has seen significant improvement over the last several years, with adjusted corporate operating margins expanding from 16.3% (sic) [16.4%] in fiscal 2012 to 20.6% in fiscal 2016. The improvement has been primarily driven by better store-level margins as well as higher percentage of franchise stores and a shift to a more highly franchised system by us.

By the end of 2017, we should be substantially done with this refranchising effort and in that have an even more lean, more profitable company-owned drive-in portfolio. And despite our continued SG&A investment and development, ICE, and IT systems, our SG&A rate as a percentage of system sales will be right around 2%, which you probably know, well, it's one of the lowest rates amongst highly franchised peer group. We believe we should be well positioned to maintain this level of profitability for the foreseeable future.

Now, another area of significant progress since the recession is our share of voice. You've heard us talk about this before, but our shift to more national media in 2013 has driven substantial gains in share of voice. And going forward, our goal will be to sustain this competitive advantage as we activate our ICE program and incremental digital tools.

So as it relates to that ICE program, much of our confidence stems from the strong momentum in the POPS installations. We closed the year with almost two-thirds of our system converted to POPS, and we plan to close fiscal 2017 at over 80%. We continue to see a nice one-time lift or year-one lift from the installation, and much of this year, fiscal 2017, will be devoted to helping our system absorb the change brought to bear by this technology, as well as testing some of the enhanced functionality which we'll speak more about later in the presentation here.

Now, we've also seen good evolution of our cash deployment over the recent years as we've improved profitability, reduced capital intensity, and revitalized our new unit growth. And with our recent refinancing and the conclusion of our refi – once we have the conclusion of our refinancing refranchising effort, we have largely completed the transition of our business model, enabling us to narrow our focus towards driving profitable AUV growth for our system and developing – helping franchisees develop more drive-ins. All of this historically has culminated very solid earnings growth for a number of years as you see portrayed here.

So with this progress we've made across these various components of our multi-layered growth strategy, what does that mean for 2017, a year in which our financial results are projected to come in a little below our long-term targets? So we're focused on consolidating the gains we've made and kind of recalibrating our system to resume growth from this kind of higher plane at an improved level.

And from our viewpoint, this is what it means. We need to cycle through the next six months of commodity deflation and difficult comparisons, resist any temptation there might be to alter our long-term strategic priority in a face of temporary factors. We need to apply our learnings on how to better execute value in this current environment and do that across our BLADE framework and we're in the process of doing that. We've done that in part. We need to do it more across these various day-parts.

We need to continue to invest in our store-level labor model to handle our higher level of operation, something we're – a leadership we're providing for our system. And we need to complete our franchising initiatives. So these are paths that we are down on each case and focusing on substantially.

So, to the here now, while there are always many cross-currents impacting the business, right now one of the biggest impact is food deflation. So pictured here, you can see what I know you're very familiar with. It shows the widening spread between prices consumers are paying in grocery stores versus what they're paying at restaurants. The gaps are widest it's been in the last 15 years. But the environment is somewhat anomalous in that food deflation is not coinciding with the recession or at least not a consumer recession.

In immediate term, our view is that this deflation is impacting consumer buying patterns and channel preferences, but it's also heightening the depth and frequency of competitive activity as well as consumer sensitivity to discounting. And this persistent upward pressure on labor costs, in our view, will continue to make this environment that much more difficult to manage in the near-term.

So as far as Sonic specific impacts, our ice cream business underperformed over the summer, driven, we believe, in part by the meaningful encroachment from the grocery channel where ice cream sales were growing above the long-term trends. We saw periods of double-digit declines in the core shake activity for the quick service restaurant industry over the summer. And the pressure on QSR ice cream category hits us harder than most of our peers because of our sales mix and our historical growth of this line of our business.

And another call-out is that we continue to perform very well with our loyal customers, generally defined as those that visit us eight times or more a year. We've seen very little change in their behavior, where we've seen more variability is with the newer or less frequent customers. And these customers or consumers tend to be frequent. They're frequent brand switchers and are more value driven. That's more likely to be influenced by a broader environment. There's no doubt this group of consumers helped drive our market share over the last several years and it's critical that we continue to win them back over time.

Now, how are we responding in this environment? Well, we've made significant progress at dinner and evening, and particularly through increased focus on value, such as the BOGO Wing offering that we have right now, Monday through Thursday. We also have an offering of $0.50 Corn Dog on weekend nights. And we see the opportunity to use these type of tactics during other day-parts and we should see progress as we get to the other side of some really difficult comparisons in the second half of the fiscal year. But we'll continue to focus on these promotional tactics in order to drive traffic in multiple day-parts in spite of the more challenging comps.

Excuse me – we are also being sharper on our menu pricing. For the past several years, we've rolled 2% to 3% pricing to the menu on an annual basis. But given the gap to grocery pricing, we're likely to be well below that rate this fiscal year. We are projecting our commodity basket approximately flat in fiscal 2017, which helps to mitigate the impact of lower pricing on restaurant margins, but it won't be enough to offset the impact of labor investments.

Another exciting initiative for 2017 is the testing of the enhanced ICE functionality. And what are these enhancements? It's what's essentially customizing the consumer message, that is displayed on the digital menu boards based on data from our other transactions. In other words, it's like Smart POPS, evolution of POPS to Smart POPS. And so we're going to harness the data that we have collected from a myriad of transactions. For example, testing suggested sale based on ticket affinity. In other words, we can change the message or the suggested, so that shows upon the POP screen based on your specific order, which we think has the potential to increase ticket. So we anticipate expanding this into the system significantly in the immediate future.

And another example is store segmentation. So here we're testing segmenting drive-ins based on store characteristics such as demographics, average check, product mix, that's appropriate for a single store. Then we're testing the impact of delivering unique messaging to that store based on what we think is the most relevant to that significant customer segment for that store. So for example, stores that are over-index on breakfast in rural locations would have a different messaging than stores with big happy hour businesses in the metropolitan suburbs.

Now, the activation of various ICE tools is going to be evolutionary. We're excited to be entering the next phase of the initiative and look forward to sharing some of their learnings with you as we move forward.

So this is intended to show where we expect to be as we move through the fiscal year. We intend to be outperforming the competition and driving positive comps, given pricing action, product innovation and easier second half comparisons.

We intend to be almost 95% franchise with a leaner, more profitable company-owned store base. We'll be at critical mass in our POPS installation and be deploying enhanced functionality with POPS, including data-driven messaging appropriate by store level and oftentimes transaction level.

And we intend to return a meaningful portion of our cash flow to our stockholders in the form of dividends and stock repurchases. In our view, the continued progress against our initiatives in 2017 leaves us in a strong competitive position throughout the year. And we're excited and confident in the ability to resume stronger earnings growth in 2018.

With that, I'm now going to turn it over to Claudia San Pedro to provide the financial overview. Claudia.

Claudia S. San Pedro - Sonic Corp.

Hello. For the quarter, we reported an earnings per share increase of 6% and an adjusted earnings per share increase of 5%. These results were primarily result of the decrease in same-store sales and the deleveraging impact they had at the drive-in level. Franchise royalties and fees increased by 1.5%, reflecting increased franchise-operated units offset by same-store sales declines.

From an operating income perspective, total company adjusted operating margin improved 120 basis points to 24.3% in the quarter. And in the fourth quarter, SG&A declined approximately 21 basis points as a percentage of sales versus an increase of 40 basis points for the full year. This decrease was really driven primarily to the timing of technology and head count investments, higher capitalization of technology projects, and lower incentive comp as a result of the decrease in same-store sales.

As we go to the next slide and talk about operating leverage at the drive-in level margin perspective, company drive-in margins contracted by about 210 basis points in the quarter. Food and packaging costs drove a little bit of this and they were unfavorable by 10 basis points as a result of slightly higher discounting and the establishment of the system Brand Technology Fund.

It is also worth noting that we are lapping over the benefits of our point-of-sale system which was a significant driver to the 170 basis points of food and packaging improvement in last year's fourth quarter. We have locked in a majority of our commodity costs for the first half of the fiscal year and anticipate our commodity basket inflation to be flattish for the full year, with the first half of the year more favorable than the second half.

We are currently running pricing at a little more than 2% at both our company drive-ins and our system, and as stated previously, are taking a more conservative approach on that front. The primary driver of our deleveraging was in the labor line for this fourth quarter and that's being driven by our investments in labor. As you all know, we are in the midst of a multi-year initiative to drive investments in our people at the drive-in level. We started that initiative a couple of years ago. This past fiscal year, our emphasis has really been on investing in assistant manager wages in addition to providing an additional layer at the assistant manager bonus level.

And then finally we offered employee meals as a big benefit, a little probably will lap that over in November, December. But those are the primary drivers of that deleveraging impact. We feel strongly that these investments that we're making today will pay off in the long-term as we strive to reach our $1.5 million AUV and do anticipate that we'll get leverage off of these, not in the short-term, but in the long-term.

Other operating expenses deleveraged by 70 basis points in the quarter and were flat as a percentage of sales for the year. As you may recall, all drive-ins now pay technology fee into the system Brand Technology Fund effective March 1, which equates to approximately 25 basis points or 25% of – or 0.25% of sales. This fee runs through the other operating expense line, deleverage on lower same-store sales, drove the remaining deleverage on this line in the quarter, particularly impacting property, tax and rent. We estimate that the new Brand Technology Fund will continue to negatively impact company-owned drive-in margins by approximately 50 basis points per quarter in the first half of fiscal 2017. Half of this will be in the other operating line item and the other half in food and packaging.

And as we go to the next slide, we talk a little bit more about our capital structure. As you know, last week, our board of directors approved a $40 million increase to our share repurchase program, consistent with our stated strategy to offset the impact of our planned refranchising with incremental share repurchases. We currently have authorization to repurchase up to $173 million in stock through the end of fiscal 2017.

In fiscal 2016, we repurchased approximately $148 million in stock, representing 9.7% of shares outstanding. We are pleased with the progress we are making with our refranchising initiative as we work towards an approximate 95% franchised system. We refranchised the small market during the fourth quarter, and are on track to refranchise the remaining identified markets during fiscal 2017.

As part of our refranchising initiatives, our franchisees are also committed to new unit growth in the market. So for example, with this recent small market that we refranchised, we were also able to garner additional unit commitments over the next few years, which also contributes to brand growth.

Our earnings guidance reflects the impact of planned divestitures, though exact timing is uncertain. For modeling purposes, we would weigh the transaction towards the middle of the year. The targeted markets have a slightly below average AUV and weaker restaurant margins. And while we expect the refranchising to be modestly dilutive to EBITDA, offset on the earnings line will be done through share repurchases.

And just as a reminder, in the third fiscal quarter of 2016, we closed on a new $575 million debt securitization, which included a $425 million in fixed rate notes and an undrawn variable funding note with $150 million of capacity. We ended the fourth fiscal quarter of 2016 with $72 million in unrestricted cash. We anticipate free cash flow of approximately $60 million to $65 million this year, with capital expenditures of between $40 million to $45 million. We define free cash flow as net income, depreciation, amortization expense, and stock compensation expense, less capital expenditures.

So, as we go to our outlook, you can see the various components of our 2017 outlook. We have projected adjusted earnings per share of negative 7% to flat year-over-year, reflecting system same-store sales of negative 2% to flat. The same-store sales forecast assumes continued negative traffic for the industry and minimal menu pricing, reflecting a continuation of the recent industry dynamics that Cliff described.

I would note that we have built in modest acceleration in same-store sales in the second half of the year as comparisons ease. Our assumption for negative same-store sales will likely drive modest operating deleverage for company drive-ins with particular pressure on labor.

For 2017, this deleverage will be masked by the impact of our refranchising, which all other things equal, would be accretive to our restaurant margin rate in fiscal 2017. As it relates to company drive-ins, we expect margins of 16% to 17% for fiscal 2017. This includes incremental investment into store manager wages related to a new incentive comp structure to drive performance and retention, as well as increases related to compliance with the new Department of Labor Regulations on exempt employees.

So again, this is a continuation of our multi-year initiative to invest in labor for the long-term future of the brand. We project SG&A expense to be between $85 million and $86 million or roughly 3.5% to 4.5% growth versus fiscal 2016. As Cliff noted, although visibility is low in the immediate term, we remain confident in our longer-term strategic initiatives, and believe we will exit the year in a strong competitive position.

As a result, we are continuing to invest in our ongoing future investments in relocations and rebuilds, information technology or ICE, though we maintain flexibility to adjust spending levels, should our outlook change. So while 2017 is setting up to be a more challenging year from a same-store sales and earnings growth perspective, we feel that long-term, our multi-layered growth strategy remains relevant and that consistent high-teens EPS growth is achievable.

Our five-year plan and year 2020 targets are predicated on driving contribution from each of our strategic layers as they have in the past, including same-store sales growth, development, modest operating leverage, our ascending royalty rate and return of free cash flow. As we get closer to fiscal 2018, we will give further clarity on how we expect each of these components to drive performance in future years.

With that, we will open the call for questions.

Question-and-Answer Session

Operator

Thank you. We'll go first to Matthew DiFrisco with Guggenheim.

Matthew DiFrisco - Guggenheim Securities LLC

Thank you. I guess, just curious, I think a lot of us are probably a little surprised on that initial guidance on the G&A side. I know you detailed a little bit about that, but I guess the technology spend, how does that – it sounds a little counterintuitive since the franchisees are already starting to pay into the Technology Fund, yet your G&A seems to be going up, and you're citing in part technology. Can you sort of dig into how come in a 95% franchise model or on your way to that, that G&A is not going down?

Claudia S. San Pedro - Sonic Corp.

Sure. So there are a couple of components there, Matt. So one caveat I would list is, as you know, every year we provide guidance on SG&A and depending on our performance, we will adjust accordingly based on the variable comp component, and that remains the same.

The investments in technology that we're making for the brand involve a number of different aspects. Some of those are engaging with new partners and are being funded out of the Brand Technology Fund. But we also believe that in order to have that core technology infrastructure, we need to have a solid team here at our headquarters. And similar to other major areas of our business, whether that be development or marketing, we think it's important to make the right investments in that area.

So we view this as a short-term blip, if you will, as we look at our performance for fiscal year 2017. And as we look over the next few years in the capacity of our system to grow through these technology initiatives, we think it's important to continue to make these investments. Again, as you know, we have a long history of depending on our performance, if that changes we will adjust SG&A.

Matthew DiFrisco - Guggenheim Securities LLC

I guess, can you just tell us what is sort of the core G&A or instead of the blip, so if we were to look at what is an ongoing G&A versus a one-year or a two-year investment in technology? If you could extrapolate out that technology investment if it's possible?

Claudia S. San Pedro - Sonic Corp.

So, as you look at that, with the way we look at that, it's really looking at it as what does it take to support the entire system. And so we look at SG&A about 2% of system sales. We think that is one of the frameworks and guardrails that we use that we think is appropriate, and we're...

Matthew DiFrisco - Guggenheim Securities LLC

Okay.

Claudia S. San Pedro - Sonic Corp.

...still at that level.

Matthew DiFrisco - Guggenheim Securities LLC

Thank you.

Operator

We'll continue on to Nicole Miller with Piper Jaffray.

Nicole Miller Regan - Piper Jaffray & Co.

Thanks. Good afternoon. Two quick ones. Looking at the store-level margin goal of 16% to 17% for this upcoming year, I'm just trying to get a sense of first half versus second half. So is it flat more or less across the board and up a little in the back-half or should we look at store-level margin being down in the first half and then up pretty substantially in the second half to get us within the guided range?

Claudia S. San Pedro - Sonic Corp.

There are two main areas that are going to impact those margins, Nicole. So the first really is the cadence of same-store sales. And as we talked about, we anticipate that that will be more challenging in the first half of the fiscal year. So I think you'll definitely see some deleveraging in the first half of the fiscal year with improvement in the second half.

Now, the other piece that's going to impact that will be the timing of the divestitures. Overall, once we divest ourselves of these targeted markets, our overall margins will be stronger. So, depending on the timing of that may impact that. And as I said, I think for modeling purposes at this point, I would anticipate that being more in the middle of the year. So, again, seeing a little bit more favorability on the margin side is related to that in the second half of the fiscal year.

Nicole Miller Regan - Piper Jaffray & Co.

Okay, great. And then just as a quick follow-up, testing the Smart POPS sounds really neat. It sounds – I just want to make sure I understand this correctly, you're doing it down to a one to one store level basis. Ultimately then do you take the individuals and group them and then maybe actually get to an individual level? How does this play out?

J. Clifford Hudson - Sonic Corp.

So there are several initiatives that will involve varying characteristics of what you just described. The most immediate thing is not responding to individual characteristics nor individual patterns. Rather, there will be associations, for want of a better term, I think I did say a ticket affinity, but an association. People who ordinarily order X also order Y. People who ordinarily order A also order B. And at a time of day they'll order A and X; certain time of day. So what it will be is the set of rules that – and this is one of our first system-wide initiatives here, but it will be a set of rules like this that will be rolled out to all stores that – I was going to say system-wide, but to all stores that have POPS, and then as new stores are installed with POPS they'll have that characteristics.

So it's not transactional data by individual and it's not tracking that piece, does not track an individual. As we evolve over time and some other initiatives that will get much more detailed than that, but the most immediate implementation of Smart POPS is this kind of general ticket affinity or associations on a macro basis, rather than transactional related to a specific customer and their patterns. We will eventually get to what you described, meaning much more individualized. That is at some future date as all this evolves.

Nicole Miller Regan - Piper Jaffray & Co.

Thank you.

J. Clifford Hudson - Sonic Corp.

I also mentioned, Nicole, I'll give you just an expansion because there were two concepts I think you fused in your question. So the immediate-term initiative is the association or the product affinity. In the coming months, because we're already testing this, there will be analysis of customer, nature of customer characteristics and transactions by trade area around a store. And so the data, we're experimenting with this in about six markets right now. But the characteristics around that store and then with the data we have, we offer varying offerings based on those characteristics in that store. So in a marketplace, in Oklahoma City, Tulsa, Chicago, wherever it is, the offerings maybe within the marketplace, they may be very different by store. And I'm not talking about limited time offers. I'm just talking about things on the menu that have greater affinity for that trade area.

So that's an immediate – that's something we're already testing in calendar 2017, something we'll start moving through the system. Those types of elements, once we move to the mobile order, mobile pay, which we anticipate doing later 2017, then can enable us to start moving to real personalized data collection and personalized marketing on- and off-premises. So this is an evolution of this over time.

Nicole Miller Regan - Piper Jaffray & Co.

Thank you.

J. Clifford Hudson - Sonic Corp.

Yes.

Operator

Our next question comes from Will Slabaugh with Stephens.

Will Slabaugh - Stephens, Inc.

Yeah. Thank you. So, last quarter you talked about a modestly dilutive impact to EBITDA from the refranchising process and then to expect more of a cost benefit on the labor line since that's where you account for some of your field level costs or I think you said most of the field level costs. And now I'm looking at the middle part of the guide which gets me to kind of a mid- to high-single digit drop in EBITDA. So I'm curious if you can kind of help me bridge that as well as how – it looks like the improvement in restaurant level margin for next year doesn't really include much of a benefit there as you might have mentioned at the labor line. Is it being offset by some of the things you mentioned or just curious if you could help me bridge those two together.

Claudia S. San Pedro - Sonic Corp.

I really think it's really dependent, Will, on the timing of those divestitures. So we do anticipate – so all other things equal, we do expect and based on the historical P&L performance, the targeted markets that are being refranchised, as we do that, we will see a positive impact to company drive-in margins. So that piece is in place. It just really depends on the timing of those. The other aspect of that quite frankly is the same-store sales performance of our drive-ins. So that's the one factor that's impacting it. So as we look at both the cadence of our same-store sales, again, to Nicole's point, the first half is anticipated to be challenging, but as we get into the second half, we expect that same-store sales will improve and we should see some modest leveraging from that as well.

Will Slabaugh - Stephens, Inc.

Okay. And then just one more question if I could on the D&A line. It looks like that's roughly flattish, maybe down just slightly year-over-year despite selling off roughly or almost of half your company stores. Can you talk about what's going into that line item to make that stay up as high as it is?

Claudia S. San Pedro - Sonic Corp.

Sure. So, as I said before, we are continuing with our investments in capital initiatives like information technology, relocations and rebuilds, and in fact, when you see our 10-K being filed this next week, what you will find is that from a CapEx perspective, we're seeing good results from relocations and rebuilds from our information technology. So we're continuing to make those investments in our business. And what you'll notice as well is that in the fourth quarter, our capital expenditures picked up quite a bit and the two main areas where you can see that are, again, technology and a little bit on the investments in drive-ins. So we expect that to continue because we're seeing good returns and we think those are good investments to make.

Will Slabaugh - Stephens, Inc.

Thank you.

Operator

And we'll go on to Sharon Zackfia with William Blair.

Sharon Zackfia - William Blair & Co. LLC

Hi. Good afternoon. A couple of questions. I guess on the idea that comps will get better in the second half of the year, can you kind of let us know whether you're in that zero to negative 2% so far in November? And then I think ice cream was softer than maybe the overall mix in August. So can you give us any kind of indication of how bad ice cream was and how that flows as a percent of sales seasonally?

Claudia S. San Pedro - Sonic Corp.

So with respect to your first question, I think we haven't seen any trends meaningfully change since probably the beginning of the fourth fiscal quarter with respect to sales. So no significant change from that perspective. To your second point on ice cream, yes, and Cliff alluded to this earlier and he may want to interject, but essentially what we've seen in this low commodity cost environment is that grocery stores have been a lot more competitive than they have in the past, particularly with respect to ice cream. So we did see disproportionate decline in ice cream sales in the fiscal fourth quarter, as we look at that part of our business.

J. Clifford Hudson - Sonic Corp.

And we saw the shakes decline with competitors on a broad basis. You saw gourmet ice cream being up in single-digits at grocery stores. But what did keep working for us kind of a more specialty ice cream items that we have and the higher dollar ones actually continued to work, but the greater volume; i.e., just shakes, just plain flavored shakes is where the decline was through the summer.

Sharon Zackfia - William Blair & Co. LLC

But just to be clear, as shakes have gone down as a percent of the mix, that hasn't really benefited same-store sales it sounds like.

J. Clifford Hudson - Sonic Corp.

Well...

Sharon Zackfia - William Blair & Co. LLC

Just meaning seasonally as it gets cooler.

J. Clifford Hudson - Sonic Corp.

I see, as we move into the fall.

Sharon Zackfia - William Blair & Co. LLC

Yeah, exactly. Sorry. I didn't phrase that well.

J. Clifford Hudson - Sonic Corp.

Yeah. Ice cream does not make up the same mix. If nothing else, once the summer is over, we have not continued our half priced shakes after 8 o'clock. So the volume in the last couple of years – once the summer is over, the volume declines appreciably.

Now, I would also say – I mean, I'm not going to quantify this, but just directionally and I may be redundant here, so if I am, I apologize. But we got spring into summer, so May, June, July and then July, August. Once we got beyond just the Boom Box thing of really much more of a (42:31) offering and to something that's a little bit more our product and our promotion, we think we're moving more to a formula because it can permit us to utilize the value demand that it's got a – the nature of the value demand has kind of shifted in the last five months, consumer outlook, and evolving that into fitting our BLADE strategy.

So there is a picture that I can look at and say this is better. This is better than five months ago. Why? Because that we've done targeted promotions, that we are very comfortable with from a branding standpoint that have achieved what we intended to achieve with those day-parts. Now what we've got to do is back in and get appropriate counterparts for other day-parts, and we are on that.

So the better would not necessarily meet your definition from the standpoint of the total circumstance of the average drive-in, but pieces that we need in order to start building our way forward, we're feeling good about those pieces.

Sharon Zackfia - William Blair & Co. LLC

Thank you.

Operator

We'll go to Brian Bittner with Oppenheimer.

Brian Bittner - Oppenheimer & Co., Inc. (Broker)

Thanks. I just have a question about the EPS guidance. When I use all your assumptions and run it through my model, and you said down 2% to flat comps, I get more of an EPS down slightly to up 6%, 7%. So what's the big discrepancy there between that and your guidance? Is it a lot of refranchising headwinds hitting the operating line that maybe I'm not modeling? If you could kind of just walk me through why I'm seeing such a difference than what your EPS guide suggests?

Claudia S. San Pedro - Sonic Corp.

Sure. The other impact that you might not be modeling in, and I mentioned this just briefly, is again, we're in the midst of a multiyear initiative to make investments in people. And so there will be an additional investment that we're going to be making that will be effective in the second fiscal quarter pertaining to our drive-in level managers.

And so as you think about it, what we've attempted to do over the past few years is work through various aspects of our drive-in level teams to really try to achieve our goal of being employer of choice and being able to operate at a higher level. So we've worked on you crew. We've worked on assistant manager. This year we're focusing on operating partners which is drive-in level managers. So we anticipate that will cause an increase in that labor costs. Again over the long-term, we anticipate we'll be able to leverage that. But in the short-term that will be also cause some pressure on that labor line.

Brian Bittner - Oppenheimer & Co., Inc. (Broker)

Yes. But, Claudia, that's anticipated in your 16% to 17% margin guidance, right? What I'm saying is I'm literally using your guide's assumptions from a company-owned margin line and SG&A line, the D&A line, comps, and I'm just not coming to the negative 7% to flat EPS. I'm using your shares – I'm assuming my own shares outstanding based on how much stock you're going to buy back. But you haven't given us, I guess the one thing I'm missing is what the refranchising dilution may be, and I'm wondering if that's a big piece I'm missing.

Claudia S. San Pedro - Sonic Corp.

I think that is the big piece you're missing. And I think that we can talk offline, Brian, because part of that obviously a lot of that's dependent on the timing of when you have that figured into your model. So let's visit offline about that and where you've got that.

Brian Bittner - Oppenheimer & Co., Inc. (Broker)

Okay. Just but the last thing, I mean have you guys put something internal in your guidance that you can share with us as far as what the headwind from refranchising on the operating line is, on the operating profit line, so that we can better understand this within our own models?

Claudia S. San Pedro - Sonic Corp.

I think the best way to model it out is, again, we can kind of take this offline, but it's based on what the impact will be from a revenue perspective as we get through that. So let's work through that offline and we can get to that so.

Brian Bittner - Oppenheimer & Co., Inc. (Broker)

Okay.

Claudia S. San Pedro - Sonic Corp.

All right.

Brian Bittner - Oppenheimer & Co., Inc. (Broker)

All right. Thank you.

Operator

Thank you. We'll now hear from Brett Levy with Deutsche Bank.

Brett Levy - Deutsche Bank Securities, Inc.

Good afternoon. If we could follow up a little bit more on the sales. I'm just curious why you're willing to talk about greater confidence that you're going to get through this malaise, but we're seeing lower guidance, and just is there anything that you're seeing within the region, within the check, within the pricing, within the customer traffic, that's leading you to have that greater confidence? And also, any thoughts, anything you're willing to share in terms of estimated proceeds on a per franchise basis? Thanks.

Claudia S. San Pedro - Sonic Corp.

So, I'll address the first question first. So on the same-store sales perspective, really as we looked at what we're comping over in the first half, if you look at our performance last year, I want to say we were over 5%, maybe 5.3% for the first fiscal quarter last year. Maybe 6.5% second fiscal quarter last year. So as we look at what we're comping over and in this current environment, that's a lot more competitive than from our perspective due to the commodity cost environment than a year ago, I think that's the primary reason on the sales front, Brett, as you look at that. I think that's one of the factors that's a little bit different from us.

So, again, as Cliff mentioned earlier, we're not comping over slightly positive or flat same-store sales. We've had two really good years. And in fact, as a testament to that, I think as we mentioned before, two of our top five monthly AUVs were this past year, even though it was kind of a negative same-store sales environment. So that's the same-store sales question. And what was your second question?

Brett Levy - Deutsche Bank Securities, Inc.

Could you share anything in terms of what you're expecting on a per unit proceed as you refranchise the units?

Claudia S. San Pedro - Sonic Corp.

No. We will share that as the year progresses, but not at this point.

Brett Levy - Deutsche Bank Securities, Inc.

Thank you.

Operator

Thank you. Our next question will come from John Glass with Morgan Stanley.

John Glass - Morgan Stanley & Co. LLC

Thanks very much. It's not an ideal environment to refranchise, just given where same-store sales are at least today. So do you feel confident in your ability to get them done in this timely fashion? Do you have – are you already negotiating? Do you already have deals done? I guess just discuss the risks as you see them, if any, to getting to the refranchising goals given the sales environment.

J. Clifford Hudson - Sonic Corp.

So the – unless you have something in particular.

Claudia S. San Pedro - Sonic Corp.

No. Go ahead, go ahead.

J. Clifford Hudson - Sonic Corp.

Okay. So we feel good about being able to dispose off these stores, sell them to existing franchisees and some people new to the system. So the answer is, I think we've already filed – filing on the – so we haven't filed a 10-K? Okay. So, the first transaction? Okay.

So we have consummated the sale of all of our company stores in Florida. So that one – and that's where we turned our focus first. So we're kind of doing these, John, and we're intentionally kind of sequencing them. And so we've closed the Florida transaction. We have two markets under negotiation, markets which I won't disclose.

One of those is with a very long-time existing franchisee. We have another market under negotiation with someone new to our system who is a very well capitalized long-time operator of other concepts and then we have another market we will be – we intend to dispose off the stores there. And we have, because of the number of stores in that market, we will likely divide it among let's just say two or three existing franchise groups, and we probably have four or five franchise groups interested in those stores in that market.

We have at least one franchisee who wants the whole market. So sometimes – and that person's appetite can get a little big and may not reach the finish line for the whole market. But the point I'm making is that we have interest in all of these stores, all of these markets, and we will get it done. It's just a question of when during the fiscal year.

Claudia S. San Pedro - Sonic Corp.

I would also add that, I think it's important to note, again, as you've seen our results, these investments are for a long term. Our franchisees have had really good years, confidence in the system, and as we look at entering into these negotiations with the sale of the most recent market, we were again able to leverage that not only with the sale of the company drive-ins, but also with the commitment for new unit growth.

And as we look at other transactions, we're doing the same. So I think that shows great confidence on behalf of our existing franchisees. It's great to see interest from new franchisees on a number of different level as well.

John Glass - Morgan Stanley & Co. LLC

Just on a related matter, I know there is a lot going on in corporate G&A with some of the investments you're making, but how much G&A goes away in dollars when you have completed this re-franchising?

Claudia S. San Pedro - Sonic Corp.

So, at this point, what I can tell you is the majority of our store-level management, so supervisors that oversee five to six drive-ins, that cost is really already incorporated in our company drive-in level margins. So that will go away as those drive-ins are refranchised. And then as we progress throughout the year and as we refranchise, if there are opportunities for efficiencies, we will take them and then we'll report to you as they occur.

John Glass - Morgan Stanley & Co. LLC

Just so I understand, almost all of it's in the store level, that there really will be no on the line item of G&A, that really wouldn't be impacted by refranchising?

Claudia S. San Pedro - Sonic Corp.

There might be a little bit at this point. That's part of the process that we're going through now. I think it's important though to note that because the majority of the costs do occur and are already incurred at the company drive-in level margins, it's not a significant opportunity for us.

John Glass - Morgan Stanley & Co. LLC

Got it. Helpful. Thank you.

Operator

Thank you. Our next question comes from Alex Slagle with Jefferies.

Alexander Russell Slagle - Jefferies LLC

Thanks. I guess, my question is sort of a follow-up on that, an earlier question, and just if you could talk to any kind of other contingencies you have for additional cost reduction opportunities beyond the variable comp and some of that manage your labor, if we face some more challenging external environment with negative comps beyond what you've guided?

Claudia S. San Pedro - Sonic Corp.

Well, Alex, I think if you go back, we've got a good history of, if the environment continues to be challenging, then we'll make appropriate adjustments. I think I can confidently say that. When you look at our SG&A as a percentage of system sales, we have trended to be below our peers and our goal is just to make sure that we're making the appropriate investments for the long-term growth of the brand.

We see this as a short-term issue. And so from our perspective, it's important not to be shortsighted and immediately cut back when – as we look at fiscal year 2018 and the latter half of this fiscal year, we see some really good things from some of the initiatives that we've got going on.

Alexander Russell Slagle - Jefferies LLC

Okay. Thanks. And then on store closures, I'm not sure if you mentioned it. Do you expect 2017 to be similar or lower than 2016 levels?

Claudia S. San Pedro - Sonic Corp.

We expect them to be pretty comparable.

Alexander Russell Slagle - Jefferies LLC

Got it. Thank you.

J. Clifford Hudson - Sonic Corp.

Thank you.

Operator

Thank you. We'll continue on to Jeffrey Bernstein with Barclays.

Jeffrey Bernstein - Barclays Capital, Inc.

Great. Thank you very much. Just a couple of questions as well. First, just on the comp, I think you said it's been relatively stable since June, so I just want to make sure I understand this correctly, sequentially we're running in maybe the down couple of percent range, starting in June and through September, October. I mean any color in terms of – well, to confirm that. And then if you can give any color in terms of comp by day-part or by region. I think you mentioned something about the dinner and the evening, we're hit hard, I'm just trying to get a feel for where the comps fell out again by day-part or by region.

J. Clifford Hudson - Sonic Corp.

Well, let's do that in reverse order. And we made reference to dinner and evening being hit particularly hard. What I had made reference to was post-April, some shifting in promotional strategy and limited time offers that were focused on in some cases specific day-parts and some not. And so I think what I had made reference to was the BOGO Wings, the buy one, get one free after 5 PM Monday through Thursday, Weekday BOGO Wings. So we're on something that drives traffic and check. And so now we've got to find that something and how we're going to do that for other day-parts. And as a matter of fact, the dinner and evening in the more recent past have been our strongest. So just slight reversal of what impression you got from my comment.

The progression then of same-store sales more recently, we did not comment on and I don't think we ever comment on things really by day-part in terms of break-out in a quarter. So no comment on the day-part break-out in the quarter. And we've given you some general guidance as it relates to our first half of this year. The specifics on the quarter, we'll divulge when we report our first fiscal quarter ended November.

Jeffrey Bernstein - Barclays Capital, Inc.

Got it. I thought there was some reference to since the start of the fiscal fourth quarter, the trend has been sequentially stable. So, right, if you're not looking by day-part, but just looking at the overall system comp, is it fair to say that they are up three months of fiscal 4Q and thus far in fiscal 2017 that we're not seeing big variations month to month in terms of the comp?

J. Clifford Hudson - Sonic Corp.

Well, the answer I just gave you, I could repeat it, but there's no need to. The other comment I made a moment ago was that as we've refined the promotions, we've had more August, September into October, it gives us confidence that we can kind of find a way forward even as this value demand stays with us, if that's where the consumer kind of maintains their perspective.

So from my view, there's – and this does go back to the question a moment ago, what makes us more optimistic in the coming months and more so in the latter half of the year, but what makes us more optimistic. And it is how we're seeing some of the things working that we're doing and our need to kind of expand them into other day-parts and see if the promotional activity can stick. But we see our way through that today much better than we did five months ago. So – go ahead.

Jeffrey Bernstein - Barclays Capital, Inc.

Go ahead.

J. Clifford Hudson - Sonic Corp.

No, no, you go ahead.

Jeffrey Bernstein - Barclays Capital, Inc.

No, I had a separate question just on the refranchising. I am wondering as you talk about maybe it's incentivizing the franchisees to open up new stores along with acquiring your existing, is there a thought process that you sell some of these stores at somewhat of a discount to the franchisee to support or incentivize the growth? Or you think you're getting on both ends in terms of selling for a fair price and then above and beyond that, they're still keen to open up new?

J. Clifford Hudson - Sonic Corp.

So, we do not sell them at a discount, number one. Number two, we do require everyone acquiring stores to enter into an area development agreement for additional develop of Sonic drive-ins in that marketplace. So that is part and parcel of each transaction and that's not been difficult as part of the deal.

Jeffrey Bernstein - Barclays Capital, Inc.

Great. Good to see the demand is there. Thank you.

J. Clifford Hudson - Sonic Corp.

The demand is there. The interest in these stores, I'll guarantee the interest is there. There are more franchisees with more interest in buying more stores than there are stores we're selling.

Operator

And ladies and gentlemen, we have time for one more question. We'll go to Joseph Buckley with Bank of America.

Joseph Terrence Buckley - Bank of America Merrill Lynch

Thank you. I just want to follow up on Jeff's question. So Claudia, you said there's been no material change in trends since the start of the fourth quarter. So you just have expectations where this should be. Are you comping down roughly 2%? I mean that was my take-away from your comment. And Cliff, you just confused the issue I think, so I just want to verify. That's my first question.

Claudia S. San Pedro - Sonic Corp.

So really I think that context should be with respect to what we're seeing with industry trends. So no significant change with industry trends as we look at that. And again, as we provided context, I know you guys want us to pinpoint the exact same-store sales, but we've already provided the fact that the first half of the fiscal year will be more challenging, based on what we're seeing with industry trends and based on what we're comping over from a prior-year perspective. And then in the second half of the fiscal year, seeing improvement.

Joseph Terrence Buckley - Bank of America Merrill Lynch

Okay. And then, just kind of a quick factual one. The royalty rate, I believe, goes up and down with the sales levels. Was it down year-over-year in the fourth quarter and what is your guidance for same-store sales implied for the royalty rate for the new year?

Claudia S. San Pedro - Sonic Corp.

So one of the aspects that impacts our royalty rate is not only our same-store sales, but obviously our unit growth numbers. So if you look at our royalty rate for the fourth quarter, sure you'll see a slight increase I want to say of about 6 basis points or 7 basis points and that's really relating to the fact that we close drive-ins probably at an AUV level of $700,000 or $800,000 and we're opening up drive-ins at a higher – that not only perform better but are generally at a higher license terms. So that offsets the decline in same-store sales impact that you might see from an ascending royalty rate perspective.

Joseph Terrence Buckley - Bank of America Merrill Lynch

Okay. And one last one. Cliff, the ice cream sales, I would view a Sonic ice cream visit as more of an experience and not really comparable to a grocery store or going home and taking the ice cream out of the freezer that you bought at the grocery store. So do you feel confident that the weakness in that part of the business wasn't something else like service related or time of service or speed of service or some operational issue that might be important?

J. Clifford Hudson - Sonic Corp.

Well, a couple of things. I mean, there's always the potential for that. And I think even with our operators, this kind of momentary pause in the business is an opportunity for them to double back from an investment and people standpoint and ensure that they can take the average store from a talent pool standpoint and quantity and quality of staff, help take the drive-in to another level.

All of our businesses have been transitioned over the last several years within the Sonic system. So there are those kind of demands, and meaning the challenges of growth. However, when we looked at peer data, peer, peer data this past summer, we saw shake sales down in almost all of our competitors.

So this was not a – the second thing we saw, we saw select customers with feedback claiming – select customers claiming they're eating out less and my suspicion is what may be happening, whether they're preparing food at home, I don't know, well, they may be buying prepared food at grocery stores and they're buying their ice cream there.

So you're right, it is an occasion and it is an experience at Sonic. So our late evening business was our higher dollar items that you're less likely to find at a grocery store, we had continued movement of those items. It was the shakes where he we had the softness. And it was not just Sonic by far. We saw this with a whole slew of competitors.

Joseph Terrence Buckley - Bank of America Merrill Lynch

Okay. That's helpful. Thank you.

J. Clifford Hudson - Sonic Corp.

Okay. Thank you, Joe.

J. Clifford Hudson - Sonic Corp.

I think that was the last question. We appreciate you all participating today. Claudia and Corey will be available at the number given at the outset of the presentation if you have questions. We appreciate your interest in the brand.

We've got a lot of good stuff coming down the pike. A lot of it's not this quarter sort of stuff, though we have some good news from that standpoint too. But more in long run, well, into 2017 and next several years, should be a very exciting time for our brand, and we look forward to sharing that with you along the he way. Take care. Thank you.

Operator

Thank you. Once again, ladies and gentlemen, that does conclude today's conference. Thank you all, again, for your participation.

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