Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Sonic Corporation (NASDAQ:SONC)

F1Q08 Earnings Call

January 4, 2008 10:00 am ET

Executives

Pat Watson - Corporate Communications

J. Clifford Hudson - Chairman of the Board, President, Chief Executive Officer

W. Scott McLain - Executive Vice President; President of Sonic Industries Services Inc.

Stephen C. Vaughan - Chief Financial Officer, Vice President

Analysts

Joe Buckley - Bear Stearns

Sharon Zackfia - William Blair & Co.

Steven Rees - JPMorgan

Mitchell J. Speiser - Telsey Advisory Group

Dean Haskell - Morgan Joseph & Co.

Matthew DiFrisco - Thomas Weisel Partners

Rachael Rothman - Merrill Lynch

Nicole Miller - Piper Jaffray

Christopher O’Cull - Suntrust Robinson Humphrey

Howard Penney - Friedman, Billings, Ramsey & Co.

Operator

Good day and welcome to the Sonic first 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 Mr. Pat Watson. Please go ahead, sir.

Pat Watson

Thank you and good morning, everyone. This is Pat Watson with Corporate Communications. Sonic is pleased to host this conference call regarding results for the company's first quarter of fiscal year 2008, which ended on November 30, 2007. These results were issued yesterday afternoon.

Today's audio and video presentation may be accessed at the investor section of the company's Website, www.sonicdrivein.com.

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 risks. It should be noted that the company's future results might 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 yesterday afternoon and 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 which is accurate only as of today's date, January 4, 2008. For this reason and as a matter of policy, Sonic limits the archive 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 express written consent of the company is prohibited.

With those announcements, I’ll turn the call over to Cliff Hudson, the company's Chairman, Chief Executive Officer, and President. Good morning, Cliff.

J. Clifford Hudson

Good morning, Pat and good morning to all of you. We appreciate your participation in our conference this morning. As in the past, Sonic has consistently earned good quality returns on the assets you have invested in our company and this quarter is no exception with our EPS coming in at -- earnings per share coming in at $0.22 a share and as you know, that exceeds the market’s expectations by a penny a share, with those expectations having been at $0.21.

One of the things we’re pleased about on the quarter is that the operating income matched that 16% growth rate, and this reflects good ongoing growth in drive-in level profits as well, so we’re very pleased with the quarter, pleased with the performance, and pleased to talk to you today about the things that have driven that historically and will continue to drive it going forward.

For a long period of time, we have talked about our multi-layered growth strategy and the trends that you see in our business, top and bottom line growth, really reflect this multi-layered growth strategy.

While many in the restaurant industry have continued to confront challenges, higher commodity costs, increasing minimum wage rates, a consumer environment that seems a little cloudy, et cetera, the fact is that we’ve been able to continue to achieve top and bottom line growth with these multi-layered strategies. And it is those multi-layered strategies that we believe will be able to keep us growing in that 2% to 4% range that we have for some time, with an increase in this quarter of 2.1% system wide. Partner drive-ins, as you have already seen, continue to outperform the system as they have for a number of quarters now with partner drive-ins at 2.9% comp store sales increase for the quarter. And this of course reflects the benefit of a variety of initiatives we have in place that our partnership drive-ins a little further ahead on, like the retrofit and other sales driving initiatives.

Now I’d like to spend a few minutes talking about traffic and how our sales have been growing in the recent past. We typically don’t discuss individual monthly sales results and I think I should also say we don’t intend to make a practice of it in the future, just as we haven’t in the past.

But this quarter, there were a number of initiatives and changes in our business that impacted check and traffic and I believe those are worth discussing with you today. We talked in our last conference call, which I guess was in October, we talked about the performance for the quarter, the fourth quarter ending August as well as the experience we had the month of September and that we experienced growth in our average check but a decline in traffic.

So to gain a more complete understanding of our sales growth in the quarter, we’ve broken out sales growth between growth in check versus traffic growth for each month in the quarter and you should be able to see how that performs. This trend shifted dramatically in the month of October. While average check was positive, it didn’t increase as much as September and more importantly, we saw a nice improvement in traffic. These combined to produce a solid sales increase for the month of October with a nice balance between growing check and traffic.

So I think it’s fair to say that the solid performance in October was reflected in the success of a number of our sales driving initiatives, including the continued rollout of our national coffee program, our emphasis on alternative day parts through new product introductions like our Spicy Southwest Breakfast Burrito and our Whopper Shake, both of those were featured in the month of October, and a continued rollout of our retrofit program, which gained considerable momentum during the quarter.

So this solid momentum continued into November with ongoing implementation of our coffee and retrofit initiatives but it gained an additional boost from the implementation of our Happy Hour initiative in the month of November. For those of you on the line who aren’t familiar with our Happy Hour program, this initiative features half-price drinks from 2:00 p.m. to 4:00 p.m. every day and as you can see from the slide, the impact of Happy Hour further enhanced our positive growth in traffic.

Now, at our partner drive-ins, where we have sales information broken down by time of day, you’ll see that we experienced double-digit traffic growth in the afternoon day part during November along with a nice increase in overall sales.

As all of you know, we look at our business as a series of initiatives and we began working on Happy Hour initiatives last fiscal year. We started working on this because over half of our franchisees, including by the way many of our most successful franchisees, but over half of our franchisees have been doing one form or another of a Happy Hour for a long time in many cases, some with very strong results, including sales and profits well ahead of the system average in many cases. And given their success and quite frankly at the urging of many of them, we decided to launch a system-wide version of Happy Hour and that’s now being actively promoted for the first time beginning in November and it will become, along with of course, all of our other 168,000 drink options we offer, it will become another reason that Sonic is the best place for folks to stop in and get drinks. So this has had a very nice impact on our business but for the quarter, we achieved an increase in traffic and check.

And then looking forward, we plan to continue to build awareness of the Happy Hour drink initiative and expect that that, combined with our other sales driving initiatives, the balance blend of positive growth in traffic and average check will continue to produce strong sales over a longer period of time.

While adverse weather conditions in many of our core markets during the month of December have had a negative impact on sales, we continue to expect same-store sales growth in the 2% to 4% price range -- excuse me, 2% to 4% range going forward for the quarter and the year, with partner drive-ins at the higher end of this range.

Now, one of the things that we also want to review is our price increases and the impact of our initiatives on our price increases. You’ll recall that during our last conference call, we told you that our partner drive-ins had increased prices 4% in the summer in response to minimum wage, federal minimum wage increases. And that had been on top of a 1% price increase taken two different times earlier in the year.

The average menu price increase was somewhat offset the months of September and October by our focus on our non-traditional day parts, meaning breakfast, afternoon, and evening. Because these non-traditional day parts have a lower check average than lunch and dinner and because they grow disproportionately during the quarter, they actually offset the average check growth slightly.

The additional discounting and change in mix associated with our Happy Hour drink initiative had the further effect of reducing a significant portion of our price increase resulting in an average check growth in the range of 2% to 3% for the months of November and December.

So as we look forward related to menu pricing, we expect that our current pricing strategies, including Happy Hour and this focus we’ve talked about on non-traditional day parts that we talked about for a long time in our business, that those things along with the lapping of our January 2007 price increase will yield an average check increase in the range of 1% to 2% for the remainder of the quarter -- that’s the months of January and February -- and we’ll continue to evaluate the appropriateness of our menu and pricing but currently, we don’t have any plans to take another menu price increase.

We continue to be very optimistic though about our ability to drive same-store sales and store level sales going forward. Our focus, as you would expect, will be to continue to drive business in alternative day parts, like we have for some period of time. This matches our business well and we think matches where consumers are going.

But we’ll do it by focusing on products like Cheesecake Bites and a Double Berry Smoothie this month. We’ll do it also by increasing media expenditures, roughly $100 million this year, including almost $100 million on national cable and the effect of these should be continued positive impact on our business. We’ll do it also through the addition of drive-thru windows in our system. We’ll continue to have a very positive impact as well.

Now, one of the things I should say on the national cable, that the addition of -- and the cable expenditures, expenditures all together is a 9% increase over our fiscal spending in 2007. The national cable strategy continues to be beneficial in raising overall brand awareness in all of our markets, even more so in new markets. And I should say as well while this has had an enormously positive impact across our system growing sales and profit, it has also had a tremendous impact on attracting new franchisees to our brand, something we’ll talk about more in just a few minutes.

But the ongoing increased media support will also help lift sales the morning, afternoon, and evening, so it will continue to pay off these non-traditional day parts that make up more than half of our sales.

So back to the other point, there are other drivers that continue to drive our business. The retrofit is one. Scott’s going to talk about that more in a few minutes. Electronic signs is another that will help drive multiple messages throughout the day at various drive-ins as customers are going past the drive-ins. We have this in about 20 -- a little more than 20% of our system now, a great day part initiative.

As I said a moment ago, the addition of drive-thru windows and the extended hours that this permits. The rollout of a new coffee program is something that’s been hugely positively impactful on our -- I shouldn’t say but it’s been a very nice impact on our business as we’ve implemented store-by-store a line of real espresso based drinks, including hot and ice lattes, as well as a product that is our own, the Java Chiller, now in -- the whole program now in over 80% of our drive-ins. By the time we complete fiscal year ’08, we’ll have that in place throughout the entire system.

So it should be no surprise to you that drive-ins have implemented a series of these sales driving initiatives. They are experiencing the strongest growth in sales and profits in our system, in many cases above our targeted range and we expect that the more drive-ins in markets as they reap, as they implement these programs, they’ll reap a similar benefit in terms of good sales growth market by market.

So as we think about our business going forward we, our management team, remain very focused on driving sales and development, both new stores and reinvesting in existing stores, not just for the fiscal year but for the long run and we continue to have a lot of confidence that this multi-layered growth strategy, being able to pull a number of levers to keep our business growing, this multi-levered growth strategy will continue to produce good, consistent results for our business and for our shareholders and while there will always be a lot of factors which will play a part in future performance, including consumer confidence as well as food and labor costs and things like weather, which we do have to deal with, particularly at this time of year, that those will be things that will impact us in the short run but we in fact have a number of proven strategies that are in place that will continue to grow our brand, not just over the next few quarters but over the next several years and the positive impact of these strategies is evidence in many markets now already and should continue to work for us very well going forward.

So with that, I’d like to turn the meeting over to Scott McClain to talk about our development and franchising activities.

W. Scott McLain

Thank you, Cliff. We did have an active quarter on the development front as we opened 36 new drive-ins as well as experienced a considerable increase in both retrofits and the relocation and rebuild of existing drive-ins. During the first quarter, we completed 240 retrofits, including 202 by franchisees. That was ahead of what we were anticipating and puts us somewhat ahead of our expected pace of 750 to 850 for the year.

Over 30% of our system now has the new look and we should be close to 50% by the end of the fiscal year. The fact that our franchisees are using their own money and completing the retrofit faster than expected is a strong testament not only to the returns we’re seeing but also to their continued optimism for the Sonic brand and our future.

Relocations to better trade areas and the complete scrape and rebuild of existing drive-ins are also increasing. Last year, we completed 35 of these and that was more than double the average of the last few years. During the first quarter, we completed 15 relocations and rebuilds versus five in the same period a year ago and more than 50 additional drive-ins have scheduled completion dates.

Now, we don’t count these as new store openings but they do require a new drive-in to be built and they are probably our highest return on investment activity, routinely generating sales increases of greater than 25%. Were we to count these as new stores, it would add roughly 2% to our overall system growth rate.

Now, the fact that many of our existing franchisees are devoting a considerable amount of their resources to retrofits and relocations does tend to constrain short-term development a bit. However, prospects for increased new drive-in openings going forward continue to be strong, as evidenced by our growing pipeline.

Our ADA commitment stood at 919 at the end of the first quarter. That’s a 60% increase from the beginning of fiscal 2007 and typically it takes three to five years for all drive-ins under an area development agreement to open as a new store. Now, a large portion of the growth in ADAs came from new franchisees and with continued strong interest in new markets, we expect our ADA commitments to grow to over 1,000 at some point in the next several months.

We also sold 481 development options last summer. These options gave existing franchisees the right to open under the more favorable number six license agreement any time in the next five years.

Now when you consider the development options on top of record area development agreements, the committed portion of our pipeline is indeed significantly stronger than at any time in our history.

Now, the increase in ADA commitments is all well and good but we don’t actually start recording revenue until the drive-in opens. What was most encouraging in the first quarter was that we began to see the increase in ADA commitments move further down the pipeline towards increased new store openings.

As of the end of November, we had 207 projects under contract. That’s a 20% increase from the same period a year ago and typically it takes 10 to 12 months to go from under contract to a new drive-in opening.

We also began the second quarter with 36 drive-ins under construction, which with winter weather always a wildcard positions us well to surpass the 22 drive-in openings in the second quarter last year and on track to open 155 to 165 new franchise drive-ins this fiscal year.

Performance of new drive-ins overall continues to be strong, with average opening volumes now approaching $1.3 million, roughly 30% greater than what we were seeing just three to four years ago. Volumes in the many new markets that we’ve opened over the last 18 months have been even stronger, averaging more than $2 million in sales. In several cases, we’ve also begun opening additional drive-ins in these markets, with no let-up in performance from either the initial stores or the newer drive-ins.

Some of you may be interested to know that we opened our first drive-in in New Jersey in the month of November and I’m happy to report that the folks in Waretown, New Jersey apparently were anxious for Sonic as this drive-in did almost $300,000 in sales in its first four weeks.

Our first drive-in in New Jersey marks the sixth new state we’ve entered since March of 2006 and we now operate a total of 3,374 drive-ins in 35 states from coast to coast. We’ve also sold territory in five additional states and we are well on our way to becoming a truly national brand with operations in every state at some point in the next several years.

It’s now my pleasure to turn the call over to Steve Vaughn, our Chief Financial Officer, for his remarks on our financial performance.

Stephen C. Vaughan

Thank you, Scott. We’re very pleased with our multi-layered growth strategy and the ability that it had to drive our consistent earnings growth as demonstrated here in the past quarter. As Cliff mentioned earlier, the cornerstones of this strategy are built around low single digit same-store sales growth, our unique ascending royalty rates, additional operating leverage at both the store levels and the bottom part of our income statement, and strategic use of our balance sheet and strong cash flow for share repurchases and franchise acquisitions.

We believe the combination of these elements can consistently produce earnings per share growth in the mid to high teens over the long term. As Cliff mentioned at the outset of the call, during the first quarter all of these elements came into play to produce earnings per share of $0.22, an increase of 16% over the comparable quarter last year.

Sales at our partner drive-ins continued to outpace those of our franchisees during the first quarter, increasing 2.9%. The month of November marked our seventh straight month of higher performance by partner drive-ins. We believe this performance is largely the result of a larger percentage of our package of sales driving initiatives, such as the retrofit, electronic message centers and the implementation of extended hours being implemented in our partner drive-ins.

As Cliff mentioned, the rollout of these initiatives is proceeding in more markets and in more franchise drive-ins that we expect an increasing benefit from these initiatives on the franchise side going forward.

However, in the short-term, inclement weather across a number of our markets combined with warmer-than-average weather last year has resulted in same-store sales during the month of December coming in below our targeted range. Notwithstanding December’s results, we remain very optimistic about sales, both in the second quarter and beyond. Not only will we have broader implementation of our sales driving initiatives going forward, sales during January a year ago were particularly weak as a result of bad weather and we will benefit from an extra day of sales in February due to the leap year.

As further evidence of the strong performance we are seeing in our new drive-in openings, average unit volumes for partner drive-ins increased 3.3% during the quarter.

Our franchising income, including franchise fees and royalties, increased $3.7 million during the quarter. This increase reflected the impact of new store development, solid growth of same-store sales, as well as the positive impact of our ascending royalty rate. During the quarter, our royalty rate increased by approximately 25 basis points. This increase was driven by our unique ascending rate, which each of our license agreements feature, as well as approximately $1 million in incremental franchising income from the license conversion which we implemented last April. This incremental franchising income has relatively less associated costs. It was a major factor in our earnings growth for the quarter.

Looking forward, franchising income should continue to grow in future quarters and we expect $13 million to $15 million in incremental franchising income this year.

Despite higher prices for several commodity items, as well as higher labor costs resulting from the July increase in the federal minimum wage, drive-in level margins improved by 50 basis points during the first quarter. This improvement was largely the result of the price increase taken during the summer. Looking forward, food inflation and additional minimum wage hikes in several states where we operate will continue to pressure costs.

As Cliff mentioned earlier, the continuation of Happy Hour will result in higher discounting and in turn, higher costs as a percentage of sales. While we will continue to receive the benefit of December price increase mitigated by our Happy Hour initiative, we will be [inaudible] over the 1% price increase implemented last January. This lower rate of growth in pricing should be partially offset by leverage from higher sales volumes but will likely constrain our ability to continue to improve margins at the restaurant level in the next few quarters.

During the first quarter, we also experienced leverage from the bottom part of our income statement, particularly in SG&A expenses, which increased by 6%. However, we do expect both SG&A and depreciation and amortization to grow more in the 10% to 12% range for the year.

There were a couple of other items in our first quarter results that I would like to bring to your attention. First, you will note that other income decreased by $1.2 million. This decrease was the result of the favorable resolution of a non-income tax matter settled in the first quarter a year ago. Also, our income tax rate for the first quarter was 38%, considerably higher than the 35% rate from the first quarter of last year. The lower rate last year was the result of a favorable settlement of state taxes. We expect the tax rate will be more in the range of 37% to 38% going forward.

Our earnings per share continued to benefit from our tender offer last fall, as well as our subsequent share repurchases, including $12.2 million that we’ve bought back in the first quarter. We have now repurchased over $590 million of stock, or more than 30% of the company, over the last five quarters.

During the first quarter, the accretion from our repurchases added roughly $0.01 to our earnings per share growth and should continue to be accretive, particularly in the latter half of the year.

For the year, we expect our share repurchase activity to add $0.03 to $0.04 per share to our earnings, which will increase our EPS growth rate by approximately three to four percentage points.

In addition, we continue to have the borrowing capacity to make other strategic investments on an opportunistic basis. As of the end of the quarter, we had approximately $57 million available under our revolving credit facility. We would expect to continue to access these funds opportunistically, including acquisitions of franchise drive-ins or additional share repurchases under our remaining share repurchase authorization of approximately $30 million.

Looking forward, we remain confident that our multi-layered growth strategy should allow us to achieve earnings in the range of $1.10 to $1.12 per share in fiscal year 2008 and we continue to expect that pursuing this strategy can produce earnings growth in the 18% range over the longer term.

However, in the short term, I would remind you that the second quarter is always our most volatile quarter as a result of the potential impact of weather. We benefited a year ago from an unusually low tax rate and we will likely face some near-term pressure on restaurant level margins. However, we should still be able to show solid growth from our performance of a year ago, which was $0.13 per share after adjusting for the debt extinguishment charges associated with the securitized debt refinancing, which we completed in the second quarter last year, as well as the retroactive reinstatement of a federal tax credit program.

This concludes our prepared remarks. We would be happy to accept your questions.

Question-and-Answer Session

Operator

(Operator Instructions) We’ll go first to Joe Buckley with Bear Stearns.

Joe Buckley - Bear Stearns

Thank you very much. Just a question on the Happy Hour initiative and the margin impact; I guess what your comments are implying is that the margin impact is negative. I would as wondering if you could just kind of walk through that a little bit, given that we typically view drinks as very high margin products. I mean, I realize you are doing a half price or a two-for-one sale basically, but just walk us through the dynamics of that, how much impact you would expect going forward.

Stephen C. Vaughan

Joe, I think from a discounting standpoint, it has added a couple of percentage points to our discount rate. However, as you pointed out, drinks are a higher margin item for us to start out with and so what we have seen is we have further shifted our mix towards drinks and so while we expect to see some slight impact on our margins, we don’t expect that it will be as dramatic as you might think from a two percentage point increase in our discounting rate.

W. Scott McLain

We also tend, Joe, to sell a lot of snacks during Happy Hour. Because we have such a wide menu, we have a lot of snack items and so those prove to be very popular to consumers as well.

Joe Buckley - Bear Stearns

I should tell you, at least on my phone, you’re breaking up. This only started with the Q&A, so just to be aware. And just one more follow-up question, really to Scott; the expansion pipeline continues to build dramatically and all the numbers sound great and the expansion numbers continue to look a little bit light. And I guess -- do the remodels, do the retrofits, the capital spending that -- the spending on that, is that a constraint in terms of --

W. Scott McLain

Yeah, I think, Joe -- can you hear me okay?

Joe Buckley - Bear Stearns

You’re fading pretty badly.

W. Scott McLain

I’m fading. Well, I’m about an inch from the microphone. That’s as close as I can get.

J. Clifford Hudson

Well, I can tell you, Scott, that I’m in a remote location. I can hear you well enough, so I’m not sure if there’s some other issues.

W. Scott McLain

Well, I’ll go ahead and try to answer your question, Joe. I think for our existing franchisees, they are actively investing in our brand, probably at a greater rate than they have ever historically. In the first quarter, they opened 31 stores but they also rebuilt or relocated 15 drive-ins, so their total new unit development in the first quarter was 46 as compared to something in the 30s last year.

In addition, they also completed 202 retrofits, which was ahead of our expectations. So while they are busy retrofitting and relocating as well as opening new drive-ins, that may have somewhat of a temporary constraint on new drive-in openings. However, what we are seeing is that the large increase in our area development agreements last year, in our commitments, most of that came from new franchisees and those new franchisees, once they begin opening stores should more than offset that temporary slowdown, if you will, by existing franchisees. But we probably won’t see that dynamic in full force until the latter part of the year.

Joe Buckley - Bear Stearns

Scott, do you know offhand, of the 919 commitments, what percentage of that or how many stores are from new franchisees?

W. Scott McLain

Well, I don’t know that off the top of my head but one thing I might also point out, Joe, is that our existing franchisees not only have area development agreements but they also bought 481 development options last summer, which gives them the right to open up stores in addition to what they have under an area development agreement any time over the next five years.

So I think their appetite for continued growth is strong. It’s just hard to do everything at once -- retrofit, relocate, rebuild a drive-in and build new stores.

Joe Buckley - Bear Stearns

Okay. Thank you.

Operator

We’ll go next to Sharon Zackfia with William Blair.

Sharon Zackfia - William Blair & Co.

Good morning. I guess given the commentary on Happy Hour and the impact on margins, excuse me if I missed this because my phone was breaking up too, are you expecting full year restaurant operating margins to be flattish to down at this point? I think when you initially gave guidance, you were expecting some improvement there in fiscal ’08.

Stephen C. Vaughan

Yes, I think the guidance, Sharon, is that for the remainder of the year, we expect flat to slightly unfavorable restaurant operating margins.

Sharon Zackfia - William Blair & Co.

Okay, and then maybe could you update us on -- I think there were several initiatives you were working on with theoretical food costs and labor scheduling. Is anything there likely to be rolled out this year and might that help buffer some of the impact from the Happy Hour?

W. Scott McLain

Yes, Sharon, we do have an ideal food cost system that is in use at a number of our drive-ins, including our company drive-ins and it is making a difference and we expect to continue to roll that out to more franchise stores over the next several months but there are tools available to our operators which should help them deal with some of the food inflation that we’ll face over the next several months.

Sharon Zackfia - William Blair & Co.

And then on labor scheduling?

W. Scott McLain

Labor scheduling, we don’t -- we’re not as far along on labor scheduling as we are on the food cost side but there are some limited tools available on the labor side as well.

Sharon Zackfia - William Blair & Co.

Okay, and then just so I understand, I mean clearly you are expecting though for fiscal ’08 that per unit profitability continues to improve?

W. Scott McLain

Yes.

Sharon Zackfia - William Blair & Co.

Okay. Thank you.

Operator

We’ll go next to Steven Rees with JPMorgan.

Steven Rees - JPMorgan

Thanks. I wanted to ask about credit card payments and how those trends are holding up. Are they still growing year over year? And I think those transactions used to be higher average check and perhaps why you think that isn’t offsetting some of the impact you are seeing on average check from the beverages and focus on other day parts?

Stephen C. Vaughan

Well, Steven, we are continuing to see our credit card transactions grow year over year. It isn’t the same level of growth as the first year that we had the pace program implemented but I think we continue to see an average check that is about 40% higher than our cash check and we do continue to see a nice increase in our average check. It was up roughly -- for the system, it was up about 1.5% for the quarter.

Steven Rees - JPMorgan

Okay, and then Steve, could you just talk about your visibility on commodities as you move throughout the calendar year? How those are looking and I guess specifically dairy, if you have any visibility there as you look forward to the summer months.

Stephen C. Vaughan

Well, we do expect to continue to see some pressures on the commodity front, dairy in particular. We have locked in some of those costs. I believe it’s about half on the dairy side out several months but it is on a fairly significant year-over-year increase.

We will continue to look for opportunities to lock in costs where we think it makes sense but at this point, I think we’ll continue to expect that we’ll have an unfavorable year-over-year comparison in terms of just overall commodity costs.

Steven Rees - JPMorgan

Okay, and then just finally on the pricing, I know you seem pretty reluctant to take additional pricing here in the near term as you lap some of these smaller ones in the winter but how are you thinking about pricing longer term? And do you think you still have more room to take pricing, specifically on some dairy or some dessert items in the summer?

Stephen C. Vaughan

Well, I think when the next federal minimum wage increase occurs in July, we will certainly reevaluate at that time whether we feel like that another price increase is necessary. However, at this point in time, we don’t have a plan in the next six months to take additional pricing.

Steven Rees - JPMorgan

Okay, great. Thank you very much.

Operator

We’ll go next to Mitchell Speiser with Telsey Advisory Group.

Mitchell J. Speiser - Telsey Advisory Group

Thanks very much. Good morning. A few questions; first on developing markets, I saw the comp was down 2.4%, a bit of a deceleration versus the previous couple of quarters. Can you just talk about that -- in particular, what was going on in developing markets?

W. Scott McLain

Well, one of the things that happens to us, Mitch, in developing markets is that we tend to have a more pronounced honeymoon period, so sometimes you can get a better feel for how developing markets are performing by looking at average unit volumes and I think you’ll note that our average unit volume growth in developing markets was positive during the second quarter.

The other thing that I think bodes very well for us going forward, particularly as we expand to additional new markets and additional new states is that we, as I mentioned, we’ve opened many new markets since March of 2006 and six new states and without exception, we’ve gotten tremendous results from new stores and new markets and as we are opening the second and third stores, we’re also seeing similar results from those as well.

Mitchell J. Speiser - Telsey Advisory Group

Okay. Thank you and moving along, did you pay down any debt in the quarter?

Stephen C. Vaughan

Mitch, no, we did not pay down any debt.

Mitchell J. Speiser - Telsey Advisory Group

I’m sorry?

Stephen C. Vaughan

We bought back about $12 million of stock during the quarter, and so we -- our borrowing slightly increased during the quarter.

Mitchell J. Speiser - Telsey Advisory Group

Okay. I thought there was like a monthly or a quarterly debt pay down schedule, or no?

Stephen C. Vaughan

Well, we have a fixed portion that we do actually make monthly payments on but we also have a variable portion, so we pay down some of the fixed portion, drew some on the variable portion.

Mitchell J. Speiser - Telsey Advisory Group

I understand. Thank you. And moving along, it may have been in the presentation slideshow, but did you tell us what you thought the traffic number was in the fiscal first quarter?

Stephen C. Vaughan

Yes, the traffic increased about a half a percent for the quarter.

Mitchell J. Speiser - Telsey Advisory Group

Okay, thank you. And lastly, I think you mentioned that you expect your long-term earnings growth rate to be 18%. It’s 15% to 17% now. I don’t think you’ve perhaps thrown out an 18% number in a while. Could you just -- was that the first time that you’ve talked about an 18% number?

Stephen C. Vaughan

No, that’s really consistently been our -- our belief is that the multi-layered growth strategy can produce that 18% earnings per share growth rate over the long term and that’s consistently been our objective.

Mitchell J. Speiser - Telsey Advisory Group

Great. Thank you very much.

Operator

We’ll go next to Dean Haskell of Morgan Joseph.

Dean Haskell - Morgan Joseph & Co.

Thank you. Congratulations on a great first quarter. Scott, you answered some of my questions about under construction for new units, so what about remodels for the second quarter? How many are under construction or do we anticipate getting completed?

W. Scott McLain

Well, we have in the first quarter, Dean, we completed 15. We have more than 50 more that have scheduled completion dates but I’m not exactly sure how many of those will get completed in the second quarter. But for the year, we should complete 60 plus relocations or rebuilds, which would be roughly four times what we [did last year]. And as I mentioned before, these are very positive investments for our franchisees because they routinely generate sales increases in excess of 25%.

Dean Haskell - Morgan Joseph & Co.

Scott, the question’s on the remodels, not the relocations.

Stephen C. Vaughan

Yeah, retrofit and Scott’s --

W. Scott McLain

Retrofit, I’m sorry. Your question was how many are we going to complete in the second quarter?

Dean Haskell - Morgan Joseph & Co.

Yes, do you anticipate?

W. Scott McLain

I don’t know, Dean. It’s a little hard to predict the second quarter with weather always an impact. However, we’re ahead of our expected pace for the year of 750 to 850 and we should continue to stay ahead throughout the course of the year. How many are completed in the second quarter versus the third quarter versus the fourth quarter, I don’t have a really good feel for as we sit here on the call.

But what I do have a good feel for is that our franchisees are clearly embracing the retrofit and wanting to get it implemented, so we feel very good about the 750 to 850 for the year.

Dean Haskell - Morgan Joseph & Co.

Okay, good.

Operator

We’ll go next to Matthew DiFrisco with Thomas Weisel Partners.

Matthew DiFrisco - Thomas Weisel Partners

A question with respect to the income statement; looking at the other operating expense line as a relative percent of sales, it looks like it’s the first time in a couple of quarters, maybe almost a year-and-a-half, that you got leverage on that. Can you -- is there something in there? I mean, it looks as though that you remodeled more stores. You’re saying credit card fees have also should have gone up as share moves towards credit cards away from dollars, if that’s correct. Those have been the drivers in the past to deleveraging that. I was curious why or how you are able to lever that in still somewhat of a low single digit comp environment.

Stephen C. Vaughan

Well, Matt, I believe a couple of things; one, we had the price increase that was working in our favor for the entire quarter. In addition, the 3% comp that our partner drive-ins put up, 2.9%, was a stronger comp growth than we’ve seen for the last several quarters out of our partner drive-ins, so very nice increase there and just got some leverage from that incremental sales.

Matthew DiFrisco - Thomas Weisel Partners

Okay, and then also, can you just speak about historically, have you ever done a campaign like this before over a prolonged period of time, sort of the Happy Hour? I’m wondering the effect of -- are you concerned with maybe conditioning consumers to think of you, look for you when you’re on deal and maybe move their buying habits and start going when the Happy Hour is in effect and moving volume from maybe traditional meal day parts?

J. Clifford Hudson

One reaction to that is the framework we utilized for making this decision in the first place. In other words, in looking at doing Happy Hour system wide on a sustained basis, we looked to the 45% of our system which was all franchisees, but the 45% of the system that have been doing Happy Hour for a sustained period of time -- and by that, we don’t mean six months. In many cases, for years and years. And in analyzing their businesses, what we saw was that they had above average sales and above average store level income and store level profit and the -- so we had a case study that showed pretty clearly that the impact was positive for this business versus those who were not doing Happy Hour on a sustained basis.

And our belief too was that by doing it nationally, it would actually help us strengthen their business as well, that is the 45% that are already doing it because they’ve been doing it for years without marketing support. And by bringing that kind of marketing support, it would help the program where it had already been implemented as well as where it was not in place, so this was the basis for overcoming that concern.

Matthew DiFrisco - Thomas Weisel Partners

Okay, and then lastly, what is your comfort or how high could debt go? I mean, you are around $700 million now in cash, balance wise. I’m curious how -- debt balance wise -- how much higher are you willing to take that in this environment and also to sustain a certain credit rating that you are comfortable with?

Stephen C. Vaughan

Well, Matt, at this point we have $57 million available under our existing credit facility and so we are very comfortable with that level of debt. We will continue to evaluate whether we are comfortable with additional debt as our business grows but I think at this point, we’re very comfortable with the current availability.

Matthew DiFrisco - Thomas Weisel Partners

Can you talk about it in capital structure as a percentage then?

Stephen C. Vaughan

Right now, we’re in the range of about four times debt to EBITDA and I think we are very comfortable with that of debt.

Matthew DiFrisco - Thomas Weisel Partners

Okay. Thank you.

Operator

We’ll go next to Rachael Rothman with Merrill Lynch.

Rachael Rothman - Merrill Lynch

Just a follow-up on the developing markets and kind of the lagging same-store sales growth there; can you talk about what percentage of your stores are currently in developing markets and what percentage of your unit growth has been in those developing markets?

And then maybe when we should see a reversal of that trend, because I guess if you’re -- I’m guessing that if those stores were not losing same-store sales that your overall blended same-store sales growth would be much stronger.

Stephen C. Vaughan

Well, we have between 20% and 25% of our drive-ins are in developing markets. I believe that this past year, a little over or roughly half of our development came in developing and new markets, which are included in that developing market number. And I’m sorry, did you catch the third part of the question? Can you repeat the third part of your question?

Rachael Rothman - Merrill Lynch

Sure, just when do you think that that trend should normalize? I guess in -- does the honeymoon flow in six months after, eight months after, 12 months after?

Stephen C. Vaughan

Well, it depends somewhat on whether it’s a brand new market or a market that we’ve had drive-ins in for a number of years. It tends to normalize faster in a market that’s a developing market, under-penetrated but where we’ve had presence before.

I think that we would expect over time some of these markets will become core markets as we continue to build drive-ins and so you will always have a little bit of a potential for your same-store sales being lower than your core markets, because you are moving markets over to core as they become more penetrated. But we would expect that over time, those markets stabilize and that’s really what we’ve seen historically.

Rachael Rothman - Merrill Lynch

And can you just remind us where you are with extended hours, coffee, and the drive-thru as a percentage of the stores, both company and franchise?

W. Scott McLain

From a drive-thru perspective, we probably have 45% to 50% of our drive-ins that have a drive-thru.

Rachael Rothman - Merrill Lynch

Company and franchise, or is that just company?

W. Scott McLain

Company and franchise. From a coffee implementation standpoint, we are actively implementing our coffee program across our entire system and that will be completed in this calendar year.

And then from an extended hours standpoint, I don’t have a -- Steve, do you have a good feel for how many stores with extended hours?

Stephen C. Vaughan

It’s probably 150 to 200 that are doing extended hours in the system. And I think just a little more clarification, we have coffee in a little over 80% of our system now at this point.

Rachael Rothman - Merrill Lynch

And in terms of the planned or targeted penetration of drive-thru and extended hours by the end of ’08, do you expect it to increase? I mean, are you rolling out the extended hours in the drive-thru or should we expect the penetration to stay roughly the same?

J. Clifford Hudson

Well, I’m not sure that the late night initiative in terms of pace within the system or extensiveness is something we’ve communicated historically.

Rachael Rothman - Merrill Lynch

No time like today. How about the drive-thru?

J. Clifford Hudson

Yeah, and it’s not something we anticipate doing today either.

Rachael Rothman - Merrill Lynch

Okay, how about the drive-thru?

W. Scott McLain

I think on the drive-thru, Rachael, a couple of points; number one, all of our new stores are being built with a drive-thru, and so just by virtue of that, the percentage will increase. I think a lot of our franchisees, as they are relocating, rebuilding and retrofitting are also looking at the potential addition of a drive-thru as a means to increase their business over time. I don’t have a specific number for you but it is something that is a big part of our business and will probably be a growing part of our business going forward.

Rachael Rothman - Merrill Lynch

Okay, and then one last question; you guys are pretty far along in the retrofit to the company operated stores. I guess pretty near term, we should be hitting the inflection point in terms of the capital spending on the remodels or the retrofits. Can you talk about what the allocation of that incremental free cash will be post? Are you guys focused at these levels more on debt reduction or on future buy-backs? And obviously it will depend on the stock price but you are able to repay the debt, is that correct? That’s kind of your worst-case alternative?

Stephen C. Vaughan

Yes, we would be able to repay the debt. We have about $140 million on our revolving credit facility, so that’s all able to be prepaid without penalty. However, I think we will continue to look at the same strategy we’ve pursued for a number of years, which is opportunistically buying back stock and opportunistically reacquiring franchise drive-ins, so those will be our first choices.

Rachael Rothman - Merrill Lynch

And as you go into fiscal ’09 and fiscal 2010, how should we think about your CapEx trending? What would be a normalized rate, post the retrofit?

Stephen C. Vaughan

Well, some of that will depend upon the level of new store development that we pursue on the partner drive-in side. However, I think if you look at 2009, we will continue to be implementing the retrofit on partner drive-ins. In 2010, that might start to tail off somewhat and this year I believe we’ll spend somewhere in the neighborhood of $20 million to $25 million on retrofits, so that would give you kind of an idea of what amount might start going away.

Rachael Rothman - Merrill Lynch

Perfect. Thank you so much.

Operator

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

Nicole Miller - Piper Jaffray

Good morning. If possible, can you quantify the December weather impact in terms of comps and/or lost days of business?

Stephen C. Vaughan

I guess one comment that we could make, we had one week where we had a significant impact from an ice storm that came across a pretty wide swath of our markets in our core markets, and if you exclude that week, our sales for the other three weeks were within the 2% to 4% range. However, for that particular week where we were significantly impacted by weather, our sales were negative so it did drag the month down below the 2% to 4% range.

Nicole Miller - Piper Jaffray

And then in terms of the retrofit, you’ve given results in the past of the stores that have been retrofitted to date. Can you just review that with us and then the stores that were remodeled in this last completed quarter, are you seeing more -- you know, improved results or a decrease or any change?

W. Scott McLain

Nicole, I think what we’ve said in the past is that we expect the retrofit to add 1.5% to 2% to our system wide sales on an ongoing basis. I guess probably the best evidence I can give you that the retrofit is working is the fact that the franchisees are doing it faster than they are required to and they are in many cases asking to do it early and when they are willing to spend their own money to make that investment, that’s a good indication that it is paying dividends for their business.

Nicole Miller - Piper Jaffray

Fair enough. And then in terms of the promotions, in addition to Happy Hour and coffee, what are the other specific promotions right now in January?

Stephen C. Vaughan

We had Cheesecake Bites that we are continuing to promote and then a Double Berry Smoothie.

J. Clifford Hudson

And a steak, egg, and bacon breakfast burrito.

Nicole Miller - Piper Jaffray

And on the Happy Hour, is it just slushy drinks? I mean, it’s not just coming on the coffee side?

Stephen C. Vaughan

It is just our fountain and slushes.

Nicole Miller - Piper Jaffray

Thanks. That’s all I had. Thank you.

Operator

We’ll go next to Chris O’Cull with Suntrust.

Christopher O’Cull - Suntrust Robinson Humphrey

Good morning, guys. Steve, it appears the restaurant margin came in a little better than you expected, yet much of the price increases was negated by mix shift and the half price Happy Hour promotion. Could you explain or maybe give us a little more explanation on what caused the better-than-expected margin?

Stephen C. Vaughan

Well, we did have a little more leverage, particularly in controlling our labor costs. I think going into the quarter, we probably expected a little more deterioration in the labor line item. And I think also, as Scott mentioned, the ideal food cost program, we do feel like we are starting to see some benefits from that. So probably I would say the number one reason for that is just good controlling of costs.

Christopher O’Cull - Suntrust Robinson Humphrey

Okay. What opportunities are there with labor? I mean, when you say labor costs, how do you realize better labor productivity?

Stephen C. Vaughan

Well, I think it’s really just a focus at the store level and giving our operators tools to try to schedule labor better to meet the rush periods and then reduce labor when you’re not busy, so it’s really just kind of been an increased focus and I think with the minimum wage increase, that kind of re-emphasized the importance of managing that area and I think our operators really stepped up and did a nice job in that area in the first quarter.

Christopher O’Cull - Suntrust Robinson Humphrey

Okay, and then Scott, when you were -- when you had the bad weather in December, was that difficult to manage labor during that week? I mean, did you see some cost issues because of that?

W. Scott McLain

Not really. I mean, I think our operators are fairly skilled at managing their business and when -- first of all, we had a number of drive-ins, as Steve mentioned, that were closed in one particular week but I think our guys, particularly on the company side where they do have some good labor tools from a technology standpoint, they are good at managing their business and understanding what’s happening to their business.

So it’s not the first time we’ve ever had bad weather, so they know how to deal with that.

Christopher O’Cull - Suntrust Robinson Humphrey

Okay, and Cliff, I know the company strategy has been to focus on alternative day parts but at what point does lunch and dinner need to become a focus for traffic building, especially in light of what we’re seeing in some of the other fast food chains?

J. Clifford Hudson

Well, it continues to be a focus in ways that we don’t necessarily talk about from a tactical marketing standpoint. It is on an ongoing basis for us.

The difference is and our belief is that the -- two things; one, that the opportunity for growth, breakfast in the industry generally, afternoon with the industry generally but also with the peculiarities or the specialties of our business and then evening, with ice cream, which the industry hasn’t shown a big growth in but we have appreciably. These are opportunities for growth that lunch and dinner in the industry and in our business don’t present the same opportunity.

So in fact, we do continue to focus on lunch and dinner with some specific marketing tactical initiatives that we simply don’t discuss on this phone call because it’s too tactical. But it’s not as though we’ve let lunch and dinner go. Our business has grown substantially over time. It’s just that those alternative day parts have grown disproportionately more strongly and quite frankly, I think that that’s what sets us apart versus most of our competition. It’s also something most of our competition is trying to mimic.

Christopher O’Cull - Suntrust Robinson Humphrey

Well, that’s right and I know that lunch and dinner has been -- I think you’ve said that the traffic has been negative in those two day parts. At what point does it become more of a defensive measure in terms of just the product, the quality of the product relative to the peers in terms of just some of the basic combos?

J. Clifford Hudson

Well, we do over time continue to promote various entrees and new entrees to attempt to attract people with new products, but we also do have marketing initiatives to drive business to those day parts. And the -- but the broader point is one of -- the declines in that business or the lack of growth at times in those day parts is not something particular to Sonic. That is reflective of what’s happening with the consumer and the shifting in the way they are spending their money.

And so to some degree, one of the things we are mindful of is we need to continue to support those traditional day parts but we don’t need to chase them -- we don’t need -- likely a fish swimming upstream when consumers are shifting their dollars into other day parts, and particularly other day parts where we think we have some particular strengths.

Christopher O’Cull - Suntrust Robinson Humphrey

Okay, thanks.

J. Clifford Hudson

That strategy really has for some period of time driven pretty good same-store sales I think that out-strip most of our competition.

Operator

(Operator Instructions) We’ll go next to Howard Penney with FBR Capital Markets.

Howard Penney - Friedman, Billings, Ramsey & Co.

Thanks very much. Knowing what you know about today about the difficult sales environment, had you not done the Dutch auction a few years ago, would you make the decision, that same decision to do that today?

J. Clifford Hudson

Well, the Dutch auction is a long-term strategy based one on our historical capital structure and two, where we see the performance of our business going over time. And with that in mind, long-term strategy based on capital structure and where we see the business go over time, the answer is yes.

The fact is over an extended period of time, we had bought back 25% of the company already and you will begin seeing more as we get later into the year accretion from an EPS standpoint of the impact of that and we’re in the business for the long term, so two, three, four and five years from now, we’ll look back and we’ll say here is an appreciable pay-off to that strategy that we implemented ’06, ’07.

Howard Penney - Friedman, Billings, Ramsey & Co.

Thanks.

Operator

It appears there are no further questions at this time. Mr. Hudson, would you like for me to turn the call back over to you for closing remarks?

J. Clifford Hudson

That would be fine. We appreciate your listening in today and your engagement in our business. One of the things you should be able to tell from us is as our management team looks at the long run performance of the business is we continue to be very optimistic about it. I think if you look at Sonic versus almost any of our competition, there is no one else in the QSR business that I know of that fits this category, and that is we have significant market penetration in many states in the United States but enormous virgin territory in which to grow as well. And in spite of that, we’ve had five plus years of national marketing and the consequence of this is that we are in peculiar and unique position to be able to grow our business quite handsomely for years to come and we hope that all of you continue to have interest in our brand, and if you buy the stock and hold on, you’ll see good performance for years to come.

So thanks for listening in today and we look forward to visiting with you soon. Take care.

Operator

Once again, this concludes today’s conference. We do appreciate your participation. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Sonic F1Q08 (Qtr End 11/30/07) Earnings Call Transcript
This Transcript
All Transcripts