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Unloved Stock Suddenly Gets Top Rating

BOSTON ( TheStreet) -- Sonic (SONC - Get Report) was added to the 5-Star Stock List at Morningstar (MORN - Get Report) at the onset of 2011. The quick-service restaurant chain, which sells burgers, fries and shakes at some 3,000 drive-in locations, has steadily improved its business in the past few quarters. It's also cheap on the basis of earnings and cash flow. Morningstar values the equity at $13, suggesting a potential return of 44% as fundamentals strengthen.

Sonic was founded in the 1950s by Troy Smith, a former milk-and-bread delivery man with entrepreneurial aspirations. He opened Troy's Pan Full of Chicken in Shawnee, Oklahoma in 1953 and, soon after, added a root-beer stand, The Top Hat Drive-In. The Top Hat quickly exceeded the Pan Full in profit, so Troy focused his efforts on perfecting the American drive-in diner. He added speakers for ordering at each parking space and hired carhops to deliver the food. A supplemental intercom system, which could play music, helped attract a younger crowd. Sales subsequently tripled. The first franchise opened in 1956 under the name Sonic, as Top Hat was already trademarked by another company.

The franchise grew steadily throughout the South, taking root in small towns, and by 1972 there were 172 locations. That number had multiplied to 1,000 by 1978. As growth accelerated, the owners managed to avoid strict operational requirements or menu mandates and charged modest franchise fees. This laissez-faire approach hurt marketing efforts as restaurant quality and offerings varied considerably between locations. By the 1980s, this strategy had become unprofitable. At this juncture, joint marketing efforts, higher franchise fees and strict operational requirements were implemented, improving public perception and efficiency. The chain then embarked on another expansion, becoming a truly national chain. A leverage buyout privatized Sonic in 1984.

Sonic again went public, on the New York Stock Exchange, in 1991. Its stock has been a perennial laggard since the recession, falling from a high of $25.09 in 2007 to less than $9. To put that performance into context, shareholders have endured an annualized decline of 25% since 2008. Sales and net income dropped 12% and 25% annually, on average, over that span. Morningstar, seeing value in the depressed equity, upgraded it to five stars, the researcher's highest rating, on December 31. Stressing margin buoyancy and uniqueness of format, Sonic is Morningstar's preferred play in the QSR, or quick-service restaurant, space. Its valuation is, indeed, compelling relative to peer restaurant investments.
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