BOSTON (TheStreet) -- Sonic (SONC) was added to the 5-Star Stock List at Morningstar (MORN) - Get Morningstar, Inc. 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.
Sonic's stock trades at a trailing earnings multiple of 20, a forward earnings multiple of 15 and a sales multiple of 1, equivalent to respective discounts of 38%, 37% and 63% to restaurant peer averages. Although the stock's relative value is apparent, its absolute value isn't. To most investors, 15-times forward earnings is no discount multiple. However, analysts expect the company to resume its growth trajectory in the years ahead. The stock's PEG ratio, a measure of value relative to growth, at 0.4, indicates a 60% discount to fair value. Even so, Sonic is an equity investment rife with risk amid signs of consumer retrenchment and commodity inflation. Morningstar assumes restaurant margin expansion to "the high teens."
This may prove overly optimistic. The restaurant margin declined modestly in the latest quarter, missing Morningstar's estimate for more than 14%. Food input prices, ranging from dairy to beef, are escalating as are Sonic's costs. Also, a recently poor consumer sentiment read, evident in the March drop (to a three-month low) in the Conference Board's consumer confidence index, could hurt Sonic. Americans, still struggling under elevated unemployment are now being taxed at the pump. Crude oil is maintaining its foothold over $100 per barrel and pushing up gasoline prices, cannibalizing consumer discretionary spending. These are material risks to Sonic.
Morningstar remains focused on longer-term trends, including Sonic's fourth-quarter comparable-store sales, the key metric for retailers and restaurants, which climbed 1.2% for system-wide stores and 2.2% for company-owned stores, which make up a comparatively small number of outlets. The rise was due, for the most part, to traffic gains rather than higher prices. Sonic franchisees own and operate roughly 87% of total restaurants and the company uses an ascending royalty rate structure. So, as sales at franchises increase, so does the rate that the company charges for its distribution and services. This leverages equity performance to revenue expansion.
Sonic's fourth-quarter comparable store sales increase was the first since the fourth quarter of 2008, signaling a possible turnaround. However, the year-earlier comparison, at negative 13%, provided an easy hurdle to clear. Aside from same-store improvement, Sonic has commitments for more than 1,000 franchise locations over the next seven years. Morningstar views expansion as cost-efficient, predicting that corporate-level expenditure, namely, advertising and overhead costs, will drop on a per-unit basis, helping profit spreads. However, the firm awards Sonic no "economic moat" or sustainable competitive advantage.
Although Sonic offers a unique venue and differentiated offerings, it goes toe-to-toe with established hamburger peers such as
. Furthermore, the aforementioned 1,000 restaurant expansion is in non-core markets where entrenched players have preferred real estate and an existing customer base. In spite of these risks, Morningstar sees significant upside in Sonic shares, though its $13 target, equivalent to 26-times current fiscal year earnings and an enterprise value to EBITDA ratio of 10, is expensive relative to other quick/casual restaurant stocks. But, management believes that comparable store sales will remain positive in 2011 and the aggressive expansion plan will succeed. Ongoing elevated unemployment and inflation are downside risks.
Sell-side firms give Sonic a mixed review. It receives five "buy" recommendations, eight "hold" calls and four "sell" rankings.
Oppenheimer & Co.
are in the bull camp with Morningstar, forecasting that Sonic's stock will rise 34% to $12 in the next 12 months. In contrast,
forecasts that the stock will drop to $8.
-- Written by Jake Lynch in Boston.
Become a fan of TheStreet on Facebook.
Readers Also Like:
Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.