BOSTON ( TheStreet) -- Sonic ( SONC) was added to the 5-Star Stock List at Morningstar ( MORN) 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'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 McDonald's ( MCD) and Burger King ( BKC). 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. and Piper Jaffray are in the bull camp with Morningstar, forecasting that Sonic's stock will rise 34% to $12 in the next 12 months. In contrast, Credit Suisse forecasts that the stock will drop to $8.
-- Written by Jake Lynch in Boston.
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