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| SONC > SEC Filings for SONC > Form 10-K on 30-Oct-2008 | All Recent SEC Filings |
30-Oct-2008
Annual Report
Overview
Description of the Business. Sonic operates and franchises the largest chain of drive-in restaurants in the United States. As of August 31, 2008, the Sonic system was comprised of 3,475 drive-ins, of which 20% were Partner Drive-Ins and 80% were Franchise Drive-Ins. Sonic Drive-Ins feature signature menu items such as specialty drinks and frozen desserts, made-to-order sandwiches and a unique breakfast menu. We derive our revenues primarily from Partner Drive-In sales and royalties from franchisees. We also receive revenues from initial franchise fees, and to a lesser extent, from the selling and leasing of signs and real estate.
Costs of Partner Drive-In sales, including minority interest in earnings of drive-ins, relate directly to Partner Drive-In sales. Other expenses, such as depreciation, amortization, and general and administrative expenses, relate to the Company's franchising operations, as well as Partner Drive-In operations. Our revenues and expenses are directly affected by the number and sales volumes of Partner Drive-Ins. Our revenues and, to a lesser extent, expenses also are affected by the number and sales volumes of Franchise Drive-Ins. Initial franchise fees and franchise royalties are directly affected by the number of Franchise Drive-In openings.
Overview of Business Performance. Fiscal year 2008 marked our 22nd consecutive year of positive same store sales growth and earnings per share increased slightly. Investments by franchisees in new and existing development remained solid throughout the year, with the opening of 140 new drive-ins, the relocation or rebuilding of 64 existing drive-ins, and the completion of 800 retrofits for the fiscal year. We also opened the first Sonic drive-ins in several new markets and new states with very strong opening results.
Despite the strength of our business in core and new markets, we face a number of challenges in our transition from a regional to a national brand, particularly in developing markets (which represent approximately 25% of all drive-ins). In addition, the performance of our Partner Drive-Ins has lagged behind our franchisees. Our profitability has also been negatively impacted by the general business climate including low consumer sentiment and rising commodity and labor costs.
As a result, we plan to refine our strategy in the coming year including refranchising underperforming Partner Drive-Ins and slowing the growth of new Partner Drive-Ins. We believe reducing the number of Partner Drive-Ins we operate will allow us to improve sales and operations for remaining Partner Drive-Ins while we continue to emphasize new store development, promotions and other initiatives to drive sales for the entire system.
The refranchising initiative is anticipated to occur over the next four years and will target underperforming Partner Drive-Ins in core and developing markets. Currently, Partner Drive-Ins comprise approximately 20% of the entire system. Over time, accelerated expansion by franchisees, combined with the refranchising and slower growth of Partner Drive-Ins, is anticipated to reduce this number to 12% to 14% of the system. Increased development of new Franchise Drive-Ins is expected to continue with particular emphasis on new markets. Further, implementation of the franchise retrofit program will continue to be an important initiative for the Sonic system. In addition to refranchising efforts, other initiatives, such as increases in media expenditures, new product news and improved sales performance of Partner Drive-Ins, are expected to have a positive impact on earnings in fiscal year 2009.
The growth and success of our business is built around implementation of our multi-layered growth strategy, which features the following components:
· Positive same-store sales growth fueled by the ongoing retrofit program, the relocation and rebuilding of existing drive-ins and the installation of electronic messaging signs;
· Expansion of the Sonic brand through new unit growth, particularly by franchisees;
· Increased franchising income stemming from franchisee new unit growth, same-store sales growth and our unique ascending royalty rate; and
· The use of excess operating cash flow and proceeds from refranchising of Partner Drive-Ins to pay down debt.
The following table provides information regarding the number of Partner Drive-Ins and Franchise Drive-Ins in operation as of the end of the periods indicated as well as the system-wide growth in sales and average unit volume. System-wide information includes both Partner Drive-In and Franchise Drive-In information, which we believe is useful in analyzing the growth of the brand as well as the Company's revenues since franchisees pay royalties based on a percentage of sales.
System-Wide Performance
($ in thousands)
Year Ended August 31,
2008 2007 2006
Percentage increase in sales 5.6 % 8.6 % 10.7 %
System-wide drive-ins in operation (1):
Total at beginning of period 3,343 3,188 3,039
Opened 169 175 173
Closed (net of re-openings) (37 ) (20 ) (24 )
Total at end of period 3,475 3,343 3,188
Core markets (2) 2,602 2,500 2,435
Developing markets (2) 873 843 753
All markets 3,475 3,343 3,188
Average sales per drive-in:
Core markets $ 1,175 $ 1,145 $ 1,105
Developing markets 973 998 954
All markets 1,125 1,109 1,070
Change in same-store sales (3):
Core markets 2.4 % 3.6 % 5.3 %
Developing markets (5.2 %) 1.2 1.5
All markets 0.9 % 3.1 4.5
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(1) Drive-ins that are temporarily closed for various reasons (repairs, remodeling, relocations, etc.) are not considered closed unless the Company determines that they are unlikely to reopen within a reasonable time.
(2) Markets are identified based on television viewing areas and further classified as core or developing markets based upon number of drive-ins in a market and the level of advertising support. Market classifications are updated periodically.
(3) Represents percentage change for drive-ins open for a minimum of 15 months.
System-wide same-store sales increased 0.9% during fiscal year 2008 as a result of slight increases in traffic (number of transactions per drive-in) and average check. The increase in traffic was aided by the system-wide implementation of Happy Hour in November 2007, which features half-price drinks from 2:00 pm to 4:00 pm every day.
The Company continues to pursue specific sales-driving initiatives including, but not limited to:
· The ongoing physical retrofit of drive-ins with a new look;
· The relocation and rebuilding of existing drive-ins which often result in significant sales increases;
· The ongoing installation of electronic messaging signs;
· Increasing our share of sales in non-traditional day parts including the morning, afternoon, and evening day parts;
· Providing an exceptional customer service experience;
· Using technology to reach customers and improve the customer experience;
· Promoting new products on a monthly basis focused on quality and expanded choice for our customers; and
· Growing brand awareness through increased media spending and greater use of network cable advertising.
During fiscal year 2008, our system-wide media expenditures were approximately $190 million as compared to $175 million in fiscal year 2007, which we believe continues to increase overall brand awareness. Approximately one-half of our media dollars are spent on system-wide marketing fund efforts, which are largely used for network cable television advertising. Expenditures for national cable advertising increased from approximately $90 million in fiscal year 2007 to approximately $95 million in fiscal year 2008. Increased network cable advertising provides several benefits including the ability to more effectively target and better reach the cable audience, which has now surpassed broadcast networks in terms of viewers. In addition, national cable advertising also allows us to bring additional depth to our media and expand our message beyond our traditional emphasis on a single monthly promotion. The balance of our system-wide media expenditures is focused on local store advertising. Looking forward, we expect system-wide media expenditures to exceed $200 million in fiscal 2009, with the system-wide marketing fund representing approximately one-half of total media expenditures.
The following table provides information regarding drive-in development across the system. Retrofits represent investments to upgrade the exterior look of our drive-ins, typically including an upgraded building exterior, new more energy-efficient lighting, a significantly enhanced patio area, and improved menu housings.
Year ended
August 31,
2008 2007 2006
New drive-ins:
Partner 29 29 35
Franchise 140 146 138
System-wide 169 175 173
Rebuilds/relocations:
Partner 5 7 6
Franchise 64 35 11
System-wide 69 42 17
Retrofits, including rebuilds/relocations:
Partner 167 175 120
Franchise 800 316 12
System-wide 967 491 132
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Results of Operations
Revenues. The following table sets forth the components of revenue for the reported periods and the relative change between the comparable periods.
Revenues
($ in thousands)
Percent
Increase/ Increase/
Year Ended August 31, 2008 2007 (Decrease) (Decrease)
Revenues:
Partner Drive-In sales $ 671,151 $ 646,915 $ 24,236 3.8 %
Franchise revenues:
Franchise royalties 121,944 111,052 10,892 9.8
Franchise fees 5,167 4,574 593 13.0
Other 6,451 7,928 (1,477 ) (18.6 )
Total revenues $ 804,713 $ 770,469 $ 34,244 4.4
Percent
Increase/ Increase/
Year Ended August 31, 2007 2006 (Decrease) (Decrease)
Revenues:
Partner Drive-In sales $ 646,915 $ 585,832 $ 61,083 10.4 %
Franchise revenues:
Franchise royalties 111,052 98,163 12,889 13.1
Franchise fees 4,574 4,747 (173 ) (3.6 )
Other 7,928 4,520 3,408 75.4
Total revenues $ 770,469 $ 693,262 $ 77,207 11.1
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The following table reflects the growth in Partner Drive-In sales and changes in comparable drive-in sales for Partner Drive-Ins. It also presents information about average unit volumes and the number of Partner Drive-Ins, which is useful in analyzing the growth of Partner Drive-In sales.
Partner Drive-In Sales
($ in thousands)
Year Ended August 31,
2008 2007 2006
Partner Drive-In sales $ 671,151 $ 646,915 $ 585,832
Percentage increase 3.8 % 10.4 % 11.4 %
Partner Drive-Ins in operation (1):
Total at beginning of period 654 623 574
Opened 29 29 35
Acquired from (sold to) franchisees, net 6 5 15
Closed (5 ) (3 ) (1 )
Total at end of period 684 654 623
Average sales per Partner Drive-In $ 1,007 $ 1,017 $ 980
Percentage increase (1.0 %) 3.8 % 2.4 %
Change in same-store sales (2) (1.6 %) 2.5 % 1.9 %
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(1) Drive-ins that are temporarily closed for various reasons (repairs, remodeling, relocations, etc.) are not considered closed unless the Company determines that they are unlikely to reopen within a reasonable time.
(2) Represents percentage change for drive-ins open for a minimum of 15 months.
For fiscal year 2008, Partner Drive-In sales increased 3.8%. The increase was comprised of sales from newly constructed drive-ins and acquired drive-ins, offset by the decrease in sales from lower same-store sales. During fiscal year 2007, Partner Drive-In sales increased 10.4%. The majority of this increase came from sales for newly constructed drive-ins as well as increases in same-store sales.
During fiscal year 2008, same-store sales at Partner Drive-Ins declined 1.6%, as compared to the 0.9% increase for the system. The Company believes the declining performance at Partner Drive-Ins is attributable, at least in part, to consumer reaction to aggressive price increases taken last year combined with a decline in service. Since the deterioration in performance became apparent during the third quarter, several actions have been taken, including an organizational restructure (management and other personnel changes) as well as a simplified incentive compensation plan, which strengthens the partnership program and places increased emphasis on customer service, particularly at the assistant manager level. In addition, we are implementing a more strategic approach to pricing. These efforts are expected to have a positive impact on Partner Drive-In sales.
The following table reflects the growth in franchise income (franchise royalties and franchise fees) as well as franchise sales, average unit volumes and the number of Franchise Drive-Ins. While we do not record Franchise Drive-In sales as revenues, we believe this information is important in understanding our financial performance since these sales are the basis on which we calculate and record franchise royalties. This information is also indicative of the financial health of our franchisees.
Franchise Information
($ in thousands)
Year Ended August 31,
2008 2007 2006
Franchise fees and royalties (1) $ 127,111 $ 115,626 $ 102,910
Percentage increase 9.9 % 12.4 % 11.4 %
Franchise Drive-Ins in operation (2):
Total at beginning of period 2,689 2,565 2,465
Opened 140 146 138
Acquired from (sold to) Company, net (6 ) (5 ) (15 )
Closed (32 ) (17 ) (23 )
Total at end of period 2,791 2,689 2,565
Franchise Drive-In sales $ 3,139,996 $ 2,961,168 $ 2,735,802
Percentage increase 6.0 % 8.2 % 10.6 %
Effective royalty rate 3.88 % 3.75 % 3.59 %
Average sales per Franchise Drive-In $ 1,154 $ 1,132 $ 1,092
Change in same-store sales (3) 1.4 % 3.3 % 5.1 %
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(1) See Revenue Recognition Related to Franchise Fees and Royalties in the Critical Accounting Policies and Estimates section of Management's Discussion and Analysis of Financial Condition and Results of Operations.
(2) Drive-ins that are temporarily closed for various reasons (repairs, remodeling, relocations, etc.) are not considered closed unless the Company determines that they are unlikely to reopen within a reasonable time.
(3) Represents percentage change for drive-ins open for a minimum of 15 months.
Franchise royalties experienced a 9.9% increase related primarily to royalties from new Franchise Drive-Ins and the increasing effective royalty rate. A smaller portion of the increase relates to growth in same-store sales at Franchise Drive-Ins.
The increase in the effective royalty rate includes the beneficial impact from the conversion of licenses for approximately 790 Franchise Drive-Ins in April 2007. These conversions resulted in the franchisees paying a higher royalty rate in exchange for the extension of their license term.
Franchisees opened 140 new drive-ins in fiscal year 2008, down from 146 new drive-ins in fiscal year 2007. However, franchisee investment in existing drive-ins increased considerably during fiscal year 2008, including the relocation or rebuild of 64 drive-ins (versus 35 in the prior year) and the retrofit of 800 drive-ins (versus 316 in fiscal year 2007). Despite the decrease in new drive-ins opened, franchise fees increased 13.0% to $5.2 million. Fees associated with the termination of area development agreements increased $0.5 million in fiscal year 2008 compared to prior year. These termination fees were the primary reason for the year-over-year increase in overall franchise fees, and despite the termination of some of these agreements, the number of drive-ins expected to be built in connection with such agreements has increased over the prior year. For fiscal year 2007, franchise fees decreased 3.6% as a result of approximately $0.3 million more in fees recognized in fiscal year 2006 from terminations of area development agreements.
Other income decreased 18.6% to $6.5 million in fiscal year 2008 from $7.9 million in fiscal year 2007. The decrease relates primarily to the net favorable impact of non-income tax matters recognized in fiscal year 2007 with no comparable benefit in fiscal year 2008.
Operating Expenses. The following table presents the overall costs of drive-in operations, as a percentage of Partner Drive-In sales. Minority interest in earnings of Partner Drive-Ins is included as a part of cost of sales, in the table below, since it is directly related to Partner Drive-In operations.
Restaurant-Level Margins
Percentage
Year ended points
August 31, Increase/
2008 2007 (Decrease)
Costs and expenses:
Partner Drive-Ins:
Food and packaging 26.5 % 25.7 % 0.8
Payroll and other employee benefits 31.1 30.4 0.7
Minority interest in earnings of Partner Drive-Ins 3.3 4.1 (0.8 )
Other operating expenses 20.9 20.1 0.8
81.8 % 80.3 % 1.5
Percentage
Year ended points
August 31, Increase/
2007 2006 (Decrease)
Costs and expenses:
Partner Drive-Ins:
Food and packaging 25.7 % 25.9 % (0.2 )
Payroll and other employee benefits 30.4 30.0 0.4
Minority interest in earnings of Partner Drive-Ins 4.1 4.3 (0.2 )
Other operating expenses 20.1 19.8 0.3
80.3 % 80.0 % 0.3
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Restaurant-level margins declined overall in fiscal year 2008 as a result of higher commodity prices, higher labor costs driven by minimum wage increases and the de-leveraging impact of lower same-store sales. These negative impacts were offset by the decline in minority partners' share of earnings reflecting the margin pressures described above. Looking forward, the Company expects the cost pressures to continue into 2009 as another increase in the minimum wage occurred in July 2008 and commodity cost pressures are ongoing.
Selling, General and Administrative ("SG&A"). SG&A expenses increased 4.2% to $61.2 million during fiscal year 2008 and 12.8% to $58.7 million during fiscal year 2007 reflecting, in part, ongoing efforts to manage expenses with slowing revenue growth. Headcount additions, offset by reduced management bonuses, were the primary contributor to the increase for fiscal year 2008. The increase in fiscal year 2007 related to the addition of headcount and other infrastructure to support growth of our business. As a percentage of total revenues, SG&A expenses remained relatively constant at 7.6% in both fiscal year 2008 and 2007 and 7.5% in fiscal year 2006. Stock-based compensation is included in SG&A, and, as of August 31, 2008, total remaining unrecognized compensation cost related to unvested stock-based arrangements was $13.4 million and is expected to be recognized over a weighted average period of 1.7 years. See Note 1 and Note 12 of the Notes to the Consolidated Financial Statements included in this Form 10-K for additional information regarding our stock-based compensation.
Depreciation and Amortization. Depreciation and amortization expense increased 12.3% to $50.7 million in fiscal year 2008 primarily as a result of additional capital expenditures for newly-constructed Partner Drive-Ins, the retrofit and relocation of existing Partner Drive-Ins and the acquisition of Franchise Drive-Ins. Depreciation and amortization expense increased 10.8% to $45.1 million in fiscal year 2007 due, in part, to additional depreciation stemming from acquisitions, as well as the reduction in remaining useful life for certain assets related to the retrofit of Partner Drive-Ins in the late 1990s. Capital expenditures during fiscal year 2008 were $127.2 million, including $20.9 million related to the acquisition of drive-ins from franchisees. For fiscal year 2009, capital expenditures are expected to be approximately $60 to $70 million.
Provision for Impairment of Long-Lived Assets. We assess drive-in assets for impairment on a quarterly basis under the guidelines of SFAS 144 - "Accounting for the Impairment or Disposal of Long-Lived Assets." During fiscal year 2008, seven properties were impaired, resulting in charges of $0.6 million to reduce the carrying cost of the related assets to estimated fair value. During fiscal year 2007, five properties were impaired which resulted in charges of $1.2 million to reduce the carrying cost of the assets to estimated fair value. During fiscal year 2006, three properties were impaired which resulted in a provision for impairment of $0.3 million for carrying cost in excess of estimated fair value for the assets. We continue to perform quarterly analyses of certain underperforming drive-ins. It is reasonably possible that the estimate of future cash flows associated with these drive-ins could change in the future resulting in the need to write-down assets associated with one or more of these drive-ins to fair value. While it is impossible to predict if future write downs will occur, we do not believe that future write-downs will impede our ability to continue growing earnings at a solid rate.
Interest Expense. Net interest expense increased $3.5 million to $47.9 million in fiscal year 2008 and increased $36.8 million to $44.4 million in fiscal year 2007. The increase in fiscal year 2008 is the result of interest on increased borrowings primarily used to fund share repurchases earlier in the year and drive-in acquisitions from franchisees. The increase in fiscal year 2007 was the result of interest on increased borrowings used to fund the purchase of shares in the Company's tender offer and subsequent repurchases, as well as $6.1 million in debt extinguishment charges related to financing the Company's tender offer and other share repurchase activities.
Income taxes. The provision for income taxes increased for fiscal year 2008 with an effective federal and state tax rate of 37.4% compared with 36.4% in fiscal year 2007 and 36.6% in fiscal year 2006. The lower rate in fiscal year 2007 related to the favorable resolution of state tax matters and the retroactive extension of the Work Opportunity Tax Credit. Our tax rate may continue to vary significantly from quarter to quarter depending on the timing of option exercises and dispositions by option-holders and as circumstances on individual tax matters change.
Financial Position
During fiscal year 2008, current assets increased 34.9% to $99.4 million compared to $73.7 million as of the end of fiscal year 2007. Cash balances increased by $20.3 million primarily as a result of advances taken on the Company's variable credit facility to ensure adequate liquidity for the Company's short-term financing needs. In addition, the combination of current and non-current notes receivable increased $3.7 million, primarily as a result of proceeds of $4.1 million in transit at year-end for the sale of two drive-ins to a franchisee. Net property and equipment increased by $56.3 million primarily . . .
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