Sonic Corp Stock Analysis

April 13, 2009

Johnson & Company, Inc. Restaurant Quick Service

Sonic Corp (NASDAQ: SONC)

Analysts: Josh Bloom Phil Cullen David Johnson Ross Pysh

Investment Summary Sonic has underperformed in the first two quarters of FY2009 due to a tough economic downturn. Nevertheless, we feel that the implementation of a new $1 value meal and a corporate plan to refranchise will help earnings improve in the second half of 2009. As a result, we feel that Sonic’s current price is a fairly accurate representation of the company’s true economic standing.

Company Update

Company Profile

Rating: Price: Price Target:

Neutral/Hold $10.76 $10.58

Market Data 52-Week Range: Market Cap (MM): Total Shares Out. (MM): Avg. Daily Vol.:

$5.78-22.92 $584.41 60.56 842,647

Financial Summary Book Value (MM) Debt (MM)

($64,166) $796,807

USD

2008A

2009E

2010E

Rev. (MM)

804,713

768,770

748,550

EBITDA (MM)

216,783

--

--

EPS Nov

0.15

0.12A

--

Feb

0.22

0.08A

--

May

0.28

0.26

--

Aug

0.33

0.31

--

FY Aug

0.97

0.77

0.92

Sonic competes in what is called the “drive-in restaurant” industry. Competition includes Burger King, CKE Restaurants, and Jack in the Box, among others. Sonic is a franchisor, much like Boston Chicken, which we discussed earlier this semester. 80% of Sonic’s 3,500 restaurants are franchises and the remaining 20% are classified as partnership stores. Sonic Corp. is classified as either a minority or majority owner in their partnership restaurants. The company is currently working to increase the number of franchise restaurants from 80% to 90% and to decrease the number of partnership stores from 20% to 10%. Its business strategy includes: 1.) 2.) 3.) 4.)

Providing a unique drive-up experience Maintaining a strong focus on customer satisfaction Continuing U.S. store expansion Maintaining strong franchisor/franchisee relationships

Sonic’s business strategy will enable it to sustain profitability. Even amidst the current recession, Sonic recorded a healthy $8.6 million net income for the most recent quarter ended Feb 28, 2009. Sonic’s recent introduction of their value menu, in combination with their increased advertising presence, has enabled them to maintain strong levels of profitability. We believe that Sonic will continue to succeed in the very competitive fast food industry because it has a 50+ year proven winning formula that delivers positive profits every year regardless of the economic climate.

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Accounting Issues Overall, Sonic’s accounting accurately reflects their underlying business reality. Because of the lack of apparent accounting distortions, we decided to illustrate the affect FASB’s 2009 FAS 160 will have on the presentation of Sonic’s minority interest in net assets. Prior to September 1, 2009, Sonic has and will continue to present their minority interest in partnership stores on the balance sheet between liabilities and equities. However, for all statements thereafter, Sonic will be required to present their non-controlling interests in the equity section of the balance sheet. If FAS 160 were in effect for the year ended 2008, a reconciliation of Sonic’s equity section would appear like the table to the right.

= In 2008, there were 684 partner drive-ins. Sonic had a 65% ownership interested in these partner-drive-ins. The 35% non-controlling interest was composed of $5,220,000 interest, as shown above. As a result of this increased stockholders’ equity, various accounting ratios will be impacted, such as a decrease to ROE. Financial Analysis Cash flow analysis Sonic has positive cash flow from operations (CFO) to either distribute to debt and equity holders or reinvest in the business. There is a gap in 2008 between CFO and Net Income of $33,543,000. However, it is only 4% of total assets so it does not raise a red flag. The difference is mostly attributable to the deprecation add back when calculating CFO. For 2008, Sonic has Free Cash Flow (FCF) to common equity of $16,384,000 and FCF to all investors of $929,000. Both of these numbers are significantly lower than Sonic’s competitors. For example, Jack in the Box (mkt. cap 1.4B) has FCF to investors of $4,082,000 which is more than 4 times as large as Sonic (mkt. cap 584M). This suggests that Sonic is using its FCF’s to grow the business. Also, capital expenditures in 2008 were $106,905,000 while Deprecation for 2008 was $60,319,000 which also suggests Sonic is growing its capital base. This is in line with Management’s Discussion and Analysis where they state their plans to open new franchise stores. Earnings Quality The average of Operating Accruals/Net Operating Assets between 2006-2008 for Sonic was 12%, which raises a red flag in the eVal software. Compared to Sonic’s competitors, Burger King has 9.2% and Jack in the Box has 11.5%. However, when looking closer at the Sonic financial statements, the majority of the accruals comes from non-current operating accruals, specifically, expensing the depreciation of capital expenditures. Sonic’s earnings quality is therefore good since a small percentage of the accruals are associated with receivables and other current asset accounts. Growth Rates, Profitability and Margins Sonic has a 4 year average sales growth rate of 10.73%. Comparatively, the average sales growth rate of Burger King, CKE Restaurants, and JACK in the Box’s 4 year average growth rates is 3.7%. This implies that Sonic’s sales have been growing at a faster pace than the industry average sales growth rates in the past 4 years.

2005

Sales Growth Rates BKC CKR JACK 10.60% 7.50% 7.80%

2006

5.60%

-10.00%

8.80%

2007 2008

9.10% 9.90%

4.60% -3.40%

5.60% -11.70%

average

8.80%

-0.33%

2.63%

3.70%

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Sonic bought back a significant amount of shares outstanding through a tender offer in 2007, which actually made their shareholder equity negative. Due to this, Return on Equity and the Sustainable Growth Rate are not applicable ratios. The applicable ratio to assess the future profitability of projects is Return on Net Operating Assets (RNOA) which is a measure of the firm’s operating performance. Sonic’s average RNOA over the past 4 years is 15.13%. Because Sonic has no common equity outstanding, the cost of debt will be used as the hurdle rate for projects. Currently, Sonic has $573.3M in outstanding debt at a fixed interest rate of 5.7% and $185M in variable note debt outstanding at 3.7% which gives a weighted average cost of debt of 5.21%. The spread between RNOA and their cost of debt shows that future expansion projects will be profitable. Also, the spread between RNOA and NBC for Sonic is 9.3% in 2008, which also shows that future projects will have a positive return as well. Sonic’s Gross Margin has been consistently around 78% for the past 4 years. Comparatively, for 2008 Gross Margins for their competitors were: BKC 34.8%, CKR 19.7%, and JACK 17.2%. Sonic’s high gross margin is attributable to their low Cost of Goods Sold because they receive royalty payments and franchise fees from their franchisees but do not record any associated expenses with the franchisee’s operations. Sonic’s growth plans state that they are looking to transition their partnership stores to franchises, which will reduce their COGS, and keep their gross margin high. Not only does Sonic have high gross margins but they also have a high EBIT margin that has been consistently around 21% for the past 4 years. Their EBIT margins in 2008 were higher than any of their competitors. Sonic’s ability to turn gross profits into EBIT gives the firm high marks on operating performance. Turnover Analysis Sonic has an inventory holding period of 9.249 for 2008, which is the highest between its competitors. In comparison, Burger King has an inventory holding period of 3.536. Since the inventory is mostly perishable goods, a very low holding period is a great indicator of quality and efficiency of operations. Sonic’s higher than normal holding period is cause for concern because it negatively reflects the efficiency of operations as well as the quality of their product. However, as stated above Sonic is still able to produce high gross margins from their products so the quality of their food must not be a major issue with the end consumer. Capital Structure and Risk Analysis In 2007, Sonic significantly changed their capital structure by issuing $591,037,000 in debt and buying back $562,687,000 in common stock outstanding. Their CFO to Debt ratio sits at 12.1% in 2008, which is fairly low and reflects the significant amount of debt financing Sonic took on in 2007. Sonic’s current ratio is 0.883 which is cause for some concern considering that they now have large fixed interest payments. However, their EBIT interest coverage ratio is 3.326, which shows that despite their high amount of debt outstanding, their EBIT can still cover their interest payments. To compare to Sonic’s competitors, BKC’s EBIT/Interest Coverage ratio is 5.284 and JACK’s is 7.691. The higher ratios show that Sonic has taken on more debt proportionally than its competitors, especially given that Sonic’s EBIT margins are well above its competitors. Sonic’s average implied default probability is only 4.5% which is mixed between their competitors probabilities, and is relatively low. Overall the large debt financing seems to be appropriate given their high RNOA and low default probability. Forecasting Sonic has seen historical success with increasing sales and profit margins. However, the recent economic downturn has had a large impact on many industries, including the restaurant and food business. As a result, Sonic expects to produce its first negative same-store sales growth in 22 years. Our financial forecast includes an analysis of several different account balances, which are broken into expected, worst, and best case scenarios. The combination of these variable effects produced a “low to high” range for the appropriate price to be attributed to a share of Sonic common stock. In other words, the combination of all the worst scenarios would result in the lowest possible share prices. On the contrary, an evaluation of all the best possible scenarios would produce the highest current stock price. The variables, their respective values, and reasoning are presented below: Page 3 of 10

Forecasting Variables Sales COGS/Sales SG&A/Sales Net Ending PPE/Sales

Expected 2009 2010 -2.5% -1.8% 23.0% 22.9% 52.5% 52.3% 75.0% 74.8%

Worst Case 2009 2010 -4.5% -2.6% 25.0% 25.3% 55.0% 55.3% 77.0% 77.6%

Best Case 2009 2010 -1.0% -0.4% 22.1% 22.1% 51.0% 51.0% 73.0% 73.0%

Sales 2008 revenue totaled $804.7 M, composed of $671.2M from Partnership stores and $133.6M from Franchise stores. Sonic’s total revenue is predominantly composed of revenue from Partnership stores because only royalty payments and fees are recorded as revenue from Sonic Franchise stores. During the first and second quarters of 2009, company-wide revenue per store decreased 3.6%. Based on this trend, we forecast revenue per store decrease of the same amount (3.6%) for the second half of 2009. Store expansion has slowed, and therefore we project only 25 new stores to open in the second half of 2009. Based on the above facts and analytics performed, 2009 total revenue is projected to be $784.8 M.

Total 2008 Revenue Number of Stores 2008 Average Revenue/Store/Year Forecasted Revenue Change New 2009 sales/store/yr

Partnership-Stores $671,151,000 684 $981,214.91 -3.6% $945,891.18

Franchise Stores $133,562,000 2791 $47,854.53 -3.6% $46,131.77

In the worst case scenario, we looked at analysts’ current outlook of Sonics annual performance. Due to the economic conditions, it is very likely that Sonic will experience negative growth in sales. As a result, some estimates are expecting sales growth as poor as -4.5% and -2.6% for Sonic in FY2009 and FY2010, respectively. Cost of Goods Sold Cost of goods sold (COGS) will be affected by various factors in the upcoming years. As a part of their ongoing operations, Sonic’s partner stores purchase large volumes of different commodities, such as beef, potatoes, chicken, and dairy products. As noted in their latest 10K report, Sonic does not rely upon hedging activities to mitigate their potential losses as a result of changing commodity prices. Instead, Sonic relies upon contractual agreements with their vendors through the use of price floors or caps. However, Sonic has not entered long-term contracts to purchase substantial amounts of commodities; therefore, Sonic is still vulnerable to increasing commodity prices. An increase in the commodity prices coupled with the new value meal food options (menu items with reduced sales prices) will result in an increase in the COGS as a percentage of sales figure. Additionally, increased labor costs, particularly in regards to the increase in the federal minimum wage, will increase the ratio of cost of goods sold to the amount of sales. As a part of our sensitivity analysis, we estimate that the expected COGS to sales ratio to be 23%, the worst-case scenario will be ratio will be 25%, and the best-case scenario will result in a COGS to sales ratio of 22%. Selling, General, & Administrative Expenses Towards the beginning of Sonic’s fiscal year 2009, Sonic introduced various value meal food options to their existing menu. To provide Sonic restaurants with the ability to sell the value meal items Sonic will incur more costs, namely Page 4 of 10

costs associated with marketing and promotions, to successfully implement the new value menu items. While these value meal food options will be comprised of lower margin food options, they will be helpful in attracting more customers seeking budget-friendly dining options. But, the additional costs will be necessary to alert existing customers and potential customers of the new offerings. Additionally, positive sales growth in Sonic restaurants will depend upon the ability of Sonic to drive customers away from the new value menu meal options towards the pricier food options (items offering a greater profit margin) using marketing and promotional campaigns. Furthermore, Sonic will attempt to transition from a regional brand to a national brand. This will likely require additional SG&A costs to make this transition come to fruition. We estimate the effect of these changes will result in a higher level of SG&A costs. Using data from previous years, we estimate the expected value of the SG&A costs to be 52.5% of sales, a modest increase from fiscal year 2008. To conduct out sensitivity analysis we have created a range of SGA per sales using a figure of 55% for the worst-case scenario and 51% for the best case scenario. Once these figures have been input into the eVal model for fiscal year 2009, the eVal model is allowed to create a slightly decreasing trend for SG&A costs relative to sales since fixed components of SG&A costs will provide economies of scale. Capital Expenditures For fiscal year 2009 Sonic plans to invest in many new restaurants. As a result of their expansion efforts, Sonic plans to incur capital expenditures in the amount of $60 to $70 million. Using data from previous years, an average depreciation rate was calculated. Values of $60 million, $65 million, and $70 million, were added to the ending PP&E balance for 2008, and an average depreciation rate was used to calculate the estimated ending balance of PP&E for fiscal year 2009. Using the calculated PP&E balance as a basis, the 2009 ratio for ending PP&E/sales was adjusted to arrive at the expected amount of PP&E for 2009 shown on the forecasted balance sheet. Using the three values of capital expenditures listed above the following values for ending PP&E/sales: 74% for $60 million in capital expenditures, 75% for $65 million, and 75.6% for $70 million. Using these figures, an expected value for ending PP&E/sales is estimated to be 75%. For our sensitivity analysis, we utilized a ratio of 77% as a worst case scenario, and 73% for a best case scenario.

PP&E Depreciation Depreciation Rate

2007

2008

529993 -45103 0.0851

586245 -50653 0.0864

Capital Expenditures (CAPX) PP&E after CAPX Ending PP&E Ending PP&E/Sales 60000 646245 590828 74.00% 65000 651245 595400 75.00% 70000 656245 599971 75.60% Refranchising Sonic Corp is currently operating under a combination of franchises and partner stores which are 80 and 20 percent of the business, respectively. Recently, The Company began to undergo a procedure to move away from their partner restaurant operations and focus more on franchising their brand name. As a result, Sonic is likely to give up a large amount of their sales revenue from partner relationships. However, the Cost of Goods Sold related to these restaurants will also decrease significantly. Though it is unclear how Sonic’s reorganization will play out, it is apparent that the firm is attempting to become dependent on its franchising operations. Since the ability and effects of such a process are very suspect and difficult to predict, we have omitted the refranchising variables from our financial forecasting and valuation.

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Valuation Discount Rate The cost of equity was calculated using the Capital Asset Pricing Model (CAPM). We used a risk-free rate of 5.5% and a market premium of 6%. An average of industry comparables was calculated in order to arrive at an appropriate value of beta for our analysis.

Sonic BK CKE Restaurants Jack in the Box Average

Beta 1.35 1.00 1.30 1.00 1.1625

As seen in the table above, Sonic has historically been a risky stock compared to the market and other fast-food chains. We feel that their expansion and implementation of more competitively priced food will eventually result in a less risky security. Using the aforementioned information, the CAPM produced a cost of equity of approximately 12.5%. Target Price Analysis In order to arrive at a range of target stock prices, we inserted our forecasted scenarios into the eVal software and valued the stock based on the Discounted Cash Flow Method. The results of the computations are presented below: Valuation to Common Equity Free Cash Flow to Common Equity (2009) Present Value of FCF (2009) Present Value Beyond 20 Years Present Value of First 20 Years Forecast Equity Value Before Time Adj. Forecasted Value as of Valuation Date Less Value of Contingent Equity Claims Value Attributable to Common Equity Common Shares Outstanding at BS Date Equivalent Shares at Valuation Date Forecast Price/Share

Target Price

Expected $10.58

Worst Case $8.12

41,486 36,876 146,905 413,139 560,044 640,915 0 640,915 60,560 60,560 $10.58

Best Case $12.35

Our expected target price of $10.58 is only slightly lower than Sonic’s current stock price of $10.76. Furthermore, the best and worst case scenarios provide a relatively tight range of possible share prices. This further supports the validity of the current market perception of Sonic. Though our evaluation shows that the company is slightly overvalued, the volatility of today’s market does not allow us to apply a sell rating to Sonic Corp. stock. Many other analysts currently evaluate the price and performance of Sonic in a similar manner. Recently, Citi downgraded the stock from “neutral” to “underperform,” which is comparable to our understanding that the price of Sonic is overvalued. Furthermore, analysts currently forecast an EPS of $0.77 for FY 2009. This is aligned with our estimate of -2.5% sales growth, which produces a 2009 projected EPS of $0.73. Any discrepancies seem to develop from the expectations of sales growth and operating expenses. Other analysts are predicting a higher decrease (-4.5%) in

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revenue with less increase in COGS and SG&A. However, these differences are very minor and do not seem to have any material effect on the valuation.

Sources Basham, Mark. “Standard & Poor’s Industry Report: Restaurants.” March 19, 2009. Forbes.com. “Sonic traffic improving, sales poised to rally.” March 24, 2009. . MSN Money. . Sonic Corporation Financial Statements (2008 10-K, 2009 10-Q1, 10-Q2). “Sonic Announces Fiscal 2009 Outlook.” “Sonic Reports Second Quarter Earnings.” . Yahoo! Finance. < http://finance.yahoo.com/q?s=sonc>.

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Supporting Exhibits Financial Analysis

SONIC Corporation (SONC) Cash Flow Analysis Fiscal yr. 2005 119,544.00

Fiscal yr. 2006 125,928.00

Fiscal yr. 2007 135,411.00

Fiscal yr. 2008 93,862.00

Cash from Investing

(79,838.00)

(108,137.00)

(134,412.00)

(102,721.00)

Cash from Financing Net Change in Cash Ending Cash Balance FCF to common equity FCF to all investors

(41,268.00) (1,562.00) 6,431.00 (6,568.00) 21,461.00

(14,625.00) 3,166.00 9,597.00 74,929.00 20,242.00

28,350.00 29,349.00 38,946.00 562,687.00 (2,117.00)

29,113.00 20,254.00 59,200.00 16,384.00 929.00

Fiscal yr. 2007 -3.60% 15.20% 11.70%

Fiscal yr. 2008 4.30% 7.20% 11.40%

Fiscal yr. 2007 11.10% 18.90% -110.50% 45.10%

Fiscal yr. 2008 4.40% 10.30% N/A -70.60%

Fiscal yr. 2007 45.10% 58.40% 15.10%

Fiscal yr. 2008 -70.60% -85.20% 13.30%

Fiscal yr. 2007 78.4% 22.3%

Fiscal yr. 2008 77.9% 20.6%

Fiscal yr. 2007 9.473 1.291

Fiscal yr. 2008 9.249 1.17

Fiscal yr. 2007 (7.02) 25.6% 29.8%

Fiscal yr. 2008 (12.43) 15.5% 12.1%

Fiscal yr. 2007 0.644 4.171

Fiscal yr. 2008 0.883 3.326

Fiscal yr. 2007 4.30%

Fiscal yr. 2008 4.50%

Cash from operations

Earnings Quality Fiscal yr. 2005 Fiscal yr. 2006 Current Op. Accruals/NOA -3.00% -1.60% Non-Current Op. Accruals/NOA 9.80% 14.30% Operating Accruals/NOA 6.80% 12.70% Annualized Growth Rates Fiscal yr. 2005 Fiscal yr. 2006 Sales 16.10% 11.30% Assets 8.60% 13.30% Free Cash Flow to Investors N/A -5.70% Sustainable Growth Rate N/A 20.20% Profitability Fiscal yr. 2005 Fiscal yr. 2006 ROE 19.50% 20.20% ROE before non-recurring 23.20% 24.10% Return on Net Operating Assets 15.80% 16.30% Margin Analysis Fiscal yr. 2005 Fiscal yr. 2006 Gross Margin 77.90% 78.10% EBIT Margin 22.30% 22.60% Turnover Analysis Fiscal yr. 2005 Fiscal yr. 2006 Avg. Inventory Holding Period 9.679 9.575 Net Operating Asset Turnover 1.32 1.337 Leveral Analysis -- Long Term Capital Structure Fiscal yr. 2005 Fiscal yr. 2006 Debt to Equity Ratio 0.254 0.406 FFO to Total Debt 95.8% 91.8% CFO to Total Debt 108.0% 97.7% Leverage Analysis -- Short Term Liquidity Fiscal yr. 2005 Fiscal yr. 2006 Current Ratio 0.539 0.544 EBIT interest Coverage 21.661 17.718 Credit Risk Analysis Fiscal yr. 2005 Fiscal yr. 2006 Average Implied Default Probability 3.3% 3.3%

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Liquidity Analysis Credit Risk

Long Term Capital Structure

Turnover Analysis

Margin Analysis

Profitability

Annual Growth Rates

Earnings Quality

Cash Flow Analysis

Average Implied Default Probability

Cash from operations Cash from Investing Cash from Financing Net Change in Cash Ending Cash Balance FCF to common equity FCF to all investors Current Op. Accruals/NOA Non-Current Op. Accruals/NOA Operating Accruals/NOA Sales Assets Free Cash Flow to Investors Sustainable Growth Rate ROE ROE before non-recurring Return on Net Operating Assets Gross Margin EBIT Margin Avg. Inventory Holding Period Net Operating Asset Turnover Debt to Equity Ratio FFO to Total Debt CFO to Total Debt Current Ratio EBIT interest Coverage 4.50%

93,862.00 (102,721.00) 29,113.00 20,254.00 59,200.00 16,384.00 929.00 4.30% 7.20% 11.40% 4.40% 10.30% N/A -70.60% -70.60% -85.20% 13.30% 77.90% 20.60% 9.249 1.17 (12.43) 0.16 0.12 0.883 3.326 3.50%

223,000.00 (170,000.00) (57,000.00) (4,000.00) 166,000.00 61,000.00 100,447.00 -1.10% 10.30% 9.20% 9.90% 6.80% -40.70% 20.00% 24.30% 23.80% 13.50% 34.80% 14.40% 3.536 1.423 1.121 0.219 0.236 0.886 5.284 5.30%

40,574.00 11,438.00 (50,699.00) 1,313.00 19,993.00 263,478.00 68,893.00 0.20% -4.10% -3.90% -3.40% -0.30% -12.40% 6.70% 11.90% 12.40% 9.20% 19.70% 5.80% 7.107 2.805 2.699 0.146 0.142 0.772 2.674

Sonic (SONC) Burger King (BKC) CKE Restaurants (CKR)

Fiscal Year 2008 (in thousands)

Cross-Sectional Analysis

4.60%

17,210.00 6,419.00 8,553.00 32,182.00 47,884.00 71,753.00 4,082.00 11.70% 0.20% 11.50% -11.70% 8.40% -98.60% 27.40% 27.40% 27.00% 15.00% 17.20% 8.50% 7.998 2.785 1.134 0.241 0.036 1.109 7.691

Jack in the Box (JACK)

Franchise Stores Number of stores on Day 1 of 2009 2791 2009 Q1 Net number of new stores 25 2009 Q2 Net number of new stores 19 2009 Q3 FORCASTED Net number of new stores 14 2009 Q4 FORCASTED Net number of new stores 9

2009 Sales/Store Analysis

% of the year stores Partnership Stores will generate revenue 684 (12/12) 5 (12/12) 2 (9/12) 1 (6/12) 1 (3/12)

2009 Forecasted 2009 Forecasted 2009 Forecasted Franchise 2009 Forecasted Total Partnership-Store Partnership-Store Sales/Store/Year Franchise Revenue Sales/Store/Year Revenue $46,131.77 $128,753,768.00 $945,891.18 $646,989,564.00 $46,131.77 $1,153,294.23 $945,891.18 $4,729,455.88 $46,131.77 $657,377.71 $945,891.18 $1,418,836.76 $46,131.77 $322,922.38 $945,891.18 $472,945.59 $46,131.77 $103,796.48 $945,891.18 $236,472.79 $130,991,158.81 $653,847,275.02

Sales Growth

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