A few years ago, Sonic (NASDAQ:SONC) discovered something interesting about its business: Its franchise stores were delivering bigger profits than its company-owned stores were, despite lower percentage margins in the franchise outlets. How did it happen? Simple: Franchise stores had higher average sales, to the tune of more than 15%.
I love this type of analysis, because it points out an inescapable truth of multi-unit operations: You deposit cash, not percentages, in the bank. The franchisees were investing more in labor and customer service. That resulted in higher sales, which in turn led to greater cash earnings. Company-owned stores, meanwhile, were focused on hitting target percentages. The lesson was clear: Take care of the customer, and sales growth will more than compensate for a minor drop in margin percentages. Loyal Motley Fool readers have heard this refrain from me before, in articles complimenting big-box retailers like Target (NYSE:TGT) and Motley Fool Stock Advisor selections Costco (NASDAQ:COST), and Best Buy (NYSE:BBY), but it applies to restaurant operators just as well.
Sonic's third-quarter results, released last night, suggest that its focus on customers and sales growth continues to pay off. Quarterly revenues rose by 15%, operating income moved up at the same rate, and net income grew by 19% -- this despite a 100-basis-point increase in store operating expenses. General and administrative (G&A) and occupancy leverage made up the slack. Also notable is that this quarter was pitted against an unusual $800,000 real estate gain a year ago. Excluding that item, Sonic would have reported net income growth north of 20%.
The company was particularly forthright in its earnings call, noting a cloud or two on the horizon. Sonic seems to have locked in future beef prices with a supplier that has reneged on the deal, so cost of goods could be under a little pressure in the upcoming months. Sonic also benefited from favorable health expenses that are not expected to recur in the next quarter.
But there's a lot of favorable news as well. Comparable-store sales were up 5.5% for the quarter, continuing the strong trend from last year. The company is on track to open about 175 stores this year. And Sonic is also having particular success growing sales during specific parts of the day and will continue to build on that advantage with a "summer nights" promotion.
Average unit volumes have surpassed the $1 million mark, as measured over the past four quarters. Sonic says the throughput capacity (the rate at which a system produces money) of its stores is well over $1.5 million, with some stores doing in excess of $2 million annually. That leaves a lot of room for comparable-store growth in addition to the new-store program. The company has a solid pipeline of franchise development agreements in hand, and let's not forget its strong record of positive cash flow in recent quarters. Sonic is using some of that cash flow to buy back from franchisees; the rest is going to share repurchases.
The stock is trading off by about 2.5%, and I'm not sure why. Analysts continued their focus on margin percentages, and the company countered by stating that it's driving sales growth and cash profits in favor of margins. The slip could also be due to the beef contract issue or a general worry over mad-cow disease and the beef supply -- although it's worth noting that McDonald's (NYSE:MCD) and Wendy's (NYSE:WEN) were on the rise in early trading.
Whatever the short-term reason, it's my opinion that readers consider any pullback in the shares as a buying opportunity. And there's no doubt that Sonic is a solid growth company with a nicely differentiated offering in a crowded quick-service restaurant environment.
For more fast-food news, check out:
Fool contributor Timothy M. Otte indulges his wife and teenage daughter regularly by going to Sonic. He welcomes comments on his articles but doesn't own the stock of any company mentioned in this article.
