| [X] | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 | |
| For the quarterly period ended February 28, 2005 | ||
| OR | ||
| [ ] | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 | |
| For the transition period from __________ to __________ |
| Commission File Number 0-18859 | ||
| SONIC CORP. |
||
| (Exact name of registrant as specified in its charter) | ||
| Delaware |
73-1371046 | |
| (State of Incorporation) | (I.R.S. Employer Identification No.) | |
| 300 Johnny Bench Drive | ||
| Oklahoma City, Oklahoma |
73104 | |
| (Address of Principal Executive Offices) | (Zip Code) |
Registrant's telephone number, including area code: (405) 225-5000
Indicate
by check mark whether the Registrant (1) has filed all reports required by Section 13 or
15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for the
shorter period that the Registrant has had to file the reports), and (2) has been subject
to the filing requirement for the past 90 days.
Yes X . No .
As of February 28, 2005, the Registrant had 60,360,110 shares of common stock issued and outstanding (excluding 15,098,687 shares of common stock held as treasury stock).
| ASSETS | (Unaudited) February 28, 2005 |
August 31, 2004 |
||||||
|---|---|---|---|---|---|---|---|---|
| Current assets: | ||||||||
| Cash and cash equivalents | $ | 16,235 | $ | 7,993 | ||||
| Accounts and notes receivable, net | 15,806 | 18,087 | ||||||
| Other current assets | 7,127 | 8,503 | ||||||
| Total current assets | 39,168 | 34,583 | ||||||
| Property, equipment and capital leases | 544,735 | 511,167 | ||||||
| Less accumulated depreciation and amortization | (150,187 | ) | (134,852 | ) | ||||
| Property, equipment and capital leases, net | 394,548 | 376,315 | ||||||
| Goodwill, net | 87,994 | 87,420 | ||||||
| Trademarks, trade names and other intangible assets, net | 6,401 | 6,450 | ||||||
| Investment in direct financing leases and noncurrent portion of | ||||||||
| notes receivable | 8,566 | 11,566 | ||||||
| Other assets, net | 2,029 | 2,299 | ||||||
| Intangibles and other assets, net | 104,990 | 107,735 | ||||||
| Total assets | $ | 538,706 | $ | 518,633 | ||||
| LIABILITIES AND STOCKHOLDERS' EQUITY | ||||||||
| Current liabilities: | ||||||||
| Accounts payable | $ | 9,559 | $ | 7,695 | ||||
| Deposits from franchisees | 3,048 | 2,867 | ||||||
| Accrued liabilities | 24,160 | 27,711 | ||||||
| Income taxes payable | 1,871 | 4,841 | ||||||
| Obligations under capital leases and long-term debt | ||||||||
| due within one year | 20,655 | 6,006 | ||||||
| Total current liabilities | 59,293 | 49,120 | ||||||
| Obligations under capital leases due after one year | 36,668 | 38,020 | ||||||
| Long-term debt due after one year | 49,594 | 78,674 | ||||||
| Other noncurrent liabilities | 18,236 | 18,057 | ||||||
| Stockholders' equity: | ||||||||
| Preferred stock, par value $.01; 1,000,000 shares | ||||||||
| authorized; none outstanding | – | – | ||||||
| Common stock, par value $.01; 100,000,000 shares | ||||||||
| authorized; 75,458,797 shares issued (74,617,554 shares | ||||||||
| issued at August 31, 2004) | 755 | 746 | ||||||
| Paid-in capital | 116,561 | 105,012 | ||||||
| Retained earnings | 379,997 | 351,402 | ||||||
| 497,313 | 457,160 | |||||||
| Treasury stock, at cost; 15,098,687 common shares (15,098,687 | ||||||||
| shares at August 31, 2004) | (122,398 | ) | (122,398 | ) | ||||
| Total stockholders' equity | 374,915 | 334,762 | ||||||
| Total liabilities and stockholders' equity | $ | 538,706 | $ | 518,633 | ||||
See accompanying notes.
3
| (Unaudited) Three months ended |
(Unaudited) Six months ended |
|||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| February 28, 2005 |
February 29, 2004 |
February 28, 2005 |
February 29, 2004 |
|||||||||||
| Revenues: | ||||||||||||||
| Partner Drive-In sales | $ | 112,655 | $ | 94,105 | $ | 232,866 | $ | 193,850 | ||||||
| Franchise Drive-Ins: | ||||||||||||||
| Franchise royalties | 18,169 | 15,906 | 38,275 | 33,040 | ||||||||||
| Franchise fees | 874 | 833 | 1,809 | 1,867 | ||||||||||
| Other | 915 | 751 | 1,890 | 1,546 | ||||||||||
| 132,613 | 111,595 | 274,840 | 230,303 | |||||||||||
| Cost and expenses: | ||||||||||||||
| Partner Drive-Ins: | ||||||||||||||
| Food and packaging | 29,415 | 24,505 | 61,988 | 50,709 | ||||||||||
| Payroll and other employee benefits | 34,910 | 29,527 | 71,875 | 59,723 | ||||||||||
| Minority interest in earnings | ||||||||||||||
| of Partner Drive-Ins | 4,048 | 3,693 | 8,627 | 7,414 | ||||||||||
| Other operating expenses | 23,309 | 18,595 | 46,976 | 38,326 | ||||||||||
| 91,682 | 76,320 | 189,466 | 156,172 | |||||||||||
| Selling, general and administrative | 10,060 | 9,083 | 19,553 | 18,204 | ||||||||||
| Depreciation and amortization | 8,870 | 8,165 | 17,276 | 15,988 | ||||||||||
| Provision for impairment of long-lived | ||||||||||||||
| assets | 387 | 675 | 387 | 675 | ||||||||||
| 110,999 | 94,243 | 226,682 | 191,039 | |||||||||||
| Income from operations | 21,614 | 17,352 | 48,158 | 39,264 | ||||||||||
| Interest expense | 1,712 | 1,989 | 3,491 | 3,910 | ||||||||||
| Interest income | (180 | ) | (310 | ) | (354 | ) | (652 | ) | ||||||
> | ||||||||||||||
| Net interest expense | 1,532 | 1,679 | 3,137 | 3,258 | ||||||||||
| Income before income taxes | 20,082 | 15,673 | 45,021 | 36,006 | ||||||||||
| Provision for income taxes | 7,487 | 5,838 | 16,426 | 13,412 | ||||||||||
| Net income | $ | 12,595 | $ | 9,835 | $ | 28,595 | $ | 22,594 | ||||||
| Net income per share - basic | $ | .21 | $ | .17 | $ | .48 | $ | .38 | ||||||
| Net income per share - diluted | $ | .20 | $ | .16 | $ | .46 | $ | .37 | ||||||
See accompanying notes.
4
| (Unaudited) Six months ended |
||||||||
|---|---|---|---|---|---|---|---|---|
| February 28, 2005 |
February 29, 2004 |
|||||||
| Cash flows from operating activities: | ||||||||
| Net income | $ | 28,595 | $ | 22,594 | ||||
| Adjustments to reconcile net income to net cash provided by | ||||||||
| operating activities: | ||||||||
| Depreciation and amortization | 17,276 | 15,988 | ||||||
| Tax benefit related to exercise of employee stock options | 4,114 | 2,684 | ||||||
| Other | 1,091 | 839 | ||||||
| (Increase) decrease in operating assets | 2,168 | (1,288 | ) | |||||
| Increase (decrease) in operating liabilities: | ||||||||
| Accounts payable | 2,057 | 584 | ||||||
| Accrued and other liabilities | (6,738 | ) | (9,966 | ) | ||||
| Total adjustments | 19,968 | 8,841 | ||||||
| Net cash provided by operating activities | 48,563 | 31,435 | ||||||
| Cash flows from investing activities: | ||||||||
| Purchases of property and equipment | (38,407 | ) | (30,340 | ) | ||||
| Proceeds from collection of long-term notes receivable | 3,623 | – | ||||||
| Other | 2,140 | 2,525 | ||||||
| Net cash used in investing activities | (32,644 | ) | (27,815 | ) | ||||
| Cash flows from financing activities: | ||||||||
| Payments on long-term debt | (22,327 | ) | (67,376 | ) | ||||
| Proceeds from long-term borrowings | 8,250 | 59,340 | ||||||
| Proceeds from exercise of stock options | 7,444 | 3,552 | ||||||
| Other | (1,044 | ) | (864 | ) | ||||
| Net cash used in financing activities | (7,677 | ) | (5,348 | ) | ||||
| Net increase (decrease) in cash and cash equivalents | 8,242 | (1,728 | ) | |||||
| Cash and cash equivalents at beginning of period | 7,993 | 13,210 | ||||||
| Cash and cash equivalents at end of period | $ | 16,235 | $ | 11,482 | ||||
| Supplemental Cash Flow Information: | ||||||||
| Additions to capital lease obligations | $ | – | $ | 9,298 | ||||
See accompanying notes.
5
The unaudited Condensed Consolidated Financial Statements include all adjustments, consisting of normal, recurring accruals, which Sonic Corp. (the “Company”) considers necessary for a fair presentation of the financial position and the results of operations for the indicated periods. In certain situations, these accruals, including franchise royalties, are based on more limited information at interim reporting dates than at the Company’s fiscal year end due to the abbreviated reporting period. Actual results may differ from these estimates. The notes to the condensed consolidated financial statements should be read in conjunction with the notes to the consolidated financial statements contained in the Company’s Form 10-K for the fiscal year ended August 31, 2004. The results of operations for the six months ended February 28, 2005, are not necessarily indicative of the results to be expected for the full year ending August 31, 2005.
Certain amounts have been reclassified on the condensed consolidated financial statements to conform to the fiscal year 2005 presentation.
The following table sets forth the computation of basic and diluted earnings per share:
| Three months ended | Six months ended | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| February 28, 2005 |
February 29, 2004 |
February 28, 2005 |
February 29, 2004 |
|||||||||||
| Numerator: | ||||||||||||||
| Net income | $ | 12,595 | $ | 9,835 | $ | 28,595 | $ | 22,594 | ||||||
| Denominator: | ||||||||||||||
| Weighted average shares outstanding - basic | 60,263 | 59,237 | 60,136 | 59,073 | ||||||||||
| Effect of dilutive employee stock options | 2,525 | 2,452 | 2,451 | 2,369 | ||||||||||
| Weighted average shares - diluted | 62,788 | 61,689 | 62,587 | 61,442 | ||||||||||
| Net income per share - basic | $ | .21 | $ | .17 | $ | .48 | $ | .38 | ||||||
| Net income per share - diluted | $ | .20 | $ | .16 | $ | .46 | $ | .37 | ||||||
The Company has entered into agreements with various lenders and an agreement with GE Capital Franchise Finance Corporation (“GEC”), pursuant to which GEC made loans to existing Sonic franchisees who met certain underwriting criteria set by GEC. Under the terms of the agreement with GEC, the Company provided a guarantee of 10% of the outstanding balance of loans from GEC to the Sonic franchisees, limited to a maximum amount of $5.0 million. As of February 28, 2005, the total amount guaranteed under the GEC agreement was $4.3 million. The Company ceased guaranteeing new loans under the program during fiscal year 2002 and has not been required to make any payments under its agreement with GEC. Existing loans under guarantee will expire through 2012. In the event of default by a franchisee, the Company has the option to fulfill the franchisee’s obligations under the note or to become the note holder, which would provide an avenue of recourse with the franchisee under the notes.
6
The Company has obligations under various lease agreements with third party lessors related to the real estate for Partner Drive-Ins that were sold to franchisees. Under these agreements, the Company remains secondarily liable for the lease payments for which it was responsible as the original lessee. As of February 28, 2005, the amount remaining under the guaranteed lease obligations totaled $3.8 million.
The Company has not recorded a liability for its obligations under the guarantees and none of the notes or leases related to the guarantees were in default as of February 28, 2005.
The Company accounts for its stock-based employee compensation plans under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations. No stock-based employee compensation cost is reflected in net income, since all options granted under those plans were fixed-price options with an exercise price equal to the market value of the underlying common stock on the date of grant.
The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” to stock-based employee compensation:
| Three months ended | Six months ended | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| February 28, 2005 |
February 29, 2004 |
February 28, 2005 |
February 29, 2004 |
|||||||||||
| Net income, as reported | $ | 12,595 | $ | 9,835 | $ | 28,595 | $ | 22,594 | ||||||
| Less stock-based compensation expense | ||||||||||||||
| using the fair value method, net of related | ||||||||||||||
| tax effects | (1,322 | ) | (1,075 | ) | (2,208 | ) | (2,250 | ) | ||||||
| Pro forma net income | $ | 11,273 | $ | 8,760 | $ | 26,387 | $ | 20,344 | ||||||
| Net income per share: | ||||||||||||||
| Basic: | ||||||||||||||
| As reported | $ | .21 | $ | .17 | $ | .48 | $ | .38 | ||||||
| Pro forma | $ | .19 | $ | .15 | $ | .44 | $ | .34 | ||||||
| Diluted: | ||||||||||||||
| As reported | $ | .20 | $ | .16 | $ | .46 | $ | .37 | ||||||
| Pro forma | $ | .18 | $ | .14 | $ | .42 | $ | .33 | ||||||
In December 2004, the Financial Accounting Standards Board issued the final statement on accounting for share-based payments. Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. The Statement establishes fair value as the measurement objective in accounting for share-based payment transactions with employees except for equity instruments held by employee share ownership plans. The Company is required to adopt the provisions of SFAS 123R as of the beginning of its fiscal year 2006. The Company is currently evaluating the two adoption alternatives, which are the modified-prospective application and the modified-retrospective application. The Company is also evaluating which valuation model is most appropriate.
7
The Company is involved in various legal proceedings and has certain unresolved claims pending. Based on the information currently available, management believes that all claims currently pending are either covered by insurance or would not have a material adverse effect on the Company’s business or financial condition.
The Company has $30.0 million of senior unsecured Series B notes maturing in April 2005. As of August 31, 2004, the Company intended to refinance the entire $30.0 million through availability under its line of credit and had classified that amount as long-term debt on its balance sheet. However, as a result of strong cash flow from operations for the first six months of fiscal year 2005, the Company now plans to repay $15.0 million of the amount maturing using cash on hand and has reclassified that amount as a current liability as of February 28, 2005. The Company expects to refinance the remaining $15.0 million using amounts available under its line of credit.
In October 2004, legislation was signed into law retroactively reinstating the Work Opportunity Tax Credit as of January 1, 2004. As a result, the Company recognized a cumulative adjustment to the income tax provision in the first quarter of fiscal year 2005 relating to the benefit of the reinstated tax credit. The provision for income taxes reflects a reduction in the effective federal and state tax rate to 36.5% for the first six months of fiscal year 2005 as compared to 37.3% in the same period of 2004, primarily as a result of the tax credit reinstatement.
On April 7, 2005, the Board of Directors approved an increase in the Company's share repurchase program from $60 million to $150 million and extended the program through August 31, 2006.
8
Description of the Business. Sonic operates and franchises the largest chain of drive-ins in the United States and also has a small number of Franchise Drive-Ins in Mexico. As of February 28, 2005, the Sonic system was comprised of 2,934 drive-ins, of which 548 were Partner Drive-Ins and 2,386 were Franchise Drive-Ins. Sonic Drive-Ins feature Sonic signature items such as made-to-order sandwiches and hamburgers, extra-long chili-cheese coneys, salads, hand-battered onion rings, tater tots, specialty soft drinks including cherry limeades and slushes, and frozen desserts. We derive our revenues primarily from Partner Drive-In sales and royalty fees from franchisees. We also receive revenues from initial franchise fees and the selling and leasing of signs and real estate. In addition, we also own and receive income from a minority ownership interest in a few Franchise Drive-Ins.
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 both Partner Drive-In operations, as well as the Company’s franchising 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. Our strong business performance continued during our second fiscal quarter ended in February 2005. Net income increased 28% and earnings per share increased 25% to $0.20 per diluted share. For the first half of fiscal 2005, net income increased 27% and earnings per share increased 24% to $0.46 per diluted share. We believe these results reflect our multi-layered growth strategy that features the following components:
| • | Solid same-store sales growth; |
| • | Increased franchising income stemming from the solid same-store sales growth and our unique ascending royalty rate; |
| • | Expansion of the Sonic brand through new unit growth, particularly by franchisees; |
| • | Operating leverage at both the drive-in level and the corporate level; and |
| • | The use of excess operating cash flow for franchise acquisitions and share repurchases. |
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 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.
9
| Three months ended | Six months ended | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| February 28, 2005 |
February 29, 2004 |
February 28, 2005 |
February 29, 2004 |
|||||||||||
| Percentage increase in sales | 13.3 | % | 12.9 | % | 14.2 | % | 13.3 | % | ||||||
| System-wide drive-ins in operation: | ||||||||||||||
| Total at beginning of period | 2,917 | 2,743 | 2,885 | 2,706 | ||||||||||
| Opened | 32 | 32 | 66 | 70 | ||||||||||
| Closed (net of re-openings) | (15 | ) | (2 | ) | (17 | ) | (3 | ) | ||||||
| Total at end of period | 2,934 | 2,773 | 2,934 | 2,773 | ||||||||||
| Core markets | 2,094 | 2,004 | 2,094 | 2,004 | ||||||||||
| Developing markets | 840 | 769 | 840 | 769 | ||||||||||
| All markets | 2,934 | 2,773 | 2,934 | 2,773 | ||||||||||
| Average sales per drive-in: | ||||||||||||||
| Core markets | $ | 232 | $ | 218 | $ | 483 | $ | 451 | ||||||
| Developing markets | 194 | 177 | 410 | 374 | ||||||||||
| All markets | 222 | 207 | 463 | 430 | ||||||||||
| Change in same-store sales (1): | ||||||||||||||
| Core markets | 6.5 | % | 6.5 | % | 7.2 | % | 6.4 | % | ||||||
| Developing markets | 8.8 | 6.9 | 8.6 | 5.9 | ||||||||||
| All markets | 7.0 | 6.6 | 7.5 | 6.3 | ||||||||||
(1) Represents percentage change for restaurants open for a minimum of 15 months.
System-wide same-store sales increased 7.0% during the second quarter of fiscal year 2005, primarily as a result of traffic growth (the number of transactions) across multiple day parts (e.g. morning, lunch, afternoon, dinner, and evening). Given the continued strong sales performance and our confidence that the sales driving strategies we have in place will continue to positively impact our business, we are raising our sales guidance for the second half of fiscal 2005 to the 4% to 6% range. We believe our strong sales performance is not only the result of generally more favorable industry and consumer conditions, but is also a consequence of our specific sales driving initiatives including:
| • | Growth in brand awareness through increased media spending and greater use of network cable advertising; |
| • | Strong promotions and new product news focused on quality and expanded choice for our customers; |
| • | Continued growth of our business in non-traditional day parts including the morning and evening day parts, which increased significantly during the quarter; and |
| • | Implementation of PAYS (Pay At Your Stall) Program at Partner Drive-Ins was completed during the second quarter. |
During fiscal year 2005, our total system-wide media expenditures will be in excess of $120 million as compared to approximately $110 million in fiscal year 2004, which we believe will continue to increase overall brand awareness and strengthen our share of voice relative to our competitors. We have also shifted more of our marketing dollars to our system-wide marketing fund, which is largely used for network cable television advertising, and anticipate growing this area of our advertising from approximately $32 million last year to almost $60 million in fiscal year 2005. We believe this increased network cable advertising will provide several benefits including the ability to target more effectively and better reach the network cable audience, which has now surpassed broadcast
10
networks in terms of viewership. In addition, national cable advertising also allows us to bring additional depth to our marketing by expanding our media messages beyond our monthly promotions.
We continue to use our monthly promotions to highlight our distinctive food offerings and to feature new products. We also use our promotions and product news to create a strong emotional link with consumers and to align closely with consumer trends for fresh ingredients, customization, menu variety and choice. During the second quarter, our new product offerings included a Smoky SuperSONIC® Cheeseburger and a Holiday M&M® Mint Blast, a new Chicken Smokehouse Club Wrap and a Sweetheart Blast™ in February. We will continue to have new product news in the coming months spanning the entire breadth of our product line and all designed to meet customers’ evolving taste preferences, including the growing desire for fresh, quality product offerings and more healthy alternatives.
We continue to be pleased with our progress towards penetrating the morning day part through our breakfast program, which has been offered in all drive-ins since the spring of 2003. Sales during the morning day part have grown to approximately 12% of total sales. We also continue to view breakfast as instrumental in helping us grow our annual average unit volumes to well over $1.0 million, more in the range of our larger competitors.
In addition to growth during the morning day part, we experienced sales increases in every other day part during the second quarter, including dinner and evening business. Every day part has seen an increase in sales in each of the past five quarters. The momentum in our evening business, which we experienced during the summer with our Sonic Nights initiative, continued during the fall and winter and we believe we have continued opportunity to grow our non-traditional day parts during the coming months.
One of the more positive developments over the last several quarters has been the performance of developing markets. System-wide same-store sales in developing markets have outpaced same-store sales in core markets, increasing 8.8% during the second quarter and 8.6% for the first six months. We believe this increase was due to increased spending on national cable, which has benefited all of our markets, and particularly our developing markets. From an average unit volume standpoint, developing markets, which represent roughly 29% of the store base, increased 9.8% during the first six months continuing the positive trend of the last year and well ahead of the average unit volume increase in core markets. The improved sales environment helped offset the impact of higher commodity prices and produced strong growth in average unit dollar profit during the first six months of the year which translated into higher earnings for our franchisees and partners in our Partner Drive-Ins.
We opened 32 drive-ins during the second quarter, consisting of six Partner Drive-Ins and 26 Franchise Drive-Ins, which was consistent with the total number of drive-in openings during the second quarter a year ago. For the first six months, we have opened 66 drive-ins compared to 70 during the first six months of last year. Openings, particularly on the franchise side, were impacted earlier in the year by persistent wet weather across many of our markets as well as the lingering effect of the summer hurricanes on development in many areas of Florida and the Southeast. Despite the cumulative effect of this slowdown on annual development output, we continue to believe we remain on track for approximately 200 new drive-in openings this fiscal year, including 50 to 55 during the third quarter of 2005.
We completed the implementation of the PAYS Program at all of our Partner Drive-Ins during the second quarter. Under the PAYS Program, a credit card payment terminal is added to each drive-in stall to facilitate credit card transactions. Approximately 160 Partner Drive-Ins had PAYS installed in the fall of 2003. The remaining two-thirds of our Partner Drive-Ins had PAYS installed during the fall and winter of 2004. The Company began the rollout of the PAYS Program to Franchise Drive-Ins in February and expects to complete its system-wide implementation over the next 24 months. The average investment to install PAYS in a typical Sonic Drive-In is approximately $25,000. In evaluating an initiative that requires investment at the store-level, we typically target an “increased sales to investment ratio” of 1 to 1. It has been our experience that the installation of the PAYS Program has met and often exceeded this targeted sales to investment ratio.
11
Revenues. Total revenues increased 18.8% to $132.6 million in the second fiscal quarter of 2005 and 19.3% to $274.8 million for the first six months of fiscal 2005. The increase in revenues primarily relates to strong sales growth at Partner Drive-Ins and, to a lesser extent, increased franchising income from Franchise Drive-Ins.
| February 28, 2005 |
February 29, 2004 |
Increase/ (Decrease) |
Percent Increase/ (Decrease) | |||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Three months ended | ||||||||||||||
| Revenues: | ||||||||||||||
| Partner Drive-In sales | $ | 112,655 | $ | 94,105 | $ | 18,550 | 19.7 | % | ||||||
| Franchise revenues: | ||||||||||||||
| Franchise royalties | 18,169 | 15,906 | 2,263 | 14.2 | ||||||||||
| Franchise fees | 874 | 833 | 41 | 4.9 | ||||||||||
| Other | 915 | 751 | 164 | 21.8 | ||||||||||
| Total revenues | $ | 132,613 | $ | 111,595 | $ | 21,018 | 18.8 | % | ||||||
| Six months ended | ||||||||||||||
| Revenues: | ||||||||||||||
| Partner Drive-In sales | $ | 232,866 | $ | 193,850 | $ | 39,016 | 20.1 | % | ||||||
| Franchise revenues: | ||||||||||||||
| Franchise royalties | 38,275 | 33,040 | 5,235 | 15.8 | ||||||||||
| Franchise fees | 1,809 | 1,867 | (58 | ) | (3.1 | ) | ||||||||
| Other | 1,890 | 1,546 | 344 | 22.3 | ||||||||||
| Total revenues | $ | 274,840 | $ | 230,303 | $ | 44,537 | 19.3 | % | ||||||
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.
| Three months ended | Six months ended | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| February 28, 2005 |
February 29, 2004 |
February 28, 2005 |
February 29, 2004 |
|||||||||||
| Partner Drive-In sales | $ | 112,655 | $ | 94,105 | $ | 232,866 | $ | 193,850 | ||||||
| Percentage increase | 19.7 | % | 25.8 | % | 20.1 | % | 23.9 | % | ||||||
| Drive-ins in operation: | ||||||||||||||
| Total at beginning of period | 544 | 499 | 539 | 497 | ||||||||||
| Opened | 6 | 2 | 10 | 4 | ||||||||||
| Acquired from (sold to) franchisees | (2 | ) | 2 | – | 2 | |||||||||
| Closed | – | – | (1 | ) | – | |||||||||
| Total at end of period | 548 | 503 | 548 | 503 | ||||||||||
| Average sales per drive-in | $ | 208 | $ | 188 | $ | 431 | $ | 388 | ||||||
| Percentage increase | 10.4 | % | 13.9 | % | 10.8 | % | 12.1 | % | ||||||
| Change in same-store sales (1) | 9.8 | % | 7.4 | % | 10.0 | % | 6.6 | % | ||||||
(1) Represents percentage change for restaurants open for a minimum of 15 months.
12
Partner Drive-In sales increased $18.6 million in the second fiscal quarter of 2005, of which $9.5 million resulted from the net addition of 49 Partner Drive-Ins in the 15 months ending February 28, 2005 ($10.3 million from the addition of newly constructed and acquired drive-ins less $0.8 million from drive-ins sold or closed during the period). Same-store sales increases of 9.8% accounted for $9.1 million of the increase.
During the first six months of fiscal year 2005, Partner Drive-In sales increased $39.0 million, which consisted of $20.2 million from the net addition of 49 Partner Drive-Ins in the 15 months ending February 28, 2005 ($21.5 million from the addition of newly constructed and acquired drive-ins less $1.3 million from drive-ins sold or closed during the period). Same-store sales increases of 10.0% accounted for $18.8 million of the increase.
During the second quarter of fiscal year 2005, same-store sales increases at Partner Drive-Ins exceeded the same-store sales performance of our franchisees. The increase in average unit volume was even stronger – growing 10.4% during the quarter and 10.8% for the first six months as a result of continued strong performance from new store openings and the acquisition of higher volume drive-ins in Colorado. Effective July 1, 2005, we roll over the acquisition of the Colorado drive-ins which have accounted for approximately four percentage points of the growth in revenues since their acquisition and are expected to be accretive to earnings over time.
As mentioned previously, we completed the implementation of the PAYS Program at all of our Partner Drive-Ins during the second quarter. Under the PAYS Program, a credit card payment terminal is added to each drive-in stall to facilitate credit card transactions. Approximately 160 Partner Drive-Ins had PAYS installed in the fall of 2003. The remaining two-thirds of our Partner Drive-Ins had PAYS installed during the fall and winter of 2004.
At our Partner Drive-Ins, we have implemented long-term initiatives designed to close the approximately $100,000 sales gap in annual average unit volumes between Partner Drive-Ins and Franchise Drive-Ins. To a large degree, this effort is modeled on the best practices of our top-volume Partner and Franchise Drive-Ins. Our intent is to complement the strong profit motive created through our partnership program with strong incentives focused on top-line growth. During fiscal year 2004, this gap narrowed by 25% or approximately $30,000 per drive-in. That trend remained evident in the first two quarters of fiscal year 2005 as same-store sales growth at Partner Drive-Ins outpaced same-store sales of Franchise Drive-Ins closing the gap by another $10,000.
Over the past several years, we have completed several acquisitions of Franchise Drive-Ins in various markets including the acquisition of 51 drive-ins located in the San Antonio, Texas market in May 2003 and the acquisition of 22 drive-ins located in the Denver and Colorado Springs, Colorado markets in July 2004. The drive-ins acquired in Colorado performed well during the first six months of fiscal year 2005, as did the drive-ins acquired in previous acquisitions. We continue to view these types of acquisitions of core-market drive-ins with proven track records as a very good, lower-risk use of our capital and they remain a very viable potential use of our excess cash flow in future years.
The following table reflects the growth in franchising 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.
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| Three months ended | Six months ended | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| February 28, 2005 |
February 29, 2004 |
February 28, 2005 |
February 29, 2004 |
|||||||||||
| Franchise fees and royalties (1) | $ | 19,043 | $ | 16,739 | $ | 40,084 | $ | 34,907 | ||||||
| Percentage increase | 13.8 | % | 14.3 | % | 14.8 | % | 13.9 | % | ||||||
| Franchise Drive-Ins in operation: | ||||||||||||||
| Total at beginning of period | 2,373 | 2,244 | 2,346 | 2,209 | ||||||||||
| Opened | 26 | 30 | 56 | 66 | ||||||||||
| Acquired from (sold to) company | 2 | (2 | ) | – | (2 | ) | ||||||||
| Closed | (15 | ) | (2 | ) | (16 | ) | (3 | ) | ||||||
| Total at end of period | 2,386 | 2,270 | 2,386 | 2,270 | ||||||||||
| Franchise Drive-In sales | $ | 533,982 | $ | 476,665 | $ | 1,115,078 | $ | 986,086 | ||||||
| Percentage increase | 12.0 | % | 10.6 | % | 13.1 | % | 11.4 | % | ||||||
| Effective royalty rate | 3.40 | % | 3.33 | % | 3.43 | % | 3.35 | % | ||||||
| Average sales per Franchise Drive-In | $ | 226 | $ | 211 | $ | 471 | $ | 439 | ||||||
| Change in same-store sales (2) | 6.3 | % | 6.4 | % | 7.0 | % | 6.3 | % | ||||||
(1) See Revenue Recognition
Related to Franchise Fees and Royalties in the Critical Accounting Policies and Estimates
section of MD&A.
(2) Represents percentage change for drive-ins open for a minimum
of 15 months.
Franchising income, which consists of franchise royalties and franchise fees, increased 13.8% to $19.0 million in the second fiscal quarter of 2005 and 14.8% to $40.1 million for the first six months of fiscal year 2005.
Franchise royalties increased 14.2% to $18.2 million in the second quarter of 2005, compared to $15.9 million in the second fiscal quarter of 2004. Of the $2.3 million increase, approximately $1.5 million resulted from franchise same-store sales growth of 6.3% in the second fiscal quarter of 2005, combined with an increase in the effective royalty rate to 3.40% during the second fiscal quarter of 2005 compared to 3.33% during the same period in fiscal year 2004. Each of our license agreements contains an ascending royalty rate whereby royalties, as a percentage of sales, increase as sales increase. The balance of the increase was primarily attributable to growth in the number of franchise units over the prior period.
Franchise royalties increased 15.8% to $38.3 million in the first two fiscal quarters of 2005, compared to $33.0 million during the same period of the prior year. Of the $5.3 million increase, approximately $3.4 million resulted from Franchise Drive-Ins’ same-store sales growth of 7.0% in the first six months of fiscal year 2005, combined with an increase in the effective royalty rate to 3.43% during the first two fiscal quarters of 2005 compared to 3.35% during the same period in fiscal year 2004. The balance of the increase was primarily attributable to growth in the number of franchise units over the prior period.
As mentioned previously, the Company began the rollout of the PAYS Program to Franchised Drive-Ins in February and expects to complete its system-wide implementation over the next 24 months. Under the PAYS Program, a credit card payment terminal is added to each drive-in stall to facilitate credit card transactions.
Franchisees opened 26 new drive-ins in the second quarter and 56 new drive-ins for the first six months as compared to 30 openings in the second quarter of 2004 and 66 for the first six months of fiscal 2004. Openings were impacted by persistent wet weather earlier in the year across many of our markets as well as the lingering effect of the summer hurricanes on development in many areas of Florida and the Southeast. Despite the cumulative effect of this slowdown on annual development output, our franchise pipeline continues to strengthen and we believe we are
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on track to open approximately 170 Franchise Drive-Ins this fiscal year, including approximately 40 during the third quarter of 2005. Substantially all of these new drive-ins will open under our newest form of license agreement, which contains a higher average royalty rate and initial opening fee. During the second quarter, we experienced a higher number of franchise closings than normally occurs. These closings were primarily the result of two weaker franchise operators in two different markets. We believe that the closing of drive-ins by these two operating groups is not indicative of the Sonic brand’s success. Going forward, we have taken steps to strengthen the financial qualifications of new franchisees, which we believe will significantly mitigate this type of risk. In addition, we expect that many of these drive-ins may re-open under new franchisee ownership in the coming months. As a result of new Franchise Drive-In openings and the continued benefit of the ascending royalty rate, we expect approximately $9.0 to $10.0 million in incremental franchising income in fiscal year 2005.
Other revenues, which are derived primarily from the selling and leasing of signs and real estate, increased by $0.1 million during the second fiscal quarter of 2005 to $0.9 million compared to $0.8 million in the same period of fiscal year 2004, and increased by $0.4 million during the first six months of fiscal year 2005 to $1.9 million compared to $1.5 million in the same period of the prior year. Looking forward, we expect other revenues to be in the range of $0.8 to $0.9 million per quarter for the remainder of fiscal year 2005.
Operating Expenses. Overall, drive-in cost of operations, as a percentage of Partner Drive-In sales, increased to 81.4% in the second fiscal quarter of 2005 compared to 81.1% in the same period of fiscal year 2004, and increased to 81.4% for the first six months of 2005 compared to 80.6% for the same period of fiscal year 2004. Minority interest in earnings of 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.
| Three months ended | Six months ended | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| February 28, 2005 |
February 29, 2004 |
February 28, 2005 |
February 29, 2004 |
|||||||||||
| Cost and expenses (1): | ||||||||||||||
| Partner Drive-Ins: | ||||||||||||||
| Food and packaging | 26.1 | % | 26.0 | % | 26.6 | % | 26.2 | % | ||||||
| Payroll and other employee benefits | 31.0 | 31.4 | 30.9 | 30.8 | ||||||||||
| Minority interest in earnings of | ||||||||||||||
| Partner Drive-Ins | 3.6 | 3.9 | 3.7 | 3.8 | ||||||||||
| Other operating expenses | 20.7 | 19.8 | 20.2 | 19.8 | ||||||||||
| Total Partner Drive-In cost of operations | 81.4 | % | 81.1 | % | 81.4 | % | 80.6 | % | ||||||
(1) As a percentage of Partner Drive-In sales.
Food and packaging costs increased by 0.1 percentage points during the second quarter of fiscal year 2005 and 0.4 percentage points during the first six months of fiscal year 2005 compared to the same periods of fiscal year 2004 as a result of upward pressure on most commodity costs, particularly beef, dairy and tomato costs. The increase in the second quarter was less than had been previously expected due to the moderation of increases in beef prices and the implementation of a 1% price increase in Partner Drive-Ins in early January. We have locked in our costs for beef, which represent approximately 14% of our food and packaging costs, through the end of the calendar year at slightly higher prices on a year-over-year basis. In addition, dairy costs, which represent approximately 13% of our food and packaging costs, have moderated in recent months. As a result of these positive developments, we expect that food and packaging costs, as a percentage of sales, will be relatively flat to slightly lower during the third and fourth quarters of fiscal year 2005.
Labor costs decreased by 0.4 percentage points during the second quarter of fiscal year 2005 and increased by 0.1 percentage points for the first six months of fiscal year 2005 compared to the same periods of fiscal year 2004. We continued to make significant payments under our sales-based incentive program during the second fiscal quarter of 2005, however these higher payments were more than offset by the higher sales. Additionally, our assistant manager staffing levels remain at all-time highs, which should serve us well as we enter our seasonally higher sales months. We continue to believe that the investments we are making in our store-level management are a
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major driver of the strong sales performance at Partner Drive-Ins. We continue to see very little increase in average wage rates, which were relatively flat for the quarter as compared to the same period of the prior year.
Looking forward, we plan to continue making additional investments in labor, but the leverage from strong sales and seasonally our highest volume months should offset the impact of these investments and produce flat to slightly lower labor costs, as a percentage of sales, on a year-over-year basis.
Minority interest, which reflects distributions to our store-level partners through our partnership program, increased by $0.4 million during the second fiscal quarter of 2005 and by $1.2 million during the first six months of fiscal year 2005 compared to the same periods of fiscal year 2004, reflecting the increase in average profit per store. We continue to view the partnership program as an integral part of our culture at Sonic and a large factor in our overall success and we are pleased that profit distributions to our partners increased during the quarter. Looking forward, because we expect our restaurant-level margins to be relatively flat in the coming quarters, we would likewise expect minority interest to remain relatively flat versus the prior year as a percentage of Partner Drive-In sales.
Other operating expenses increased by 0.9 percentage points during the second quarter of fiscal year 2005 and increased by 0.4 percentage points in the first six months of 2005 compared to the same periods in fiscal year 2004. A portion of this deterioration came from a review of our accrual processes implemented as a part of our Sarbanes-Oxley compliance procedures. As a result of this review, we determined that our processes for accruing repair and maintenance invoices were inadequate resulting in a one-time catch-up accrual. We are also experiencing some cost increases for credit card charges resulting from the increase in credit card transactions by customers stemming from the success of the PAYS Program, as well as higher repair and maintenance expenses as we continue to increase our focus on the physical appearance of our drive-ins, both inside and outside. As a result of continuing increases in credit card charges and repair and maintenance expenses, we expect other operating expenses will likely continue to increase as a percentage of sales during the remainder of fiscal year 2005, but probably not to the magnitude of the second quarter and more in the 0.3 to 0.5 percentage point range.
To summarize, we are expecting overall restaurant-level margins to be relatively flat to slightly improved during the remaining quarters of fiscal year 2005 on a year-over-year basis.
Selling, General and Administrative. Selling, general and administrative expenses increased 10.8% to $10.1 million during the second fiscal quarter of 2005 compared to the same period of fiscal year 2004, and increased 7.4% to $19.6 million for the first six months of 2005 versus the same period of 2004. We continue to see leverage as the growth in these expenses was considerably less than the growth in revenues. As a percentage of total revenues, selling, general and administrative expenses decreased to 7.6% in the second quarter of fiscal year 2005 compared to 8.1% in the second quarter of fiscal year 2004, and decreased to 7.1% for the first six months of fiscal year 2005 compared to 7.9% for the same period of 2004. We anticipate that these costs will increase in the range of 10% to 12% for fiscal year 2005 as compared to the prior year and will likely be near the higher end of this range as we incur additional expenses related to the costs of complying with Sarbanes-Oxley 404.
Depreciation and Amortization. Depreciation and amortization expense increased 8.6% to $8.9 million in the second quarter of fiscal year 2005, and increased 8.1% to $17.3 million for the first six months of 2005. These increases were due in part to additional depreciation stemming from the Colorado acquisition, which will continue through June 2005. Capital expenditures, excluding acquisitions, were $38.4 million during the first six months of fiscal year 2005, in line with planned capital expenditures for fiscal year 2005 in the range of $60 to $70 million. We expect depreciation to grow in the 9% to 11% range for the remainder of the year.
Provision for Impairment of Long-Lived Assets. During the second quarter of fiscal year 2005, one mall location became impaired under the guidelines of FAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” As a result, a provision for impairment of $0.4 million was recorded for the drive-in’s carrying cost in excess of its estimated fair value. During the second quarter of fiscal year 2004, a drive-in was similarly impaired, resulting in a provision for impairment of $0.7 million. 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.
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Interest Expense. Net interest expense decreased 8.8% to $1.5 million for the second quarter of 2005 and decreased 3.7% to $3.1 million for the first six months of fiscal year 2005 compared to the same periods in fiscal year 2004. Strong cash flow from operations continues to result in lower interest expense. The reduction in interest expense more than offset the reduction in interest income relating to the outsourcing of our partner notes to a third party financial institution. Going forward, we expect interest income to decrease by approximately $150 thousand per quarter until we lap the disposition of partner notes during the fourth quarter of fiscal year 2005. However, we expect our strong free cash flow will continue to result in lower net interest expense in future quarters depending upon the amount of shares repurchased or potential franchisee acquisitions.
Income Taxes. The provision for income taxes reflects an effective federal and state tax rate of 37.3% for the second quarter of fiscal year 2005, compared to 37.2% for the same period of 2004. The effective rate for the first half of fiscal year 2005 was 36.5% compared to a rate of 37.3% for the same period of 2004. The cumulative decrease for fiscal year 2005 resulted from a retroactive tax law change reinstating expired tax credits in the first quarter. Going forward, we expect our tax rate to vary from quarter to quarter, but to generally be in the range of 37%.
During the first six months of fiscal year 2005, current assets increased 13.3% to $39.2 million compared to $34.6 million as of the prior fiscal year end as a result of strong cash flow from operations. Net property and equipment increased by 4.8% as a result of capital expenditures and was partially offset by a reduction in notes receivable, which combined with the increase in current assets to produce a 3.9% increase in total assets to $538.7 million as of the end of the second quarter of fiscal year 2005.
Total current liabilities increased $10.2 million or 20.7% during the first six months of fiscal year 2005 primarily as a result of the reclassification of $15.0 million in long-term debt maturing in April 2005, which the Company no longer expects to refinance due to excess cash on hand at the end of the reporting period. Similarly, long-term debt decreased $29.1 million or 37.0% as a result of the debt reclassification and as cash generated from operating activities was used to repay the outstanding balance under the line of credit. Overall, total liabilities decreased $20.1 million or 10.9% as a result of the items discussed above.
Shareholders’ equity increased $40.2 million or 12.0% during the first six months of fiscal year 2005 primarily resulting from earnings during the period of $28.6 million. Proceeds and the related tax benefit from the exercise of stock options accounted for the balance of the increase. At the end of the second fiscal quarter of 2005, our debt-to-total capital ratio was 22.2%, down from 26.8% at the end of fiscal year 2004. For the twelve months ended February 28, 2005, return on average stockholders’ equity was 20.6% and return on average assets was 13.2%.
Net cash provided by operating activities increased $17.1 million or 54.5% to $48.6 million in the first six months of fiscal year 2005 as compared to $31.4 million in the same period of fiscal year 2004, primarily as a result of an increase in operating profit before depreciation and amortization and the timing of tax payments. We also anticipate continuing to generate increasing positive free cash flow going forward. We believe free cash flow, which we define as net income plus depreciation and amortization less capital expenditures, is useful in evaluating the liquidity of the Company by assessing the level of funds available for share repurchases, acquisitions of Franchise Drive-Ins, and repayment of debt. This year we expect free cash flow to exceed $40 million.
On April 7, 2005, the Board of Directors approved an increase in the Company's share repurchase program from $60 million to $150 million and extended the program through August 31, 2006. We did not repurchase any shares under the share repurchase program during the first six months of fiscal year 2005.
We opened ten newly constructed Partner Drive-Ins and acquired two drive-ins from franchisees during the first two fiscal quarters of 2005. During the first six months of this fiscal year, we used cash generated by operating activities to fund capital additions totaling $38.4 million, which included the cost of newly opened drive-ins, new equipment for existing drive-ins, drive-ins under construction, the acquisition of Franchise Drive-Ins, and other
17
capital expenditures. During the six months ended February 28, 2005, we purchased the real estate for eleven of the twelve newly constructed and acquired drive-ins.
We plan capital expenditures of approximately $60 to $70 million in fiscal year 2005, excluding acquisitions and share repurchases. These capital expenditures primarily relate to the development of additional Partner Drive-Ins, stall additions, relocations of older drive-ins, store equipment upgrades, enhancements to existing financial and operating information systems, and tenant improvements for our new corporate office. We expect to fund these capital expenditures through borrowings under our existing unsecured revolving credit facility and cash flow from operations.
We entered into an agreement with certain franchisees during fiscal year 2003, which provides them with the option to sell 50 drive-ins to us anytime during the period commencing January 1, 2004 and ending June 30, 2005. We estimate that the cost of the acquisition, if it were to occur, would be in the range of $32 to $38 million and anticipate that the acquisition would be funded through operating cash flows and borrowings under our existing line of credit.
We have an agreement with a group of banks that provides us with a $125.0 million line of credit expiring in July 2006. We did not have any amounts borrowed under the line of credit as of February 28, 2005, however we did have $0.7 million in outstanding letters of credit. The amount available under the line of credit as of February 28, 2005, was $124.3 million. We have long-term debt maturing in fiscal years 2005 and 2006 of $38.0 million and $8.1 million, respectively. We plan to refinance $15.0 million and $4.6 million of long-term debt under our senior unsecured notes that will be maturing in April and August 2005, respectively, using amounts available under our line of credit. We also plan to extend the amounts maturing in 2006 under the line of credit. We believe that free cash flow will be adequate for repayment of any long-term debt that does not get refinanced or extended. We plan to use the line of credit to finance the opening of newly constructed drive-ins, acquisitions of existing drive-ins, purchases of the Company’s common stock and for other general corporate purposes, as needed. See Note 9 of the Notes to Consolidated Financial Statements in the Company’s Form 10-K for the fiscal year ended August 31, 2004 and Note 7 of the Notes to Consolidated Financial Statements included in this Form 10-Q for additional information regarding our long-term debt.
As of February 28, 2005, our total cash balance of $16.2 million reflected the impact of the cash generated from operating activities, borrowing activity, and capital expenditures mentioned above. We believe that existing cash and funds generated from operations, as well as borrowings under the line of credit, will meet our needs for the foreseeable future.
Though increases in labor, food or other operating costs could adversely affect our operations, we do not believe that inflation has had a material effect on income during the past several years.
We do not expect seasonality to affect our operations in a materially adverse manner. Our results during the second fiscal quarter (the months of December, January and February) generally are lower than other quarters because of the climate of the locations of a number of Partner and Franchise Drive-Ins.
The Consolidated Financial Statements and Notes to Consolidated Financial Statements included in this document contain information that is pertinent to management’s discussion and analysis. The preparation of financial statements in conformity with generally accepted accounting principles requires management to use its judgment to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities. These assumptions and estimates could have a material effect on our financial statements. We evaluate our assumptions and estimates on an ongoing basis using historical experience and various other factors that are believed to be relevant under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.
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We annually review our financial reporting and disclosure practices and accounting policies to ensure that our financial reporting and disclosures provide accurate and transparent information relative to the current economic and business environment. We believe that of our significant accounting policies (see Note 1 of Notes to Consolidated Financial Statements in the Company’s Form 10-K for the fiscal year ending August 31, 2004), the following policies involve a higher degree of risk, judgment and/or complexity.
Impairment of Long-Lived Assets. We review each drive-in for impairment when events or circumstances indicate it might be impaired. We test for impairment by comparing the estimated future cash flows expected to be generated by a drive-in, including its disposal, to the carrying amount to determine if the investment will be recovered. If the sum of undiscounted future cash flows is less than the carrying amount of the asset, an impairment loss is recognized. The impairment loss is measured by comparing the estimated fair value of the asset to its carrying amount. The estimated fair value of the asset is measured by calculating the present value of estimated future cash flows using a discount rate equivalent to the rate of return we expect to achieve from the investment in newly constructed drive-ins. This process requires the use of estimates and assumptions, which are subject to a high degree of judgment. In addition, at least annually, we assess the recoverability of goodwill and other intangible assets related to our brand and drive-ins. These impairment tests require us to estimate fair values of our brand and our drive-ins by making assumptions regarding future cash flows and other factors. If these assumptions change in the future, we may be required to record impairment charges for these assets.
Ownership Program/Allowance for Uncollectible Notes and Accounts Receivable. Our drive-in philosophy stresses an ownership relationship with supervisors and drive-in managers. Most supervisors and managers of Partner Drive-Ins own an equity interest in the drive-in, which was previously financed by the Company. We outsourced the financing of partner notes to a third party in the fourth fiscal quarter of 2004. Supervisors and managers are not employees of Sonic or of the drive-in in which they have an ownership interest.
The investments made by managers and supervisors in each partnership or limited liability company are accounted for as minority interests in the financial statements. The ownership agreements contain provisions, which give Sonic the right, but not the obligation, to purchase the minority interest of the supervisor or manager in a drive-in. The amount of the investment made by a partner and the amount of the buy-out are based on a number of factors, primarily upon the drive-in’s financial performance for the preceding 12 months, and are intended to approximate the fair value of a minority interest in the drive-in.
The net book value of a minority interest acquired by the Company in a Partner Drive-In is recorded as an investment in partnership, which results in a reduction in the minority interest liability on the Consolidated Balance Sheet. If the purchase price exceeds the net book value of the assets underlying the partnership interest, the excess is recorded as goodwill. The acquisition of a minority interest for less than book value results in a decrease in purchased goodwill. Any subsequent sale of the minority interest to another minority partner is recorded as a pro-rata reduction of goodwill and investment, and no gain or loss is recognized on the sale of the minority ownership interest. Goodwill created as a result of the acquisition of minority interests in Partner Drive-Ins is not amortized but is tested annually for impairment under the provisions of FAS 142, “Goodwill and Other Intangible Assets.”
We collect royalties from franchisees and provide for estimated losses for receivables that are not likely to be collected. General allowances for uncollectible receivables are estimated based on historical trends. Although we have a good relationship with our franchisees and collection rates are currently high, if average sales or the financial health of franchisees were to deteriorate, we may have to increase reserves against collection of franchise revenues.
Contingency Reserves. From time to time, we are involved in various legal proceedings and have certain unresolved claims pending involving taxing authorities, franchisees, suppliers, employees, competitors and others. We are required to assess the likelihood of any adverse judgments or outcomes to these matters as well as estimate potential ranges of probable losses. A determination of the amount of reserves required, if any, for these contingencies is made after careful analysis of each issue. In addition, our estimate of probable losses may change in the future due to new developments or changes in approach such as a change in settlement strategy in dealing with these matters. Based on the information currently available, we believe that all claims currently pending are either covered by insurance or would not have a material adverse effect on our business or financial condition.
Advertising. Under our license agreements, both Partner Drive-Ins and Franchise Drive-Ins must contribute a minimum percentage of revenues to a national media production fund (Sonic Advertising Fund) and spend an
19
additional minimum percentage of gross revenues on local advertising, either directly or through Company-required participation in advertising cooperatives. A portion of the local advertising contributions is redistributed to the System Marketing Fund, which purchases advertising on national cable and broadcast networks and other national media and sponsorship opportunities.
As stated in the terms of existing license agreements, these funds do not constitute assets of the Company and the Company acts with limited agency in the administration of these funds. Accordingly, neither the revenues and expenses nor the assets and liabilities of the advertising cooperatives, the Sonic Advertising Fund, or the System Marketing Fund are included in our consolidated financial statements. However, all advertising contributions by Partner Drive-Ins are recorded as an expense in the Company’s financial statements.
Revenue Recognition Related to Franchise Fees and Royalties. Initial franchise fees are nonrefundable and are recognized in income when we have substantially performed or satisfied all material services or conditions relating to the sale of the franchise. Area development fees are nonrefundable and are recognized in income on a pro-rata basis when the conditions for revenue recognition under the individual development agreements are met. Both initial franchise fees and area development fees are generally recognized upon the opening of a Franchise Drive-In or upon termination of the agreement between Sonic and the franchisee.
Our franchisees are required under the provisions of the license agreements to pay Sonic royalties each month based on a percentage of actual net sales. However, the royalty payments and supporting financial statements are not due until the 20th of the following month. As a result, we accrue royalty revenue in the month earned based on estimates of Franchise Drive-In sales. These estimates are based on actual sales at Partner Drive-Ins and projections of average unit volume growth at Franchise Drive-Ins.
Income Taxes. We provide for income taxes based on our estimate of federal and state tax liability. In making this estimate, we consider the impact of legislative and judicial developments. As these developments evolve, we will update our estimate, which could result in an adjustment to the tax rate.
In December 2004, the Financial Accounting Standards Board issued the final statement on accounting for share-based payments. Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. The Statement establishes fair value as the measurement objective in accounting for share-based payment transactions with employees except for equity instruments held by employee share ownership plans. As disclosed in Note 5 under Notes to Condensed Consolidated Financial Statements included in this Form 10-Q, based on current assumptions and calculations used, had we recognized compensation expense based on the fair value of awards of equity instruments, net earnings would have been reduced by approximately $1.3 million and $2.2 million for the quarter and six months ended February 28, 2005, respectively, and $1.1 million and $2.3 million for the quarter and six months ended February 29, 2004, respectively. The Company is required to adopt the provisions of SFAS 123R as of the beginning of its fiscal year 2006. The Company is currently evaluating the two adoption alternatives, which are the modified-prospective application and the modified-retrospective application. The Company is also evaluating which valuation model is most appropriate.
This Form 10-Q contains various “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements represent our expectations or beliefs concerning future events, including the following: any statements regarding future sales or expenses, any statements regarding the continuation of historical trends, and any statements regarding the sufficiency of our working capital and cash generated from operating and financing activities for our future liquidity and capital resource needs. Without limiting the foregoing, the words “believes,” “anticipates,” “plans,” “expects,” and similar expressions are intended to identify forward-looking statements. We caution that those statements are further qualified by important economic and competitive factors that could cause actual results to differ materially from those in the forward-looking statements, including, without limitation, risks of the restaurant industry, including risks of and publicity surrounding food-borne illness, a highly competitive industry
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and the impact of changes in consumer spending patterns, consumer tastes, local, regional and national economic conditions, weather, demographic trends, traffic patterns, employee availability and cost increases. In addition, the opening and success of new drive-ins will depend on various factors, including the availability of suitable sites for new drive-ins, the negotiation of acceptable lease or purchase terms for new locations, permitting and regulatory compliance, our ability to manage the anticipated expansion and hire and train personnel, the financial viability of our franchisees, particularly multi-unit operators, and general economic and business conditions. Accordingly, such forward-looking statements do not purport to be predictions of future events or circumstances and may not be realized.
There were no material changes in the Company’s exposure to market risk for the quarter ended February 28, 2005.
As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rule 13a-14 under the Securities Exchange Act of 1934). Based upon that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective. There were no significant changes in the Company’s internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.
During the fiscal quarter ended February 28, 2005, Sonic Corp. (the “Company”) did not have any new material legal proceedings brought against it, its subsidiaries or their properties. In addition, no material developments occurred in connection with any previously reported legal proceedings against the Company, its subsidiaries or their properties during the last fiscal quarter.
None.
None.
On January 20, 2005, the Company held its annual meeting of stockholders, at which the stockholders re-elected Leonard Lieberman and H. E. “Gene” Rainbolt as directors for three-year terms expiring at the annual meeting to be held in 2008. The following table sets forth the voting results for the directors:
| Director | Votes For | Votes Withheld |
| Leonard Lieberman | 51,608,778 | 5,715,523 |
| H. E. “Gene” Rainbolt | 49,593,901 | 7,730,400 |
Other directors of the Company whose terms continued after the meeting are J. Clifford Hudson, Federico F. Peña, Robert M. Rosenberg, Margaret M. Blair, Frank E. Richardson and Pattye L. Moore.
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None.
Exhibits.
| 31.01 | Certification of Chief Executive Officer Pursuant to SEC Rule 13a-14 |
| 31.02 | Certification of Chief Financial Officer Pursuant to SEC Rule 13a-14 |
| 32.01 | Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350 |
| 32.02 | Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 |
Form 8-K Reports.
| The Company filed a report on Form 8-K on February 28, 2005 reporting its press release announcing attendance at an investment conference and updating earnings guidance. |
| The Company filed a report on Form 8-K on January 7, 2005 reporting an amendment to the Sonic Corp. Rights Agreement. |
| The Company filed a report on Form 8-K on January 4, 2005 reporting its press release announcing results for the Company’s first fiscal quarter. |
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Pursuant to the requirements of the Securities Act of 1934, the Company has caused the undersigned, duly authorized, to sign this report on behalf of the Company.
| SONIC CORP. | ||
| By: | /s/ Stephen C. Vaughan | |
| Stephen C. Vaughan, Vice President | ||
| and Chief Financial Officer | ||
| Date: April 8, 2005 |
| Exhibit Number and Description |