Sonic Could Be a Boom

 | Jan 27, 2012 | 12:30 PM EST
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Last night, I had a chance to catch up with a good friend of ours on the left coast. After we discussed the truly important issues, such as whether it will be the Angels or Yankees for the American League pennant this year and the merits of Kentucky Wildcats over the Syracuse Orangemen in the NCAA, we turned to the investment business. He asked, as he always does, if I was still buying my collections of cigar butts. Of course, I'm still buying stocks below tangible book value, trading below net current assets and those with very low EV/EBITDA ratios. My friend is more of a great company investor and likes to look for those with high returns on capital invested in the business.

There's nothing wrong with that approach. I just don't use it most of the time. In a true meltdown like 2008, I will buy stocks such as like Disney (DIS) and Intel (INTC), but that has more to do with valuation than my love of big companies. I bought Disney because it traded at roughly a 40% of my asset appraisal, not because it is one of the great companies of our time. For me, it's all about valuation.

However, many smart investors use the return on equity (ROE) or capital approach to locating stocks. My friend likes to look at return on total capital, including the amount of debt used to finance the business. I think more like a private equity or vulture investor and prefer ROE, since I'm only really concerned with the return of the dollars I have in the business. The debt either gets paid out of cash flow, reorganization or refinancing or defaults. As an investor, the only thing that matters to me is the impact it has on the return I earn.

With that in mind, I ran a screen looking for companies that earn a very high ROE and can be reasonably expected to continue doing so. I will be the first one to admit that I cherry picked this list to find companies that I thought were interesting and a little closer to my value and distressed approach to investing.

One possibly intriguing company on the list is Sonic (SONC), the drive-through eatery. The company has more than 300 locations in the U.S., and if my wife and kids had their way, we would find our way to all of them. I have to admit that they have better offerings than most fast-food joints, and if given a choice between Sonic and most other eat-and-go places, I'll take Sonic every time.

The company attracted the interest of private equity investors back in 2007, and management fended them off by selling a lot of debt and using the proceeds to buy back stock. Long-term debt swelled to more than $700 million, the shares outstanding dropped from about 84 million to 60 million and private equity investors quickly lost interest in buying a highly levered burger-and-hot dog chain. In the recession that followed, interest payments were up, and the profits, the company and the stock price struggled.

The business and stock price could be on the verge of improving. Although same-store sales remained weak in 2011, the company has opened new locations, and sales posted a little better than in 2010. The debt levels are coming down, with long-term debt currently a bit more than $500 million. As conditions improve, the returns on shareholders' equity have improved from a deficit to about 45%. Going forward, Sonic should be able to maintain an annual ROE of more than 25% and generate double-digit profit growth. Revenue improvements, cost controls and lower interest costs should enable Sonic to grow profits by 25% to 30% in fiscal 2012.

The stock is not cheap on book value, but the Enterprise Value to EBITDA ratio stands at less than 2, one of the lowest in the restaurant sector. The price-to-sales ratio of 0.76 is about 25% below the industry average; it's about 25% of industry leader McDonald's (MCD), and McDonalds does not have Coney Island style hot dogs and chili fries.

If this company can continue to earn a high ROE, generate free cash flow and pay down debt, the stock could easily move back into the mid-$20s range over the next three to five years. The use of leverage to scare away private equity investors has created a stub stock that offers private-equity style returns for the rest of us. 

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